Govt To Introduce Draft Rules For Valuation, Angel Taxation

According to media reports, the Union government will soon issue draft rules in a week to address taxation and valuation concerns expressed by startups and investors after the controversial angel tax was imposed in the Union Budget for fiscal year 2024.

Startups are already facing a funding crunch due to rising interest rates across the globe. Moreover, the ecosystem is witnessing less investments from PEs and VCs, and is concerned that revisions to the conditions of the angel tax may drive away international investments.

The implementation of the angel tax will have an impact on investments made by foreign investors. Indian startups that raise funds from international investors will face an angel tax. This may limit funding for the sector and drive more businesses to relocate their operations outside the country.

"The foreign investors who were previously exempted from the application of the angel tax have now been bought under the ambit of angel tax. If the share price allocated to investors is more than the share's fair market value (FMV), an angel tax is imposed as per Section 56.2.VII B of the Income Tax Act, 1961. However, the resident investors have always been under the ambit of taxation and introducing angel tax will remove the tax disparity between residents and non-residents," said Manish Khanna, Co-founder, Unlisted Assets.

Furthermore, the government is set to propose draft rules for standardising the valuation method under the Income Tax Law and FEMA, thereby making acquisition costs similar for domestic and foreign institutional investors. "The angel tax may defer foreign institutional investment for the short term but will not be a reason for driving away foreign investment," Khanna added.

Government officials said that administration had done extensive consultation with all the associations and have submitted their suggestions to the ministry of finance. The draft would address the issue of differences in terms of valuation technique used under the income tax act and the  foreign exchange management act (FEMA).

To provide clarity and put an end to tax conflicts, the government may accept the valuation formula used under the FEMA  for the angel tax on investments by foreign investors in startups. For context, under the income tax law, FMV is calculated using a discounted cash flow (DCF) method or net asset value (NAV) method.

Explaining the standardisation new provisions will bring, Amit Pamnani, Chief Investment Officer for Investment Banking at Swastika Investmart, said, "By considering several variables, including the startup's financial predictions, market conditions, and comparable transactions, the suggested method seeks to create a more objective framework for calculating the FMV of shares. As a result, the valuation process will become more transparent, and the income tax division will find it simpler to evaluate the fair market value of the shares. Standardising the valuation procedure will eventually assist in establishing a positive atmosphere for the startup ecosystem."

The startup ecosystem largely depends on foreign capital, and investors betting on the future growth of the company buy shares at a premium to their FMV. Hence, early-stage startups are particularly concerned that the new amendment in Section 56.2.VII B could be applied to foreign investment.

The government previously said that the angel tax, or Section 56.2.VII B, targets 'hawala' transactions rather than startups, and that eliminating 'preferential treatment' for foreign investors will level the playing field because Indian residents are already subject to this tax.

Due to the fact that the potential impact of Section 56.2.VII B tax could negatively affect foreign investments, the government is likely to exempt funds such as Abu Dhabi Investment Authority, Qatar Investment Authority, and GIC.