The “angel tax” provided for under Section 56(2) (viib) of the Indian Income-tax Act, 1961, has, right from its introduction in 2013, evoked a mixed response and been the subject of much debate in recent years. The provision was introduced with an objective of preventing tax evasion and was one of the specific anti-avoidance rules made effective before a statutory general anti-avoidance rule came into effect from April 1, 2017. However, it has since been criticized for introducing uncertainty and impacting funding of Indian startups, as it is essentially seen as an undesirable tax on capital.
The provision requires Indian private companies to pay tax on the consideration received for issue of shares which is in excess of the fair market value of such shares. Until now, Indian private companies had to pay tax under Section 56(2)(viib) only where shares were issued at a premium to Indian resident investors. In accordance with the relevant provisions, fair market value for equity shares at the option of the taxpayer can be decided by prescribed valuation methods—based on net asset value, or by the discounted cash flow method.
The Finance Bill, 2023, introduced by the Indian finance minister, has now proposed an amendment to Section 56(2)(viib) whereby Indian private companies will have to pay tax in cases of shares issued at a premium even to nonresident investors. This means that investments made by nonresident investors can be subject to the angel tax if they are undertaken at a value above the fair market value. This amendment is proposed to be effective from April 1.
While certain exemptions from angel tax were provided—for example, to registered Indian startups subject to certain conditions, and to funds raised by Indian alternative investment funds—the proposed applicability of angel tax to both domestic and foreign investment is likely to have a significant impact on Indian private companies looking to raise funds for market growth and expansion. Given that foreign investment is an important source of funding for Indian startups, the applicability of angel tax may have a negative impact.
Heightened tax regulation and differing tax treatment of investment routes and instruments has an impact on taxpayers’ behavior and can encourage aggressive tax planning if there exists an arbitrage. The applicability of angel tax to foreign investment may encourage such behavior, which from a policy perspective may not be desirable. As investments made by Indian alternative investment funds aren’t subject to angel tax, many nonresident investors may seek to invest through such Indian funds, or may favor instruments other than equity shares to which this provision doesn’t apply, or even if it applies, which provide more flexibility in terms of valuation methodology. Further, this also could make debt instruments attractive for a nonresident investor, which from an overall tax base erosion perspective may not be aligned with tax policy.
The term “externalization” in the Indian context generally means transfer of ownership of an Indian company to an offshore holding company based in a foreign jurisdiction which may be considered as business- or tax-friendly. The proposed applicability of angel tax to foreign investments could lead to an increased number of Indian private companies and startups flipping their ownership to holding companies established in more favorable jurisdictions that don’t impose tax on capital receipts.
The transfer pricing regulations in India (and globally) require that international transactions between related entities/associated entities should be undertaken at arm’s length, in order to prevent profit shifting and base erosion of income and taxes. Transfer pricing regulations shouldn’t be applicable to capital account transactions or fund raises: However, in cases where the angel tax as contemplated under Section 56(2)(viib) becomes applicable in case of an offshore entity subscribing to shares of its Indian associated entity at a premium, this would mean that the amount of premium received by the Indian company would be taxable as “income from other sources,” leading to an inference that such related party transaction would also be subject to the Indian transfer pricing regulations.
If the proposed amendment to Section 56(2)(viib) is implemented, it may result in additional transfer pricing compliance requirements for Indian private companies raising capital from their offshore associated enterprises, and an increased risk of disputes with the tax authorities due to a lack of clarity as to what would constitute an arm’s length price in such a scenario.
It is likely that all fund raises would be subject to more scrutiny by the Indian tax authorities, especially startups with high valuations. As valuation isn’t an exact science, the risk of having a difference of opinion with regard to valuation of a business can never be ruled out. In the past there have been instances where the Indian tax authorities have challenged tax valuations. These provisions would also give a tax officer the ability to step into the shoes of an investor and question commercial decisions.
Availability of GAAR
In the Indian context, a statutory general anti-avoidance rule—GAAR—came into effect from April 1, 2017. The GAAR may be invoked by the tax department (subject to certain rules and guidelines) if they hold an arrangement to be an impermissible avoidance arrangement, which means an arrangement whose main purpose is to obtain a tax benefit. In a case where a GAAR is invoked, the tax officer has the discretion to determine the appropriate consequences. This may include re-characterization of a transaction. A GAAR provides the tax officers with the power to scrutinize transactions which may include fund raises by Indian private companies at high premiums. As the GAAR has inbuilt safeguards for a taxpayer, the relevance of having a parallel specific anti-avoidance rule like angel tax with lower safeguards, may need to be re-evaluated.
The proposal to include nonresident investors within the ambit of angel tax is likely to cause a re-think by various stakeholders around ways to raise capital. There is a genuine concern among startups and foreign investors around this proposal, since in certain circumstances it seems to limit their flexibility to value a business other than through the prescribed valuation methods. This proposal effectively fixes a ceiling price for issuance of equity shares to nonresident investors, when there could be other valuation methods or commercial considerations that the parties may want to use to value a business. In case of non-equity shares it may heighten the risk of scrutiny. Any proposal that aims to be prescriptive about the price in effect interferes with commercial decision making.
It is expected that the Indian government will consider some of these concerns to ensure that the provision is applied fairly and doesn’t unduly burden genuine investments in startups made by nonresident investors.
Given that there have been significant developments since this provision was introduced in 2013, with the GAAR being operationalized along with better information collection and sharing, and availability of technology including AI for selecting high risk transactions for scrutiny, there are good arguments to abolish the entire angel tax regime. As an interim measure, the government may introduce relaxations from angel tax for specific investment into startups and other Indian private companies by nonresident investors.