I. Introduction

In recent times, the “Angel Tax” has emerged as a highly controversial issue in India, sparking intense debate and discussion among entrepreneurs, investors, and policymakers. This term is derived from “Angel Investing,” a practice in which investors provide essential capital to start-ups. It refers to the taxation of the consideration or share premium paid above the Fair Market Value (FMV). While it was introduced as an anti-abuse measure aimed at curbing money laundering and preventing resident investors from funnelling unaccounted funds into the financial system, the tax has drawn criticism for the financial strain it can place on nascent businesses, even when the investments are legitimate. The recent amendments of 2023 have further escalated this criticism due to the inclusion of non-resident investors. Furthermore, this has resulted in companies diverting their attention from core business operations towards tax issues.

This article seeks to unravel the complexities of the Angel Tax, exploring the recent amendments and the challenges presented by the provisions. It also aims to evaluate the measures taken to mitigate its impact and identify those that still need to be considered and addressed by the Government.

II. Overview of Angle Tax

The concept of “income” in the realm of taxation typically excludes capital receipts. Share premium paid for shares issued is, by default, a capital account transaction¹. However, there are exceptions to this rule, such as Section 2(24)(vi) of the Income Tax Act, 1961, which stipulates that ‘income’ includes capital gains under Section 45.

Section 56(2)(viib), introduced by the Finance Act of 2012, incorporates a legal fiction to categorize share premium as a taxable revenue receipt. The provision stipulates that the share premium received in excess of the FMV of the shares should be treated as taxable income for the unlisted company. This income is subject to taxation as “income from other sources” at regular income tax rates. Concurrently, Section 2(24)(xvi) was introduced to categorize share premiums as ‘income’.

To trigger the provisions of Section 56(2)(viib), three essential conditions must be satisfied:

1. An unlisted company must issue the shares.
2. The investor investing must be a resident of India (original provisions did not apply to non-resident investors).
3. The share premium received for the shares issued must exceed its FMV.

Recognizing that this amendment could pose challenges for investors and issuing companies, particularly in accurately determining the FMV of start-ups², the Government excluded specific categories of investors from the provision’s scope, including ‘venture capital undertakings’³, ‘specified funds’⁴, and start-up approved by the Department for Promotion of Industry and Internal Trade (DPIIT)⁵. Consequently, the Central Board of Direct Taxes (CBDT) issued notifications⁶ and circulars⁷ stating that Angle Tax does not apply to start-ups recognized by the DPIIT. In cases where approval is not obtained from the DPIIT, an inquiry can only be initiated with the approval of a supervisory officer. Applying the circular, the Tribunal has held once the company is a recognized start-up, the provisions will not be applicable.^{8</sup >}

The legislature provided valuation options to ensure that companies have the flexibility to establish the FMV of their shares. The provisions offer two options, the higher of which is to be considered:

1. Companies can choose between two prescribed valuation methods under Rule 11UA – Net Asset Value (NAV) or Discounted Cash Flow (DCF). The company has the discretion to opt for the method that best represents the FMV of the shares.
2. The company can substantiate the value of the shares to the satisfaction of the Assessing Officer (AO) based on the

In summary, Section 56(2)(viib) of the Income Tax Act introduces provisions that tax share premiums received from resident investors in unlisted companies when they exceed the FMV of the shares, subject to certain conditions and exceptions, and provides prescribed methods for computing the FMV.

III. Consequence of Angle Tax.

The valuation of shares, which is central to the application of the Angel Tax, requires a high degree of estimation and is based on various assumptions, particularly when applying the DCF method. These estimates and assumptions, which include projected revenues, discount rates, terminal values, etc., have a substantial impact on the final valuation. Changes to any of these assumptions can result in significantly different valuations.

The Hon’ble Supreme Court, in the case of G.L. Sultania⁹, noted that the valuation by an expert should not be challenged “… unless it has been shown that the valuation was made on a fundamentally erroneous basis, or that a patent mistake has been committed, or the valuer has adopted a demonstrably wrong approach, or a fundamental error going to the root of the matter.”</em > Similarly, in the case of Cinestaan Entertainment¹⁰, the Court held “if the law provides the assessee to get the valuation done from a prescribed expert as per the prescribed method, then the same cannot be rejected because neither the Assessing Officer nor the assessee has been recognized as an expert under the law.”</em > These observations by the Court underscore the complexities involved in valuing shares and emphasize the importance of relying on expert judgment and recognized valuation methods. It also guides the circumstances under which a valuation may be challenged.

Contrary to the decision, the Revenue has continuously challenged the valuation report on unjustified grounds and without bringing any evidence or valuation report on record. In the case of Deep Jyoti Wax Traders (P.) Ltd¹¹</em >, the Tribunal held that when the assessee has followed a prescribed method, such as the DCF method, the tax authorities are not justified in challenging the method and changing it to NAV Method without demonstrating any defects or inaccuracies in the valuation report. In the case of Brio Bliss Life Science (P.) Ltd¹², the Tribunal held that the AO was not justified in rejecting the valuation report solely on the grounds that the projected financials do not match the actual financial performance. Further, the Court noted that the DCF method is mainly based on projected financials of future years and depends upon various estimations and assumptions, which may differ from actual performance. In the case of Caddie Hotels (P.) Ltd13, the Tribunal held that the AO is bound to follow the same method unless he brings cogent material on record that establishes perversity in the method adopted by the assessee.

The provisions have increased tax litigation and tax burdens on start-ups and young businesses. The manner in which tax authorities have implemented the provisions of the Angel Tax has, at times, overshadowed its original purpose. As mentioned earlier, the complexities associated with the Angel Tax have shifted the focus of entrepreneurs and investors away from their core business operations and towards tax- related concerns.

IV. Recent Amendment in the Law and its Consequences

The Finance Act of 2023 introduced changes to the provisions, expanding their scope to include foreign investors by removing the phrase ‘being a resident’. Hence, the provisions will be applicable regardless of the residency status. This amendment will take effect from the financial year 2024-25.

In response to the expansion, the CBDT issued Notification¹⁴ and a letter¹⁵ to reiterate and clarify that section 56(2)(viib) does not apply to start-up companies. According to the letter, start- up companies recognized by DPIIT and fulfilling the prescribed conditions will not be subject to Angle Tax on share premiums received from residents and non-residents. In cases where approvals are not obtained from DPIIT, an inquiry can only be initiated with the approval of the supervisory officer.

Further, the CBDT issued a Notification to exclude various investors, including the Government, Central Banks, Sovereign Wealth Funds, international organizations owned by the Government, Foreign Portfolio Investors (FPIs), etc¹⁶. Additionally, the Notifications extend the exemptions to ‘Notified Entities’¹⁷ from 21 ‘Specified Territories’. However, the list of specified territories excludes countries like Mauritius, Singapore, Netherlands, and the United Arab Emirates (UAE), which are significant sources of foreign investment. Foreign investors from these four countries already suffer from tax litigation due to revenue authorities contesting their residency and investment abilities¹⁸. Moreover, the Indian tax authorities’ ability to apply the Principal Purpose Test and General Anti-Avoidance Agreements has raised concerns among foreign investors. The exclusion of investment from these nations and other factors raises concerns about the potential impact on equity inflows in India.

Section 5(2) stipulates that a non-resident is liable to pay tax on the income derived by them which is received or deemed to be received in India or which accrues or arises or is deemed to accrue or arise in India during the relevant year. In the case of non-residents, Section 5(2) does not permit taxation of amounts remitted into India from sources outside India which are not incomes under provisions of the Act. The CBDT has also acknowledged this in its circular¹⁹, which states that funds brought into India by non-residents for investment or other purposes are not liable to income tax. In the case of Finlay Corporation Ltd²⁰, the Tribunal held that the provisions of section 68 or 69 would apply to non-residents only with reference to those amounts whose origin of source can be located in India. Hence, there is no question of remittance into India being subjected to income tax unless there is evidence to show that the amount in question has a source in India.

However, the amended provision aims to tax share premiums paid by a non-resident without establishing the source of the funds in India.

Notably, an Indian company issuing shares to a foreign investor must comply with the Foreign Exchange Management Act, 1999 (FEMA), as well as the pricing guidelines issued by the Reserve Bank of India (RBI). The pricing guidelines are designed to ensure that the shares are issued at a minimum of FMV. This means that issuing shares below FMV is not permissible. This raises the question of whether a valuation accepted for FEMA should also be accepted for income tax. It is relevant to note that the judiciary has consistently held that if one department of the Government accepts a valuation, it should be accepted by another department of the Government²¹.

V. New Valuation Method and Other Conditions

With the expansion of the provisions, the Rules have introduced additional valuation methods, providing companies with more options to determine the FMV of shares issued to foreign investors. The NAV and DCF methods apply to both resident and non-resident investors. However, all other methods are used exclusively for non-resident investors. These methods collectively provide a thorough approach to valuation, catering to the varied needs of different investors and investment scenarios. The methods and their brief descriptions:

1. Net Asset Value (NAV) Method

This method involves subtracting the company’s liabilities from its assets to determine the net worth or net asset value. This value is then divided by the total number of outstanding shares or units to calculate the per-share or per-unit NAV. The NAV method provides a transparent and easily understandable measure of the value of an investment fund, allowing investors to track their investments and make informed decisions. However, it may have limitations, particularly in reflecting the true market value of illiquid or unique assets.

2. Discounted Cash Flow (DCF) Method The DCF method is the most commonly used for valuing start-ups and emerging businesses. It calculates the FMV of shares by forecasting the company’s future cash flows and discounting them to present value using a discount rate, which accounts for the time value of money and investment risk. The DCF method, determined by a merchant banker, involves considerable estimation and assumptions. This approach provides a comprehensive view of the company’s value by considering its expected future performance and the risks associated with the investment.

3. Comparable Company Multiple Method (CCMM)

The CCMM assesses the target company’s valuation by drawing comparisons with publicly traded companies that share similar characteristics and financial metrics. This method assumes that companies with comparable attributes provide a reasonable benchmark for estimating the target company’s value.

4. Probability Weighted Expected Return Method (PWERM)

The PWERM calculates a company’s fair market value by identifying possible exit scenarios, such as an Initial Public Offering (IPO), acquisition, or remaining private. It then estimates the expected future values of these scenarios and assigns probabilities to each. These values and probabilities are used to compute a weighted average expected return. The method necessitates a meticulous evaluation of potential scenarios, their anticipated future values, and associated probabilities.

4. Option Pricing Method (OPM)

The OPM estimates the fair market value of shares by considering the value of the option to purchase or sell those shares in the future. This method assesses the value of an option or a right to buy or sell something in the future, such as shares in a company, considering factors like the current market price, exercise price, time to maturity, volatility, and risk-free interest rates. OPM is used to value companies with complex capital structures and multiple classes of securities.

5. Milestone Analysis Method (MAM)

The MAM is a valuation technique that estimates a company’s FMV based on the achievement of specific milestones or performance targets. This method involves identifying a set of milestones that the company is expected to achieve over a certain period, such as product development, revenue targets, or regulatory approvals. The expected values and probabilities for each milestone are then used to calculate a weighted average expected return, which represents the company’s estimated FMV.

6. Replacement Cost Methods (RCM)

The RCM is a valuation technique based on the cost of replacing an asset with equivalent assets. It involves estimating the cost of acquiring or constructing assets to replace the existing ones, considering materials, labour, technology, and resources needed for replication. The method assumes that a buyer will not pay more for a company than the cost of replacing it with a similar company.

7. Price Matching Method

The Price Matching Method operates on the principle that similarly situated investors should not face discrimination. This method asserts that the price determined as the FMV for a ‘Notified’ entity can be adopted as the FMV for other investors who are not ‘Notified’ entities. However, this method is subject to two conditions: (a) the consideration received from shares issued at FMV does not exceed the total consideration, and (b) the previous investment round occurs within 90 days of the subsequent share issuance.

Furthermore, the rules introduce the contemporaneous requirement for the valuation report and establish a safe harbour limit.

Contemporaneous Valuation.

To ensure that the valuation accurately represents the company’s present financial health and the current market conditions, rule 11UA(3) has been introduced, necessitating contemporaneous valuation reports. This rule mandates that the valuation report must be dated within 90 days of the issuance of the shares. This change will result in a more accurate and reliable estimate of the shares’ fair market value. However, it poses challenges for companies undergoing multiple investment rounds exceeding the period of 90 days.

Safe Harbour Limit

Recognizing that valuation is not an exact science and involves assumptions that can vary based on the valuer’s perspective, the safe harbour rule provides a degree of flexibility for companies in their valuation efforts. Rule 11UA(4) has established a safe harbour threshold of 10% on the consideration paid for shares issued. This implies that if the issue price of the shares exceeds the FMV by up to 10%, it will still be accepted. The safe harbour provision applies to shares issued to both resident and non-resident investors and is relevant for all valuation methods.

VI. Challenges and Issues

In practice, the pricing of equity shares in transactions is usually determined through independent negotiations between the parties involved. However, the implication of Angle Tax could limit start-ups from negotiating higher prices, even if their ideas or products have potential value. For example, the popular TV show ‘Shark Tank’ highlights how the value of shares can increase when multiple investors show interest in a business. The constraints imposed by income tax provisions could hinder the ability of Indian companies to compete on a global scale. The recent amendment could pose a significant risk to initiatives like “Make in India” and/or “Invest in India,” especially given the current global economic climate. In addition, there are still open issues that need to be clarified, as below:-

1. Evidence on Record

The provision was introduced to monitor and regulate unaccounted money. However, it does not mandate the Revenue to present evidence of unaccounted money. This has empowered tax authorities to challenge every valuation indiscriminately without considering the relevant facts. To reduce litigation, the legislature should require Revenue to prevent evidence proving that investments made are from unaccounted money. This would encourage a more equitable and evidence-driven approach that does not negatively impact legitimate investments.

2. Substitution of Projection with Actuals Figures

A significant area of dispute between the assessee and Revenue authorities is the practice of replacing projected numbers used in valuations with actual numbers. The judiciary has affirmed that projected numbers should not be substituted with actual numbers, as the former is based on various perceptions and assumptions that may differ from actual performance. Despite this, the issue has led to numerous legal disputes. To address this issue, the legislature should either stipulate that projected figures should not be replaced with actual figures or establish conditions that govern the substitution of projected figures with actual numbers. This would provide clarity and help reduce potential litigation.

3. Extension of 80-IAC Exemption

The exemption for start-up companies under section 80-IAC is available until 1st April 2024. This means start-ups incorporated after that date will not be eligible to apply for the DPIIT exemption. The expiration of this exemption could increase litigation related to valuation reports and hinder the ability of start-ups to compete with companies globally. Given the current financial environment, it is crucial to extend the exemption period to support the growth and competitiveness of Indian start-ups.

4. Taxability at the time of infusion or conversion

In cases involving the issuance of shares in place of Compulsory Conversion of Preference Shares (CCPS) and Compulsory Convertible Debentures (CCDs), the capital has already been contributed at an earlier stage, meaning that there is no fresh infusion of funds during the conversion process. The Tribunal has ruled that section 56(2)(viib) applies at the time of conversion (issuance of shares) and not at the time of infusion22. However, this does not consider the practical realities, as the company’s valuation may change between the time of infusion and the issuance of shares. To alleviate the difficulties, the legislature should allow the application of these provisions at the time of infusion to more accurately reflect the actual circumstances.

VII. Conclusions

Valuation reports, which fundamentally explain the rationale behind an investor’s decision to invest in a company, are primarily based on estimates and assumptions that can vary widely from one perspective to another. Companies must mitigate potential tax liabilities by maintaining proper documentation and adhering to regulations. Additionally, companies should ensure they have a comprehensive valuation report that provides details of relevant assumptions, such as growth rates and metrics used, to substantiate the basis of their valuation and defend their positions in case of any scrutiny.

1. Vodafone India Services (P.) Ltd. v. Union of India [2014] 50 taxmann.com 300/368 ITR 1 (Bombay)
2. CBDT Circular No. 3 of 2012, dated 12/06/2012. 
3. These included “venture capital company”, “venture capital fund” and “venture capital undertaking” defined under section 10(23FB) </em >
4. Defined in the Explanation (aa) to section 56(2)(viib). 
5. DPIIT Notification G.S.R. 127(E) dated 19/02/2019 
6. CBDT Notification No. 13 dated 5/03/2019. 
7. CBDT Circular No. 16 of 2019, dated 7/08/2019. 
8. Phasorz Technologies Pvt. Ltd [TS-32-ITAT-2020(CHNY)] or I.T.A.No.2763/Chny/2019 </em >
9. G.L.Sultania v. SEBI (2007) 5 SCC 133 
10. Pr. CIT v. Cinestaan Entertainment [2021] 433 ITR 82
11. Deep Jyoti Wax Traders (P.) Ltd. vs. Income-tax Officer [2023] 154 taxmann.com 367 (Kolkata – Trib.) </em >
12. Brio Bliss Life Science (P.) Ltd. v. Income-tax Officer [2023] 149 taxmann.com 89 (Chennai – Trib.) ; DCIT v. Credtalpha Alternative Investment Advisors (P.) Ltd. [2022] 134 taxmann.com 223 (Mumbai – Trib.) </em >
13. Caddie Hotels (P.) Ltd. v. PCIT [2023] 153 taxmann.com 524 (Delhi – Trib.) </em >
14. CBDT Notification No. 30 of 2023, dated 24-05-2023.
15. CBDT Letter No F. No 173/149/2019-ITA- 1, dated 10/10/2023.
16. CBDT Notification No. 29 of 2023, dated 24-05-2023.
17. Notified entities – (a) entities registered with Securities and Exchange Board of India as Category-I Foreign Portfolio Investors; (b) endowment funds associated with a university, hospitals or charities; (c) pension funds created or established under the law of the foreign country or specified territory; (d) Broad Based Pooled Investment Vehicle or fund where the number of investors in such vehicle or fund is more than fifty and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies</em >
18. Blackstone Capital Partners (Singapore) Vi Fdi Three Pte. Ltd. v. ACIT [2023] 146 taxmann.com 569 (Delhi) and CIT v. JHS (Mauritius) Ltd. [2017] 84 taxmann.com 37 (Bombay) </em >
19. CBDT Circular No. 5 [F. No. 73A/2/69-IT(A-II)], dated 20-2-1969 </em >
20. DCIT v. Finlay Corporation Ltd. [2003] 86 ITD 626 (Delhi) 
21. AT India Auto Parts (P.) Ltd. v. ACIT [2023] 150 taxmann.com 368 (Bangalore – Trib.) and ACIT v. GP Global Energy (P.) Ltd. [2022] 138 taxmann.com 484 (Delhi – Trib.)</em >
22. ITO v. Appealing Infrastructure (P.) Ltd. [2023] 152 taxmann.com 385 (Delhi – Trib.)</em >