The ‘angel tax’ conundrum

The investor community, particularly those in the venture capital and private equity space, are in a bit of disbelief on account of the recent budget announcement that proposes to amend Section 56(2)(viib) of the Income-tax Act, 1961 (“the Act”). Hitherto applicable to resident investment in ‘closely-held’ companies (typically private limited companies), any share premium over and above fair market value (FMV) of shares issued is taxable in the hands of the Indian company, issuing the shares. Certain exceptions have been carved out in the legislation, such as investment by registered venture capital funds, category I or II Alternative Investment Funds, and investment received by registered start-ups, venture capital undertakings etc.

Back in the day, when Section 56(2)(viib) or ‘angel tax’ provisions as it is (un)popularly known, were introduced, the intension was to check unaccounted black money, when resident investors infused capital at a significant premium into private companies. However, it appears that the proposed amendment also goes beyond the original purpose behind the introduction of the provisions in 2012, since subscription to shares by non-residents will only come though banking channels, with appropriate KYC checks in place on the investor. Interestingly, recently, some foreign investors including foreign funds have been asked to provide details of their ‘source’ of investment, through questions raised on investee companies under Section 68 of the Act. Perhaps the proposed amendment is an extension of this practice, which essentially seeks to question investment into Indian entities. Unfortunately, the proposed amendment is likely to have some impact on the structuring of investment into India.

The FEMA and tax (t)angle

Since India is amongst the ‘Article 14 countries’ that have foreign exchange regulations, any foreign investment into India must reckon with the Foreign Exchange Management Act (FEMA). Per the FEM (Non-debt Instruments) rules, a non-resident investor may invest into India at any value, which is equal to or higher than the fair market value. FMV in this case may be determined as per any internationally acceptable pricing guidelines, though the discounted cash flow (“DCF”) method has been the preferred valuation methodology. Given that the foreign exchange laws only prescribe a minimum value, foreign investors typically subscribed at higher values as well. The proposed amendment would, at the outset mean that investment by non-residents will also require a valuation report for tax purposes, hitherto only required for FEMA purposes.

Foreign investors have been subscribing to shares at more than FMV, allowing for a buffer, to allow for appropriate conversion formulae, considering various commercial considerations. With the proposed amendment, this arrangement is faced with a challenge. While foreign exchange laws require that the issuance cannot be at a value less than FMV, any value above FMV will invite tax implications for the issuing company. It must be noted that as per the existing valuation rules for Section 56(2)(viib), two valuation methodologies exist for equity shares i.e., net asset value method or DCF method. However, for preference shares, the FMV shall be ‘the price such preference shares would fetch if sold in the open market (based on report obtained from merchant banker)’. It is pertinent to note that merchant bankers normally follow the DCF method for valuing preference shares also. Since DCF is also popularly adopted for foreign exchange regulations purposes, one could surmise that as a result of the proposed amendment, an issuance of shares to a non-resident can only be undertaken AT FMV, if tax implications on the investee company are to be avoided. Typically, non-resident investors however subscribe to the shares of an Indian company at a higher value than FMV, mostly to obtain various value protection and economic rights (such as anti-dilution or liquidation preference by way of adjusting the conversion ratio and conversion price of such convertible security). However, the proposed amendment will result in adverse tax consequences, if shares were to be issued at more than FMV. Therefore, the proposed tax changes are likely to raise a lot of commercial issues such as non-availability of value protection and economic rights, potentially resulting in dilution of ownership in the Indian company at a future date, and if not, adverse tax consequences for the investee.

The valuation game

Now, one of the main questions that arise is whether tax authorities will start questioning the valuations, even after it has been accepted by the Reserve Bank of India under the foreign exchange laws. As is their wont, the Indian tax authorities have time and again questioned valuations undertaken by taxpayers. This will create unnecessary hassles for the investee company, including potential cash flow issues, if the tax authorities challenge the valuation and slap high pitched tax demands on the company. It is pertinent to note that jurisprudence on the valuation aspects recognise that although the tax authorities cannot change the method of valuation adopted by taxpayer, they do have the power to scrutinize the valuation report by challenging the underlying assumptions,[1] thereby potentially resulting in tax authorities questioning the valuations relied on by the taxpayers, including resulting in tax outflow. Accordingly, it is pertinent that the unbridled powers of the Indian tax authorities to question valuations also be checked, particularly for non-resident share subscriptions.

The ‘registered’ start-up

As far as start-ups go, the finance minister and chairman of the Central Board of Direct Taxes have clarified that since start-ups, which are registered with the Department for Promotion of Industry and Internal Trade (DPIIT), the rigours of S.56(2)(viib) will not impact investment into India. In fact, based on publicly available information, only around ninety-one thousand companies are registered with the DPIIT, which means that all other private companies in India that seek foreign investment, will essentially be required to comply with the tax valuation requirements. This will indeed be a tight rope walk to balance both tax and FEMA valuation requirements. Moreover, the DPIIT recognition itself is fraught with various conditionalities, which inter alia include those linked to maximum turnover, maximum paid up capital, restrictions on investments in various assets by the company, etc. These conditions are likely to therefore adversely impact the number of start-ups that can even avail of the exemption.

A case of ‘presumptuous’ taxation

The finance ministry’s position also wrongly assumes that only start-up entities avail foreign infusions in India. The reality is that a multitude of other private companies too avail of foreign investment through primary infusion.

A question could also arise whether transfer pricing implications would arise in the case of issuance of shares to associated enterprises. At the outset, it is pertinent to note that the  Bombay High Court in the case of Vodafone India Services Private Limited (WP No.1877 of 2013) had held that no income arises in case of issuance of shares, being a capital account transaction and therefore, transfer pricing provisions will not apply on issuance of shares. Since all share issuances at a premium by closely-held companies are proposed to be covered within the ambit of S.56(2)(viib), one can reasonably assume that henceforth, transfer pricing provisions will apply in case of issuances to non-resident associated enterprises. The second question, which may arise would be with respect to the valuation methodology to treat the issuance at arm’s length as per Indian transfer pricing regulations. It is hoped that the transfer pricing officer will not challenge the price of shares issued as per valuation determined under relevant tax rules and accept such valuation as being at ‘arm’s length’. It goes without saying that the adjunct reporting and documentation as per transfer pricing will have to be undertaken by the Indian company.

Another key aspect that rears its head is the trigger of Section 68. The said section, being an anti-tax avoidance measure, requires the taxpayer to explain the nature and source of any sum found credited in the books of account (which includes share application money, share capital, and share premium). It is pertinent to note that where the taxpayer fails to satisfy the tax officer with his explanation, the tax officer may proceed to treat such sum as unexplained cash credit and tax the same at the higher rate of 60%, which shall be further increased by surcharge of 25% and cess of 4% resulting in effective tax rate of ~78% (excluding potential 10% penalty). However, in case of Section 56(2)(viib), at least the tax rate would be a normal tax rate (i.e. 25.17% assuming the company has opted for beneficial corporate tax regime under section 115BAA). The issue which may arise is whether the provisions of Section 56(2)(viib) and Section 68 can operate simultaneously. If yes, which provision would be invoked over the other, given differential tax rates. Thus, the hapless taxpayer may be entirely left to the mercies of a tax officer!

What’s the solution?

If Section 56(2)(viib) continues in the tax statute, one wonders whether non-residents will now prefer convertible debt instruments, when it comes to investing into India, since Section 56 (2)(viib) applies only to shares and not debt instruments. However, issuance of convertible debt instruments is also not entirely free from concerns, since the provisions of section 56(2)(viib) may be triggered subsequently, at the time of conversion of the debt instrument into equity shares. Based on existing jurisprudence on the matter, the conversion ratio, and consequential valuation, may also be required to be justified at the time of such conversion. Indeed, a limited liability partnership seems to be best equipped to beat the rigours of Section 56(2)(viib) in its entirety.

Perhaps a few investors may set up fund structures in India that are exempt from the rigours of Section 56(2)(viib). Of course, this may also require the investee entity to have strong bargaining power to convince a non-resident investor to register as a category I or II AIF, since the tax liability will be on the investee entity only, and not on the investor. Risk averse foreign investors may continue to prefer externalised structures, in which case, the vision in the Economic Survey, 2023 that ‘flipped’ company structures undertake a reverse flip to reside in India, may not be easily achieved.

Alternatively, in order to mitigate this issue, the Government ought to provide a tolerance band (say in the range of 10% to 15%) wherein the shares can be issued to non-resident investors at a price higher than FMV, but within the prescribed tolerance limits. Similar tolerance bands are available under Section 50C and Section 43CA of the Act.

In any case, the non-resident ‘angel tax’ provision is ill-conceived, particularly in a scenario where India is looking to attract more foreign investment. Ideally, one hopes that the provision gets scrapped by the time the Finance Bill, 2023 receives presidential asset, at least in the interest of free flow of capital across the globe!

Authored by: Shruti KP (Partner) and Gaurav Goyal (Senior Associate)

[1] Town Essential (P.) Ltd. v. CIT(A)-7 Bengaluru [2021] 130 taxmann.com 263 (Bangalore – Trib.)