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Will Angel Tax Amendments Give Start-up Sector A Much-Needed Shot In The Arms?

The inclusion of five new valuation methods will give stakeholders much-needed flexibility during the funding process

Will Angel Tax Amendments Give Start-up Sector A Much-Needed Shot In The Arms?
POSTED ON May 26, 2023 8:26 AM

The Central Board of Direct Taxes (CBDT) proposed changes to Section 56(2)(viib) of the Income Tax (IT) Act, commonly referred to as angel tax, yesterday. These amendments are expected to give the growing country's start-up ecosystem a leg up, especially when founders struggle to raise capital at their preferred valuation due to the funding winter. 

Angel tax has been a long-standing concern for start-ups in India. Under this provision, funds raised by start-ups at a valuation higher than their 'fair market value' (FMV) were treated as income and subjected to taxation. 

Moreover, angel tax was earlier only applicable to resident investors. The Budget 2023–24 introduced provisions to extend it to non-resident investors as well from April 1, 2024, bringing overseas investment in unlisted held companies under the tax net.

This classification led to several challenges for founders, including unnecessary scrutiny, lengthy assessments, and cash flow issues. Many complained that this impeded the growth and investment climate for start-ups in the country.

CBDT's latest announcement aims to alleviate the burden of taxation on start-ups and encourage more investments, fostering growth and innovation in the Indian start-up sector, which is now the third largest in the world. Stakeholders have welcomed this move, which they believe will benefit the start-up community positively. 

Saurrav Sood, practice leader of international tax and transfer pricing at SW India
Saurrav Sood, practice leader of international tax and transfer pricing at SW India

According to Saurrav Sood, practice leader of international tax and transfer pricing at SW India, a tax advisory firm, the introduction of five new methods of valuation along with the power to exclude notified entities by the central government will give relief to the non-resident investor.  

"The initial fear of ramification still exists as this notification does not create exceptions but provides an elaboration. However, we hope that with the inputs from various stakeholders, the government may create an exception to a certain pool of investors through it," he stated. 

A Pick-Me-Up Dose

The revised CBDT rules provide relief to start-ups by relaxing the criteria for determining FMV and removing the requirement for valuation certificates. This, in turn, will simplify the funding process, reduce compliance burdens and mitigate the risk of unnecessary taxation.

The amendment is also likely to instil confidence among investors, both angel and venture capitalists (VC), leading to increased investment inflows in the coming months. According to Bain & Company's India Venture Capital Report 2023, written in collaboration with Indian Venture and Alternate Capital Association (IVCA), funding momentum in India softened in line with the global slowdown as total deal value saw a compression from $38.5 billion to $25.7 billion from 2021 to 2022.

Karthik Reddy, managing partner of Blume Ventures and chairperson of IVCA
Karthik Reddy, managing partner of Blume Ventures and chairperson of IVCA

Karthik Reddy, managing partner of Blume Ventures and chairperson of IVCA said that the notification from CBDT and MF has been well received by the private equity and VC industry as it provides more clarity to Indian start-ups and investors in relation to the angel tax. 

Thanking the Finance Ministry for actively addressing the industry's concerns and acknowledging a broader range of institutional investors in the exempted list, he noted that this inclusive approach would facilitate ongoing investments in the country. "The proposed norms aim to expand valuation methodologies and eliminate price differentials between resident and non-resident investors," Reddy added.

Recalibrating Funding Funnels

Funding is often subject to various market conditions, which include forex fluctuations, bidding time and macroeconomic indicators. These could affect the valuation of the unquoted equity shares during multiple rounds of investment that take place over some time. Hence, the new angel tax laws provide a safe harbour of 10 per cent variation from the determined value.

This inclusion will allow some flexibility to start-up founders to negotiate for a better price while seeking capital raise. "Along with safe harbour tolerance of price variation, the exclusion of government-controlled funds, SEBI registered entities is also an added exception from these new rules," Sood elaborated.  

Though the government's statement did not provide details for this exclusion, industry experts presume that it includes such funds as exceptions where a public fund is involved and are funds registered in jurisdictions with a robust regulatory framework.

With these new rules, start-ups can focus on their core activities rather than grappling with tax-related complexities. The simplified process will also attract more early-stage investments, enabling start-ups to scale up and innovate more rapidly.

However, Vaibhav Gupta, partner at tax and regulatory firm Dhruva Advisors, eagerly awaits the draft rules, including the new valuation methodologies. "Deeming value at which funds are raised from certain prescribed non-residents as the FMV is an interesting proposition as it also aligns with the FEMA provisions, which permit raising funds from non-residents at a value higher than the certified FMV as per internationally acceptable valuation methodologies," he noted. 

Over the past three years, Indian start-ups have witnessed significant growth in terms of funding. This funding influx has been driven by both domestic and foreign investors, attracted by the country's vast consumer base, technological innovation, and entrepreneurial talent.

A GlobalData report pointed out that India accounted for 5.1 per cent and 6.3 per cent share of global VC funding value and volume, respectively, in 2022. By alleviating the burden of taxation and simplifying compliance, the amendment of angel tax is expected to boost funding and encourage investments. It represents a significant step towards creating a favourable environment for start-ups in the country. 

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