If beauty lies in the eyes of the beholder, does valuation lie in the eyes of the investor? That’s the question start-ups in India seem to be grappling with thanks to the new angel tax norms that kicked in this fiscal, as these question the very basis of funding for such ventures.
Start-ups, already dealing with a funding winter, are trying to assess the impact of the angel tax norms that the Union Budget 2023-24 extended to non-residents. Despite several exemptions provided by the Central Board of Direct Taxes (CBDT), the start-up community is ill at ease over how to justify valuations as well as the higher compliance burden.
According to the reply to an RTI application filed by BT, only 8,204 start-ups have received exemption from angel tax. In all, 114,000 start-ups are registered with the DPIIT and 10,939 start-ups have applied for exemption from the tax, the reply reveals.
“The angel tax amendments to include non-resident investors have injected material uncertainty into the investment process. A lot more time is being spent to navigate the valuation requirements under the Companies Act, 2013, Foreign Exchange Management Act, 1999, and the Income Tax Act, 1961,” says Siddarth Pai, Founding Partner of 3One4 Capital, and Co-chair of Regulatory Affairs Committee at the Indian Venture and Alternate Capital Association (IVCA). He adds that for the same transaction, there can now be four different valuation reports under these three bodies of law.
The Angel Tax Conundrum
But what is angel tax? It was introduced by the Finance Act, 2012, by then finance minister Pranab Mukherjee as an anti-abuse provision to prevent the setting up of shell companies and laundering money through them. A new Section 56(2) was inserted in the Income Tax Act, 1961, to tax share premiums in excess of the fair value as income at 30 per cent. While the provision was limited to residents at that time, Budget 2023-24 expanded its scope to include foreign investors “to eliminate the possibility of tax avoidance”.
DPIIT-recognised start-ups, where the aggregate amount of paid-up share capital and share premium post the proposed share issue is not over `25 crore, can apply for tax exemption. However, based on representations from the industry and discussions with the Department for Promotion of Industry and Internal Trade (DPIIT, which looks after start-ups), the finance ministry has provided some exemptions and flexibility from the levy. The CBDT has also exempted specified entities such as Sebi-registered Category 1 foreign portfolio investors, foreign investors related to central banks of other countries, sovereign wealth funds, endowment funds associated with a university, hospitals or charities and pension funds from 21 countries from the tax. It also provided five more valuation methods for non-resident investors, apart from the discounted cash flow (DCF, which arrives at the present value of expected future cash flows using a discount rate) and net asset value (NAV, the difference between the total value of all assets and all liabilities) methods available to resident investors. The final rules also provide for the valuation of compulsorily convertible preference shares (CCPS)—a popular investment instrument—as well as a 10 per cent safe harbour.
Pritha Jha, Partner at Pioneer Legal, says that the tax changes for non-resident investors are now on par with domestic investors. “The CBDT has tried to accommodate some of the concerns of investors by providing a mechanism to arrive at fair market value for CCPS and keeping other valuation methodologies intact,” she notes.
Business Today’s emailed questionnaire to the CBDT remained unanswered till the time of going to press.
Greater Scrutiny?
Gokul Chaudhri, President-Tax at Deloitte India, says that the government likely hoped to curb some unhealthy practices related to the valuation of shares by extending the angel tax regime. “But what I think happened was that it hurt the start-up ecosystem and, thereafter, the tax department tried to create various exceptions and carve-outs. But I don’t think they have been able to fully address all the situations connected to the start-up ecosystem, which is getting hurt by the angel taxation rules that have also created some degree of complexity for their business.”
Jha says, “Start-ups still remain concerned that the income tax authorities are on a witch hunt and sending scrutiny notices arbitrarily over valuations, to companies”.
However, Pai points out that income tax notices usually go out during the fiscal’s last quarter. “It is unfortunate that this issue hasn’t been settled despite the Form 2 exemption and stellar work done by DPIIT and Startup India to mitigate this,” he says, adding it is important for tax officers to undergo training to understand why investors would fund loss-making start-ups, which has often been cited as a red flag for being picked up by the system. Incidentally, CBDT’s National Academy of Direct Taxes in Nagpur has been holding training sessions for tax officials on emerging issues in new-age sectors such as start-ups.
Amit Maheshwari, Tax Partner at AKM Global, a tax and consulting firm, warns that there will be a manifold rise in litigations around angel tax as tax officials can always challenge the assumptions of the valuation. “The eligibility threshold for the exemption is very low, as a result of which larger start-ups will not be able to get the benefit,” he says, adding that jurisdictions such as Mauritius and Singapore have also been excluded from the list of exempt nations although many investments flow in from there.
The Art of Valuations
Chaudhri points out that valuation is an art and what two people perceive as the value of a business may be quite different. Pai agrees and says that the core issue of angel tax remains unsolved—the practice of the tax officers to compare the projections in the valuation report with the actual performance of the company, with deviations being a reason to reject the valuation report. “The 10 per cent variation given in the notification is not sufficient. Investors are actively looking at how to navigate this,” he says.
Pai adds that since many start-ups do not have a long operating history or profitability, it is often difficult to apply a standard valuation method to these companies. “Even the list of five valuation methods, which only apply to non-residents and not residents, suffer from this issue,” he contends.
But, Jha says, the government has tried to balance its concerns with those of start-ups. “Some of it stems from the government’s past experience regarding highly valued firms suddenly disappearing or being heavily devalued,” she notes.
The sector is hoping for a review if not a roll-back of the tax regime. “Given the mandatory dematerialisation of private companies and start-ups, there is hope that such a provision need not exist as all holdings and their ultimate beneficial ownership can be traced through the depository system,” says Pai.
As and when funding revives for the sector, it could help provide a better assessment to investors and the tax department of how the levy is hurting businesses. For now, further tweaking of the regime may not be on the cards and companies may not have any other option but to work on new strategies to comply with the tax requirements.
@surabhi_prasad