Angel tax: Experts suggest safe harbour for investment via convertible preference shares too

The Central Board of Direct Taxes (CBDT) on May 26 issued draft rules providing more flexibility for valuation of equity investments made in unlisted startups.

For non-resident investors the valuation methods provided under the rules are: book value or net asset value method, valuation by a merchant banker using DCF (discounted cash flow), and valuation at which a venture capital fund/specified fund has invested in a Venture Capital Undertaking (VCU).

Additionally, a 10 per cent leeway or safe harbour is provided where investment valuation is 10 per cent more than the valuation determined under above rules.

On Friday, the CBDT invited suggestions from stakeholders on the draft rules by June 5, 2023. The new rules, once notified, would be effective from April 1, 2023.

PwC India Deals Leader Bhavin Shah said although almost all fresh investments by VC funds in startups have historically been through compulsorily convertible preference shares (CCPS), the relaxation provided under draft rules for price matching and 10 per cent safe harbour is restricted to equity shares.

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“It is important that these relaxations are extended to investments by way of CCPS as well,” Shah said. For price matching, the draft rules provide for separate baskets for VCFs and offshore notified entities. The government may consider combining both these under a single basket if they invest in the same round, Shah added.

Tax and consulting firm AKM Global Partner-Tax Sandeep Sehgal said the draft rules seem to provide more flexibility to the companies raising capital at the same time acknowledging that DCF and NAV are not the only two valid methods of valuation.

“The key would be implementation since valuation is anyway a subjective matter and the valuers may have different approaches to apply a particular method. For example, Comparable Company Multiple Method is one of the proposed methods.

“There are several transfer pricing litigations, especially on the difference of opinion between the taxpayers and the tax department on the kind and size of comparables selected. Similar would be the case of replacement cost methods where each valuer may have a different opinion on replacement cost. Hence, such litigations are sure to arise with regard to valuations as well,” Sehgal said.

The safe harbour of 10 per cent provided for higher allotment from the fair market value (FMV) may address the situation to some extent, he added.

The CBDT was expected to come out with valuation guidelines for valuing non-resident investment in unrecognised startups for levying income tax.

Under the existing norms, only investments by domestic investors or residents in closely held companies were taxed over and above the fair market value. This was commonly referred to as an angel tax.

The Finance Act, 2023 has said that such investments over and above the FMV will be taxed irrespective of whether the investor is a resident or non-resident.

Post the amendments proposed in the Finance Bill, concerns have been raised over the methodology of calculation of fair market value under two different laws.

Shardul Amarchand Mangaldas & Co Partner Gouri Puri said the main tweak for both issuances to residents and non-residents is that VCUs can use the share price at which they issue shares to VCFs and Category I and Category II AIFs to benchmark for fair market value for issuances to other investors, subject to certain conditions.

“Similarly companies can use the share price at which they issue shares to the recently notified investors (such as government, sovereign wealth funds, banks, specified investors resident in notified jurisdiction, etc.) to benchmark for fair market value for issuances to other investors, subject to certain conditions. Having such a notified investor on-board in a funding round may be of more value to justify the issue price offered across investors (coming in at same or lower price),” she said.

Puri said the two key positives that have been introduced in the draft rules are a 10 per cent toleration range for the issue price from the prescribed FMV for levying the angel tax. Second, the ability to rely on valuation reports issued within a 90-day period prior to issuance (previously, valuation date was defined as the date of share issuance – parties had to typically get comfortable with a valuation issued prior to closing or obtain a true-up post-closing of the share issuance transaction).

“Through its recent notification of exempt investors and the draft rules on angel tax, it appears that the government is trying to balance policy considerations of checking round tripping, money laundering without hurting capital inflows,” Puri said.

The CBDT on May 24 had notified classes of investors who would not come under the angel tax provision.

Excluded entities include those registered with Sebi as Category-I FPI, Endowment Funds, Pension Funds and broad-based pooled investment vehicles, which are residents of 21 specified nations, including the US, UK, Australia, Germany and Spain, as per the notification.

The other nations mentioned in the notification are Austria, Canada, Czech Republic, Belgium, Denmark, Finland, Israel, Italy, Iceland, Japan, Korea, Russia, Norway, New Zealand and Sweden.

Nangia & Co LLP Partner Amit Agarwal said the harmonisation of valuation rules with internationally accepted methods of valuation denote alignment of India’s tax valuation rules with global best practices in taxation and regulatory frameworks.

“The new valuation methods are likely to bridge the gap between the valuation rules outlined in the FEMA regulations and the Income Tax Rules. Implementing consistent valuation norms can enhance transparency and reduce ambiguity, ultimately facilitating smoother cross-border transactions,” Agarwal added.