“Angel tax” is a term used to refer to the tax imposed on investments made in unlisted Indian companies at valuations exceeding their fair market value.

Under Section 56(2)(viib) of the Indian Income-tax Act, 1961, Indian unlisted companies receiving funds from resident investors were liable to pay tax on the excess amount over the fair market value of their shares, to be determined in line with specific valuation methodologies provided under the income tax rules. The government granted certain exemptions from applicability of angel tax to venture capital undertakings and registered Indian startups.

This provision was introduced to prevent money laundering and the use of unaccounted money. However, over the years, it had unintended consequences for Indian private companies looking to raise money, particularly Indian startups.

Until April 1, Indian private companies had to pay tax under Section 56(2)(viib) only where shares were issued at a premium to Indian resident investors.

However, in a major change to the scope of the angel tax provisions, with effect from April 1, Indian private companies had to pay the angel tax in cases where shares were issued at a premium to nonresident investors.

Given that this provision applied indiscriminately to all investments in Indian private companies, it became a hindrance to fundraising by genuine businesses. Stakeholders have sought to either abolish the angel tax or to exempt certain types of fundraising.

Tax Rules Eased

Given the concerns raised by stakeholders on the change in the scope of the angel tax, the Indian government recently issued certain exemptions from its applicability in cases where Indian private companies issue shares at a premium to:

• Government and government-related investors such as central banks, sovereign wealth funds, international or multilateral organizations.
• Agencies including entities controlled by the government or where direct or indirect ownership of the government is 75% or more.
• Banks or entities involved in the insurance business where they are subject to applicable regulations in their home jurisdiction.

Exemption from angel tax also has been granted to Indian private companies issuing shares at a premium to the following entities that are residents of any of the 21 countries listed in the notification (Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Iceland, Israel, Italy, Japan, Korea, New Zealand, Norway, Russia, Spain, Sweden, UK and US):

• SEBI registered category I foreign portfolio investors.
• Endowment funds associated with a university, hospital or charity.
• Pension funds created or established under the law of the foreign country or specified territory.
• Broad-based pooled investment vehicles or funds where the number of investors in such vehicle or fund is more than 50 and such fund isn’t a hedge fund or a fund that employs diverse or complex trading strategies.

It is noteworthy that some key jurisdictions such as Singapore, Netherlands, United Arab Emirates, and Mauritius have been specifically left out of the scope of the exemption. According to some estimates, India receives more than 50% of its total foreign direct investment from these jurisdictions, due to their favorable regulatory regimes among other reasons.

Potential Impact

The government’s decision to provide an exemption from angel tax to investments from the 21 notified jurisdictions is welcome and should encourage foreign investment from these jurisdictions with strong regulatory frameworks.

However, it is the exclusion of favored jurisdictions like Singapore, Mauritius and Netherlands that has limited the scope of the exemption and raised concerns about the perception of the excluded jurisdictions. At a broader level, it seems to be a policy decision to discourage investment from these jurisdictions.

As these excluded jurisdictions have been a source of investment for a long period, the exemption may not have an immediate impact, but may encourage tweaking of investment structuring without triggering the angel tax provisions, for example, by using convertible debt instruments. This may not be a desirable policy outcome, but given the favorable regulatory regime and tax benefits offered under their respective tax treaties, these jurisdictions may still continue to be popular.

Proposed Valuation Rules

Currently, the income tax rules provide a taxpayer with the option to determine the fair market value of unlisted equity shares for the purposes of Section 56(2)(viib) by applying the net asset value method or the discounted cash flow method.

To address investors’ and investees’ concerns regarding the expanded scope of the angel tax, and to introduce some flexibility on valuation of shares for determining its applicability, the Indian government recently released draft valuation rules proposing some additional methodologies to determine the fair market value of shares issued by Indian companies to nonresident investors.

These include the comparable company multiple method, probability weighted expected return method, option pricing method, milestone analysis method, and replacement cost method. The draft rules also have proposed a 10% safe harbor for both resident and nonresident investors.

Conclusion

As certain jurisdictions have been exempted from the applicability of angel tax, going forward this may be one of the factors that foreign investors will take into account when considering investment in India. Having said that, excluded jurisdictions that provide a favorable regulatory regime and tax benefits may still continue to be attractive for foreign investors.

From a tax policy perspective, cases where the introduction of multiple exemptions and valuation methods results in any tax arbitrage may result in unintended and undesirable outcomes.