The Income Tax Department will soon notify rules specifying the class of investors and norm of valuation for implementation of the Budget provision of taxing foreign investment in unlisted companies. The modified valuation rules would provide for ascertaining the fair market value (FMV) of shares of unlisted companies to levy tax on non-resident investments.
The Finance Act, 2023, has amended Section 56 (2) (viib) of the I-T Act, thereby bringing overseas investment in unlisted closely held companies, except DPIIT-recognised start-ups, under the tax net. The amendments are needed as I-T Act and FEMA provide different methodologies for calculating the FMV of shares of unlisted companies.
Rule 11UA of I-T Rules will be re-prescribed taking into account the concerns expressed by stakeholders to harmonise it with the FEMA regulations. Rule 11UA deals with the determination of FMV of assets, other than immovable property.
Under the existing norms, only investments by domestic investors or residents in closely held companies were taxed over and above the fair market value. This was commonly referred to as an angel tax. The Finance Act, 2023, has said that such investments over and above the FMV will be taxed irrespective of whether the investor is a resident or non-resident. The provisions would come into effect from April 1.
The startup and venture capital industry has sought exemption for certain overseas investor classes. The finance ministry, in the rules, is expected to specify to which investor class these modified tax rules would be applicable.
However, no tax would be levied on investments in startups, which meet the prescribed norms and are recognised by the Department for Promotion of Industry and internal trade (DPIIT). Post the amendments proposed in the Finance Bill, concerns have been raised over the methodology of calculation of fair market value under two different laws.
FEMA regulations mandate that issue of a capital instrument by an Indian company shall not happen at any value less than Fair Market Value computed as per FEMA laws.
Under I-T law, the tax would be levied on any excess price recovered over and above Fair Market Value (calculated as per the income tax laws) on issuing shares to a non-resident. Suppose the FMV of a share computed under FEMA law is Rs 100, whereas under income tax is Rs 80. Now, let’s assume that the shares are issued to foreign investors at Rs 100 only. Even in such cases, the income tax department will impose a tax on Rs 20 (100-80) in the hands of the recipient company.