Introduction:
Taxation and tariffs are essential for generating government revenue worldwide, and the Indian economy exemplifies the significance of these measures. India has a well-structured tax system that incorporates progressive and proportional taxation based on income and other relevant factors, implemented by federal and state governments. The revenue generated through income tax is utilized for diverse purposes, including the development of public infrastructure and amenities.
India’s startup ecosystem has experienced significant growth, with a substantial number of recognized startups contributing to the country’s economic landscape. However, the introduction of angel tax, as per Section 56(2)(viib) of the Income Tax Act[1], aimed at addressing money laundering concerns and ensuring that startups contribute a specific amount of funding from angel investors to the government, has raised concerns. There have been instances of limited utilization and harassment of genuine startups due to potential misuse of the provision. Angel tax is applicable when the overall investment amount surpasses the fair market value (FMV) of the company.
To address these concerns and maintain parity between domestic and foreign investors in startups, the Finance bill 2023 introduced amendments to the angel tax provisions. The amendments extended the scope of angel tax to include the issuance of shares by Companies having Common Heritage Certificates (CHCs) to non-resident investors.
What is Angel Tax:
Introduced to combat money laundering and ensure government funding from angel investors, Angel Tax (Section 56(2)(viib) of the Income Tax Act)[2] aims is to prevent the flow of undisclosed funds through excessive share premium from resident investors in closely held companies, except for consideration received from non-resident investors. However, concerns have emerged over its misuse, leading to limited utilization and potential harassment of legitimate startups, with the tax being applicable when the investment surpasses the fair market value (FMV) of the company.
The Necessity of Angel Tax
Angel tax aims to combat money laundering issues and tackle the creation of black money by taxing private companies on excessive share premiums received above the FMV. This addresses concerns about non-compliance with tax requirements and inaccurate reporting of assets by startups, contributing to the creation of black money.
Finance Bill 2023:
The Finance Bill 2023 included revisions to the provisions related to angel tax and maintained parity between domestic and foreign investors in startups.
1. Extension to Non-Resident Investors: The bill extended the application of angel tax to include the issuance of shares by Companies having Common Heritage Certificates (CHCs) to non-resident investors.
2. “Notified entities” originating from “Specified Nations’’ is exempted under angel tax: Under the angel tax regulations, entities that have been officially notified and originate from nations specified by the authorities are granted an exemption. Notified entities are- Government and Government-related investors, financial institution or regulated insurance entities, entities in specified territories, entities classified as Category-I by SEBI FPIs, endowment funds, pension funds and comprehensive pooled investment vehicles involving a minimum of 50 investors (excluding hedge funds or funds with elaborate trading strategies). A total of 21 countries are designated as specified nations..
3. Both resident and non-resident investors are subject to the price matching method: the “Notified Entity” acquired shares at a specific FMV, and the investee company has the choice to extend that FMV to other investors, but only for investments up to Rs 50,000, and within 90 days of the “Notified Entity” receiving their consideration.
4. Both resident and non-resident investors are afforded the protection of the safe harbor provision: this provision grants a degree of leniency by accepting the issue price as the FMV if it does not exceed the FMV by more than 10 percent. This provision applies to both resident and non-resident investors and is available for various valuation methods except for the “Price Matching” method. It recognizes the inherent subjectivity in valuation and offers some flexibility to companies, particularly start-ups.
5. The Draft Rule 11UA for Non-residents introduces five additional valuation methods that align with the provisions of the Foreign Exchange Management Act (FEMA): Resident investors have access to the discounted cash flow (DCF) method and net asset value (NAV) method[3]. Non-resident investors, on the other hand, are provided with additional methods facilitated by merchant bankers, which include the Comparable Company Multiple Method, Probability Weighted Expected Return Method, Option Pricing Method, Milestone Analysis Method, and Replacement Cost Methods[4]. These methods aim to align with the Foreign Exchange Management Act (FEMA) rules, which allow the use of internationally accepted valuation methods. The inclusion of these methods provides non-resident investors with a broader range of options and ensures conformity with global valuation practices
Impact of Angel Tax on Companies
The revised provisions present substantial challenges for start-ups, encompassing factors such as declining valuations, concerns about tax scrutiny and associated litigation costs, and the possibility of unreasonable tax demands. The additional premium received by Indian unlisted companies from foreign investors is categorized as “income from other sources.” This classification has the potential to initially discourage foreign investments. However, it also introduces an opportunity to encourage foreign investments. Investments made through AIFs remain exempt from the angel tax provision, which can attract international investors seeking tax breaks.
These challenges are particularly burdensome for financially struggling start-ups, subjecting them to a dual impact. Consequently, loss-making start-ups find themselves vulnerable to potential issues arising from Angel Tax. Despite the potential benefits for non-resident investors, the implementation of the modified section may lead to increased scrutiny and compliance requirements for foreign investors. This elevated scrutiny raises the risk of income tax litigation, as investors navigate the complexities of the revised provisions.
Government Initiatives:
The Indian government has taken initiatives to facilitate and encourage foreign investment in Indian companies. Exemptions from angel tax have been provided to startups certified by the DPIIT. Additionally, selecting the right entity structure and jurisdiction is of utmost importance, including the option to employ a flip structure for attracting foreign investments or utilizing notified entities in specific territories to optimize the investment strategy. Choosing CCDs over CCPS for investment instruments offers greater security, while maintaining a robust valuation report and considering legal jurisprudence safeguards against potential tax department challenges.
Conclusion:
In conclusion, while angel tax was introduced to address money laundering concerns, its potential misuse has raised concerns and led to limited utilization and harassment of genuine startups. The amendments introduced by the Finance bill 2023 aim to maintain parity between domestic and foreign investors. However, the impact on companies and foreign investment depends on a comprehensive evaluation of various factors such as market potential, regulatory environment, and expected returns. The Indian government’s initiatives, including exemptions and notifications, seek to facilitate and encourage foreign investment in Indian companies. Continuous evaluation and refinement of the angel tax provisions are necessary to strike a balance between addressing concerns and promoting a favorable investment climate.
[1] https://incometaxindia.gov.in/pages/acts/income-tax-act.aspx
[2] https://incometaxindia.gov.in/pages/acts/income-tax-act.aspx
[3]https://pib.gov.in/PressReleaseIframePage.aspx?PRID=1925651#:~:text=Rule%2011UA%20currently%20prescribes%20two%20valuation%20methods%20with,to%20the%20DCF%20and%20NAV%20methods%20of%20valuation.
[4] https://incometaxindia.gov.in/news/11ua-public-comments.pdf
Author’s Note- This article is written by Aakriti Pandey, a final-year law student pursuing the BBALLB program at ICFAI University Dehradun. As an aspiring legal professional, I have a keen interest in exploring the intersection of law and tax
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