Sidhant Bishnoi*

Source : Vajiram and Ravi

The blog acknowledges the positive aspect of the government’s decision to abolish the “Angel Tax” on the Indian startup framework but suggests a more desirable approach. The author focuses on streamlining the current “Angel Tax” framework to foster a conducive atmosphere for startups while preserving the integrity of investment channels. The blog will concentrate on international best practices to devise a startup-friendly “Angel Tax” framework that optimizes opportunities while minimizing risks.

The first part of the blog introduces the ‘Angel Tax’ framework in India. The second part of the blog outlines the 2023 Amendment to the existing framework. The third part of the blog submits that several oddities persisted even after the amendments. To streamline the existing framework, the author proposes a two-pronged reform scheme. The first component of the scheme buckles down to rationalization of levying of ‘Angel Tax’ on Indian startups, and the second component accentuates the significance of establishing robust ‘Angel Investor’ networks in India.

The Union Finance Minister unveiled the budget on July 23, 2024. An important announcement, celebrated as a significant relief for startups was the abolition of the “Angel Tax”. The decision was primarily aimed at strengthening the startup ecosystem in India, as investments in Indian startups experienced a notable decline. However, concerns persist regarding the potential misuse of investment channels for money laundering, less oversight on the credibility of investors, and apprehensions about the valuation of shares.

The author acknowledges the positive impact of the initiative on the startup framework but suggests a more desirable approach. The author focuses on streamlining the current legal framework regarding the ‘Angel Tax’ to foster a conducive atmosphere for startups while preserving the integrity of investment channels. The blog will concentrate on international best practices to devise a startup-friendly “Angel Tax” framework that optimizes opportunities while minimizing risks. However, international practices must acclimate to the Indian entrepreneurial and regulatory context.

The first part of the blog introduces the ‘Angel Tax’ framework in India. The second part of the blog outlines the 2023 Amendment to the existing ‘Angel Tax’ framework. The third part of the blog submits that several oddities persisted even after the amendments. To streamline the existing framework, the author proposes a two-pronged reform scheme. The first component of the scheme buckles down to rationalization of levying of ‘Angel Tax’ on Indian startups, and the second component accentuates the significance of establishing robust ‘Angel Investor’ networks in India.

The “Angel Tax” Framework in India

The Angel Tax was introduced in India as part of the 2012 budget, to combat money laundering and prevent the exploitation of investment avenues. The tax provision incorporated under Section 56(2)(vii) (b) of the IT Act mandates a substantial tax rate of 30.9% on investments surpassing the fair value of shares. The surplus amount is labelled as “income from other sources” under Section 56 of the IT Act. The provision presented significant difficulties for early-stage firms, whose valuations are sometimes subjective and not grounded in physical assets or established revenue streams. Consequently, numerous startups encountered funding shortages, impending their growth and innovation capacity

As of July 2024, the Angel Tax applied to unlisted companies in which there is no substantial public interest, and which issue shares at a price exceeding the fair value of shares, as calculated by Rule 11UA of the Income Tax Rules of 1962. The fair value of the shares is calculated using the Net Asset Value (NAV) and Discounted Cash Flow (DCF) methods. The fair market value of unquoted preference shares is ascertained by the price achievable in an open market transaction on the valuation date.

The government implemented various exemptions to the Angel Tax requirements to balance the promotion of startups with preventing investment channels from being used for money laundering. The provision is inapplicable when the investor is a venture capital business or fund as defined in Section 10(23F) (B) of the Income Tax (IT) Act, or an Alternative Investment Fund categorized as either Category I or Category II, regulated by the Securities and Exchange Board of India (SEBI). Furthermore, startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) are exempted from the scope of the Angel Tax. To attain recognition, a startup must satisfy certain prerequisites: incorporated for less than ten years, have an annual turnover below ₹100 crores in any financial year since its incorporation, and keep paid-up capital under ₹25 crores.

Furthermore, the startup must be engaged in innovation, development, or improvement of products or demonstrate a high potential for wealth creation and employment generation. Importantly, any investment acquired by these startups must not be reinvested in specific assets for seven years. These stipulations ensure that the funds are employed solely for business purposes. Noncompliance with these stipulations may lead to the retroactive revocation of the exemption. Consequently, when the genuineness of startups and the sources of their investment are thoroughly validated, the ‘Angel Tax’ cease to apply.

The Amendment to the IT Rules: The Saga of Unsullied Gaps

In response to the preceding concerns, the Central Board of Direct Taxes (CBDT) unveiled amendments to the existing Angel Tax regulations. The amendments added five new methods for calculating the fair value of shares for non-resident investors, in addition to the traditional methods available to resident investors. Furthermore, the amendment stipulates that if shares compensation is received from any designated non-resident entity within ninety days preceding or succeeding the issuance of shares, the price of the equity shares corresponding to such consideration may the fair value of the equity shares. Thereby enabling companies to correlate share valuation with received funding, rather than relying on conventional valuation methodologies that are inadequate for startups. The ninety-day period affords startups increased flexibility in ascertaining the fair value of the shares.

Furthermore, the amendment introduces a ‘safe harbour’ margin, whereby the fair value of a share may fall within 10% of the price determined according to NAV or DCF methods for resident investors. For non-resident investors, the issue price of equity shares must also be within 10% of the price determined by NAV, DCF, or any of the five newly introduced methods. A valuation assessment issued by a merchant banker within 90 days before the issuance date of equity shares is appropriate for determining the fair value of shares.

Notably, the benefits of price matching and the ‘safe harbor’ provision also extend to Compulsorily Convertible Preference Shares (CCPS). However, there remains ambiguity concerning the valuation of preference shares other than CCPS. The author suggests that the valuation of these shares could be determined using the Open Market Value Principle based on the most recent price paid by investors in the open market to purchase a share.

Hence, the author acknowledges that despite recent amendments to the IT Rules, several deficiencies in the Indian ‘Angel Tax’ framework remain unsullied. In this context, the author seeks to balance improved financial flow and technical support to startups, which is crucial during their incubation phase, while simultaneously preventing the potential exploitation of investment avenues for illicit behoofs.

Reforming Angel Tax Framework and Revitalization of the Indian Startup Landscape.

To vitalize the startup ecosystem in India while maintaining the anti-abuse provision of ‘Angel Tax’, it becomes quintessential to undertake reforms on both the supply side (investor-centric reforms) and demand side (startup-centric reforms) of the investment chain.

A. Demand Side Reforms: Pruning the Process

The understated objective is to rationalise the levying of ‘Angel Tax’. A crucial factor in this process would be improved flexibility in determining the fair value of shares. Since the fair value is highly subjective due to the startup’s reliance on future contingencies.

Moreover, to reduce legal disputes, transactions where no actual profit accrues to the assessee, should be exempted from taxation. For instance, a capital injection from a parent company to its subsidiary is exempted from taxation under the ‘Angel Tax’ provision.

I. Non-resident Investors and the Calculation of FMV of Shares

The amendment fails to reconcile the discrepancies between the frameworks established by the Foreign Exchange Management Act (FEMA) and the IT Act for calculating the fair value of shares. The issue has garnered further traction after the inclusion of non-resident investors under Section 56(2)(vii)(b) of the IT Act. FEMA Regulations prohibits conversion of financial instruments at a price lower than their fair value. In contrast, the IT Act imposes a tax liability if the share price exceeds the fair value of shares.

Furthermore, FEMA allows for the use of any internationally recognized valuation methods for the calculation of fair value of shares, whereas the IT Act is restricted to the use of NAV and DCF methods. Therefore, FEMA Regulations and IT Rules are bluntly at loggerheads. The submission can be better illustrated through an illustration.

Suppose the fair value of a share is assessed at $100 under the FEMA model. A private company is prohibited from issuing shares below this price. However, if the fair value of a share is calculated at $80 under the IT Act, the entity is prevented from issuing shares at a price over $88 after administering the ‘safe harbor’ margin. In this situation, a share is priced at $100 under the FEMA Regulations, but the startups are still obligated to pay Angel Tax on the difference of $12 under the IT Act.

Therefore, it become imperative to adopt valuation methods that satisfy the FEMA and the IT Act. Otherwise, the valuation disparity will require a two-stage regulatory compliance in calculating the fair value of shares for foreign investors. The existing mechanism translates into considerable compliance difficulties for startups dealing with international investors.

The author recommends incorporating internationally used valuation methods for calculating the fair value of shares for resident investors. This alignment would bring Rule 11UA in conformity with FEMA Regulations.

II. Rationalising the ‘Safe Harbor’ Provisions

The blog endorses the introduction of the ‘safe harbor’ limit as affording the necessary flexibility in calculating the fair value of shares. However, the blog found the initiative inadequate to streamline the share valuation process for startups.

The ‘safe harbour’ limit should not be uniform for all corporations, considering the provision’s objective of alleviating future risks that may impact share valuation. Such contingencies vary from one organisation to another. Therefore, a one-size-fit policy is undesirable. The ‘safe harbour’ clause, in its present state, unleashes a multitude of challenges including share overvaluation, fund round-tripping to fabricate a misleading capital flow, evasion of regulatory scrutiny, among others.

The blog advocates that the ‘safe harbor’ margin should be calculated individually using methodologies similar to Section 409A of the Internal Revenue Code (U.S.). The valuation methodologies under Section 409A account for any pertinent facts that may influence the company’s valuation in future. Thereby mitigating the danger of exploitation of ‘safe harbour’ provision while benefiting startups, whose valuations relies on future potential. The onus of evidence rests with the concerned startup to demonstrate that the requested margin is not “grossly unreasonable.” The proposed mechanism accounts for diverse considerations such as forex fluctuations, bidding processes, etc.

Furthermore, depending squarely on the book value of assets and cash flow is sometimes insufficient for determining the fair value of shares. For instance, in the case of an insolvent corporation, the acquisition price depends on various aspects, including the resolution plan, business fundamentals, contingent liabilities, regulatory obstacles, and associated timescales. These factors often results in a value considerably lower than the fair value, as assessment under the existing framework predominantly emphasises the book value of assets and cash flow of the entity.

III. Calculation of Fair Value of Shares: Combinations and Permutations

Moreover, the Income Tax Act does not permit the use of multiple valuation methods for the valuation of the share price simultaneously. However, it is a common practice among valuers to assign varying degrees of importance to different valuation techniques. For instance, a valuer might allocate 60% weight to the DCF method and 40% to the NAV method in calculating the fair value of shares, and so on. The article advocates for allowing various combinations of methodologies to improve the flexibility of the valuation process for shares in the context of S. Section 56 of the IT Act, in conjunction with the acknowledgement of internationally accepted valuation methodologies.

IV. Fair Value of Preference Shares other than CCPS

The Open Market Value method is the exclusive method for calculating the fair value of preference shares other than CCPS. The blog submits that such an approach restricts the flexibility of the startups in issuing preference shares. Furthermore, valuation methods under s. 56(2)(vii)(b) of the Act applies to ‘shares’ in general. The term should not be given restrictive meaning. Therefore, the valuation methods under s. 56(2)(vii)(b) of the Act are relevant for calculating the fair value of preference shares.

Furthermore, a flurry of decisions shows that the Income Tax Tribunal has accepted the valuation methodologies used for equity shares, such as NAV and DCF, for determining the fair value of preference shares other than CCPS on numerous occasions.

To summarise, the new methods introduced by the CBDT for calculating the fair value of shares for non-resident investors should also apply to domestic investors and, by extension, to the valuation of the preference shares.

B. Supply Side Reforms: Enhancing the Role of Angel Investors

The understated objective of the reforms is to incentivise “Angel investors” to invest in Indian startups, particularly those acknowledged by the DPIIT. Angel investors provide funding along with expertise and direction to startups during their early stages. The blog submits policy recommendations for establishing a robust ‘Angel Investor’ network in India, drawing on successful practices from other countries. These policy suggestions consist: a) introducing incentives for Angel investors, b) pooling public funds with private investment funds, and c) incubating Angel associations in India.

I. Tax Incentives for Angel Investors

Tax incentives encompass a range of benefits related to investments, including deductions and deferrals on gains and losses from capital assets. The Enterprise Investment Scheme (EIS) in the United Kingdom encourages investments in small and medium enterprises. A mechanism parallel to the UK’s EIS can be adopted in India. In this context, there can be two categories of investment. The first component entails direct investment in firms acknowledged by DPIIT. The second components involves investing in an EIS Fund, which possesses limited cash and allocates funds to these established startups.

Investors partaking in these programs qualify for a tax exemption on the invested amount, contingent upon the fulfilment of two conditions. First, investment is subject a lock-in period. Second, the invested entity must either concentrate on innovation or enhancement of products or services or exhibit significant potential for wealth production and job creation for a minimum of three years from the investment date. Moreover, when divesting from the investment, any resultant returns would be free from capital gains tax. Nonetheless, if the share value diminishes at the time of sale, investors may elect to pursue share loss relief, applicable to the initial purchase price of the shares.

However, the scheme is not infallible. Offering substantial incentives to high-net-worth individuals may attract more financial investors than true “Angel” investors. Furthermore, these schemes levies a significant fiscal burden on state resources and are often difficult to target effectively, as evidenced by the experience in France. Consequently, careful planning, reconnoitre, continuous assessment, and acclimatization are imperative to ensure that the desired outcomes are realized. In the above context, establishing co-investment funds could be a strategic approach to addressing some of these challenges.

 II. Establishing Co-investment Funds (CIFs)

In CIFs, public funds are pooled with those of authorized private investors within a designated scheme. These programs particularly target Angel investors, with the Scottish Co-investment Fund (SCF) being a prominent illustration. The CIF acts as an investor who undertakes equal risk and adheres to the same conditions as private sector investors. In contrast to conventional investment funds, CIFs do not independently finance corporations. Rather, it establishes contractual alliances with angel networks and venture capital fund managers within the private sector. These partners are tasked with researching prospective investment opportunities, performing due diligence, negotiating arrangements, and allocating their resources in conjunction with the CIF. Upon reaching an agreement, CIF contractually guarantees the funding, with payout occurring solely after the completion of a legal investment agreement. The participants in the plan receive compensation proportional to their investment and are awarded partnership status for a specified duration.

While the benefits of the SCF are well-recognized, targeted adaptations are necessary to tailor the model to the Indian context. The blog submits that the share of CIF in any investment should not exceed 50%, as a higher proportion might discourage private sector participation. Furthermore, given the Indian context, the SCF investment cap of GBP 2 million should be increased to GBP 10 million to support the scale of investment demand. Whereas, SCF limits its investment to a maximum of GBP 1 million per company, whether in a single instalment or across multiple investment rounds, with the total investment not exceeding GBP 2 million.

The available evidence indicates that the existence of robust angel groups before establishing a co-investment fund is a critical factor in their success. Therefore, fostering a strong network of angel groups is essential for effectively introducing CIFs in India.

III. Incubating Angel Networks in India

Financial support for angel networks is increasingly seen as a critical policy tool in several countries, aimed at addressing the information asymmetry between angel investors and entrepreneurs. Angel networks play a multifaceted role, including raising industry awareness, advocating for angel investment to policymakers, educating and developing angel investors, setting professional standards, facilitating the exchange of best practices, etc.

In Europe, the primary emphasis was on Business Angel networks (BANs), which served as mediators linking prospective angel investors with businesses. Despite their extensive memberships, these networks frequently encountered difficulties in delivering the specialised assistance commonly linked to angel investing. Nonetheless, their impact should not be underestimated. A Belgian study found that 82% of the investment opportunities participated in by angel investors would have gone unnoticed without the involvement of BANs. Currently, BANs in many nations are transforming into nationwide associations, signifying their increasing significance within the entrepreneurial ecosystem.

An important aspect of this networking involves educating and cultivating angel investors. A notable example is the Power of Angel Investing (PAI) Training Program, developed by the Marion Kauffman Foundation in the United States. The PAI program offers seminars and workshops tailored for investors, economic development professionals, service providers, and entrepreneurs. The instructors of the PAI program are experienced angel investors with practical expertise in the field.

Training and development initiatives may also involve the recruitment of skilled and experienced trainers to work in a country for an extended period. These trainers would collaborate with local angel communities, conduct initial training programs, and engage in other activities to build investor capacity. In 2010, New Zealand hosted Bill Payne, an experienced angel investor, for a prolonged visit. Prof. Payne engaged with industry stakeholders and policymakers, facilitated training programs, and participated in media interactions through speaking engagements.

Moreover, investment in the education and training of angel investors enables countries to develop a more knowledgeable and proficient investment community, which is imperative for nurturing a robust startup environment.

Conclusion

The author discourages the complete abolition of the ‘Angel Tax’ and suggests that the current framework be enhanced to balance the risk of personal gain from the exploitation of investment channels with advancing a robust startup ecosystem in India through adequate cash flow.

The suggested rationalization entails a dual-faceted reform procedure. On the demand side, the recommendations entail streamlining the valuation procedure for calculating the fair value of shares and addressing the existing discrepancies in the valuation process. On the supply side, reform emphasises bolstering support for angel investors through Angel networks and effective policy initiatives.

Henceforth, the blog concludes that it is unnecessary to compromise the integrity of the investment channel to boost the startup ecosystem in India.

*The author is a third-year student at NUJS, Kolkata and the recipient of coveted Aditya Birla Scholarship. His research interest includes commercial law, capital markets, and TMT.