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Foreign investments in start-ups come under ‘angel tax’ net

The central government on Tuesday notified new rules, colloquially known as an 'angel tax', under which unlisted companies, mostly startups, will be required to pay tax on equity capital raised from foreign investors if the valuation is higher than its fair market value.
Last Updated : 27 September 2023, 02:42 IST

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The central government on Tuesday notified new rules, colloquially known as an 'angel tax', under which unlisted companies, mostly startups, will be required to pay tax on equity capital raised from foreign investors if the valuation is higher than its fair market value. The difference amount between valuation and fair value will be treated as income, and will be taxed at 30.6 per cent.

The move is expected to adversely affect start-ups looking to raise funds from foreign investors.

Such investments made by resident investors were already taxed. In the Union Budget presented in February, the government sought to extend this net of taxation to overseas investments as well. The new rules came into effect from September 25.

The Central Board of Direct Taxes (CBDT) also notified amendments to mechanisms for arriving at the fair value of an unlisted company shares. Earlier, there were two methods for the valuation of unquoted shares. These are Discounted Cash Flow method and Net Asset Value method.

The tax department has notified five additional methods. These are: Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Method.

These five new methods are only for overseas investments. For the resident investors, the old mechanism of Discounted Cash Flow method and Net Asset Value method will be applicable.

The new tax rules may negatively impact fund raising by startups as most of them negotiate diluting their stake in the company based on future valuation and not the fair market value. However, the flexibility in the valuation methods would give relief to the companies choosing to raise funds from overseas investors, analysts said. 

The government has amended 11UA of the Income Tax Rules to introduce new methods of computation of the fair market value of unlisted companies.

“The amended Rule 11UA is a welcome move, which brings in more clarity for both investor and investee,” said Atul Puri, Managing Partner and Co-founder, SW India.

Under the new rules, for any investment received from venture capital funds or specified funds, price matching for resident and non-resident investors will be available.

“The availability of multiple valuation methods simplifies the process and removes some of the previous constraints,” said Gaurav Singhvi, co-founder of We Founder Circle.

The government has extended the 10% “safe harbor” benefit to investments made in convertible preference shares as well. This means, startups can raise funds through both equity and convertible preference shares up to a certain limit (10% of the fair market value of their shares), and these investments will not be subject to angel tax as long as they meet the criteria outlined in the safe harbor provision.

“It provides relief to startups and investors by reducing the tax burden and simplifying the taxation of such investments,” said Singhvi.

Illustration of businessman holding big scissors about to cut tax paper
IT  INcome Tax
Illustration of businessman holding big scissors about to cut tax paper IT INcome Tax
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Different currencies forming a graph against grid background
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Published 27 September 2023, 02:42 IST

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