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Startup Growth vs. Valuation Struggles: Navigating Section 56(2)(viib)"

As prescribed under Section 56(2)(viib) of the Income Tax Act, 1961, can have a significant impact on startups. The rule taxes the excess of the issue price of shares over their fair market value (FMV) when a closely held company issues shares to a resident investor. This means that if a startup issues shares at a price that is higher than their FMV, the investors in the startup will be liable to pay tax on the excess amount.

The critical valuation rule can have a number of negative implications for startups. First, it can make it more difficult for startups to raise capital from investors. Investors may be reluctant to invest in startups if they believe that they may be liable to pay tax on the excess of the issue price over the FMV of the shares. Second, the critical valuation rule can discourage startups from issuing shares at a price that reflects their true value. Startups may be tempted to issue shares at a lower price in order to avoid the tax liability on the excess amount. This can lead to startups being undervalued and can make it more difficult for them to raise the capital they need to grow.

The critical valuation rule also interacts with other laws in India, such as the Foreign Exchange Management Act (FEMA) and the Companies Act, 2013. For example, the FEMA restricts the amount of foreign investment that can be made in a startup. If a startup issues shares at a price that is higher than their FMV, the foreign investors in the startup may be in breach of the FEMA regulations. Similarly, the Companies Act, 2013, requires startups to obtain a valuation report from a qualified valuer before they can issue shares. If the valuation report does not take into account the critical valuation rule, the startup may be in breach of the Companies Act regulations.

The critical valuation rule is a complex provision that can have a significant impact on startups. Startups need to be aware of the rule and its implications in order to avoid any potential tax liability or regulatory issues. They should also seek professional advice from a tax advisor or lawyer to ensure that they are in compliance with the law.

Understanding Section 56(2)(viib)

Section 56(2)(viib) of the Income Tax Act, 1961 is an anti-abuse provision that taxes the excess of the issue price of shares over their fair market value (FMV) when a closely held company issues shares to a resident investor. The provision was introduced in the Finance Act, 2012, with the objective of preventing the misuse of shares issued by closely held companies at inflated prices.

The FMV of shares is determined in accordance with Rule 11UA of the Income Tax Rules, 1962. The rule provides for a number of methods for determining the FMV of shares, including the comparable company method, the discounted cash flow method, and the net asset value method.

The calculation of the FMV of shares under Section 56(2)(viib) can be complex and there are a number of nuances that need to be considered. Some of the key factors that need to be considered include:

The type of shares being issued (equity shares, preference shares, etc.)

• The size and stage of development of the company
• The industry sector in which the company operates
• The financial performance of the company
• The valuation multiples of comparable companies

Recent updates which may impact future valuation exercise

There have been a number of recent updates to Section 56(2)(viib) and the Income Tax Rules that may impact future valuation exercises. These include:

The amendment made in the Finance Act, 2023, which expands the scope of Section 56(2)(viib) to include non-resident investors.

The changes proposed in the draft rule by the CBDT, which clarify the valuation methods that can be used to determine the FMV of shares.

Analysis of Judicial Judgements

There have been a number of judicial precedents that have interpreted Section 56(2)(viib) and the Income Tax Rules. These judgements provide guidance on the factors that need to be considered when determining the FMV of shares.

For example, in the case of CIT v. ITwiz Infosolutions Pvt. Ltd., the Supreme Court held that the FMV of shares should be determined on the basis of the intrinsic value of the shares, taking into account all relevant factors, including the financial performance of the company, the valuation multiples of comparable companies, and the prospects of the company.

Practical challenges and factors to be considered to avoid litigation and controversy

There are a number of practical challenges that can arise in the valuation of shares under Section 56(2)(viib). These challenges include:

• The lack of clarity in the law and the Income Tax Rules
• The complexity of the valuation process
• The need to consider a wide range of factors
• The risk of litigation

To avoid litigation and controversy, it is important to carefully consider all of the factors that need to be taken into account when determining the FMV of shares. It is also important to obtain a valuation report from a qualified valuer.

CBDT vide Notification No. 29/2023 dated 24.05.2023 in S.O. 2274(E) notified the persons or class of persons from the applicability of provisions of section 56(2)(viib). With this, CBDT notifies 21 countries from where non-resident investment in unlisted Indian startups will be exempt from under section 56(2)(viib) and will not attract angel tax.