Draft Rules Enhance Valuation Flexibility for Investors in Angel Tax Regime

• ByStartupStory     |    May 29, 2023

On Friday, India unveiled draft valuation regulations for foreign investments in startups, pertaining to the ‘angel tax’ system. The new rules aim to offer greater flexibility to international investors in determining the fair market value of unquoted equity shares.

The recently released rules, open for public feedback, present investors with five valuation methods to determine the angel tax impact as per Section 56(2)(vii)(b) of the Income Tax Act 1961. These methods aim to minimize valuation disputes commonly encountered with the previous cash flow method and net asset value method.

According to tax experts, the proposed regulations primarily focus on equity shares and overlook instruments like compulsorily convertible preference shares (CCPS) that are commonly used for injecting capital into startups. The draft rules do offer startup investors a safe harbor with a 10% allowance for variation from the determined value.

The inclusion of a 10% variation clause in the rules accounts for factors such as forex fluctuations, bidding processes, and changes in other economic indicators. These regulations were issued by the Central Board of Direct Taxes (CBDT).

In addition to the existing discounted cash flow method and net asset value method, the draft rules permit a merchant banker to utilize any of the five methods for determining fair market value. These methods include the comparable company multiple method, probability-weighted expected return method, option pricing method, milestone analysis method, and replacement cost methods.

Furthermore, a venture capital undertaking has the provision to offer shares to a venture capital fund, venture capital company, or specified fund at the same price that was allocated to another similar entity within a ninety-day period following the investment.

The price set for such shares will be deemed as the fair market value, but it is important to note that the total consideration for this subsequent investment must not exceed the initial investment amount. To illustrate, if a venture capital undertaking receives Rs 50,000 as consideration from a venture capital company for 100 shares at a rate of Rs 500 per share, the undertaking can issue 100 shares at the same rate to any other investor within 90 days of receiving the consideration from the venture capital company.

The final rules will be issued by the CBDT following a thorough review of public feedback. It is worth mentioning that the board has already provided exemptions for investments made by non-resident investors, which includes central banks, multilateral entities, foreign pension and endowment funds, banks and insurers, as well as foreign portfolio investors from 21 countries, from the angel tax.

“Concept of price matching, 10% safe harbour in valuation and five new methods of valuation are all very welcome,” said Bhavin Shah, partner and deals leader, PwC.

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