[BetaFin Insights] Budget 2023 : Would the angel tax stymie startup investments

The biggest news for startups, this Budget season is Section 56(2)(viib) of Income Tax Act states that when a privately held company issues shares at a particular price that is greater than fair market value (FMV), tax is charged to the amount received in excess of FMV.

The Angel Tax was introduced in 2012 to prevent generation and use of unaccounted money through the subscription of shares of a closely held company at a value that is higher than the FMV of the company's shares. The tax covers investment in any private business entity, but only in 2016 was it applied to startups.?The Angel Tax is being levied on startups at 20% on net investments in excess of the fair market value

As of today, this provision is applicable to a resident. Budget 2023 now brings in?non-residents?in the purview of this section. There has been inclusion of offshore VC funds as non-residents for angel tax

One can expect the tax department to start examining FDI in startups which will result in litigation going forward.

Each foreign investment in an unlisted company will need to be justified for fair value

Under FEMA, valuation norms prescribe the?minimum floor?for the purposes of bringing in FDI. any transfer of shares from a resident to a non-resident should not be at a price less than the fair value of such shares. The DCF method was a mandatory method for finding the ‘fair value’ under the FEMA till July 2014. Vide Circular No. 4/2014 dtd 15.07.2014, DCF valuation was replaced by any internationally accepted pricing methodology on an arms’ length basis. Although DCF has become non-mandatory, it still remains the mainstay in all valuations for the purpose of FEMA compliance.

Income-tax department would seek to tax any premium above the fair value.?Rule 11UA of IT Rules states that DCF value or Net Asset Value (NAV) – whichever is higher – should be taken as the fair market value for the purpose of Section 56(2)(viib).?So, Income Tax prescribes the upper limit for the range?

So, since non-residents are covered, we have to read FEMA and Income Tax Act together, which essentially means the intersection of DCF and DCF/NAV which?means only DCF applies - and since FEMA prescribes the floor and Income Tax prescribes the cap, so the point will essentially need to come to a single number. Which means much more litigation

Recently I attended a Startup Conference where one of the panelists said that based on his interaction with the entrepreneur, he comes to a valuation based on gut feel. And then the compliance folks retrofit his calculation in Excel. So, with DCF being allowed - there is a lot of subjectivity allowed to be built in the Excel sheet, the 'optimism?bias' of the founders?you cannot even blame them of any 'mens rhea' as well

Thus, with there is a general hue and cry around the provisions, not very sure how with DCF being the prevalent method, will there be any impact really on investments. It will surely make the life of the compliance professional more strenuous?

What are your?views ?