Taxing rules

New angel tax norms partially address startup concerns

The new angel tax rules notified by the government with effect from September 25 are unlikely to allay stakeholder concerns about potential disputes over valuation methods for foreign and domestic investors in unlisted companies (mainly startups). Confusion had become more acute after the Finance Act, 2023, proposed to extend the angel tax, which was levied on resident investors on the difference between the price of issued shares and their fair market value (FMV), to non-resident investors this year. This move was widely criticised for impacting a key source of foreign funding for Indian startups — one of the country’s signature success stories — at the height of the global funding winter globally.

To be sure, the final notified rules, passed after public consultation, have addressed a key concern over compulsorily convertible preference shares (CCPS) by bringing them within safe harbour limits, on a par with equity. This amendment to the relevant rule — 11UA of the Income Tax Act — implies that startups and other unlisted companies can now raise funds from both equity and CCPS with a variation of up to 10 per cent of the valuation of the FMV of their shares, without attracting the 30.6 per cent angel tax. This change will go some way towards reducing disputes over even minor variations that occurred on account of, say, foreign exchange fluctuations, bidding processes, and so on. According to industry estimates, an average investment of $20 billion flows in via the CCPS route. In addition to the net asset value and discounted flow method prescribed for determining the FMV, the amended rule 11UA has prescribed five more methods to determine the FMV of unlisted shares or CCPS issued to non-resident investors. The rules also relax the price-matching mechanism, allowing for equity infusions by a notified investor (that is, an investor exempt from angel tax rules) within 90 days of a previous funding round to be done at the same FMV as the previous round.

The changes introduce a measure of clarity by offering investors a range of internationally recognised methods, thus easing a key hurdle unlisted companies face in raising funds overseas. But, given the proclivities of the Indian tax authorities, the multiplicity of valuation options also expands the scope for litigation risks. Another question mark has arisen over why the five new methods of valuation are restricted to non-resident investors. As tax experts have pointed out, differential methodologies could create practical challenges in valuation and discriminate against resident investors even if the issue price is the same. Also, although the rules are applicable from September 25, questions could arise over whether the amendments would apply to shares issued between April 1 and September 24. All told, the new angel tax rules, however investor-oriented in intent, do not detract from the inadvisability of a regime that penalises the startup universe in the interests of checking money laundering. By mandating in May several immunities —such as for those entities registered with the government or those registered in 21 foreign jurisdictions — the government has created a universe of exceptions that could encourage some investors to game the system.