New Tax Directive Benefits Recognized Start-ups

October 17, 2023

The Central Board of Direct Taxes (CBDT) has taken a significant step to alleviate the concerns of start-ups by directing its officers not to scrutinize angel tax provisions for start-ups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT). This move comes in response to the issuance of scrutiny notices to many start-up companies.

Understanding the New Tax Directive

The CBDT issued a directive last week instructing its field officials not to conduct verification for recognized start-ups in cases related to Section 56(2)(viib) of the Income-tax Act. This particular section was amended in the Finance Act of 2023 to include non-resident investors in the scope of the angel tax levy.

Key Highlights of the CBDT Directive

The CBDT’s directive outlines two key scenarios:

Single Issue Scrutiny: If a start-up’s case is selected for scrutiny solely based on the applicability of Section 56(2)(viib) of the Income-tax Act, no verification of this issue will be carried out during the assessment proceedings. The contention of recognized start-up companies regarding this issue will be summarily accepted.
Multiple Issue Scrutiny: In cases where a start-up’s assessment is scrutinized for multiple issues, including Section 56(2)(viib) of the I-T Act, the applicability of Section 56(2)(viib) will not be pursued during the assessment proceedings.

What Is Angel Tax for Start-ups?

Angel tax is a form of income tax levied at a rate of 30.6% when an unlisted company issues shares to an investor at a price higher than its fair market value. Initially, it was imposed only on investments made by resident investors. However, the Finance Act of 2023 extended the scope of angel tax to non-resident investors from April 1.

Angel Tax Changes in Budget 2023-24

The Finance Act of 2023 brought about amendments to Section 56(2)(viib) of the Income-tax Act, commonly referred to as the ‘angel tax.’
This provision was initially introduced in 2012 to discourage the use of unaccounted money in closely held companies.
It stipulated that when an unlisted company, such as a start-up, received equity investment from a resident exceeding the face value of its shares, it would be considered income and subject to taxation under the ‘Income from Other Sources’ category for the relevant financial year.
With the latest amendment, foreign investors were also included in the ambit of the angel tax, meaning that funding from foreign investors would now be taxable. However, DPIIT-recognized start-ups were exempt from this tax.
In September, the Finance Ministry issued final valuation rules for both foreign and domestic investors in unlisted companies, addressing additional sub-clauses related to the valuation of compulsorily convertible preference shares (CCPS).
For non-resident investors, the tax department prescribed five valuation methods, including the comparable company multiple method, probability-weighted expected return method, option pricing method, milestone analysis method, and replacement cost method.
Additionally, in May, the Finance Ministry exempted investors from 21 countries, including the US, UK, and France, from the angel tax for non-resident investments in unlisted Indian start-ups. However, investors from countries such as Singapore, Netherlands, and Mauritius, which have traditionally been significant sources of funding for start-ups, were not included in the exemption list.

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