India’s start-up ecosystem has been in a state of flux recently, with the introduction of amended angel tax rules by the Income Tax Department. These changes, integrated into Rule 11UA of the Income Tax Rules, represent an earnest attempt to reconcile the differences between the rules outlined in the Foreign Exchange Management Act (FEMA) and the Income Tax Act.

While the amendments aim to foster transparency and fairness in taxation, they have garnered mixed reactions from the start-up community. One of the standout modifications in these rules is the inclusion of the fair market value of unquoted equity shares as a basis for valuing Compulsorily Convertible Preference Shares (CCPS).

This alteration promises more flexibility in the valuation process, which could potentially simplify the lives of both start-ups and investors. However, the scepticism within the start-up realm indicates that more needs to be done to strike the right balance.

The Finance Act, 2023, expanded the scope of the Angel Tax to cover investments exceeding the fair market value, irrespective of whether the investor is a resident or a non-resident. This move was intended to combat money laundering and questionable investments but inadvertently introduced complexity.

The crux of the issue lies in the discord between the Income Tax Act and FEMA regarding the calculation of fair market value. This discrepancy has caused uncertainty and raised questions about the tax implications for start-ups receiving foreign investments. To truly promote a thriving start-up ecosystem, there must be a harmonious understanding between these two pieces of legislation.

One significant step in the right direction is the inclusion of a tolerance threshold for minor valuation discrepancies. This mechanism adds an element of efficiency and fairness to tax assessments. It allows for a reasonable margin of error while discouraging deliberate manipulation of valuations. This is a vital preventive measure against malpractice and money laundering. Further measures in this endeavour in the start-up investment space require a multi-faceted approach.

First, regulatory authorities should work closely with start-ups and investors to establish clear guidelines and best practices for valuation. Transparency is paramount and start-ups must maintain comprehensive records of their valuation methodologies.

Additionally, conducting due diligence on investors is crucial. Start-ups should verify the legitimacy of their investors, especially those coming from overseas. Ensuring that the source of funds is legitimate and compliant with all applicable laws is a vital safeguard against illicit practices.

Moreover, government agencies can leverage technology to monitor and track investment inflows and valuations. Implementing robust reporting mechanisms and data analytics can help identify suspicious activities and prevent money laundering effectively. Incentivising ethical behaviour is another aspect that must be considered.

The extension of a 10 per cent safe harbour to CCPS investments, similar to what was in place for equity shares, is a commendable move. This margin of safety can protect against foreign exchange fluctuations and encourage legitimate foreign investments.