IT Dept Notifies Final Rules For Valuation Methods & 'Angel Tax' On Startup Investments

SUMMARY

The IT department has enacted changes to Rule 11UA of the Income Tax Rules, which govern the valuation of equity and compulsorily convertible preference shares (CCPS) issued by startups

One significant modification permits the valuation of CCPS to be based on the fair market value of unquoted equity shares

The amended rules retain five distinct valuation methods proposed in the draft rules for assessing consideration received from non-resident investors

The income tax department has notified the final rules concerning the valuation methodologies and angel tax on startup investments, amending Rule 11UA of the income tax rules.

The rule governs the valuation of equity and compulsory convertible preference shares (CCPS) issued by startups to both resident and non-resident investors.

Effective September 25, the changes, introduced by the Central Board of Direct Tax (CBDT), aim to streamline the valuation process.

One significant modification permits the valuation of CCPS to be based on the fair market value of unquoted equity shares. This adjustment provides more flexibility in determining the value of these shares, potentially benefiting startups and investors alike.

The amended rules retain five distinct valuation methods proposed in the draft rules for assessing consideration received from non-resident investors. These methods include — Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Method.

The rules have also extended a 10 percent safe harbour margin to Compulsorily Convertible Preference Shares (CCPS) investments, which was originally designed for equity shares. Any amount exceeding the valuation determined after considering a 10% safe harbor margin will be classified as a taxable premium.

The union government passed the Finance Act, 2023 earlier this year, 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.

The amendments stem from the Finance Act, 2023, which modified Section 56 (2) (VIIIB) of the Income Tax Act, 1961, bringing foreign investment in startups under the purview of new tax rules.

These modifications led to concerns among startups about the computation methodology for establishing fair market value due to discrepancies in valuation calculations between the Income Tax Act and the Foreign Exchange Management Act (FEMA).

The Angel Tax, levied at a rate of 30.6%, applies to any capital raised by startups through selling shares to investors above the fair market value (FMV). In May, the CBDT released draft rules pertaining to the valuation of funding in unlisted and unrecognised startups for the purpose of imposing Angel Tax.