Angel Tax: All You Need To Know About It

The Union Budget 2023 brought in amendments to angel tax provisions, widened its coverage, and added to the controversies surrounding it. Here is a detailed understanding of what is angel tax, how it works, and how recent amendments affect investors and corporates.

What is Angel Tax?

In 2012, the government introduced the taxation of unjustified premiums that a company receives from its investors to deter the generation and use of unaccounted money. This widening of the tax net followed the concept of benefit taxation to a shareholder when he/ she buys the share below its fair market value, introduced in 2009. The change in 2012 was the first instance of India taxing capital issue proceeds.

This became commonly known as ‘angel tax’. Angel tax provisions tax the proceeds received as a premium on the issue of shares that exceeds the fair market value of shares from residents in companies where the public is not interested.

As a concept, the introduction of angel tax has become a watershed event in India’s taxation history, as the valuation of shares became the basis of this tax event. Following this, the income tax department prescribed valuation methods to determine fair market value for angel tax.

Two methods were prescribed:

• The discounted cash flow method – a forward-looking approach of discounting the projections of the company based on its performance
• Net asset value method – based on the company’s historical results.

Given its far-reaching impact, exemption from the applicability of angel tax was provided to:

• Investments made by non-residents
• Investments by a venture capital company/ fund into a venture capital undertaking
• In 2018, investments made in a DPIIT-recognised startup were also added to this list

From April 1, 2023, the angel tax regime has been widened to include investments made by non-residents as well. This has made the valuation of shares of an Indian company a significant point of independent assessment by government agencies (such as the RBI – under extant exchange control regulations and the income tax department) as well as valuation agencies (such as registered valuers, chartered accountants, and merchant bankers). This was earlier a subject matter of commercial negotiations between the investor, the promoter, and the company.

Central Board of Direct Taxes (CBDT) vide notification dated 24th May, also notified certain class or classes of person such as Foreign Portfolio Investors, certain endowment, pension and investment funds, of 21 countries including UK, USA, France, Germany etc. which are exempted from angel tax in India.

Interestingly, this list of counties excludes Singapore, Mauritius, Netherland etc. which are top foreign direct investment inflow in India for Indian Companies. This move has baffled the investor community and has been a hot topic of debate.

The income tax department has further via a press release, proposed a revamp of the valuation rules (under rule 11UA of the Income Tax Rules, 1962) for computing the fair market value of unquoted equity shares, particularly considering the inclusion of non-resident investors. These rules were open for public comments/suggestions up to 5th June and the final rules are still awaited. Following are the key changes proposed:

• Five additional methods of valuation are prescribed specifically for non-resident investors
• Issue price and a matching contribution to that of an exempt investor (such as a Venture capital company/ fund investing in a venture capital undertaking, or any other exempted entities notified) will be exempt from angel tax
• An independent valuation report will have a validity period of 90 days only
• Variation of up to 10 per cent in the fair market value will be permitted to accommodate forex fluctuations, bidding processes, variations in other economic indicators, etc

A consequent update has also been made in exemption notification to DPIIT recognised startups to cover issues to non-residents.

Equity Vs Non-Equity Valuation for Shares

There is still a lack of guidance around valuation of other kinds of shares (such as convertible / non-convertible preference shares) convertible instruments in the recent amendments. It is quite common for non-resident investors to invest in the form of convertible instruments.

The CBDT needs to address the valuation mechanism for convertible instruments and how this will play out against the equity valuation guidelines. Current guidance is limited to an independent assessment by a merchant banker or an accountant on the price that such an instrument would fetch if sold in the open market.

Parity of Valuation: Resident and Non-Resident

While CBDT has notified five additional valuation methods for the issue of unquoted equity shares to non-residents, there is no change in the valuation guidelines for issues to resident investors. This can lead to the use of different valuation methods of the same share issued to residents and non-residents.

Even today, the income tax department is investigating the technique adopted in the earlier regime for resident investors. Making more methods available is likely to open more uncertainties and litigation and keep corporates busy with litigation rather than focusing on their business.

A Multiverse of Laws

In each scenario of issue of shares to residents and non-residents, we now have a situation where:

• The Companies Act, 2013 prescribes a valuation report from a registered valuer under private placement rules
• Exchange control law requires shares to be issued at not less than the price arrived at by a valuation of a SEBI registered merchant banker or a chartered accountant as per any internationally accepted pricing methodology on an arm’s length basis qua the non-resident investor
• Income tax and transfer pricing authorities (with the benefit of hindsight – given that assessment will be done in a 2–3-year period from the date of the investment) will need the valuation report of a merchant banker using the prescribed valuation methodology only
• Navigating obtaining valuation reports from different valuers and/or deciding on using the correct method by a valuer will become a complex process. Getting investors was the primary purpose. From an ease of doing business and commercial negotiations perspective, these regulations will be considerable impediments in the coming days.

DPIIT Recognition for Startups – Subject to Conditions

Though DPIIT-recognised startups are exempt from angel tax, losing the startup status is more than likely if the company is in a high growth trajectory. Some of the conditions required to remain within the startup regime are:

• Turnover should not exceed Rs 100 crore
• No investment in any step-down entity
• Recognised by DPIIT within 10 years of its incorporation
• The paid-up share capital and share premium of the startup after the share issue should not exceed Rs 25 crore.

So, the recent amendments to angel tax are likely to hamper the ease of doing business in India unless the genuine concerns of resident and non-resident investors and companies looking to raise funds are clarified and resolved. Further, tax authorities should rely on independent valuation exercises and not question the commercial intent of investments being made in the company. These principles will go a long way in creating a robust business and investment environment for angels and corporates.

(The author, Sridhar R, is partner-tax at Grant Thornton Bharat; Motilal Parakh, assistant manager-tax at Grant Thornton Bharat LLP, contributed to the article)