The recent amendments made to Section 56(2) (vii b) of the Income Tax Act, 1961, could be a cause of worry for foreign investors.
The tax which is popularly known as angel tax has been amended to include investments from foreign investors in Indian closely-held companies.
The angel tax is not a new provision and has been in existence in income tax law since April 1, 2013.
The objective of introducing the tax was to curb use of unaccounted money being infused in closely-held companies by subscribing to shares at a value higher than the fair market value of shares, thereby escaping the tax net.
What’s brought it to limelight is the 2023 Union Budget that proposed amendments to it.
First things first. Angel tax is charged in the hands of Indian closely held company as ‘Income from Other Sources’ when it issues shares at a price which exceeds the ‘fair market value’ of shares issued.
However, from April 1, 2023, share issue to foreign investors has been brought within its ambit. It is anyone’s guess that this will have a huge impact on inbound investments into India.
Until April 1, 2023 it applied when investments were received from domestic investors.
The valuation norm prescribed to value equity shares were adjusted Net Asset Value method, or Discounted Free Cash Flow method and higher of the two valuations can be opted as fair market value.
Further, companies could also substantiate the value of the shares before the Income Tax Authorities, based on the value of its assets, including intangible assets (such as goodwill, know-how, patents, licenses, franchise rights, etc).
Although in the new regime, angel tax will also apply to investments received from foreign investors but it does not give the same treatment for domestic and foreign investments. The exemptions and proposed rules for valuation are not the same for domestic and foreign investors.
Every investment will not be charged to angel tax, as certain relaxations are provided, such as
Investments received by eligible start-ups from non-resident investors. Until now, it was limited only to investments received from resident investors.
- Three classes of foreign investors are exempted:
- Government related investors including central banks, sovereign wealth funds, international or multilateral organizations;
- Banks or entities in the insurance business;
- Four categories of entities that are residents of specified countries, these are
- SEBI Registered category-I FPIs;
- Certain categories of Endowment and Pension funds;
- Broad-based pooled funds with 50 or more investor which are not hedge fund or a fund which employs diverse or complex trading strategies.
The specified countries include Australia, Germany, Japan, Korea, UK, and USA amongst others. Mauritius, Singapore and the Netherlands, from where substantial foreign investments are received in India, have been excluded.
Foreign investors are also allowed to value shares using Comparable Company Multiple Method; Probability Weighted Expected Return Method; Options Pricing Method, Milestone Analysis Method and Replacement Cost Methods.
Safe harbour provisions permit subscription price of shares within a range of 10% of the fair market value. A concept of price matching has been introduced. Where the investment is received from an AIF, the subscription price is considered as the fair market value for the other investors as well.
A similar price-matching benefit is proposed for investments received from the exempted class of foreign investors as mentioned earlier. This price-matching benefit will be provided only to the extent of consideration that will be received from these types of investors.
Elaborate valuation mechanism has been provided allowing flexibility in choosing a valuation method.
These new valuation rules are applicable only in respect to unlisted equity shares. For preference shares, the existing provisions would continue.
The current valuation norm considers the price of preference shares to be an amount that it would fetch if sold in the open market on the valuation date as its fair market value.
Now coming to the challenges posed by this new rule, since this is a new proposal there are already many ambiguities that need further consideration.
To take a few examples –
- The safe harbor and price matching benefit are not made available for preference shares which as we all know are the preferred instruments for foreign investors like PE and VC funds. The 10% safe harbor may not be sufficient given certain commercial and legal rights which are usually sought by such investors, such as anti-dilution, and adjustment of conversion ratio based any corporate action by investee company. Ideally, this could have a higher limit, say about 20-25%.
- Investors from popular jurisdictions like the Netherlands, Singapore, Mauritius, and Cyprus are not exempted.
- Specific condition of having more than 50 investors for broad-based funds could make it difficult for the feeder funds used for investments in India
- There are few other interpretational issues in the language of proposed rules which we hope would get addressed in the final rules.
Angel tax is one subject where issues refuse to settle. No doubt, this is a big development and will require deeper analysis as we go along. We can only hope that concerns will be addressed, and clarity will soon emerge.
The authors are Partners with J. Sagar Associates
• Kumarmanglam Vijay is a Partner & Head of Practice – Direct Tax
• Lalit Kumar, Partner – Corporate & M&A
(Views are personal)
