Angel Tax: Why Discriminate Between Domestic And Overseas Investors?

The Finance Act of 2023 amended Section 56(2) (viib) of the Income Tax Act by doing away with the specific application to domestic investors. Now, a tax is also applicable where the aggregate consideration received from an investor, which includes a foreign investor, exceeds the fair market value.

There are exceptions that are made for certain classes of investors. For example, shares issued to a venture capital fund or company or to a class or classes of persons notified by the central government, including AIF I and II, registered with SEBI and IFSCA, are exempt. Therefore, the amendment would cover a wide range of international investors to whom the tax would become applicable. To accommodate the concerns of the investors, CBDT has now issued a detailed list of entities that will be excluded from the application of the tax and also provided non-resident investors with additional methods to compute the rate of return.

CBDT notified the public that sovereign wealth funds and banking or insurance businesses are exempt from the tax. Further, this exemption has been extended to investments received through broad-based funds where the number of investors in such a vehicle or fund is more than 50 and such a fund is not a hedge fund or a fund that employs diverse or complex trading strategies. It also applies to pension funds, endowment funds, and entities registered as FPI-I with SEBI, subject to the condition that the aforementioned investors are from 21 countries.

It is interesting to note that while Germany, the U.K., and the U.S., among the significant bilateral investment partners, are now relieved from the angel tax, investors from Mauritius, Singapore, and the Netherlands, which account for close to 50% of FDI inflows to India, are not exempt.

CBDT’s unwillingness to extend the exemption to these countries hints that despite the introduction of anti-abuse measures such as the limitation of benefits clause as well as the principal purpose test, which is a GAAR-like provision, to the Singapore and Netherlands treaties as well as the automatic exchange of information, tax avoidance and money laundering remain a significant problem. In order to catch the round-trip of funds through these destinations, the application of the section has been extended.

The Base Erosion and Profit Shifting programme was to remedy the concerns of treaty abuse and tax evasion through comprehensive information reporting frameworks, the exchange of information, and the introduction of anti-abuse measures. But the fact that the specific anti-avoidance rule is being made stricter means that these reforms have fallen short. There is some evidence to corroborate this. For example, taxpayer identification data may not match in the cases of Mauritius and Singapore. It may also be reasonable to infer from the change in measures to counteract round-tripping through the foreign exchange controls in India.

The ramification of this change is that investments in unlisted firms—particularly in Mauritius, Singapore, and the Netherlands—will decline. At the same time, the investment structures in the startup space will change. It is expected that AIF-I and II, FPI category-I from the exempted countries, and debt may become preferred routes instead of equity contributions to unlisted companies. This may also, unfortunately, tilt the preference in favour of established listed companies.

Another issue that has been rather difficult for venture capital investors is the valuation of a company. The determination of the fair market value is fixed based on Rule 11 UA of the Income Tax Rules, which prescribes either a net asset value or discounted cash flow method by the merchant banker.

The latter was widely used and was also prescribed by FEMA to determine a floor price. The DCF value being typically higher became the default method in a way, and the computations according to the method were easily contested where the company possessed hard-to-value intangibles.

To offer further relief, CBDT also seeks to tweak the rules for valuation. In the case of resident investors, the NAV and DCF, as previously available, remain available as methods. Whereas, for non-resident investors, the methods available include five additional valuation methods, namely: (i) Comparable Company Multiple Method; (ii) Probability Weighted Expected Return Method; (iii) Option Pricing Method; (iv) Milestone Analysis Method; and (v) Replacement Cost Methods.

In addition, there is a safe harbour of 10% available to both categories of investment, and the valuation of a venture capital undertaking by a venture capital fund can be taken as FMV, and the price is applicable for 90 days.

The proposed changes in valuation add two levels of certainty: the range of 10% not being subject to tax and the price fixed by a VCF being considered an FMV for a 90-day period.

In my practical experience, the valuation of startups is a complex problem, as it is sensitive to the method selected and there are dispersed valuations across methods. In fact, hard-to-value factors such as the skillset of the management can drive value. It has been reported that Indian startups have higher revenue multiples than their peers in other countries. The additional method, therefore, provides flexibility to non-resident investors to value on the basis of peer valuation, an assessment of what it would cost to duplicate the firm, or option pricing. The option of these additional methods can also be useful since the company may be anywhere in the lifecycle of its maturity, which accordingly would make a specific method more applicable. For example, using DCF for cyclical companies or private companies that have unpredictable dividend payouts is difficult.

Even though the additional methods are commonly used internationally and the safe harbours can alleviate the incidence of tax in some cases, only time will tell if these will lower the incidence of discretionary tax assessments and gaps in valuation between taxpayers and tax authorities. For example, replacement costs and the comparable company method entail finding a comparable peer. It should not be that, with the amendment, the valuation of closely held firms becomes an exercise as contentious as transfer pricing, where the most appropriate method used is disputed.

In the event of a dispute relating to the method applied, tax liability may arise on account of this, which can lead to additional taxation above the capital gains that may arise on the sale of these assets. It also creates a wedge between investors from India and those from other jurisdictions, as it allows more methods of valuation for non-residents.

Bain and Co. estimates that Micro VCs and domestic funds will form a salient share of the investments in 2022. In light of this, it is worth examining why an anti-abuse measure may discriminate while providing alternative methods, even though there are established domestic investors in the market.

In an effort to strengthen and expand the anti-abuse measure, which seems to fill in gaps in existing legal frameworks of anti-abuse measures and information exchange, the uncertainty and complexity of the law may have been exacerbated. For the ease of compliance and assessment, it may be important to bring more uniformity to the approach.

Suranjali Tandon is an Associate Professor at the National Institute of Public Finance and Policy.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.