The government’s approach to the Angel Tax is like putting a band aid on a broken bone. The narrow focus on the limited aspect of increasing valuation methods to non-residents (residents are seemingly not included and are left scratching their heads) and exemption to only certain entities of select countries is equivalent to this ineffective remedy. Instead of addressing the larger issue of anti-abuse (the prime objective of introducing this provision), they are simply adding layers of complexity that will only jeopardize the very essence of ease of doing business. It’s a classic case of missing the forest for the trees.
Key points on recent changes proposed:
• Angel Tax is an anti-abuse provision applicable to capital contributions received from residents. Resident VC/AIF/IFSC funds are exempt from this provision.
• Financial Bill 2023 extended Angel Tax to non-residents as well
• CBDT recently issued notifications exempting (i) entities like foreign sovereign wealth funds, banks, insurance entities etc. SEBI registered Cat I FPI, Pension/ endowment funds, and funds with more than 50 investors not being a hedge fund from 21 jurisdictions. Interestingly, Singapore, Mauritius, and UAE do not feature in the list (Notified entities) (ii) Non-residents investing in Startups approved by the inter-ministerial board.
• CBDT also issued draft rules wherein
• 5 more valuation methods are available for non-residents (residents do not get this benefit)
• A 10% variation in investment price from the valuation permitted.
• Price matching with investments by exempt funds and notified entities to the extent of consideration brought in by them, will exempt both resident and non-resident investors if the investment is done within 90 days of investment by exempt funds/Notified entities.
To get to the depth of the issues, let’s first understand the basics.
The genesis of the Angel Tax introduction
Section 56(2)(viib) of the Income Tax Act – now called the Angel Tax, was introduced in 2012 as an anti-abuse provision to curb bogus capital building and money laundering. The provision provided for taxability of consideration received from residents for the issue of shares by a closely held company that is in excess of the FMV of such shares. The provisions were not applicable to non-residents and venture capital / Cat I & II Alternate Investment funds, later extended to funds set up in IFSC (exempt funds).
The rules provided for two methods of valuation to determine the FMV of equity shares to be opted for by the company– Net Asset Value and Discounted Cashflow (DCF).
Thus, if the value per equity share basis of the above methods is INR 100 per equity share, and 1,000 equity shares are issued at INR 120 per equity share, the price in excess of FMV per equity share is taxable i.e., INR 20,000 (1000*20) will be taxable as income from other sources.
These methods are not necessarily suitable for all industries and definitely not to startups. Startups lack financial history, and there is a high element of uncertainty in estimating market potential and growth. Further, in today’s day and age where startups operate with disruptive business models, traditional valuation methods do no justice.
But to comply with the above provisions, start-ups were being valued using the traditional methods of DCF.
Subsequently, at the time of assessment, the Assessing Officer started questioning the validity of the valuation and the accuracy of the projections used in the DCF valuation basis in comparison with the actual performance of the startup especially in case of decline in performances and sought to tax the difference. Huge tax claims were struck on the startups, which led to litigations.
This created a lot of uproar among the start-up community.
Exemption for Startups
The CBDT, after some interim notifications, then in 2019 notified that Angel Tax will not be applicable to Indian Startups (recognised by DPIIT and approved by the inter-ministerial board) complying with specified conditions, namely:
• Turnover not exceeding INR 100 Crs
• Not completed 10 years since incorporation
• Paid up capital and share premium post-issuance not exceeding INR 25 Crs (excluding capital received from non-residents and exempt funds)
• Not invested in certain qualified assets like shares or securities/ capital contributions of other entities, provided loans, acquired motor vehicles exceeding INR 10 Lacs, etc. at the time of share issuance and 7 years thereafter.
Upon breaching the above conditions, the entity would cease to be a startup and lose the exemptions.
The above exemption received a mooted response as the thresholds on paid-up capital/turnover were very low with further restrictions on investments which would stunt the growth opportunities for such startups. This resulted in very few startups availing this exemption with a majority still reeling under the tax pressures.
Non-residents now included in the realm of Angel Tax
Finance Bill 2023 has now extended Angel Tax to non-residents. Extending the Angel Tax to non-residents implies such investments being subject to three Indian regulations, being Companies Act 2013, Foreign Exchange rules and Income Tax Act. Further, the Income Tax Act requirement is at variance with the requirement of the other two laws. As per Foreign Exchange rules for a non-resident, shares need to be issued at a price higher than FMV, however under Income Tax Act if shares are issued at a price higher than FMV, the difference is subject to tax. This aspect is to some extent addressed in the draft rules.
The recent CBDT notification exempts certain foreign entities from Angel tax provisions. These entities include sovereign wealth funds, banks, insurance entities and the following entities from 21 jurisdictions.
• SEBI registered Category I FPI
• Pension and endowment funds
• Funds with more than 50 investors and which is not a hedge fund
The issues in this notification are:
Restricted jurisdictions: Interestingly, Singapore, Mauritius, and UAE which account for more than 50% of FDI do not find a place in the list.
Restricted entities from these jurisdictions:
• The exemption is only restricted to Category I FPI, which are largely government investors, pension funds, etc. This excludes the Category II FPI, which is the general investor class.
• Furthermore, only funds with more than 50 investors enjoy this exemption. Most of the overseas funds have Feeder Master structures wherein investors from a particular jurisdiction are pooled in a Feeder Fund and thereafter invest through a Master Fund. In such scenarios, will such funds qualify for an exemption?
This notification by the government is more of a dampener and will put a huge dent on investor sentiment.
CBDT has also issued draft rules amending the valuation rules applicable to Angel Tax.
• Valuation methods have been increased to 7 methods for non-residents only. The additional methods are:
o Comparable Company Multiple Method
o Probability Weighted Expected Return Method
o Option Pricing Method
o Milestone Analysis Method
o Replacement Cost Method
• Price matching benefit – Benefit of share price issued to VCFs/AIFs/IFSC funds/Notified entities (Angel tax not applicable to exempt/Notified funds) extended to other resident and non-resident shareholders if share issuance is done within 90 days. However, the benefit is only restricted to the extent of consideration received from such funds.
• 10% safe harbour (upside variation) from valuation permitted. This, to some extent, will help address navigating between Foreign Exchange and Income Tax laws.
Issues in this draft rules are:
• An increase in valuation methods is welcome as these methods will definitely aid in valuing start-ups. However, it is truly perplexing and difficult to comprehend why such a benefit is denied to residents.
• With the restriction on price matching to the extent of the consideration received from exempt funds, the benefit is largely non-existent. For example, if a VC is issued 10,000 shares for a consideration of INR 1 Cr, then resident and non-resident shareholders in aggregate can only be issued 10,000 shares for INR 1 Cr to get the exemption benefit. This provision is to curb misuse of the benefit provided. However, genuine transactions will also have to bear the burden.
• Unfortunately, the 10% safe harbour is not available on issue of convertible preference shares
Is there an alternative to avoid this mayhem?
Partner,
N. A. Shah Advisors
As Angel Tax is applicable on issue of shares, can issue of convertible debentures solve this problem? Convertible debentures need to be valued by a merchant banker at the time of issue (no valuation methods prescribed here) and it can be argued that at the time of conversion into equity shares, no consideration is received by the company. As highlighted in my earlier article on taxability of convertible instruments, taxmen are applying Angel Tax at the time of conversion of these instruments, and thus, till clarity emerges on this front, this will still not be a fool-proof solution.
An alternative, especially for funds, would be to invest through a fund based in IFSC as these funds are exempt from Angel Tax provisions. However, setting up a fund in IFSC requires one to have the infrastructure, and qualified and experienced personnel based out of IFSC, Gujarat. Sourcing such personnel for the funds will be a challenge.
Conclusion
In conclusion, the implementation and subsequent amendments to Angel Tax have created significant upheaval and uncertainty in the startup ecosystem. The recent inclusion of non-residents in the purview of Angel Tax and the limited exemptions provided have further dampened investor sentiment. It is imperative for policymakers to strike a balance between curbing abuse and fostering the growth of genuine startups to ensure a fair and conducive environment for startups and investors alike.
