[Analysis] Angel Tax | How to Determine the Value of Unlisted Equity Shares and Convertible Preference Shares?

Table of Contents

1. Introduction
2. Applicability of Section 56(2)(viib)
3. New Valuation Methods and Benchmarking
4. Valuation Methods and Benchmarking of Unquoted Equity Shares
5. Valuation Methods and Benchmarking of Compulsorily Convertible Preference Share
6. Other Changes

1. Introduction

The Central Board of Direct Taxes (CBDT) has issued1 the notification amending Rule 11UA that prescribes methods for the valuation of investments made by resident and non-resident investors in closely held companies (e.g., start-ups). The valuation helps determine if the Angel Tax will be imposed on start-ups. Earlier, the board released a draft rule and requested the stakeholders/general public to provide suggestions/comments on it.

Angel tax is imposed on unlisted companies that receive share application money or premiums from their investors over the fair market value of the unquoted equity shares. The tax was first introduced through the Finance Act 2012, under clause (viib) of Section 56(2). Originally, the provision applied to share application money/premium received from resident investors. The Finance Act 2023 expanded the scope of the provision to include share application money/premium received from a person, irrespective of his residential status. With this change, excess share application money or premium received from non-resident investors may also be subject to angel tax.

2. Applicability of Section 56(2)(viib)

The provisions of Section 56(2)(viib) apply if all of the following conditions are satisfied:

(a) It applies to a closely held company (a company other than the one in which the public is substantially interested);

(b) The consideration should be received for the issuance of shares; and

(c) The issue price of shares should exceed the face value and fair market value of such shares.

If all these conditions are satisfied, the consideration received in excess of the FMV of the shares is considered as an income of the company issuing the shares.

3. New Valuation Methods and Benchmarking

The norms for computing the FMV of shares are prescribed under Rule 11UA of the Income-tax Rules, 1962. The erstwhile Rule provided only two approaches for determining FMV: the Discounted Cash Flow (DCF) method and the Net Asset Value (NAV) method. Keeping these two methods intact, the amended Rule has included new methods and benchmarks for valuing shares. These methods and benchmarks for determining the fair market value of unquoted equity shares and compulsorily convertible preference shares (‘CCPS’) are as follows:

4. Valuation Methods and Benchmarking of Unquoted Equity Shares

The various valuation methods and benchmarking provided in Rule 11UA are as follows:

4.1. Net Asset Value (NAV)

Under the Net Asset Value method, the value of unquoted equity shares is determined based on the company’s net worth. The net worth is calculated by subtracting the liabilities of the company from the assets. This method considers the company’s balance sheet to ascertain the fair market value of the shares.

4.2. Discounted Free Cash Flow (DCF)

Under the DCF method, the FMV of unquoted equity shares is calculated as the sum of the present values of all future cash flows the company is expected to generate, discounted to the present day at a risk-adjusted discount rate. The discount rate reflects the time value of money and the risk associated with investing in the company.

The Rule provides that a Merchant Banker shall determine the FMV of unquoted equity shares per the DCF method.

4.3. Benchmarking with shares issued to VC Fund or VC Co. or Specified Fund

It provides that if a Venture Capital Undertaking receives any consideration for the issue of shares to a Venture Capital Fund, Venture Capital Company or Specified Fund (Category I or II AIF), then the price of the equity shares corresponding to such consideration may be taken as the FMV of the equity shares issued to other investors.

This benchmarking is allowed if the following two conditions are satisfied:

(a) The consideration from shares issued at FMV does not exceed the aggregate consideration received from the VC Fund, VC Company or Specified Fund; and

(b) VC Undertaking has received consideration from VC Fund, VC Company or Specified Fund within 90 days before or after the date of the issue of shares to other investors.

For example,

On December 01, 2023, VC Undertaking receives share application money of Rs 20,00,000 from a VC Fund for the issue of 1,000 shares at the rate of Rs. 2,000 per share. The shares are allotted on December 15, 2023 and credited to Demat account on December 20, 2023. The VC Undertaking can issue up to 1,000 shares at Rs. 2,000 per share to any other investor during the period between September 03, 2023 and February 29, 2024, i.e., within 90 days before or after the date of receipt of consideration (share application money) from VC Fund.

4.4. Valuation by Merchant Banker as per specified methods

The amended Rule introduced five new methods to compute the fair market value of the unquoted equity shares by the Merchant Banker. These new methods can only be used to determine the FMV of shares issued to non-resident investors.

4.4-1. Comparable Company Multiple Method

The Comparable Company Multiple Method (CCMM) is commonly used in financial analysis and investment valuation to determine the worth of a company’s shares in the market. It involves comparing the target company to similar publicly traded companies to determine a reasonable valuation.

This method assumes that companies with similar characteristics and financial metrics should have equivalent valuations. The steps include identifying comparable companies in terms of industry, size, growth prospects, and risk profile, calculating relevant valuation multiples (such as price-to-earnings, enterprise value-to-EBITDA, and price-to-sales ratios) for these companies, and then applying the median or mean multiple to the corresponding financial metric of the target company to arrive at its estimated FMV.

4.4-2. Probability Weighted Expected Return Method

The Probability Weighted Expected Return Method (PWERM) is a valuation method that estimates the fair market value of a company by considering the probability of different future outcomes. The method is based on the assumption that the value of a company is equal to the present value of its expected future cash flows, weighted by the probability of each outcome.

4.4-3. Option Pricing Method

The Option Pricing Method (OPM) is a valuation method that estimates the fair market value of shares by considering the value of the option to purchase or sell those shares in the future. The method is based on the assumption that the value of a share is equal to the present value of its expected future cash flows plus the value of the option to purchase or sell the share at any time.

4.4-4. Milestone Analysis Method

The Milestone Analysis Method is used for computing the FMV of shares, particularly in the context of start-ups or companies with limited operating history. This method involves identifying specific milestones a company aims to achieve in its business plan or development roadmap. These milestones could include product launches, user acquisition targets, revenue goals, or other significant achievements. The valuation using this method is based on the idea that achieving these milestones will directly impact the company’s value. As each milestone is reached, the company’s risk profile decreases, and its value increases.

4.4-5. Replacement Cost Methods

The Replacement Cost Method (RCM) is a valuation method that estimates the FMV of shares by considering the cost of replacing the company with a similar company. The method is based on the assumption that a buyer will not pay more for a company than the cost of replacing it with a similar company. The RCM is often used to value unquoted equity shares, such as those in privately held companies or those listed on a stock exchange but with a relatively illiquid market. The method can also be used to value publicly traded shares, but it is less common.

4.5. Benchmarking with shares issued to Notified Entities

It provides that if a company receives any consideration for the issue of shares to a notified entity, then the price of the equity shares corresponding to such consideration may be taken as the FMV of the equity shares issued to other investors.

This benchmarking is allowed if the following two conditions are satisfied:

(a) The consideration from shares issued at FMV does not exceed the aggregate consideration received from the notified entity; and

(b) The company has received consideration from the notified entity within 90 days before or after the date of the issue of shares to other investors.

For example,

On December 01, 2023, a start-up receives share application money of Rs 20,00,000 from Category-I FPI for the issue of 1,000 shares at the rate of Rs. 2,000 per share. The shares are allotted on December 15, 2023 and credited to Demat account on December 20, 2023. The start-up can issue up to 1,000 shares at Rs. 2,000 per share to any other investor during the period between September 03, 2023 and February 29, 2024, i.e., within 90 days before or after the date of receipt of consideration (share application money) from FPI.

4.5-1. Who is a notified entity?

Clause (ii) of the First proviso to Section 56(2)(viib) gives power to the Central Government to notify class or classes of persons to whom the provisions of said section shall not apply. The CBDT vide Notification No. 29/2023, dated 24-05-2023, has notified these persons, i.e., government, government-related investors, sovereign wealth funds, banks, FPI, etc. Additionally, investors from 21 countries, including the US, UK, and France, have been granted an exemption from angel tax. However, investments from countries such as Singapore, Netherlands, and Mauritius are not included in this list.

5. Valuation Methods and Benchmarking of Compulsorily Convertible Preference Share

Rule 11UA(2)(B) also provides explicit guidance on computing the FMV of CCPS. It offers two options for ascertaining the FMV of CCPS.

5.1. Independent valuation

The issuer company can determine the FMV of CCPS by following any of the methods prescribed in Rule 11UA(2)(A), except the NAV method. These methods have been discussed in Para 4.2 to 4.5.

5.2. Benchmarking with unquoted equity shares

Where the issuer company has determined the FMV of unquoted equity shares in accordance with any method prescribed in Rule 11UA(2)(A), it can take that value as the FMV of the CCPS. Here, the issuer company can also choose the NAV method used to determine the FMV of unquoted shares as the FMV of CCPS.

6. Other Changes

The Rule has provided various other reliefs to the investor and unlisted companies.

6.1. Merchant Banker’s report should not be older than 90 days

Rule 11UA(3) provides that the valuation report by the Merchant Banker would be acceptable if it is of a date not more than 90 days before the date of issue of shares, which are the subject matter of valuation.

6.2. 10% Safe Harbour Limit

Rule 11UA(4) provides a safe harbour limit of 10% for the issue of unquoted equity shares or CCPS. This means if the price at which shares are issued is higher than the value determined per Rule 11UA, but the difference does not exceed 10%, the issue price will be held as the fair market value.

For example, where the unquoted equity shares are issued at Rs. 1,100 per share, the angel tax shall not be levied as long as the FMV of such shares is above Rs. 1,000 per share.

However, the safe harbour limit shall not apply where the FMV of shares issued to VC Fund, VC Co., Specified Fund, or Notified entity is treated as a benchmark.