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Changes to angel tax will provide relief to small businesses, startups: Experts

May 23, 2023

As a funding crunch hits India’s small businesses and startups, the Finance Ministry has introduced certain exemptions to application of ‘angel tax’.

Fundraising for small businesses and startups would become easier with the Government notifying certain classes of persons being non-resident investors to whom provisions of angel tax not be applicable.

According to a statement by the Central Board of Direct Taxes, this includes, Government and Government related investors such as central banks, sovereign wealth funds, international or multilateral organizations or agencies including entities controlled by the Government or where direct or indirect ownership of the Government is 75% or more.

Banks or Entities involved in insurance business where such an entity is subject to applicable regulations in the country where it is established or incorporated or is a resident are also excluded.

The statement added that any entity, which is a resident of a certain country or specified territories having robust regulatory framework, like entities registered with Securities and Exchange Board of India as Category-I Foreign Portfolio Investors and Endowment Funds associated with a university, hospitals or charities will also be excluded.

“The notification from CBDT and MF has been well received by the PE/VC industry as it provides more clarity to Indian startups and investors in relation to section 56(2)(viib). The proposed norms aim to expand valuation methodologies and eliminate price differentials between resident and non-resident investors. We thank the Finance Ministry for actively addressing the industry's concerns and acknowledging a broader range of institutional investors in the exempted list. This inclusive approach will facilitate ongoing investments in the country,” sais Karthik Reddy, Managing Partner, Blume Ventures & Chairperson, IVCA.

The Government has also excluded Pension Funds created or established under the law of the foreign country or specified territory, and Broad Based Pooled Investment Vehicle or Fund where the number of investors in such a vehicle or fund is more than 50 and such fund is not a hedge fund or a fund which employs diverse or complex trading strategies.

Siddarth Pai, Co-Founder 3one4 Capital says the government's notification on angel tax offers relief to startups suffering under the current funding winter. “Measures such as safe harbor for a variation of 10% of price, different valuation methodologies, exempting investments from a broader set of investors reflect market practices and lay to rest fears of investors. Some terms such as a broad-based fund of 50 people will be tough to enact as large venture capital funds tend to work only with select investors. This will help the startup industry out, but excluding funds & managers regulated by IOSCO member regulators will help attract foreign capital and serve as a sound safeguard," says Pai.

The Government has also proposed to increase the valuation methods with respect to valuation of shares namely. Currently, Discounted Cash Flow (DCF) and Net Asset Value (NAV) method for resident investors is used to arrive at a valuation, but the Government proposes toinclude 5 more valuation methods, in addition to the DCF and NAV methods of valuation.

According to Kavit Sutariya, General Partner, CapFort Ventures this progressive step is particularly commendable as it aims to enhance the promotion and attraction of foreign institutional investors. “A significantly progressive step is the adoption of a broader range of valuation methods. Moreover, this inclusive approach fosters a conducive environment for startups, enabling them to attract greater interest from investors and fueling their growth and success. The recent notification from CBDT has garnered positive interest within the private equity and venture capital industry, as it offers enhanced clarity to both Indian start-ups and investors regarding the angel tax. Moving forward, the subsequent phase should involve the inclusion of individual angel investors in India, thereby extending crucial support to local investors and empowering smaller startups during their initial/early stages. The intended regulations seek to broaden the scope of valuation methodologies and eradicate price differences between resident and non-resident investors.”

Ruchi Khajanchi, CFO, A91 Partners says the proposed changes have moved in a positive direction and brought some relief to the venture ecosystem. “They allow for the adoption of diverse valuation methodologies to determine the fair market value (FMV) of shares, introduce safe harbor rules with a 10% variance, and provide exemptions under Section 56 (2) (vii)(b) to a wider set of investors. However, challenges may still arise if the difference between primary and secondary valuations exceeds 10% in case of investments by non-exempt investors,” says Khajanchi.

Shauraya Bhutani, Co-founder, Capital Connect Advisors says the funding winter has hit Indian startups hard and stifled innovation with lesser startups being launched and quite a few shutting shop, so any move which may encourage investments is a welcome relief for the overall ecosystem.

“The recently proposed changes will help mitigate the tax expense for investors, which in turn will help with their expected returns projections, with an expansion in valuation methodologies, allowing startups to move away from rigid and traditional methodologies to ones which are closer to real valuations and specific to their business models. The proposed changes also aim to bring in parity between resident and non-resident investors, which hopefully will re-open foreign capital gates in a time where startups need more capital options apart from domestic based funds,” says Bhutani.

[The Economic Times]

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