The valuation of shares issued by unlisted companies is a crucial aspect of taxation, especially for startups and investors. Section 56(2)(viib) of the Income-tax Act, 1961 (the Act) provides that where a company, not being a company in which the public are substantially interested, receives any consideration for the issue of shares from a resident person, which exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value (FMV) of the shares shall be chargeable to income-tax under the head “Income from other sources” in the hands of the company. This provision is commonly known as the “angel tax” as it affects the investments made by angel investors in startups.

The FMV of unquoted shares is determined under Rule 11UA of the Income-tax Rules, 1962 (the Rules). The Central Board of Direct Taxes (CBDT) has recently amended Rule 11UA vide Notification No. 23/2023 dated March 15, 2023, to incorporate new valuation methods and to include norms for valuing compulsorily convertible preference shares (CCPS). This essay aims to analyze the changes made by CBDT to Rule 11UA and their implications for the valuation of shares issued by unlisted companies. The essay will discuss the following points:

The changes made by CBDT to Rule 11UA in detail

The CBDT has introduced five new methods for calculating the FMV of unquoted shares, as determined by the merchant banker, namely:

• Comparable Company Multiple Method: This method involves applying an appropriate multiple to a financial metric of a comparable company or a set of comparable companies. The multiple is derived from the market price or transaction price of such comparable companies or companies. The financial metrics include revenue, earnings, cash flow, book value, etc.
• Probability Weighted Expected Return Method: This method estimates the expected future cash flows or returns from different scenarios based on their probabilities and discounts them at an appropriate rate to arrive at the present value. This method is suitable for valuing companies with uncertain or contingent outcomes, such as startups.
• Option Pricing Method: This method involves using an option pricing model, such as Black-Scholes or Binomial, to value the equity shares of a company. This method considers the volatility, time value, dividend yield, risk-free rate, and exercise price of the equity shares.
• Milestone Analysis Method: This method involves assigning different values to different milestones or stages of development of a company and weighting them according to their likelihood of achievement. This method is suitable for valuing companies with long-term projects or goals, such as biotechnology or pharmaceutical companies.
• Replacement Cost Method: This method involves estimating the cost of replacing or reproducing the assets or capabilities of a company. This method is suitable for valuing companies with unique or specialized assets or capabilities, such as technology or intellectual property.

The CBDT has also provided for price matching for resident and non-resident investors concerning investment by notified entities, venture capital funds, venture capital companies, or specified funds. This means that if an unlisted company issue shares to a resident person at a price that is not less than the price at which such shares are issued to any notified entity, venture capital fund, venture capital company, or specified fund within a period of six months from the date of issue or transfer, then such price shall be deemed to be the FMV of such shares for the purpose of section 56(2)(viib) of the Act.

The CBDT has also prescribed valuation methods for calculating the FMV of CCPS. CCPS are preference shares that are compulsorily convertible into equity shares within a specified period. The FMV of CCPS shall be determined as follows:

If CCPS are convertible into equity shares at a predetermined price within a period not exceeding ten years from the date of issue or transfer, then such predetermined price shall be deemed the FMV of CCPS.

Suppose CCPS are convertible into equity shares at a price linked to a formula within a period not exceeding ten years from the date of issue or transfer. In that case, such a formula shall be applied on the date of issue or transfer to determine the FMV of CCPS.

Suppose CCPS are convertible into equity shares at a price to be determined on the date of conversion within a period not exceeding ten years from the date of issue or transfer. In that case, the FMV of CCPS shall be determined by any of the five methods mentioned above as on the date of issue or transfer.

The CBDT has also provided a safe harbour of 10% variation in value. This means that if the FMV of unquoted shares determined by any of the five methods mentioned above does not exceed 110% of the consideration received or accruing as a result of the transfer of such shares, then such consideration shall be deemed to be the FMV of such shares for the purpose of section 56(2)(viib) of the Act.

New Rules of CBDT

The CBDT has opened the floor for public input on draft rule 11UA, which is aimed at implementing the changes brought about by the Finance Act 2023.

Previously, under section 56(2)(viib) of the Income-tax Act, 1961, if a company not publicly substantially interested received consideration for issuing shares from a resident individual that exceeded the fair market value of those shares, it would be subject to income tax under ‘Income from other sources.’ Rule 11UA of the Income-tax Rules, 1962, outlined the method for calculating the fair market value of unquoted equity shares.

However, the Finance Act of 2023 amended this provision to include consideration received from non-residents under the scope of section 56(2)(viib) of the Income-tax Act, 1961.

As a result of this amendment, concerns were raised by various stakeholders who felt that legitimate non-resident investors might face undue challenges related to share valuation and more. An amendment to rule 11UA of the Rules is being proposed to address these concerns.

The advantages and disadvantages of the changes made by CBDT to Rule 11UA

The changes made by CBDT to Rule 11UA have several advantages and disadvantages for the valuation of shares issued by unlisted companies. Some of them are as follows:

• Expanding the valuation methodologies to include globally accepted methodologies and provide a broad parity to resident and non-resident investors is a welcome step that will enhance the flexibility and reliability of valuation and reduce the scope for disputes and litigation. The new methods align more with the market realities and reflect the potential and risk profile of unlisted companies, especially startups. The price matching provision will also ensure that resident investors are not discriminated against or penalized for investing in unlisted companies at a fair price.
• The reduction of tax burden and compliance cost for startups and investors is another positive outcome of the changes made by CBDT to Rule 11UA. Introducing the safe harbour provision will provide a cushion for minor variations in valuation and avoid unnecessary tax implications for unlisted companies and their shareholders. Relaxing the requirement to obtain a valuation report from a registered valuer for CCPS will also ease the compliance burden for unlisted companies issuing such shares.
• The potential challenges and limitations of applying the new methods in practice are some drawbacks of the changes made by CBDT to Rule 11UA. The new methods may involve complex calculations, assumptions, and judgments that vary from case to case and may not be easily verifiable or acceptable by the tax authorities. The availability and quality of data, such as comparable companies, market prices, expected cash flows, probabilities, volatility, etc., may also pose difficulties in applying the new methods accurately and consistently. The market volatility and uncertainty due to factors such as the COVID-19 pandemic, economic slowdown, policy changes, etc., may also affect the valuation outcomes and create discrepancies between different methods.
• The possible impact on the valuation ecosystem and market dynamics in India is another aspect that needs to be considered while evaluating the changes made by CBDT to Rule 11UA. The new methods may have implications for stakeholders, such as unlisted companies, investors, merchant bankers, valuers, auditors, regulators, etc., who are involved in or affected by valuation activities. The new methods may also influence the behaviour and expectations of unlisted companies and investors regarding pricing, negotiation, structuring, exit, etc., which may affect the overall growth and development of the startup ecosystem in India.

Conclusion

The changes made by CBDT to Rule 11UA are significant and far-reaching for the valuation of shares issued by unlisted companies. The changes aim to provide more flexibility and rationality in valuation methods and to reduce the tax burden and compliance cost for startups and investors. However, the changes also pose some challenges and limitations in applying the new methods in practice and may impact India’s valuation ecosystem and market dynamics. Therefore, it is important to understand the implications and consequences of the changes made by CBDT to Rule 11UA and to adopt a prudent and consistent approach to valuation activities. It is also advisable to seek professional guidance and assistance from experts in valuation matters. Some areas for further research on this topic are:

• A comparative analysis of the new methods’ applicability, suitability, reliability, validity, etc., for different unlisted companies.
• A case study or empirical analysis of the impact of the new methods on the valuation outcomes and tax implications for unlisted companies and their shareholders.
• A survey or feedback from various stakeholders on their perception and experience of the new methods and their suggestions for improvement or modification.

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