Incentivising Foreign Investments: Angel Tax Exemption for Start-ups and Non-resident Entities

Earlier this year, the Finance Bill 2023 (the “Bill”) introduced a significant amendment to the tax regime popularly known as the 'Angel Tax'. The Bill, now the Finance Act, 2023 (the “Act”), shall bring the said amendment in effect from April 1st, 2024, for the assessment year 2024-2025, omitting the words ‘being a resident’ from clause (vii-b) of sub-section (2) of Section 56 of the Income Tax, 1961 (the “Amended Section”).

[Angel Tax refers to the income tax payable on capital raised by unlisted companies through the issuance of shares when the share price exceeds the fair market value of the shares sold. The excess realisation is considered income and is accordingly taxed in the hands of the recipient company.]

Under the current legal scenario [Section 56(2) (viib) of the Income-Tax Act, 1961], the applicability of Angel Tax arises when -

(i) the recipient is an unlisted company,

(ii) it receives consideration for the issue of shares from a resident person, and

(iii) such consideration exceeds the fair market value ("FMV") of the shares as determined.

[Rule 11 UA(2) of Income Tax rules, 1962 defines the method for calculating the FMV of the shares].

If all the above conditions are satisfied, the total consideration received for shares that exceed the determined FMV is taxable in the hands of the recipient company under the heading 'Income from other sources'

Angel Tax provisions, however, do not apply when shares are issued (i) by a venture capital undertaking to a domestic venture capital company, venture capital fund, or alternate investment funds (AIFs) or (ii) by eligible start-ups which are still there in the Act.

The Act recently brought a change that the excess premium received on the sale of shares by an Indian unlisted company to a foreign investor be considered "income from other sources," implying that when a company raises funding from a resident as well as a foreign investor, it will now be considered income and taxable. Although, on the forefront, the proposed amendment may discourage foreign investments in India, on the contrary, we may see an increase in non-resident investments via the Alternative Investment Fund (AIF) route, as it remains exempt from Angel Tax provisions.

The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the ‘Rules’), govern the valuation of shares issued by a resident to a non-resident. The FMV of equity instruments, which includes all compulsorily convertible instruments, whether debt or equity, is determined in accordance with internationally accepted valuation methodologies, according to the above rules.

The FMV is the floor price, and transferring the shares below it violates RBI guidelines.

Foreign transactions often occur at significantly higher prices than the calculated fair market value due to factors like exchange rate risk, global recessions, ongoing wars, and the preferences of foreign investors for rights such as anti-dilution and preferential exit. Furthermore, resident investors are typically willing to pay a higher premium than foreign investors, which may lead to a substantial reduction in the incentives offered by foreign investment to Indian companies.

As per the Amended Section, the premium amount any Indian company shall receive will be taxable in the hands of the recipient. This change will primarily affect start-ups, as ensuring the FMV under FEMA and the Income Tax Act will increase hassle for them.

The Amended Section might encourage reverse-flipping the ownership structures by Indian companies to more tax-friendly jurisdictions such as UAE or Singapore. This action contradicts the government of India's economic survey, which recommended that the government reduce the reverse flipping structure by incentivising domestic companies.

Currently, the Act imposes no additional compliance requirements on foreign investors. However, following Act's implementation, foreign investors may be subject to various income tax compliances such as TDS deduction, e-filing, etc., which may further lead to an increase in potential litigation with income-tax authorities. The proposed amendment will not apply on a retrospective basis, and accordingly, M&A transactions that are closed by March 31, 2023, shall not be impacted by the proposed amendment.

If an ongoing transaction involves issuing shares to foreign investors, parties should consider the Angel Tax implications in a strict sense.

To relieve domestic companies, the central government has exempted investments in start-up companies recognised by the Department of Industry Promotion and Internal Trade (DPIIT) from Angel Tax. Furthermore, becoming a DPIIT-recognised start-up is a fairly non-cumbersome process that will benefit India's start-up ecosystem. Also, through the notification dated May 24th, 2023, the central government has exempted certain jurisdictions from the applicability of Angel Tax. As per the notification, if any consideration is received by an Indian company for the issue of shares from the non-resident entity domiciled in the notified jurisdiction, the Indian entity shall be exempted from Angel Tax. The list of notified countries includes 21 jurisdictions that are enlisted below.

21 countries were exempted from this regime post the CBDT notification. They are - Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Iceland, Israel, Italy, Japan, Korea, New Zealand, Norway, Russia, Spain, Sweden, United Kingdom and United States

However, nations such as Singapore, Ireland, the Netherlands, Mauritius, and others, from where most inbound FDI is channeled into India, need to be added to the notification.

Kritika Krishnamurthy is the Founding Partner of AK & Partners. Sanyam Kohli is an Associate at the Firm.

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