Government may adopt Fema-like valuation norms for angel tax

India may accept the valuation criterion followed under the foreign exchange management law for the so-called angel tax on investments by overseas investors in startups, to provide clarity and end tax disputes.

The Reserve Bank of India (RBI) administered Foreign Exchange Management Act (FEMA) accepts valuation by a Sebi-registered Category 1 merchant banker using any internationally accepted pricing methodology applied on an arm’s length basis.

Tax authorities are considering adopting the same, among other options, for levying angel tax. “We are looking at various options… A certified valuation is an option that is being examined,” a finance ministry official told ET. The government will come out with draft rules in seven to 10 days, said another official.

This is expected to address valuation and tax issues.

The Department for Promotion of Industry and Internal Trade (DPIIT) has held consultations with various industry associations and submitted their suggestions to the finance ministry, the second official said.

Under Section 56(2)(vii)(b) of the Income Tax Act, if a closely held company issues shares at a price exceeding fair market value (FMV), computed in accordance with the prescribed methodology, the difference is to be taxed as income from other sources.

The tax impacts angel investment the most and therefore is popularly called the angel tax.

Under the income tax law, FMV is decided using a discounted cash flow (DCF) method or net asset value (NAV) method.

Since startups do not have many assets, they follow the DCF method that uses multiple assumptions, which usually leads to disputes.

The angel tax provision was brought in to plug potential money laundering as there had been instances of some sham entities receiving overseas fund infusions at inflated valuations.

“We will ensure that bona fide investments are not impacted,” the first official added. The Central Board of Direct Taxes (CBDT) will notify the final rules after consultations.

Other options being examined include providing a carve-out for investments by pension funds, and sovereign wealth funds, besides recognised funds from IOSCO (International Organisation of Securities Commission) countries.

If such an exception is provided, these investments will not be levied angel tax.

The government amended the angel tax provision or Section 56(2) (viib) of the Income Tax Act in the budget this year, bringing all foreign investment under its ambit. Before the amendment, the provision applied only to Indian residents and funds not registered as alternative investment funds (AIFs).

Following the wider application of the tax, the industry has called for clarification on the valuation rules as foreign exchange norms and tax laws criteria are divergent.

Tax matters

Foreign exchange laws set a minimum floor, FMV for foreign direct investment (FDI), whereas under Section 56(2)(vii)(b), tax authorities treat FMV as a ceiling — any amount beyond that is taxed.

Tax authorities are now examining if a criterion similar to that of Fema can be introduced under the tax law, which, if provided, would give relief from angel tax.

Indian startups are facing a funding squeeze amid global economic uncertainty. The collapse of Silicon Valley Bank in the US has worsened the so-called funding winter. As per the Tracxn Geo Quarterly Report, the startup ecosystem in India saw a considerable decline in investment in the first quarter of 2023 when compared with the same period in 2018.

Tax experts say if the provision remains unchanged, it is very likely to compel Indian startups to move overseas for funding since most countries do not have such “angel tax” provisions.

“The existing carve-out of startups registered under DPIIT is quite inadequate, as conditions prescribed therein are too restrictive to provide meaningful relief,” said Sudhir Kapadia, partner, tax and regulatory services, EY.

He said it is critical for the finance ministry to provide specific exemptions to foreign institutional investors from well-governed jurisdictions.

“For the rest, instead of insisting on DCF valuation, it is much better if valuation is allowed under any internationally-accepted methodology by a Category 1 merchant banker,” Kapadia said. “Also, a ‘safe harbour’ limit of up to 25% may be provided to allow for issuance of shares at valuation higher than the prescribed one by the valuer.”