The latest notification pertaining to Rule 11UA does not resolve the core issue of disputes arising from projections versus actual valuations, say valuation experts
Despite recent regulatory changes, the issue of angel tax continues to impede the growth of Indian startups, leaving founders and investors in a state of uncertainty.
The conflict between income tax regulations and FEMA adds complexity to the angel tax problem, highlighting the need for streamlined processes and simplified regulations.
Despite several notifications, reforms, and assurances from the central government, the issue of angel tax continues to plague Indian startups. The Finance Act of 23 only exacerbated the problem, leading to mounting concerns within the startup community.
Angel tax, governed primarily by Section 56(2)(viib) and Section 68 of the Income Tax Act, poses a significant threat to startups. Section 56(2)(viib) deems investments in startups above fair market value as “income from other sources,” making them liable for taxation at corporate tax rates.
Conversely, Section 68 acts as a safeguard against the misuse and distribution of undocumented funds. It mandates a uniform tax rate of 60%, which is further augmented by additional surcharges and cess, culminating in an effective tax rate of around 78%. This section also opens the door for potential penalties, placing both investors and startup founders in a position of significant risk.
The situation becomes even more dire when one considers the implications of receiving intimation letters under Section 56(2)(viib) and Section 68. These letters from tax authorities signal trouble for startups, adding to the woes of founders.
This stringent taxation regime has created a climate of uncertainty and apprehension among the startup community. Despite the government’s efforts to address the issue, startups continue to grapple with the challenges posed by angel tax.
One ecommerce startup founder, whose angel tax case has been pending since 2016, expressed frustration, stating that while notifications and assurances abound, startups are still waiting for a definitive solution. The founder has now moved to Dubai and is working to launch a gaming startup.
Section 68 grants substantial power to assessment offices (AOs), which can become problematic for startups. According to Siddarth Pai, founding partner and CFO of early-stage fund 3one4 Capital, the issue of the tax officer comparing projections used in the valuation report to the actual performance of the company and disregarding the valuation report due to deviations still exists. This is the core issue of Angel Tax.
The uncertainty surrounding whether investments will be treated as income from other sources or whether startups can justify the source of their funds has created a cloud of uncertainty, stifling the growth and innovation that the government intended to promote through initiatives like Startup India.
New Angel TaX Rules But Old Problems
Despite the government’s assurances in the past and changes in angel tax implementation policies, startups have not been able to recover angel taxes claimed by the Income Tax Department even after seven years, as in the case of the founder highlighted above.
In its latest attempt, the IT department made changes to Rule 11 UA, introducing several valuation methods, to provide more clarity and flexibility for startups and investors. Here’s what the new rules bring in:
a) Five New Valuation Methods: Non-resident investors now have access to five additional valuation methods, including the Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Method. This expansion aims to cater to the diverse needs of investors.
b) Valuation For Shares Issued To Non-Residents: The price of equity shares issued to non-resident entities can now be considered the Fair Market Value (FMV) for both resident and non-resident investors, subject to certain conditions. This provision seeks to streamline the valuation process for cross-border investments.
c) Price Matching For VCs: Price matching for resident and non-resident investors is now available for investments made by Venture Capital Funds or Specified Funds. This change aims to create consistency in valuations across different investor categories.
d) Valuation Methods For CCPS: According to the notification, the valuation of CCPS could also be based on the FMV of unquoted equity shares.
e) Safe Harbor Provision: To provide some leeway, a safe harbour of 10% variation in value has been introduced.
While these changes are seen as positive steps, they do not resolve the angel tax issue, as several founders and investors pointed out.
Nitesh Mehta, partner, M&A Tax and Regulatory Services at BDO India, highlighted that the notification addresses some aspects of the problem but does not resolve the core issue of disputes arising from projections versus actual valuations.
Source: inc42