Angel Tax: Will Govt’s New Rules Alleviate Startups’ Concerns?

Amid the ongoing debate between the finance ministry and the Department for Promotion of Industry and Internal Trade (DPIIT) over Angel Tax, the union government plans to release draft rules pertaining to the taxation of Indian startups by next week.

Any capital raised by startups via selling shares to investors above the fair market value (FMV) attracts angel tax. This tax is levied at 30.9% on net investments over the fair market value. 

This comes days after the union government passed the Finance Act, 2023, which amended Section 56 (2) (VIIIB) of the Income Tax Act, 1961. The amendments brought overseas investment in startups under the ambit of new tax rules. 

Afterwards, startups flagged concerns over the methodology of calculation of fair market value, which differed under two different laws — the Income Tax Act and the Foreign Exchange Management Act (FEMA). 

Under the proposed rules, the Central Board of Direct Taxes (CBDT) plans to amend Rule 11UA of the angel tax and seeks to notify excused entities. The government has suggested a waft of changes to the angel tax regime, which include provision for diverse valuation methodologies, safe harbour clauses and exemptions for more entities. 

While the previous rules only allowed book value or discounted cash flow as valuation methodologies, the proposed norms make available five new additional methods to adjudge valuation. Industry members believe that the move will enable diverse businesses to be valued as per the appropriate methodology applicable to their business models.

The draft rules also envisage price matching between residents and non-residents. Previously, FEMA rules barred non-residents from acquiring securities below FMV while angel tax rules prohibited startups from issuing shares above fair market value. Price matching with venture capital funds will be taken as the fair market value, enabling price matching and resolving the price differential issue. 

Tightening its noose, the new draft will set a 90-day tenure for valuation reports as against an unspecified period previously. 

The under-consideration rules also mandate the inclusion of a safe harbour clause, allowing price variation of up to 10% for startups. While previously even a small difference would trigger angel tax for founders, the government has now deemed a variation of up to 10% as acceptable. 

Another major facet of the proposed rules is the inclusion of more entities whose investments will not be liable for angel tax. Under the previous regime, only SEBI-regulated AIFs were exempted from such a tax but the new rules exempt category-I foreign portfolio investors (FPIs), university and hospital endowments, pension funds, government bodies, banks and insurance companies, university endowments, pension funds and broad-based funds with more than 50 investors from Angel Tax. 

Industry Erupts In Applause

“The notification from CBDT and MF has been well received by the PE/VC industry as it provides more clarity to Indian startups and investors in relation to section 56(2)(viib)… This inclusive approach will facilitate ongoing investments in the country,” said managing partner at Blume Ventures and Indian Venture and Alternate Capital Association’s (IVCA’s) chairperson Karthik Reddy.

“The government’s notification on angel tax offers relief to startups suffering under the current funding winter.  Measures such as safe harbour for a variation of 10% of the price, different valuation methodologies, exempting investments from a broader set of investors reflect market practices and lay to rest fears of investors,” said 3one4 Capital cofounder Siddarth Pai.

Practice leader for international tax and transfer pricing at SW India Saurrav Sood said that the safe harbour provision will offer some flexibility to the promoters to negotiate for a better price.

“The introduction of five new methods of valuation, along with the power to exclude notified entities by the central government, will give relief to the non-resident investor. The initial fear of ramifications still exists as this notification does not create exceptions but provides an elaboration, but we are hoping that with the inputs from various stakeholders, the government may create an exception to a certain pool of investors through it,” Sood said.

Another startup cofounder told Inc42 that the exclusions proposed for certain non-resident investors would bring increased funding stability in the Indian startup ecosystem and would boost the local startup ecosystem.

“This will also boost the start-up ecosystem and encourage entrepreneurial spirit. This truly shows that the government is actively working to ensure a more favourable and investor-friendly business environment… We are excited about these changes and look forward to their positive impacts,” said cofounder of Campus 365 Mayank Singh.

This comes barely a day after DPIIT secretary Rajesh Kumar Singh publicly said that the department was actively pursuing the issue of angel tax with the finance ministry.  

The move brings some respite to the Indian startup ecosystem, which has been bearing the brunt of the funding winter. Homegrown players believe that angel tax may deter foreign investors as startups often sell their shares at a higher premium to FMV, based on future growth prospects. 

This higher FMV could bring foreign investors under the ambit of new rules and could saddle them with additional tax compliances. With the announcement, the government aims to assuage startups and investors as it eyes further investments trickling into the country.