Amendment in Rule 11UA of Income Tax Rules: New Methods for Valuation of Shares for Angel Tax
The Central Board of Direct Taxes came up with a Notification dated 25th September amending Rule 11UA of Income Tax Rules (IT Rules) that provides for methods for the valuation of shares of ‘closely held companies’(e.g. Startups not registered under DPIIT), which does not have a public interest. These valuations determine whether an Angel Tax has to be imposed on the invested company.
The Angel Tax was brought into the country through the Finance Act, 2012 by inserting Section 56(2)(viib) of the Income Tax Act (IT Act). The purpose of this tax was to check on money laundering activities and catch bogus companies. This was initially just applicable to the resident investors, which was thereafter thrust onto the non-resident investors as well via the Finance Act 2023. Essentially, this tax is levied upon a company (closely held) at a rate of 30.9%, which receives consideration for the issue of shares at a price higher than the Fair Market Value of such shares. This Fair Market Value (FMV) of shares of such companies is calculated using Rule 11UA of IT Rules for assessing under section 56(2)(viib) of the IT Act.
This article will delve into the various methods introduced for calculating the FMV of shares, separately for unquoted equity shares and compulsorily convertible preference shares. Further, it shall be dealing with its implication in the startup industry vis-a-vis Angel tax and various certain standards that must be maintained by the IT Department.
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Deciphering the Amended Rule 11UA
In the erstwhile rule, it provided two methods to calculate the FMV of a share -Discounted Cash Flow (DCF) and Net Asset Value (NAV) Method.
The Amended Rule brought new methods for the assessee to choose from for resident and non-resident investments.
Rule 11U clause (i) defines the term’ unquoted shares’, which means any share or securities not quoted in any recognised stock exchange.
For Resident investors, the amendment came up with a new ‘touchstone mechanism’ (as quoted by the author), a price-matching mechanism for special scenarios. Thus, there are now four methods for a resident to calculate the valuation:-
1. Net Asset Value Method – In this method, shares are valued by assessing the company’s net assets. Net assets are determined by subtracting the company’s liabilities from its assets. This technique relies on the company’s balance sheet to establish the fair market worth of the shares.
2. Discounted Cash Flow Method – This method stands on the future cash flow that is to be actuated by the company, which is accounted along with the risk associated with such inflow.
3. Venture Capitalist Price Mechanism – This means that if a company has been invested by a Venture Capital (VC) Company or VC Fund or Specified Fund (AIF), then the price of the equity shares of corresponding consideration can be construed as an FMV of the equivalent number of equity shares issued to any other investor. However, the consideration received on such FMV through any other investor shall not exceed the aggregate consideration received by the VC Company or VC Fund or AIF, used for setting the threshold. Also, the investment made by such other investors shall not be later than 90 days from the date of investment of VC Company or AIF.
4. Notified Entry Price Mechanism – Similar to the VC Mechanism, it stipulates that if any investment is made by a ‘notified entity’ under the first proviso to Section 56(2)(viib), then the price of the equity shares of corresponding consideration can be construed as FMV of the equivalent number of equity shares issued to any other investors. But again, the new investment shall not exceed the aggregate investment made by the notified entity and not later than 90 days from the investment of the notified entity.
Notified Entity – The CBDT, vide Notification No. 29/2023, came up with a list of the notified persons, mainly consisting – government, government related investors, investors from 21 countries (Like USA, UK), etc. These notified people are not liable for the angel tax under section 56(2) of the IT Act.
In addition to all the methods available to the resident-investors. The major change that the amendment brought is the incorporation of five new methods for Merchant Bankers to calculate the FMV of an unquoted equity share for non-residents:-
1. Comparable Company Multiple Method (CCMM);
2. Probability Weighted Expected Return Method (PWERM);
3. Option Pricing Method (OPM);
4. Milestones Analysis Method (MAM); and
5. Replacement Cost Method (RCM).
It can be determined independently from the DCF Method or the two touchstone mechanisms provided for resident investors. Alternately, an FMV of a CCPS for residents can be determined based on the FMV of unquoted equity shares determined by any method available for residents.
For non-resident investors, in addition to all the methods available for a resident investor investing in CCPS, all the five new methods available to non-resident investors can be opted. Alternately, the FMV of a CCPS for non-resident investors can be determined based on the DMV of unquoted equity shares determined by any method available for non-resident investors.
As per the amended rule, the report of the merchant banker on which the valuation of any issued shares is relied upon cannot be older than 90 days from the issue of such shares.
c. Safe Harbour
The rule has additionally provided a safe harbour of 10% to both investors, which means that if the consideration for the purchase of shares exceeds the valuation price by not more than 10% of the said valuation price. Then, such consideration will be deemed as the FMV of such shares. This harbour is not present for valuation reached through a touchstone-mechanism for either of the investors.
Implication in the Startup Industry
Angel tax received a lot of criticism from the startup community for imposing such a hefty tax on the company. Thus, in 2019, the government, through a notification, exempted startups registered under the DPIIT (Department for Promotion of Industry and Internal Trade). Still, it applies to many unregistered startups. Since most of the funding comes from foreign investors, bringing non-residents into the ambit of Section 56(2) might tamper the intent of those investors. However, the Amendment will heave a sigh of relief to the industry, as it provides a decent luxury in opting for any of the above methods, especially for foreign investors. It is more so when the industry is facing a massive downturn, with most of the investors reluctant to fund in such tough times. The CBDT recently issued a directive to its officers not to pester the registered startups with show-cause notices.
Limitation of the New Regime
Though the amendment comes as a welcoming change, it has a few underpinned shortcomings which should be rectified at the earliest. It is a very known fact that the majority of the foreign direct investment (FDI) into the country comes from countries like Mauritius, Singapore, and UAE, but when the notified list is perused, it is found that it excludes such countries from the exemption, which ultimately negates the very rationale behind the thoughtful amendment.
Another aspect to ponder about is the reckless attitude of the tax personnel in sending notices demanding taxes. Recently, in the case of MobiCom Technologies v. ITO Ward, Bangalore, the tribunal ruled in favour of the IT Department that the compulsorily convertible preference shares cannot be valued using the DCF method, reasoning that the said method is only suitable for equity shares, although no such provision is prevailing in IT Act or the Rules thereof. The Tribunal erroneously supplemented its rationale with the case Agro Portfolio v. ITO Ward, New Delhi, wherein the merchant banker was found to not execute an independent exercise.
Even though the amendment is very welcoming to attract foreign investors, the frivolous interpretation of tribunals and departmental officers needs to be curbed. There has to be a downright certainty with respect to rules and provisions of valuation of investment in every level; otherwise, legislation solely would not induce the investors to set foot into such deals. Recently, CBDT laudably issued a directive to its officers to not pester the registered startup with relentless notices.
Concluding Remarks
The recent notification, based on the above discussion, is an appreciated move by the CBDT. It will impel the investors to carry out the deals, knowing they have multiple channels for the valuation of their investment as per their choice. It will also encourage the companies to fetch more investors and further their interests. At the same time, it is imperative that the legislation is supplemented with fair scrutiny and accomodating tribunals to create a cordial environment for the businesses.
[Prathmesh Agrawal is a fourth-year student at West Bengal National University of Juridical Sciences.]
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