The Income Tax Department has implemented fresh rules for valuing shares issued by unlisted start-ups to investors, expanding the scope of the so-called ‘angel tax’—a tax applied to capital received for the sale of startup shares above their fair market value. Previously, this tax was applicable only to local investors. However, the 2023-24 fiscal year budget extended its reach to include foreign investments.

According to the budget, any premium above the fair market value will be classified as ‘income from sources’ and subjected to taxation at a rate exceeding 30 percent. Notably, start-ups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) are exempt from these new regulations.

The Central Board of Direct Taxes (CBDT) has outlined the valuation methodology in a notification issued on September 25. The amendment to Rule 11UA of the Income Tax rules states that the valuation of unlisted start-ups’ compulsorily convertible preference shares (CCPS) and equity shares can be based on the fair market value.

These revised rules also maintain the five new valuation methods proposed in the draft rules for funds received from non-residents, including the Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Method.

Sumit Singhania, a Partner at Deloitte India, noted that the updated rules offer a broader range of valuation methods for investors, potentially reducing the compliance burden. He also highlighted the safe harbor provision allowing for a 10 percent deviation from fair value, which provides room for valuation adjustments when necessary.

Amit Agarwal, a Partner at Nangia & Co LLP, praised the amendments for their positive impact on taxpayers, offering flexibility through multiple valuation methods, simplifying valuation date considerations, incentivizing venture capital investments, and encouraging foreign investments. He also pointed out the inclusion of a tolerance threshold for minor valuation discrepancies, enhancing efficiency and fairness in tax assessments.

Atul Puri, Managing Partner and Co-founder of SW India, highlighted that the amended Rule 11UA brings clarity to the valuation of unquoted shares issued to both resident and non-resident investors, reducing the potential for future litigation and promoting investments in eligible startups.

Amit Maheshwari, Tax Partner at AKM Global, welcomed the extension of the 10 percent safe harbor provision to CCPS investments, offering protection against foreign exchange fluctuations.

These amendments aim to align the valuation of start-up investments for tax purposes with exchange control norms and address concerns regarding fair market value calculations under different laws. Previously, only investments by domestic investors in closely held or unlisted companies were subject to taxation above fair market value, referred to as angel tax. However, the Finance Act of 2023 expanded the scope to include investments by both residents and non-residents. These changes are intended to harmonize valuation norms under various laws and alleviate concerns about tax implications, especially for foreign investors.