New angel tax rules: India offers foreign investors more ways to value startups

Overseas investors in startups will get to assess the fair value of such companies using five more methods under the government’s final rules on the so-called angel tax that were issued on Tuesday.

The rules also allow the valuation of compulsorily convertible preference shares (CCPS), which are popular among private equity and venture capital investors, but were missing from the draft rules released in May this year.

The new rules, effective 25 September, allow investors to choose from either of the five additional approaches to valuation apart from the net asset value and discounted cash flow methods to arrive at angel tax incidence under the Income Tax Act 1961. The new regulations come primarily to reduce disputes related to angel tax and address money laundering concerns

Angel tax

Under the Income Tax Act, if a closely held firm or unlisted company issues shares at a price above its fair market value, which is determined using any of the given methods, the difference will be taxed as income from other sources.

The clause specifically hit angel investors more, and thus was termed ‘angel tax’. In India, this tax is levied at a steep 30.9% to ensure that companies aren’t using the investments as a way to hide or launder money.

Earlier, angel tax was levied only on investments made by domestic investors, but starting 1 April this year, the government brought all foreign investments under its ambit.

Exemptions

In May, India’s direct taxes authority exempted non-resident entities such as foreign pension funds, sovereign wealth funds, banks, insurers, central banks and foreign portfolio investors across 21 countries from the ambit of angel tax. The notified countries in the exempted list include the US and UK, but exclude top funding sources Singapore, Mauritius and the Netherlands.

Subsequently, key stakeholders sought clarifications from the government while pointing out the differences in valuation under foreign exchange rules and direct tax laws.

Foreign exchange laws in India set the minimum value or price at which shares can be sold to foreign investors. This is to ensure that foreign investment comes in at a fair or reasonable value. So, while one law (foreign exchange) sets a minimum value, the other (Income Tax Act) sets a “ceiling” and taxes anything beyond it, leading to concerns on unintended tax consequences among stakeholders.

Valuation methods

The five new valuation methods mentioned in the Central Board of Direct Taxes (CBDT) notification are: comparable company multiple method; probability weighted expected return method; option pricing method; milestone analysis method; and replacement cost method.

The new rules also stipulate a safe harbor of 10%, indicating that no tax is payable as long as the calculated value is within 10% of what is considered ‘fair’. The safe harbor clause, which gives companies and investors a little room for error in their valuations, will also be applicable to CCPS.

Compulsorily convertible preference shares offer the benefits of both debt and equity as investors get a fixed return, like a loan, until these are converted into regular shares, following which they can gain from the company’s growth.

As these shares will eventually convert into regular shares, their value isn’t just what they are worth now, but what they could be worth later, which makes using a single method to determine their value somewhat tricky, said tax experts.

“Application of specific valuation mechanism to CCPS does throw in a bit of apprehension as CCPS, in most cases, are based on the value of equity shares after factoring in the conversion ratios,” Sandeep Jhunjhunwala, partner at Nangia Andersen LLP, wrote in a LinkedIn post.