Section 56(2)(viib) Requires Revised Foreign Investment Reporting.

Foreign Investment, Reporting Requirements have undergone significant changes with the introduction of the Finance Act, 2023, which expanded the scope of India’s angel tax provisions under Section 56(2)(viib) of the Income-tax Act. The amendment aimed to curb the circulation of unaccounted money through inflated share premiums, but it raised concerns among startups, venture capital ecosystems, and closely held companies due to valuation complexities and regulatory uncertainty.

Key Facts

• The Finance Act, 2023, amended Section 56(2)(viib) of the Income-tax Act to extend its applicability to investments received from non-resident investors in unlisted companies.
• Notification No. 29/2023 dated 24th May 2023 exempted three categories of entities from Section 56(viib) retrospectively from 1st April 2023.
• Notification No. 30/2023 exempted startup companies from the angel tax provision if they fulfilled the conditions specified by DPIIT.
• Notification No. 81/2023 dated 25th September 2023 notified the final amended Rule 11UA, introducing a 10% safe harbour limit for valuation of equity shares and compulsorily convertible preference shares (CCPS).
• The amended Rule 11UA provides five new methods of valuation for issue of unquoted equity shares or CCPS to non-resident investors.
• The rules are applicable to all cases of issue of unquoted equity shares on or after September 25, 2023.

Statutory Context & Tax Analysis

Section 56(2)(viib) of the Income-tax Act provides that if the consideration for issue of shares exceeds the Fair Market Value (FMV) of the shares, it shall be chargeable to income-tax under the head ‘Income from other sources’. The amendment introduced by the Finance Act, 2023, aimed to prevent the generation and circulation of unaccounted money through share premium received from non-resident investors in excess of the fair market value. However, the valuation of startups and new enterprises with good business prospects was considered difficult, and the CBDT introduced amendments to Rule 11UA to provide relief measures.

Rule 11UA prescribes the methodology for determining the fair market value of shares issued to resident and non-resident investors. The amended Rule 11UA introduces a 10% safe harbour limit for valuation of equity shares and CCPS, reducing the burden of angel tax on startups and other closely held companies. The rule also provides separate valuation mechanisms for CCPS and options to adopt the fair market value of unquoted equity shares for determining the FMV of CCPS.

The amended Rule 11UA provides five new methods of valuation for issue of unquoted equity shares or CCPS to non-resident investors, including the Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Methods. These methods are exclusively applicable for determining the FMV of shares issued to non-resident investors.

Client Impact & Compliance Procedure

The amendment to Section 56(2)(viib) and the introduction of the amended Rule 11UA may impact the tax liability of startups and closely held companies receiving investments from non-resident investors. To comply with the new regulations, companies should:

1. Determine the fair market value of shares issued to non-resident investors using one of the prescribed methods under Rule 11UA.
2. Obtain a valuation report from a merchant banker, which can be accepted if it is of a date not more than 90 days prior to the date of issue of shares.
3. Maintain records of the valuation methodology used and the calculation of the fair market value.
4. File the necessary forms and returns with the income-tax authorities, including Form 2(VAL) and Form 3CEB.
5. Ensure compliance with the conditions specified by DPIIT for startup companies to avail of the exemption from the angel tax provision.

Companies should also be aware of the price matching facility, which provides that the price at which unquoted equity shares or CCPS are issued by a closely held company to notified non-resident entities or venture capital funds shall be adopted as the fair market value for the purposes of benchmarking equity and CCPS investments by both resident and non-resident investors, subject to compliance with certain conditions.

In case of any disputes or litigation, companies should be prepared to defend their valuation methodology and calculation of the fair market value. The case of Innoviti Payment Solutions Pvt. Ltd. Vs. ITO and THE DEPUTY COMMISSIONER OF INCOME TAX, CIRCLE 16(1), HYDERABAD Vs M/s NCL GREEN HABITATS PRIVATE LIMITED provide guidance on the acceptability of the valuation methodology adopted by the assessee and the role of the Assessing Officer in scrutinizing the valuation report.

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