The income tax department has notified rules for the valuation of investments by resident and non-resident investors in start-ups.

The changed rules are meant for non-resident investors to calculate the angel tax.

So far, only investments by domestic investors or residents in closely held companies or unlisted firms were taxed over and above the fair market value (FMV). This was commonly referred to as an angel tax.

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

As per the changes in Rule 11UA of IT rules, the Centre has said the valuation mechanism for compulsorily convertible preference shares (CCPS) can be based on fair market value.

Analysts said most of the investments by venture funds in India come through the CCPS route.

The fair market value of CCPS can be calculated through five new valuation methodologies: comparable company multiple method; probability weighted expected return method; option pricing method; milestone analysis method; and replacement cost method.

The existing two methods of calculating fair market value — DCF (Discounted Cash Flow) method and NAV (Net Asset Value) — remain.

Besides, the provision of 10 per cent safe harbour, earlier meant for equity shares, has been extended to CCPS. The safe harbour provision provides a clear method to determine tax liability. The safe harbour clause ensures 10 per cent of the taxable amount will not be subject to angel tax subject to meeting some criteria.

As per the Income Tax Act, share premium received by entities without substantial public interest are taxable as “income from other sources”.

Start-ups have been claiming that this affects their ability to raise capital as most of these entities negotiate diluting their stake in the company based on future valuation of the company.

By giving flexibility in the valuation methods, the government seeks to ensure that future prospects of the company are also taken into consideration in the valuation for tax purposes.

Sandeep Jhunjhunwala, M&A tax partner at Nangia Andersen LLP said: “It remains evident that anomalies and confusion persist within the community.

“For instance, it does not adequately tackle the challenges associated with the price-matching mechanism, which could potentially lead to capital dilution.

“The longstanding issues related to valuation remain, with the revenue authorities consistently scrutinising assumptions made during valuation, questioning the chosen valuation methods, and limiting the taxpayer’s flexibility to opt for alternate mechanisms, despite the legal provisions allowing for such flexibility,” he said.

Jurisdiction

The CBDT (Central Board of Direct Taxes) has already notified 21 countries, including the US, UK and France, from where non-resident investment in unlisted Indian start-ups will not attract angel tax.

The list excludes investment from Singapore, Netherlands, Mauritius and the UAE.