With the recent change, excess share application money or premium received from non-resident investors may also be subject to angel tax.
On the 25th September 2023, the Central Board of Direct Taxes (CBDT) released Notification No. 81/2023, which brings amendments to Rule 11UA. This rule outlines the procedures for evaluating investments made by both resident and non-resident investors in closely held companies (e.g., start-ups). This valuation process plays a crucial role in deciding whether Angel Tax will be applicable to these start-ups. Prior to this release, the board had issued a preliminary draft of the rule and sought feedback and comments from stakeholders and the general public.
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1. WHAT IS ANGEL TAX?
Angel tax is levied on unlisted companies that receive share application funds or premiums from their investors that exceed the fair market value of the unquoted equity shares. It was initially introduced in the Finance Act 2012 under clause (viib) of Section 56(2), targeting share application funds and premiums from resident investors. The Finance Act 2023 expanded the scope of the provision to include share application money/premium received from a person, irrespective of his residential status. With this change, excess share application money or premium received from non-resident investors may also be subject to angel tax.
The provisions of Section 56(2)(viib) apply if all of the following conditions are satisfied:
- It applies to a closely held company (a company other than the one in which the public is substantially interested);
- The consideration should be received for the issuance of shares; and
- The issue price of shares should exceed the face value and fair market value of such shares.
If all these conditions are satisfied, the consideration received in excess of Fair Market Value (FMV) of shares is considered as an income of the company issuing the shares.
2. NEW VALUATION METHODS AND BENCHMARKING
The guidelines for calculating FMV of shares are outlined in Rule 11UA of the Income-tax Rules, 1962. The erstwhile Rule provided only two approaches for determining FMV: the Discounted Cash Flow method and the Net Asset Value method.
While preserving the original two methods, the revised Rule now incorporates additional approaches for determining FMV of shares. These new methods and benchmarks are utilized in establishing the fair market value of unlisted equity shares and compulsorily convertible preference shares (CCPS), and they are outlined as follows:
- Net Asset Value (NAV)
Using the Net Asset Value method, unquoted equity shares are valued by assessing the company’s net worth, which is calculated by deducting its liabilities from its assets. This approach relies on the company’s balance sheet to determine the fair market value of the shares.
- Discounted Free Cash Flow (DCF)
According to the Rule, a Merchant Banker is required to ascertain the fair market value (FMV) of unquoted equity shares using the discounted cash flow (DCF) method.
This approach involves adding up the present values of all anticipated future cash flows generated by the company, which are then discounted to the present day using an adjusted discount rate. This discount rate takes into account the time value of money as well as the level of risk associated with investing in the company.
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- Benchmarking with shares issued to VC Fund or VC Co. or Specified Fund
This new benchmarking approach provides that that if a Venture Capital Undertaking receives any consideration for the issue of shares to a Venture Capital Fund, Venture Capital Company or Specified Fund, then the price of the equity shares corresponding to such consideration may be taken as the FMV of the equity shares issued to other investors.
This benchmarking is allowed if the following two conditions are satisfied:
- The consideration from shares issued at FMV does not exceed the aggregate consideration received from the VC Fund, VC Company or Specified Fund; and
- VC Undertaking has received consideration within 90 days before or after the date of the issue of shares to other investors.
For example,
On December 01, 2023, VC Undertaking received Rs 20,00,000 as share application money from a VC Fund in exchange for 1,000 shares priced at Rs. 2,000 each. The shares were formally allocated on December 15, 2023, and subsequently deposited into the DEMAT account on December 20, 2023.
Now, as per the benchmarking approach, the VC Undertaking can issue up to 1,000 shares at Rs. 2,000 per share to any other investor during the period between September 03, 2023 and February 29, 2024, i.e., within 90 days before or after the date of receipt of consideration (share application money) from VC Fund.
- Valuation by Merchant Banker as per specified methods
The Rule has incorporated five new methods for calculating the fair market value of unlisted equity shares by the Merchant Banker. These fresh methods are exclusively applicable for ascertaining the FMV of shares allotted to non-resident investors.
- Comparable Company Multiple Method
The Comparable Company Multiple Method (CCMM) is a widely utilized approach in financial analysis and investment valuation aimed at assessing the market value of a company’s shares. It entails evaluating the target company in relation to similar publicly traded companies in order to arrive at a reasonable valuation.
This method operates on the assumption that companies sharing akin characteristics and financial metrics should possess comparable valuations.
- Probability Weighted Expected Return Method
The Probability Weighted Expected Return Method (PWERM) is an approach used for valuing a company, which calculates its fair market value by taking into account the likelihood of various potential future scenarios. This method operates on the premise that a company’s worth is equivalent to the current value of its anticipated future cash flows, adjusted according to the probability associated with each potential outcome.
- Option Pricing Method
The Option Pricing Method (OPM) is a valuation method that estimates the fair market value of shares by considering the value of the option to purchase or sell shares in the future. The method is based on the assumption that the value of a share is equal to the present value of its expected future cash flows plus the value of the option to purchase or sell the share at any time.
- Milestone Analysis Method
The Milestone Analysis Method calculates the FMV of shares, especially for start-ups or companies with limited history. It entails identifying key milestones outlined in the business plan or development roadmap, such as product launches, user acquisition goals, revenue targets, or major accomplishments.
- Replacement Cost Methods
The Replacement Cost Method (RCM) estimates the FMV of shares by valuing a company based on the cost of replacing it with a similar one. It assumes a buyer won’t pay more than the replacement cost. RCM is typically applied to assess unquoted equity shares, especially in privately held or thinly traded publicly listed companies.
- Benchmarking with shares issued to Notified Entities
This approach provides that if a company receives any consideration for the issue of shares to a notified entity, then the price of the equity shares corresponding to such consideration may be taken as the FMV of the equity shares issued to other investors.
This benchmarking is allowed if the following two conditions are satisfied:
- The consideration from shares issued at FMV does not exceed the aggregate consideration received from the notified entity; and
- The company has received consideration from the notified entity within 90 days before or after the date of the issue of shares to other investors.
Who is a notified entity?
Clause (ii) of the First proviso to Section 56(2)(viib) empowers the Central Government to exempt specific classes of persons from the provisions of this section. The CBDT, through Notification No. 29/2023 dated 24-05-2023, has exempted entities such as government, government-related investors, sovereign wealth funds, banks, FPI, etc.
Additionally, investors from 21 countries, including the US, UK, and France, have been granted an exemption from angel tax. However, investments from countries such as Singapore, Netherlands, and Mauritius are not included in this list.
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3. VALUATION METHODS AND BENCHMARKING OF COMPULSORILY CONVERTIBLE PREFERENCE SHARE
Rule 11UA provides explicit guidance on computing the FMV of CCPS. It offers two options for ascertaining the FMV of CCPS.
- Independent valuation – The issuer company can determine the FMV of CCPS by following any of the methods prescribed in Rule 11UA(2), except the NAV method.
- Benchmarking with unquoted equity shares – Where the issuer company has determined the FMV of unquoted equity shares in accordance with any method prescribed in Rule 11UA(2), it can take that value as the FMV of the CCPS. Here, the issuer company can also choose the NAV method used to determine the FMV of unquoted shares as the FMV of CCPS.
- OTHER CHANGES
The notification has provided various other reliefs to the investor and unlisted companies.
- Merchant Banker’s report should not be older than 90 days
Rule 11UA(3) stipulates that the valuation report from the Merchant Banker will be considered valid if it is dated no more than 90 days prior to the issuance date of the shares being valued.
- 10% Safe Harbour Limit
Rule 11UA(4) provides a safe harbor threshold of 10% for the issuance of unquoted equity shares or CCPS. This implies that if the issuance price of shares is greater than the value determined according to Rule 11UA, but the disparity does not surpass 10%, the issue price will be considered as the fair market value.
For example, where the unquoted equity shares are issued at Rs. 1,100 per share, the angel tax shall not be levied as long as the FMV of such shares is above Rs. 1,000 per share.
However, the safe harbour limit shall not apply where the FMV of shares issued to VC Fund, VC Co., Specified Fund, or Notified entity is treated as a benchmark.
