Long ago, the Indian legislature felt that the pernicious practice of masquerading unaccounted money as investment in the share capital of a private company needed to be prevented, as stated in the memorandum to the Finance Bill, 2012. Hence, through Finance Act 2012, two measures were brought into the Income-tax Act, 1961 (the IT Act), which required private companies to explain the source of the investment in the hands of the investor (Section 68) and ensure compliance with fair market valuation where investment (at a premium) is received from ‘resident’ shareholders (Section 56(2)(viib)).
As per Section 56(2)(viib), Indian private companies are subject to tax on the excess of an issue price received over the fair market value (FMV) of shares, where the shares are issued at a premium to ‘resident’ investors. This is colloquially referred to as ‘angel tax’. Thus, the angel tax provision stipulates a maximum price at which shares can be issued at a premium without attracting any adverse income tax implications in the hands of the investee company.
Non-resident investors have been kept out of the ambit of angel tax. This could be because angel tax was introduced as an anti-abuse provision to curb the generation and circulation of unaccounted money, and non-residents investing in India are already subject to extant regulations under the Foreign Exchange Management Act, 1999 (FEMA). Furthermore, the inclusion of non-resident investors within the scope of the section could have acted as a deterrent to foreign investments into India.
Also, the whole thrust for the insertion of angel tax is to tax an excessive share premium, which is not backed by a proper valuation. However, as per the FEMA guidelines, non-resident investors must be issued shares at a price not less than the value determined as per the method prescribed under the FEMA. Thus, the FEMA regulations stipulate a minimum price at which investment must be made by a non-resident investor.
Amendment by the Finance Act 2023
It is now provided that the angel tax provisions should be extended to non-resident investors with effect from financial year 2023–24.
However, any investment made by a resident or non-resident investor in an eligible start-up duly registered with the Department for Promotion of Industry and Internal Trade at the Ministry of Commerce and Industry will continue to enjoy an exemption from the angel tax provisions. The aggregate amount of paid-up share capital and the share premium of the start-up after the issuance or proposed issuance of shares, if any, cannot exceed INR 250 million (approximately $3 million) and the start-up must not have invested in certain assets.
Impact of the amendment
Seemingly, the applicability of angel tax provisions to non-resident investors will be a major setback to non-eligible start-ups, as non-resident investors are generally the main source of funds for start-ups. Besides, this may result in an increase in compliance costs.
Furthermore, adherence to FMV may pose challenges for taxpayers, especially when the methodology for calculating it under the IT Act and the FEMA may not be fully aligned. Taxpayers can choose the net asset value method or the discounted cash flow method for calculating FMV under the IT Act. On the other hand, the FEMA requires valuation as per any internationally accepted pricing methodology.
The adoption of two methods of valuation is likely to cause disputes, especially considering that the FMV is often subject to challenge by the tax authorities. Furthermore, with the information exchange between various authorities in India becoming more seamless, one may expect the tax authorities to raise more disputes on FMV by referring to valuation followed for FEMA purposes, and vice versa.
Another serious challenge is the applicability of transfer pricing provisions to foreign investments. Earlier, in the case of Vodafone India Services Pvt. Ltd (writ petition No. 871 of 2014), the Bombay High Court held that transfer pricing provisions will not be applicable on share capital issued at a premium to non-resident investors on the ground that it is a capital receipt not specifically made taxable under the IT Act. The decision was accepted by the tax authorities in India (Instruction No. 2 of 2015, dated January 29 2015).
However, the legislature has sought to overcome the effect of the judgment. Thus, where a non-resident investor qualifies as an associated enterprise (AE) of the Indian entity, then transfer pricing provisions can become applicable on funds raised from the AE. Section 92A of the IT Act provides a definition of an AE, which includes within its ambit any amount invested in shares that represents at least 26% of the voting power in the other enterprise.
Also, at present, there is uncertainty on whether the conversion of convertible instruments such as debentures or preference shares into equity shares at a premium will attract angel tax. Such a transaction is exempt from capital gains tax.
The Mumbai Income Tax Appellate Tribunal (ITAT), in Rankin Infrastructure Pvt Ltd. ((2022) 142 taxmann.com 37 (Mumbai Trib.)), held that angel tax will not apply on the conversion of optionally fully convertible debentures into non-cumulative preference shares as no consideration is received in the year of conversion.
On the other hand, the Kolkata ITAT, in Milk Mantra Dairy (P.) Ltd. ((2022) 140 taxmann.com 163 (Kolkata-Trib.)), held that the conversion of compulsory convertible debentures into equity shares will attract angel tax because receipt of a consideration cannot be restricted to a monetary consideration. The tribunal held that the taxpayer receives consideration in non-monetary form, such as the extinguishment of an obligation to repay debt and interest thereon, the release of charge on various properties, a widening of the capital base, mitigation of the risk of insolvency proceedings, and a favourable debt-to-equity ratio.
Moreover, investments from non-resident investors may be subject to angel tax twice:
At the time of issuance of convertible preference shares at a premium; and
At the time of conversion into equity shares at a premium.
Investments made by non-residents in convertible instruments before April 1 2023 may also be exposed to angel taxation if the conversion into equity shares takes place on or after April 1 2023.
Final thoughts
Considering the intricacies involved in the applicability of angel tax to non-resident investors, there is a need to assess the potential impact immediately and revisit the arrangements to attract foreign capital in a tax-efficient manner.
The government should consider aligning the valuation methods under the FEMA and the IT Act to avoid confusion. Furthermore, a clarification regarding the treatment of convertible instruments and the application of transfer pricing provisions on the issuance of share capital at a premium to non-residents would go a long way in minimising disputes.
