The issue of securities by private companies is one of the most significant mechanisms for raising funds. With growing entrepreneurship, especially in the start‑up ecosystem, issuing shares at a premium has become common. However, the government introduced safeguards in the Income Tax Act to ensure that such premiums are justified and not misused for routing unaccounted money. Section 56(2)(viib), often referred to as the angel tax provision, stands at the center of this regulatory framework.
We explore the legislative background, scope of applicability, valuation rules under Rule 11UA, exemptions, judicial interpretations, and compliance requirements that businesses must follow when issuing shares.
Legislative Background of Angel Tax
Rationale for Introduction
Section 56(2)(viib) was introduced by the Finance Act, 2012 with the intention of curbing the misuse of share premium as a conduit for tax evasion. Companies, especially closely held ones, were issuing shares at abnormally high premiums without economic justification. The excess received could then be siphoned off without being taxed. By taxing the excess over fair market value as income from other sources, the government ensured accountability in fund‑raising.
Expansion through Finance Act 2023
Initially, this provision applied only where consideration was received from a resident investor. However, with effect from April 2024, non‑resident investors also fall within its ambit. This expansion significantly broadens the reach of angel tax and affects foreign direct investment, which has been a key source of capital for Indian start‑ups.
Scope and Applicability of Section 56(2)(viib)
Companies Covered
The provision applies to companies in which the public is not substantially interested. These are essentially private limited companies and closely held entities. Public companies and those listed on a recognized stock exchange are excluded.
Trigger for Taxation
Taxation under this section is triggered when shares are issued at a premium exceeding their fair market value. The three possible outcomes are:
- Shares issued at face value: No angel tax.
- Shares issued between face value and fair market value: No angel tax.
- Shares issued above fair market value: Excess portion is taxable.
Tax Treatment
The excess is taxed as income from other sources in the hands of the issuing company. Since it is deemed income, it does not matter whether the company treats it as capital receipt. For taxation purposes, the law considers it income arising out of overvaluation.
Determination of Fair Market Value
Rule 11UA Prescriptions
Fair market value of unquoted shares must be determined under Rule 11UA of the Income Tax Rules. The rule prescribes different methods depending on whether the investment is from residents or non‑residents. Companies may choose from available methods, and once selected, the Assessing Officer cannot compel a different one.
Valuation for Resident Investors
For resident investors, three options exist:
- Net Asset Value method
- Discounted Cash Flow method
- Price matching with investment by venture capital funds, venture capital companies, or specified funds within 90 days
The Net Asset Value method evaluates the company’s balance sheet strength by calculating assets minus liabilities, proportionately divided by total equity. This method is simple but not always reflective of growth potential.
The Discounted Cash Flow method values the business based on projected free cash flows discounted at a rate reflecting risk and time. This approach captures future earning potential, making it suitable for start‑ups and innovative companies. Certification by a merchant banker is required. Price matching allows companies to adopt the valuation at which a venture capital entity or notified investor invests, provided the transaction occurs within 90 days of share issuance.
Valuation for Non‑Resident Investors
Non‑resident investors may adopt a wider range of internationally recognized methods in addition to Net Asset Value and Discounted Cash Flow. These include:
- Comparable Company Multiple Method
- Probability Weighted Expected Return Method
- Option Pricing Method
- Milestone Analysis Method
- Replacement Cost Method
- Price matching with investments by specified funds or notified investors
These methods allow flexibility in complex scenarios. For instance, the Comparable Company Multiple Method benchmarks valuation against listed peers. The Probability Weighted Expected Return Method considers multiple exit outcomes such as IPO or acquisition. The Option Pricing Method suits layered capital structures. The Milestone Analysis Method ties valuation to achieving predefined goals. The Replacement Cost Method values the enterprise based on replicating assets and operations.
Timing of Valuation
The valuation report must be prepared within 90 days preceding the issue of shares. This ensures that valuation is contemporaneous and reflects current financial and market conditions. The 90‑day window also facilitates price matching with institutional investors.
Exemptions from Angel Tax
Venture Capital Companies and Funds
Investments by venture capital companies, venture capital funds, or Category I and II alternative investment funds registered with SEBI or IFSC are outside the scope of angel tax. Since these entities are regulated and subject to stringent disclosure requirements, the possibility of misuse is limited.
DPIIT Recognised Start‑ups
Start‑ups recognized by the Department for Promotion of Industry and Internal Trade enjoy significant relief. Such start‑ups are exempt from angel tax if their paid‑up share capital and premium after the issue does not exceed ₹25 crore. Investments from non‑residents, venture capital entities, and specified funds are excluded from this limit.
To retain exemption, start‑ups must not invest in restricted assets such as immovable property not used in business, shares and securities, loans and advances, luxury cars costing above ₹10 lakh, or jewellery. The restriction applies for seven years from the end of the financial year in which the shares were issued.
Notified Investors
Certain categories of investors have been specifically notified as exempt. These include:
- Sovereign wealth funds, central banks, and entities with at least 75 percent government ownership
- Banks and insurance companies regulated in their home jurisdiction
- SEBI Category I foreign portfolio investors
- Endowment funds, pension funds, and broad‑based pooled investment vehicles that are not hedge funds
Additionally, investors from approved jurisdictions such as the US, UK, Germany, France, Japan, and Australia may qualify if they belong to these categories.
Judicial Principles Governing Valuation
Choice of Valuation Method
Judicial precedents affirm that the assessee is free to choose between the prescribed methods under Rule 11UA. Once a method is chosen, the Assessing Officer cannot arbitrarily reject it or substitute another method. However, the officer may examine whether assumptions and projections used are reasonable.
Valuation Date Principle
Only information available on the valuation date can be considered. Courts have held that hindsight, such as later underperformance of the company, cannot be used to challenge valuation made earlier in good faith.
Burden of Proof on Assessee
The company must demonstrate the correctness of valuation with supporting data, market benchmarks, and industry reports. If the company can substantiate projections and assumptions, the valuation is generally upheld.
Compliance Requirements and Overlaps
Income Tax Implications
If shares are issued above fair market value without meeting exemption conditions, the excess is taxable in the hands of the issuing company. This amount is treated as income from other sources. Additionally, the excess may be classified as under‑reported income under Section 270A, attracting penalties.
Overlap with Companies Act
Under the Companies Act, shares must be issued at not less than fair value, certified by a registered valuer. The requirement ensures protection of minority shareholders and fair disclosure to investors. Thus, compliance under corporate law aligns with the intent of income tax provisions.
Overlap with FEMA
Where foreign investment is involved, the Foreign Exchange Management Act requires that shares be issued at or above fair value, certified by a chartered accountant, cost accountant, or merchant banker. This condition ensures that foreign capital is infused at justifiable valuations.
Conversion of Instruments
A grey area exists regarding conversion of compulsorily convertible preference shares or debentures into equity. One view is that valuation at the time of initial issuance should suffice, as conversion merely changes form. Another view is that conversion results in a fresh issue of equity requiring fresh valuation. In practice, companies often obtain new valuation reports at the time of conversion to mitigate risk.
Exemptions for Notified Investors
Rationale for Carving Out Exemptions
The core intent of angel tax is to deter artificial overvaluation used for laundering capital. Where investments come from regulated or government‑backed institutions, the probability of misuse is significantly lower. Recognizing this, the government notified categories of investors whose investments are automatically protected from angel tax provisions.
Sovereign and Government Entities
Investments made directly or indirectly by governments, sovereign wealth funds, central banks, and entities with at least 75 percent government ownership are fully exempt. Sovereign funds typically pursue long‑term strategic investment objectives rather than speculative valuations. Their scrutiny levels and compliance frameworks minimize risk of abuse.
Regulated Banks and Insurance Companies
Banks and insurance companies that are regulated in their home jurisdictions are also exempt. Since these institutions operate under strict prudential norms, their participation in share issuances is unlikely to be for tax evasion.
SEBI Category I Foreign Portfolio Investors
Foreign portfolio investors categorized as Category I by SEBI enjoy exemption. These include entities regulated in their home jurisdiction such as government agencies, pension funds, and other broad‑based investment vehicles. Category I FPIs are subject to high levels of disclosure and transparency, making them reliable investors.
Endowment Funds and Pension Funds
Endowment funds associated with universities, charitable foundations, and pension funds for employees are exempt as well. These funds operate with fiduciary responsibility and invest primarily to meet long‑term obligations rather than engage in aggressive arbitrage.
Broad‑based Investment Vehicles
Broad‑based pooled investment vehicles that are not hedge funds are also notified. The government differentiates hedge funds given their speculative character and risk appetite, which could undermine the purpose of the exemption.
Exemption for DPIIT Recognised Start‑ups
Policy Objective
India’s start‑up ecosystem has grown exponentially in the last decade, and to fuel this growth, the government recognized the need to shield genuine start‑ups from angel tax. Section 56(2)(viib) initially created significant concern because start‑ups often raise funds at high valuations justified by growth potential rather than present net assets. To address this, an exemption mechanism was introduced through notifications and guidelines.
Recognition Requirement
A company must be recognized as a start‑up by the Department for Promotion of Industry and Internal Trade to claim exemption. Recognition is granted if the company is incorporated as a private limited company or limited liability partnership, has been in existence for less than ten years, and has turnover not exceeding the prescribed threshold. Additionally, it must be working towards innovation, development, deployment, or commercialization of new products or services.
Threshold of Paid‑up Capital and Premium
The combined value of paid‑up share capital and premium after the issue must not exceed ₹25 crore to remain exempt. In computing this limit, shares held by non‑residents, venture capital companies, venture capital funds, and specified funds are excluded. This ensures that foreign and institutional capital does not disadvantage the start‑up.
Restricted Asset Conditions
The exemption carries conditions on deployment of funds. The company must not invest in restricted assets such as:
- Immovable property not used in the business
- Shares and securities other than those required for business operations
- Loans and advances unrelated to business activities
- Motor vehicles valued above ₹10 lakh unless used for official purposes
- Jewellery and other luxury assets
These restrictions apply for seven years from the end of the financial year in which shares were issued at a premium. If the company breaches these conditions, the exemption may be withdrawn, and the angel tax provisions could apply retrospectively.
Operational Impact
This framework ensures that capital raised at premium is utilized for genuine business expansion rather than diverted into passive or speculative assets. By aligning tax incentives with operational discipline, the exemption seeks to channel investor funds into innovation and growth.
Notified Jurisdictions and Investors
Geographical Scope
In addition to investor categories, the government has specified certain jurisdictions from which investment is considered safe. These include developed economies such as the United States, United Kingdom, France, Germany, Japan, and Australia. Investors falling into the exempt categories and hailing from these countries are automatically protected from angel tax.
Implications for Foreign Investment
This measure reduces friction for foreign direct investment. For instance, a pension fund in the United States investing in Indian equity shares will not trigger Section 56(2)(viib). Similarly, a sovereign wealth fund in Japan will also enjoy exemption. This builds confidence among international investors while maintaining safeguards against lesser‑regulated jurisdictions.
Valuation Approaches under Rule 11UA
Approaches for Resident Investors
For resident investors, the rule permits two main valuation methods and a price matching option.
- The Net Asset Value method calculates the book value of assets minus liabilities. It is straightforward but often undervalues growth companies.
- The Discounted Cash Flow method estimates future free cash flows and discounts them to present value. This method, certified by a merchant banker, is widely preferred for start‑ups.
- The price matching option allows adopting the valuation at which venture capital funds or other specified funds invest within 90 days, reducing disputes with the tax authorities.
Approaches for Non‑Resident Investors
Non‑resident investors can adopt additional international valuation standards, providing greater flexibility.
- The Comparable Company Multiple method compares the company with listed peers using valuation multiples such as EBITDA or revenue.
- The Probability Weighted Expected Return method assigns probabilities to different exit scenarios like IPO, acquisition, or continuation.
- The Option Pricing Method values shares based on rights and preferences across multiple classes of securities, particularly useful in layered capital structures.
- The Milestone Analysis Method links valuation to achieving defined goals such as regulatory approval or revenue targets.
- The Replacement Cost Method calculates the cost of replicating the business operations and assets.
Price Matching
As with resident investors, the price at which venture capital entities, specified funds, or notified investors invest can be adopted as fair value, provided it occurs within 90 days. This avoids the need for complex independent valuation in certain cases.
Importance of Flexibility
By allowing multiple methods, especially for foreign investment, the government recognizes the dynamic nature of valuation. Start‑ups and private companies may have intangible assets, intellectual property, or unique market positions that balance sheet‑based valuation cannot capture. International investors are accustomed to advanced models like OPM and PWERM, and permitting these methods aligns Indian rules with global standards.
Judicial Principles on Valuation and Exemptions
Limits of Assessing Officer’s Powers
Judicial pronouncements establish that while the Assessing Officer may scrutinize assumptions in valuation reports, they cannot substitute one method for another. The choice of method rests with the assessee as long as it falls within Rule 11UA.
Role of Contemporaneous Data
Courts emphasize that valuation should rely on data available at the time of issue. For example, a company valued on growth projections cannot be penalized later simply because actual results fell short. Such hindsight challenges would stifle fund‑raising.
Burden of Proof
The onus is on the company to demonstrate the reasonableness of its valuation. Projections must be supported by industry reports, comparable companies, and empirical data. If supported adequately, courts have upheld such valuations even when they appear aggressive.
Overlap with Other Regulatory Regimes
Companies Act Requirements
Under the Companies Act, shares must be issued at or above fair value as determined by a registered valuer. This ensures fairness to all shareholders and prevents dilution at unjustified valuations. The requirement aligns closely with income tax rules, though the definition of fair value may vary.
FEMA Requirements
When foreign investors subscribe to shares, the Foreign Exchange Management Act requires an issue at not less than fair value certified by a chartered accountant, cost accountant, or merchant banker. The compliance ensures that India does not receive foreign investment at undervalued prices that could lead to capital flight later.
Alignment Challenges
While the objectives of these laws align, companies often face compliance challenges when definitions of fair value differ. A valuation accepted under FEMA may still face scrutiny under income tax if projections are questioned. This makes comprehensive and well‑documented valuation reports critical.
Section 68 – Unexplained Cash Credits
Nature of Section 68
Section 68 empowers the tax authorities to treat unexplained amounts credited in the books of a company as taxable income. If any sum is found in the records without a satisfactory explanation of its source, identity, and creditworthiness, it is deemed to be income for that year.
When applied to securities issuance, Section 68 covers situations where companies issue shares or debentures and receive consideration from investors whose background or financial standing cannot be substantiated.
Burden of Proof
The primary burden lies on the company to prove three critical elements:
- Identity of the investor
- Creditworthiness of the investor
- Genuineness of the transaction
Failure to establish any of these can result in the amount being taxed as income. Even if the company provides initial evidence, the Assessing Officer can conduct deeper enquiries into the investor’s financial capacity.
Judicial Interpretation
Courts have consistently upheld that mere filing of incorporation documents or permanent account numbers of investors is insufficient. The company must show that the investor had adequate financial strength to invest. In the context of private placements, tax authorities scrutinize the transaction closely, particularly when large premiums are charged.
Interaction with Section 56(2)(viib)
Section 68 focuses on unexplained credit, while Section 56(2)(viib) targets excess premium over fair value. Both can apply simultaneously. For instance, if a company issues shares at an unjustified premium to an investor whose identity is doubtful, the entire sum can be taxed under Section 68, while the excess premium over fair market value can be taxed under Section 56(2)(viib).
Transfer Pricing Implications
Relevance to Securities Issuance
Transfer pricing provisions under Section 92 and related rules apply when there are international transactions between associated enterprises. If an Indian company issues shares to a foreign associated enterprise, the transaction must adhere to the arm’s length principle.
Share Issuance as International Transaction
There has been debate over whether fresh issuance of shares constitutes an international transaction. Judicial precedents initially held that issuance of shares does not result in income and therefore cannot attract transfer pricing. However, subsequent amendments clarified that certain capital financing arrangements, including issue of shares, loans, or guarantees, may fall within the ambit of transfer pricing if they result in shifting of profits.
Valuation Standards for Transfer Pricing
For share issuances, arm’s length price is determined using methodologies such as Discounted Cash Flow, Comparable Uncontrolled Price, or other internationally accepted models. The valuation should be documented in a transfer pricing report certified by an accountant.
Interaction with FEMA and Income Tax
Foreign investment regulations under FEMA also require issue of shares at or above fair value. If shares are issued at a value lower than arm’s length price, tax authorities may allege that the company shifted profits abroad by undervaluing securities. Conversely, if shares are issued at an inflated value to an associated enterprise, the issue may trigger Section 56(2)(viib).
Anti‑Abuse Provisions – Section 56(2)(x)
Scope of Section 56(2)(x)
While Section 56(2)(viib) applies to the issuing company, Section 56(2)(x) applies to the recipient of property, including shares or securities, for inadequate or no consideration. If the difference between fair value and consideration exceeds fifty thousand rupees, the excess is taxed as income in the hands of the recipient.
Application to Securities
If an investor receives shares at a price lower than fair market value, the differential can be taxed as income. For example, if an investor acquires shares worth one crore at only sixty lakh, the forty lakh difference is taxable.
Rationale for Dual Provisions
Section 56(2)(viib) and Section 56(2)(x) work together to cover both sides of a transaction. While one ensures that issuers do not raise funds at inflated valuations, the other ensures that recipients do not acquire assets below market value. Together, they form a comprehensive anti‑abuse mechanism.
Exceptions
Certain transactions are excluded from Section 56(2)(x). Transfers between relatives, mergers, demergers, and other specified restructurings are outside its scope. Similarly, transactions approved by regulatory authorities or undertaken in compliance with specific laws are often protected.
Double Taxation Avoidance Agreements (DTAA)
Role of DTAA
When cross‑border transactions are involved, Double Taxation Avoidance Agreements determine which country has taxing rights. Section 90 of the Income Tax Act allows taxpayers to apply treaty provisions if they are more beneficial than domestic law.
Classification of Income
Income arising under Section 56(2)(x) is usually classified under the Other Income article in DTAAs. Depending on the treaty, taxing rights may rest exclusively with the resident country of the investor or be shared between both states.
Impact on Angel Tax for Non‑Residents
With the Finance Act 2023 extending Section 56(2)(viib) to non‑residents, treaty protection has become more important. Non‑residents may argue that amounts taxed under angel tax provisions are not income under treaty definitions and therefore should not be taxed in India. Litigation in this area is expected to rise.
Examples of Treaty Application
- Under the India‑United States treaty, other income is taxable only in the country of residence of the recipient unless attributable to a permanent establishment in India.
- Under the India‑Singapore treaty, other income may be taxed in both countries, but credit is allowed for taxes paid in India.
Such variations make it necessary to examine each treaty separately.
Interplay of Multiple Provisions
Simultaneous Application
In practice, multiple provisions can apply to a single securities issuance. For example, if an Indian company issues shares to a foreign associated enterprise at a premium:
- Section 56(2)(viib) may tax excess premium over fair market value
- Section 68 may apply if the identity or creditworthiness of the investor is doubtful
- Transfer pricing rules may require justification of the valuation as arm’s length
- Section 56(2)(x) may apply if the investor acquires shares below market value
Compliance Challenges
Companies must navigate this complex framework by preparing detailed valuation reports, maintaining investor documentation, and ensuring compliance with FEMA and Companies Act requirements. Inadequate compliance not only leads to tax liabilities but also penalties under Section 270A for under‑reporting of income.
Judicial Principles on Overlapping Provisions
Substance Over Form
Courts emphasize examining the substance of transactions rather than their form. If securities issuance is found to be a means of tax evasion, exemptions and structures may not hold. Conversely, if the company demonstrates genuine business need and valuation methodology, courts have upheld the legitimacy of such transactions.
Non‑interference in Valuation Method
As in Section 56(2)(viib), judicial pronouncements under transfer pricing confirm that the choice of valuation methodology lies with the taxpayer, provided it is an accepted method. Authorities cannot substitute one method for another but may question assumptions.
Relevance of Contemporaneous Evidence
Whether under Section 68, transfer pricing, or anti‑abuse provisions, contemporaneous documentation is vital. Courts reject retrospective justifications and stress that valuation must reflect the circumstances existing on the date of issuance.
Policy Trends and Future Outlook
Expanding Scope of Anti‑Abuse Rules
The steady expansion of provisions such as Section 56(2)(x) and the extension of angel tax to non‑residents reflect a policy trend towards tightening anti‑abuse measures. Authorities aim to prevent misuse of securities issuance as a means to route unaccounted funds or shift profits across borders.
Balancing Regulation with Investment Promotion
While anti‑abuse provisions are necessary, excessive uncertainty may discourage genuine investment. Recognizing this, the government has offered exemptions for start‑ups, institutional investors, and certain jurisdictions. Future reforms are likely to focus on reducing litigation by prescribing safe harbours and clarifying valuation tolerances.
Global Alignment
Permitting international valuation methodologies under Rule 11UA and recognizing treaty rights under DTAAs show India’s intent to align with global practices. As cross‑border capital flows increase, India will continue refining its rules to remain attractive for foreign investors while protecting revenue interests.
Conclusion
The issuance of securities in India is governed by a complex interplay of income tax provisions, regulatory frameworks, and international treaty obligations. Over the years, the law has evolved to address the misuse of inflated valuations, unexplained credits, and cross‑border profit shifting. Provisions such as Section 56(2)(viib), Section 68, transfer pricing regulations, and Section 56(2)(x) collectively aim to ensure that share issuances reflect genuine commercial intent and are not used as vehicles for tax avoidance or money laundering.
The introduction of Rule 11UA methodologies has brought greater objectivity to valuation, while judicial principles have reinforced the importance of contemporaneous documentation and taxpayer choice of method. At the same time, exemptions for start‑ups, notified investors, and specified funds demonstrate a conscious policy to balance anti‑abuse objectives with the need to promote investment and entrepreneurship.
For companies, compliance is no longer confined to a single statute. Valuation reports must withstand scrutiny not only under the Income Tax Act but also under the Companies Act and FEMA. Where non‑resident investors are involved, treaty protections and international methods of valuation add another layer of complexity. The overlap of domestic anti‑abuse provisions with global standards reflects India’s shift towards a more integrated and cautious approach to capital inflows.
The Finance Act 2023, which extended angel tax provisions to non‑residents, illustrates the forward direction of policy. While this may increase litigation, it also underscores the intent of tax authorities to plug loopholes in cross‑border investment structures. For businesses, the way forward lies in building robust compliance systems, maintaining transparent investor documentation, and ensuring alignment with both domestic and international rules.
Ultimately, the regulatory and tax framework governing securities issuance is not merely a deterrent but also a means of instilling confidence in capital markets. By curbing practices of excessive premium, unexplained credits, and undervaluation, the law safeguards investor interests and strengthens the credibility of India’s financial ecosystem. For genuine investors and enterprises, adherence to these provisions ensures not only legal compliance but also long‑term sustainability in an increasingly globalised financial environment.