Venture capital (VC) investors welcomed the changes proposed by the government to angel tax provisions that were originally announced in the Union budget for 2023-24, saying they provide much-needed clarity on incidence of the tax while preventing it from being arbitrarily applied.

“The proposed norms aim to expand valuation methodologies and eliminate price differentials between resident and non-resident investors… This inclusive approach will facilitate ongoing investments in the country,” said Karthik Reddy, chairperson, Indian Venture and Alternate Capital Association.

The angel tax is applied on the basis of section 56 (2) (viib) of the Income Tax Act.

According to this provision, any difference between the fair market value and the face value of shares issued by a company is taxed.

The Central Board of Direct Taxes (CBDT), in a notification dated May 19, proposed that startups or companies exposed to angel tax be allowed more flexibility in accounting for valuations. It suggested five valuation methods instead of just two methods prescribed earlier.

Safe Harbour, Other Measures

The final rules will be notified by the Income Tax Department after taking public and stakeholder comments into account.

In addition to the discounted cash flow method and the net asset value method for calculating the valuation of a company, the government proposed three more methods for appropriate valuation of startups.

“Measures such as safe harbour for a variation of 10% of price, different valuation methodologies, exempting investments from a broader set of investors reflect market practices and lay to rest fears of investors,” said Siddarth Pai, founding partner at VC firm 3one4 Capital, which has backed companies such as Darwinbox, Jupiter and Open.

CBDT proposed to provide a safe harbour of 10% variation from the determined value of a company to account for forex fluctuations, bidding processes and variations in other economic indicators, which may affect the valuation of the unquoted equity shares during multiple rounds of investment.

Some Gaps Remain

Although investors indicated that the changes will prevent arbitrary imposition of the tax, some gaps remain with implementation of the rules.

“The government has defined the rules in a better way with these changes. Certain entities are being exempt from angel tax provision. They’ve defined a lot of cases where angel tax will not be arbitrarily applied. The changes provide multiple options to startups to reduce applicability of angel tax but, in a way, it doesn’t take away the whole problem,” said Anand Lunia, cofounder of early-stage investment fund India Quotient.

“While this is one part, on the ground, there are two problems — you will still get scrutiny every time you raise money, and you will need to engage tax consultants every time. The stress won’t go away, even if chances of being taxed will be lower than earlier,” he said.

Pai of 3one4 Capital said the biggest problem remains that the tax officer disputes the valuation report and compares the actual performance of the company to the projected performance a few years after the submission of the projections. “If the variation is large, the tax officer says the valuation is false and the entire capital raised is considered to be income, and is taxed. This is the true problem of angel tax,” he said.

CBDT also proposed that entities such as broad-based pooled investment vehicles or funds in which the number of investors is more than 50, barring hedge funds, be excluded from the purview of the angel tax.

Investors, however, said it will be difficult to execute such provisions.

“Some terms such as a broad-based fund of 50 people will be tough to enact as large venture capital funds tend to work only with select investors,” said Pai. “But excluding funds and managers regulated by IOSCO (International Organization of Securities Commissions) member regulators (from angel tax provisions) will help attract foreign capital and serve as a sound safeguard.”

The IOSCO is an association of organisations that regulate the world’s securities and futures markets. It has more than 100 member countries that regulate over 95% of the world’s securities markets.

Another key point flagged by investors pertained to non-institutionally funded companies. “Angel tax remains a challenge for non-institutionally funded companies, which are obviously the vast majority of early-stage startups. I hope the fine print of these regulations will retain the spirit of the rules and will make it easy for legitimate startups to benefit from these exceptions,” said Ritesh Banglani, partner, Stellaris Venture Partners.

However, Banglani said non-institutional funded companies can register to become recognised startups to get the same benefits as VC-funded companies.