Government Considering Fema-Based Valuation Rules to Address Angel Tax Issue
- ByStartupStory | May 4, 2023
India is considering adopting the valuation criterion used in foreign exchange management law for the angel tax on startup investments made by foreign investors. This move aims to resolve tax disputes and bring clarity to the process.
To bring clarity and resolve tax disputes, India may adopt the valuation criteria accepted under the Foreign Exchange Management Act (FEMA) for angel tax on startup investments made by foreign investors. According to a finance ministry official, the government is considering several options, including certified valuations by Sebi-registered Category 1 merchant bankers using internationally accepted pricing methodologies. The tax authorities plan to release draft rules within the next seven to ten days, according to another official.
The DPIIT has consulted various industry associations and submitted their recommendations to the finance ministry, as per the second official. As per Section 56(2)(vii)(b) of the Income Tax Act, any closely-held company issuing shares at a value above the fair market value (FMV) calculated as per the prescribed methodology will have the difference taxed as income from other sources.
As per the income tax regulations, the fair market value (FMV) is calculated using the discounted cash flow (DCF) or net asset value (NAV) method. Startups generally follow the DCF method, which involves making multiple assumptions and often results in disputes due to their limited assets. The angel tax provision was introduced to prevent potential money laundering, as some fraudulent entities had received overseas funds at inflated valuations.
According to the first official, the government aims to prevent any impact on genuine investments. After consultations, the Central Board of Direct Taxes (CBDT) will publish the final rules. Other options being considered include carving out exceptions for pension funds and sovereign wealth funds, as well as approved funds from countries associated with the International Organisation of Securities Commission (IOSCO).
According to the first official, the government aims to prevent any impact on genuine investments. After consultations, the Central Board of Direct Taxes (CBDT) will publish the final rules. Other options being considered include carving out exceptions for pension funds and sovereign wealth funds, as well as approved funds from countries associated with the International Organisation of Securities Commission (IOSCO).
In the event of such an exception, these investments will not be subject to angel tax. The government modified the angel tax provision, also known as Section 56(2)(viib) of the Income Tax Act, in this year’s budget, extending its coverage to all foreign investments. Previously, the provision only applied to Indian residents and funds not registered as alternative investment funds (AIFs). Following the expansion of the tax, the industry has requested clarification on the valuation regulations due to the divergent criteria of foreign exchange norms and tax laws.
Indian startups are struggling to raise funds due to the economic uncertainty, and the funding winter has worsened following the collapse of Silicon Valley Bank in the US. To provide relief from angel tax, tax authorities are considering introducing a criterion similar to that of Foreign Exchange Management Act (FEMA) under Section 56(2)(vii)(b) of the Income Tax Act. Currently, the tax authorities treat the fair market value (FMV) as a ceiling, and any amount beyond that is taxed. The startups are also facing a decline in investments, as per the Tracxn Geo Quarterly Report, which reported a considerable decrease in the startup ecosystem’s investment in the first quarter of 2023 compared to the same period in 2018.
According to tax experts, if the angel tax provision remains unchanged, it may force Indian startups to seek funding overseas as most countries do not have such provisions. The current exemption for startups registered under DPIIT is insufficient, and conditions are too restrictive to provide any significant relief, said Sudhir Kapadia, a partner at EY. Kapadia recommended that the finance ministry offer specific exemptions to foreign institutional investors from well-governed jurisdictions and allow valuations under any internationally-accepted methodology by a Category 1 merchant banker instead of insisting on DCF valuation. He also suggested providing a “safe harbour” limit of up to 25% to permit issuance of shares at valuations higher than the prescribed one by the valuer.
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