The Centre has extended the 10 per cent safe harbour, previously proposed for equity shares, to include convertible preference shares. This is among the key moves in the final valuation rules for funding in unlisted startups for both foreign and domestic investors under the new “angel tax” introduced in the Finance Act, 2023. The final valuation norms, effective from September 25, are expected to offer much-needed relief to startup funding, particularly as a considerable number of transactions occur through the route of convertible shares.
This implies that startups can now secure funds through both equity and compulsorily convertible preference shares (CCPS) up to a certain limit — 10 per cent of the fair market value of their shares. These investments will not be subject to angel tax, provided they meet the criteria specified in the safe-harbour provision.
In the past, even a minor discrepancy triggered the angel tax for founders. However, the government has now deemed a variation of up to 10 per cent as acceptable for both equity shares and CCPS.
Numerous startups had earlier expressed their concern over the draft valuation guidelines released by the Central Board of Direct Taxes (CBDT) on May 19. The concern was largely around fears that the guidelines might adversely affect foreign funding, leading startups to call for an extension of the safe harbour to convertible shares.
According to industry estimates, an average investment of around $20 billion comes through the convertible-preference route.
Angel tax is levied on the capital raised by startups through the sale of shares to investors at a price above the fair market value. This tax is imposed at a rate of 30.9 per cent on net investments over the fair market value.
Previously, the angel tax applied only to investments made by resident investors. However, the Finance Act, 2023, proposed to extend this tax to non-resident investors as well, effective from April 1, 2024.
The newly notified Rule 11UA of the Indian Income Tax Act has introduced significant improvements in the valuation process for unquoted equity shares. These changes offer taxpayers a more extensive range of valuation methods to choose from, including internationally recognised approaches, thereby attracting foreign investments and increasing clarity, said tax experts.
Bhavin Shah, partner at PwC, said: "Multiple options on valuation methods and the concept of price matching will partly ease the difficulties faced by startups in raising funds from foreign investors."
While incorporating all five valuation methodologies from the CBDT draft rules, another noteworthy change is the 90-day window for the price-matching mechanism with respect to shares issued by venture capital (VC) funds to VC undertakings or companies for notified investors.
"The CBDT draft had initially proposed a 90-day window from the date of share issuance. However, the new notification provides for a 90-day window both before and after the share issuance, offering a slightly more relaxed timeframe for companies anticipating investment rounds in the foreseeable three months," explained Sandeep Jhunjhunwala, tax partner (M&A) at Nangia Andersen LLP.
"However, the implementation will be intriguing to monitor, as valuation is a subjective matter. A range of valuation methods may be employed, increasing the potential for litigation risks," Amit Maheshwari, tax partner, AKM Global, said.
The startup industry has been awaiting the final rules, and the clarity these rules offer is expected to boost investments.
Siddarth Pai, founding partner at 3one4 Capital and co-chair of the Regulations Affairs Committee at the Indian Venture and Alternate Capital Association (IVCA), said the tax department had clarified the valuation methodologies for the issuance of unlisted shares by Indian startups. "Many investors had put their investment decisions on hold pending the issuance of these rules."
With inputs from Peerzada Abrar