Introduction
On 23 July 2024, the Government presented its inaugural budget session following re-election. The tax proposals received presidential assent on 16 August 2024. In keeping with its annual tradition, a multitude of amendments have been made to the Income Tax Act. To the relief of the investors, the legislature finally heeded to the beseech of the investors and abolished the so-called angel tax with effect from Financial Year 2024-25. As per the Budget Speech, the amendment has been made to kindle a fresh cycle of investment and to foster employment avenues in India.
The provision concerning the taxation of share premiums received by closely held companies (colloquially referred to as ‘angel tax’) has been a subject of considerable controversy since its introduction in 2012. Many investors have considered this provision as an antithesis of Invest in India initiative.
As the curtains get drawn on the provision, it is an opportune time to look back at the original rationale behind its introduction, subsequent amendments and its application and the factors leading to a backlash from the investors and investee companies. It will also be interesting to discuss what the future holds after its repeal.
The Mischief
The angel tax provision was introduced to prevent laundering of unaccounted funds which were being projected as legitimate investments in closely held companies. Capital infusion was being exploited by promoters of corporate entities to launder unaccounted funds by issuing shares of their companies at extremely high prices. Thus, accounted monies held by name lenders or proxies were infused back into the companies with minimal dilution of the control.
Even in cases where taxmen were able to identify the mischief based on obnoxiously high valuations, the unaccounted money could not be taxed in the absence of any incriminating evidence. Thus, a need was felt to shift onus back to investee companies to justify valuations.
Introduction of Angel Tax
It was against this background that anti-abuse provisions were introduced in 2012 to tax share premium received by a closely held company from resident investors in excess of the fair market value (FMV) of its shares.
The FMV was to be determined with reference to the net asset value or the discounted cash flow valuation of the investee company. The latter valuation method was subjective and was largely dependent on the management’s projections of the future cash flow.
Since the provision was introduced as a deeming fiction, the tax officer was dispensed away with the requirement of examining the genuineness of the transaction. The provisions were objective in their application, though the valuation was a bit subjective.
Impact on genuine start-ups
However noble the objects of this anti abuse provision could have been, when it came to its practical application, the budding start-up ecosystem in India became unintended casualties.
In the case of start-ups, the angel investors invest in the early stages of the company with the hope of making gains as the company grows. At this juncture, the company may be pre-revenue and asset light, often possessing nothing but an innovative business concept, which has the potential of being operationalized and scaled up in future with the help of funding. The valuation is usually pegged by the investor on intangible factors such as potential of business idea, credentials of the founders, competition, etc. As one can imagine, it may be difficult to assign a monetary value to these aspects and the FMV of shares based on traditional prescribed methods, such as net asset value and discounted cash flow method, may be negligible or even negative.
It is for this very reason that the founders of these start-ups found extremely difficult to justify the valuation of the company at which funds were infused by the resident angel investors. These collateral damages were being observed right around the time when the Government was exploring avenues of encouraging start-up ecosystem in India. To soften the blow on startups, a series of clarifications were issued and amendments were made.
Relief to eligible startups
In 2019, certain eligible startups were exempt from angel tax provisions subject to certain restrictive conditions like turnover not being in excess of INR 1 billion. In case of other start-ups and corporates, the provision continued to apply with full effect.
Non-resident investors
As a silver lining in the cloud, foreign investments from non-residents were kept outside the purview of the angel tax. As per the Foreign Exchange Control Regulations in India[1], an Indian company cannot issue equity instruments at a price which is less than the FMV of the share and thus, the Indian companies were free to maximize their valuation while issuing shares to non-residents.
However, this liberty was severely impeded in 2024 when the dreaded angel tax was extended even to investments received from non-residents. This required the companies to walk a tightrope while issuing shares to non-residents, especially due to divergence in the valuation methodologies prescribed under foreign exchange regulations and income tax. Income tax rules were also amended to prescribe new valuation methods to align with internationally accepted methods and also to do away with valuation in certain cases. Inspite of this cushioning, the Government was largely unsuccessful in assuaging the fears of non-resident investors.
As a last resort, perhaps the Government decided to repeal the angel tax provisions altogether with effect from financial year 2024-25.
Can investors breathe a sigh of relief?
Repeal of angel tax provisions for all class of investors will go a long way to instill investor confidence. This will also enable Indian corporates to maximize their valuation without inviting tax bills.
However, it does not necessarily obliviate the need for valuation certificates. The valuation may still be relevant from exchange control regulations to justify the primary issue is not less than FMV. Moreover, issuance of share at a value less than the FMV may invite tax in the hands of investor[2].
One must also not lose sight of the tax avoidance mechanism against which angel tax provisions were introduced. With the repeal of the provisions, the tax officers are likely to tax unexplained capital received as per other general and specific anti-avoidance provisions. For instance, it is possible that the tax officers may seek to classify these sums as unexplained cash credits[3] in which case, the sums received could be taxed at an exorbitant tax rate of 60% plus surcharge and penalties. Though usually meant for unexplained credit entries in its books of accounts, it could equally be invoked in high premium share issuance transactions, when the identity and credit worthiness of the investor is in doubt.
Thus, the investee companies may be asked to explain the ‘source of source’ of share capital received by them, which may prove to be a challenge, especially in case of non-resident investors not willing to share confidential financial details with Indian tax authorities like source of their investment, assets, etc. Now with the abolishment of angel tax provisions, it is possible that the tax officer may be tempted to tax the capital received as unexplained cash credit.
Conclusion
Abolition of angel tax is definitely a step in the right direction and will provide more avenues for Indian corporates to maximize their valuation. However, if the tax officers don’t show restraint in taxing the capital investment, the intended relief may not come and the tax bills may just increase due to high tax rates. To ensure that these extraordinary taxing powers are not invoked as a matter of routine, the Government may consider issuing guidelines to the tax officers and building appropriate guardrails in the legislation.
[The authors are Partner and Associate, respectively, in Direct Tax practice at Lakshmikumaran & Sridharan Attorneys]
[1] Rule 21 of Foreign Exchange Management (Non-debt Instruments) Rules, 2019
[2] Section 56(2)(x) and CBDT Circular No. 3/2019 dated 21st January 2019
[3] Unexplained cash credits as provided in section 68 of the Income-tax Act
