Startup investors breathe a sigh of relief as government proposes tweaks in angel tax

At the height of the angel tax conundrum in 2019, over 73 percent of startups, that raised capital between Rs 50 lakh and Rs 2 crore, received angel tax notice(s) from the Income Tax Department.

Startup investors hailed the finance ministry’s proposals to exclude certain parties, like pension funds and sovereign wealth funds, from the ambit of the angel tax. Even other entities with direct or indirect government ownership of 75 percent or more, giants such as Temasek and Mubadala, will also be exempt from this.

Further, the entities exposed to angel tax will also have more flexibility in accounting for valuations, as per a notification from the Central Board of Direct Taxes (CBDT), in what comes as a sigh of relief for new-age companies that are trying to navigate their way out of a tight capital market.

The angel tax regime was originally started in 2012 as an anti-abuse measure to prevent money laundering. It mandated that a startup’s fundraise could be taxed whenever the funding round happened at a valuation more than the fair value of shares – as determined by a merchant banker.

Waiver request

After the Finance Bill was presented in February this year, startups had suggested investments from PE/VC funds, sovereign wealth funds, endowment funds, and hedge funds recognised by the International Organisation of Securities Commissions be excluded from the angel tax.

“The notification from CBDT and MF has been well received by the PE/VC industry as it provides more clarity to Indian startups and investors in relation to section 56(2)(viib). The proposed norms aim to expand valuation methodologies and eliminate price differentials between resident and non-resident investors,” said Karthik Reddy, managing partner, Blume Ventures and chairperson of Indian Venture and Alternate Capital Association (IVCA).

According to Section 56(2) (viib) of the Income Tax Act, the difference between the fair market value and the face value of shares issued by a company should be taxed.

"We thank the Finance Ministry for actively addressing the industry's concerns and acknowledging a broader range of institutional investors in the exempted list. This inclusive approach will facilitate ongoing investments in the country,” Reddy added.

Along with the above changes, the CBDT also proposed five more valuation methods, which are available for non-resident investors, in addition to the Discounted Cash Flow (DCF) and Net Asset Value (NAV) method, allowing different business models to be valued appropriately.

Valuation buffer

“Depending on your business model, you may not be generating cash flows for the next 5-8 years, and if you do DCF for eight years and above, the value is going to be ridiculously low. So more valuation methodologies is definitely a welcome move,” Siddarth Pai, founding partner, of 3one4 Capital said.

In its notification, the tax body also proposed to provide a safe harbor of 10 percent variation in valuations to account for forex fluctuations, bidding processes, variations in other economic indicators, and the like.

“Previously, even a small difference could trigger angel tax. The government has now specified 10% variation as acceptable,” Pai added.

At the height of the angel tax conundrum in 2019, a survey by LocalCircles showed that over 73 percent of startups, that raised capital between Rs 50 lakh and Rs 2 crore, received angel tax notices from the Income Tax Department.