EY Tax Alert. Central Government modifies conditions for availing exemption from angel tax provision. Executive summary

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1 29 May 2018 EY Tax Alert Central Government modifies conditions for availing exemption from angel tax provision Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your Ernst & Young advisor. Executive summary This Tax Alert summarizes two recent notifications, Notification Nos. 23 and 24 of 2018 dated 24 May 2018, issued by the Central Government (CG) in relation to taxation of excess share premium received by a closely held company (CHC) from a resident under provision of the Indian Tax Laws (ITL) ( premium taxation or popularly known as the angel tax provision). Notification No. 24/2018 dated 24 May 2018 (Start-up Notification) exempts start-up companies from the angel tax provision if the start-up company has received consideration for issue of shares from an investor in accordance with the approval from the Inter-Ministerial Board of Certification (IMB) under Notification No. 5(4)/2018-SI dated 11 April 2018 issued by the Department of Industrial Policy and Promotion (DIPP). The IMB approval is subject to compliance by both the start-up company and the investor of certain new conditions introduced by the DIPP. The Start-up Notification comes into force retrospectively from 11 April 2018 and supersedes the earlier CG Notification No. 45/2016 dated 14 June 2016 which granted exemption to start-ups from the angel tax provision, without the need to comply with new conditions introduced by the DIPP.

2 Page 2 Separately, the CG, vide Notification No. 23/2018 dated 24 May 2018 (Valuation Notification) which also relates to the angel tax provision, withdraws the option to obtain a valuation report from an eligible Chartered Accountant (CA) for determining the fair market value (FMV) of unquoted equity shares basis the discounted cash flow (DCF) method to defend taxation of share premium on issue of shares by the taxpayer. Thus, with effect from 24 May 2018, the taxpayer has to obtain a DCF valuation report only from a Category-I SEBI [1] registered Merchant Banker (MB). Background Section 56(2)(viib) (Section) of the Indian Tax Laws (ITL) (popularly known as the angel tax provisions) is an anti-abuse provision which applies when a CHC issues shares (including preference shares) to a resident at a premium and receives consideration which is in excess of the FMV of the shares. The excess amount so received is deemed as income from other sources in the hands of the CHC in the year of issue of the shares. Rule 11UA of the Income Tax Rules (Valuation Rules) prescribes the valuation methodology for determining the FMV of various types of assets (including unquoted equity shares), not only for the purposes of the angel tax provision, but also for other anti-abuse provisions involving transfer of assets without consideration or at a value less than the FMV. The FMV of unquoted equity shares for the purpose of the angel tax provision read with Rule 11UA is the higher of the following: Net asset value as reflected in the audited balance sheet of the CHC (break-up value method) OR The DCF value as determined by a Category-I MB or Accountant OR The value that the company is able to substantiate to the satisfaction of the Tax Authority, basis the holding of various intellectual property rights (IPRs) like goodwill, know-how, patents, copyrights etc. In case of unquoted shares and securities other than equity shares in a company not listed in any recognized stock exchange, as per Rule 11UA, the FMV is the estimated open market value as may be determined by a Category I MB or Accountant. This rule applies to both angel tax and other anti-abuse provisions. Prior to the Valuation Notification, the term Accountant was defined as under: For angel taxation: In case of valuation of unquoted equity shares, an Accountant is a Fellow CA who is not appointed as a tax auditor under the ITL or as a statutory auditor under the Companies Act, For other anti-abuse provisions: Any CA in practice who can act as an Authorized Representative for the taxpayer and fulfils the independence criteria as prescribed under the ITL. Changes brought about by the Valuation Notification are as follows: The Valuation Notification has withdrawn the option given to the taxpayer to obtain a valuation report from a CA for determining the FMV of unquoted equity shares based on the DCF method for the purpose of the angel tax provision. As a consequential amendment, it has also omitted the definition of accountant. Thus, where the taxpayer wishes to rely on the DCF method, it can now obtain a DCF valuation report only from a Category 1 MB. A valuation report from a practising CA will no longer be a valid compliance for the angel tax provision. However, it may be noted that the above change applies only to the valuation of unquoted equity shares required for the angel tax provision by adopting the DCF method option. For shares other than unquoted equity shares (like preference shares), the taxpayer continues to have the option to obtain a valuation report from either a Category I MB or a CA. The changes in Rule 11UA are depicted in the table at Annexure. The aforesaid amendment comes into force from the date of publication in the official gazette i.e., 24 May Exemption from the angel tax provision for eligible start-ups The angel tax provision does not apply to shares issued by a venture capital undertaking to a venture capital fund or a venture capital company [2]. In addition, the provision does not apply when shares are issued to a class or classes of persons as notified by the CG. Pursuant to exercise of this power, the CG issued the following notifications with corresponding reference to the DIPP notifications. [1] Securities Exchange Board of India [2] Venture capital undertaking, venture capital fund and venture capital company shall have meaning as assigned under Explanation(c) to Section 10(23FB) of the ITL

3 Page 3 Year Applicable DIPP Notification Applicable CG Notification under the ITL 2016 Notification [3] dated 17 February 2016 Notification No. 45/2016 dated 14 June 2016 The 2016 DIPP Notification had the definition of start-up for regulatory purposes To avail tax benefits [4], the start-up should obtain a certificate of eligible business from the IMB Notified start-up as exempt category of taxpayer pursuant to powers given under the angel tax provision Start-up companies which fulfilled the conditions specified in the 2016 DIPP Notification were exempted from the angel tax provision No additional conditions prescribed either for start-up companies or investors 2017 Notification [5] dated 23 February 2017 No new Notification The 2017 DIPP Notification superseded the 2016 DIPP Notification Modification of definition of eligible start-up No new corresponding CG notification issued The 2016 CG Notification continued to refer to the 2016 DIPP Notification Simplified the procedure for obtaining recognition as start-up for regulatory purposes Prescribed certain additional conditions for availing tax benefits [6] 2018 Notification [7] dated 11 April 2018 [8] Notification No. 24/2018 dated 24 May 2018 The 2018 DIPP Notification supersedes the 2017 DIPP Notification Definition of start-up not modified The Start-up Notification supersedes earlier the 2016 CG Notification with retrospective effect from 11 April 2018 Grants exemption to start-up companies if the company and investor fulfil conditions as prescribed in the 2018 DIPP Notification Has prescribed separate additional conditions for start-up companies and investors for availing exemption from the angel tax provision (see the paragraphs that follow) Lays down the procedure for applying for tax benefit and sets out the procedure for the IMB to grant or deny approval [3] Notification No. G.S.R. 180(E) [4] Including profit linked tax holiday for three years [5] Notification No. G.S.R. 501(E) [6] For example, that the entity must be private company and incorporated between 1 April 2016 and 31 March 2019 [7 ] Notification No. F.No. 5(4)/2018-SI [8] Also, refer our Tax Alert titled - Government of India notifies revised procedure for availing tax benefits for start-ups dated 14 April 2018

4 Page 4 The additional conditions imposed by the 2018 DIPP Notification for start-up companies are: A cap of INR100m on the aggregate of paid-up share capital and share premium post issue of shares. Requirement to furnish a valuation report obtained from a Category I MB specifying the FMV of the shares, in accordance with Rule 11UA. As per the 2018 DIPP Notification, the conditions required to be fulfilled by the investor are, either: Average returned income of INR2.5m or more for the preceding three financial years. OR Net worth of INR20m or more on the last date of the preceding financial year. The Start-up Notification aligns with the 2018 DIPP Notification and provides that where shares are issued at premium for a consideration in excess of the FMV, the angel tax provision shall not apply on such consideration received from an investor by a start-up company, in accordance with the approval granted by the IMB under the 2018 DIPP Notification. This change comes into force retrospectively from 11 April 2018, being the date on which the 2018 DIPP Notification was issued/published in the official gazette. Comments The exact reason for withdrawal of the option to obtain a DCF valuation report from a CA to defend angel tax, is unclear. The Valuation Notification has come into effect from 24 May Hence, taxpayers which issue equity shares on or after 24 May 2018 need to comply with the amendment. Difficulties may arise for taxpayers which obtained a valuation report from a practising CA prior to 24 May 2018 but the actual issue of shares has taken place on or after 24 May Such taxpayers may need to obtain a fresh report from a Category I MB. Taxpayers which have issued shares between 1 April 2018 and 24 May 2018 may also need to evaluate the impact of the change in the Valuation Rules to minimize the risk of litigation. The Start-up Notification aligns with the additional conditions laid down in the 2018 DIPP Notification for start-up companies and investors for seeking approval from the IMB to avail of exemption from the angel tax provision and, hence, is made retrospectively applicable from 11 April 2018.

5 Page 5 Annexure Tabular depiction of the impact of the amendment in the Valuation Rules Rule Type of asset FMV Valuation basis Pre-amendment Post amendment FMV for gift taxation and premium/angel taxation 11UA(1)(c)(c) Unquoted shares and securities other than equity shares Estimated value which the asset would fetch in the open market Obtain the FMV valuation report either from an MB or a CA [9] Obtain the FMV valuation report either from an MB or a CA [10] FMV for premium/angel taxation 11UA(2) Unquoted equity shares Break-up value methodology If DCF valuation method is adopted Obtain the FMV valuation report either from an MB or a CA (other than tax auditor or statutory auditor) Obtain the FMV valuation report from an MB [9] Prior to the Valuation Notification, specific reference was found to the definition of accountant under the ITL in relation to Authorized Representative. [10] Even in the absence of a specific definition of accountant in the Valuation Rules, the definition of accountant, as provided under the ITL, may still be applicable.

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