Angel tax provisions contained in the Indian tax laws have been a matter of concern for closely held private companies since their introduction in 2013-14. Angel tax provisions were introduced to prevent money laundering activities related to the issue of shares of such closely-held private companies to residents at an excessive premium above the fair market value (FMV) of such unquoted shares. The excess issue price above the FMV is subject to tax in the hands of the Indian company. However, angel tax provisions are not applicable in case of issuance of shares (i) by a venture capital undertaking to a domestic venture capital company, venture capital fund and alternate investment funds (AIFs) or (ii) by eligible start-ups.
The Finance Bill, 2023, proposes to bring the issuance of unquoted shares to non-residents within the ambit of angel tax to eliminate the possibility of tax avoidance. This is a major change that will impact valuations in the primary market while raising funds from offshore investors. Luckily, investments by non-residents into eligible start-ups will continue to be outside the purview of angel tax. However, foreign direct investments (FDI) into other closely held private companies and larger start-ups that are not eligible for tax exemptions shall be subject to increased scrutiny by income-tax authorities, who may vehemently contest the FMV adopted for such transactions. This in turn shall discourage foreign investors from participating in fundraising by such entities. On the contrary, we may see an increase in investments from non-residents through the AIF route, since it continues to be exempt from angel tax provisions.
Pricing Issues
Issuance of shares of Indian companies to non-residents is in any case subject to pricing guidelines under the Indian foreign exchange regulations, which provides for FMV being the floor price for issuance of shares to such non-residents. While FMV is determined basis the discounted cash flow method, for the purposes of adherence to the floor price prescribed under the Indian foreign exchange regulations, such transactions are usually undertaken above such floor price, with several balancing rights such as anti-dilution, preferential exit, etc. It is highly unlikely that an agreed deal value in a third-party M&A transaction would be precisely equal to such FMV so that it complies with the angel tax provisions. In fact, such transactions are usually undertaken above such FMV, as non-residents are willing to pay a premium over resident investors. Subjecting the RBI-regulated FDI to angel tax will be viewed as a negative step by the global investor community intending to participate in the India growth story keenly.
Another far-reaching impact of these proposals could be on convertible instruments (shares or debentures) issued to non-resident investors in the past. The conversion ratio or at least an agreed valuation formula for the conversion of such instruments into equity shares of the company is typically agreed upon upfront. If the agreed valuation matrix adopted for such conversion exceeds the prescribed FMV, angel tax provisions may be triggered in the hands of the company in the event of such conversion. No specific grandfathering benefits have been proposed in the Finance Bill, 2023, in respect of such convertible instruments issued in the past.
Murky Litigations To Rise
The Economic Survey elaborated on several measures that should be taken by the government to encourage ‘reverse-flipping’ of the ownership structure of Indian businesses. In stark contradiction, the extension of angel tax provisions to non-residents shall prompt more Indian businesses to shift their domicile or headquarters to investor-friendly jurisdictions such as Singapore or the United Arab Emirates. Needless to say, potential litigation with income-tax authorities by Indian companies seeking foreign capital directly or indirectly through ‘flipped’ structures is only going to get murkier. The government should consider rolling back the proposal of subjecting such FDI investments to angel tax to prevent the funding winter from turning into doomsday for several closely held private companies in India seeking foreign partners.
The amendments are effective from April 1, 2023, and accordingly, M&A transactions that are closed by March 31, 2023, shall not be impacted by the proposed amendment. In case of ongoing deals that are expected to be consummated in the next financial year, the parties shall have to evaluate and suitably factor in the impact of adverse angel tax implications if a proposed transaction involves primary issuance of shares to non-residents, at an issue price above the FMV.
Kunal Savani is Partner at Cyril Amarchand Mangaldas. Raj Chheda is Senior Consultant at Cyril Amarchand Mangaldas.
Views are personal and do not represent the stand of this publication.
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