Published in Taxsutra.com on 07 February 2023 by Akshay Kenkre and Mit gaglani
The Union Budget 2023 widens the applicability of angel tax to investments from foreign investors. Such an amendment could have a far-reaching impact on reversing the landmark transfer pricing ruling by the Bombay High Court in the case of Vodafone India Services Private Limited (WP No.1877 of 2013). The amendment in the Angel tax could impact not only the start-up ecosystem but also the foreign direct investments in India. In the Budget 2023, this is one of the most significant amendments that may possibly fuel transfer pricing litigation in the near future.
Angel Tax – A walk down the memory lane
Section 56(2)(viib) of the Income-tax Act, 1961 (the Act), also known as the Angel Tax, was introduced for the first time in the year 2012 with the sole objective of preventing the generation and circulation of unaccounted money from resident investors (‘Angel investors’) in a closely held company. Earlier to the amendment, illegitimate money was converted to legitimate money by investing in the shares issued by such a closely held company at a value over and above the fair market value (‘FMV’) of such shares i.e. at a high premium.
As per the said section, any consideration received by such a closely held company that exceeds the FMV of the said issued shares shall be charged to tax in the hands of the closely held company under Income from Other Sources.
This section indeed aimed at curbing money laundering practises adopted by resident investors by investing their unaccounted-for money in closely held companies. However, the real axe of litigation was hit over start-ups when the valuation offered by the Indian start-ups was in multiples as compared to the FMV of the company as prescribed by the Indian Income- tax law. This is when the concept of the Angel tax become famous and the talk of the town.
Ok, but what has changed in Union Budget 2023?
Until now, only consideration received by closely held companies from a person resident in India was covered under the provisions of this section. However, removing the word resident from the said section has now been proposed. This means that irrespective of the residential status of a person; if a closely held company receives consideration on the issue of shares from a person at a value over and above the FMV of such shares, then the excess shall be taxed in the hands of the closely held company under this section.
Is that all?
What matters is often invisible to the eyes. Removing the word resident from the said section means that the section would now cover even non-resident investors. Many foreign venture capitalists, investors and parent companies covered in the definition of Associated Enterprises might be the soft targets for the analysis under Angel taxation and its transfer pricing implications.
The Indian TP Regulations are anti-abuse provisions introduced to prevent profit shifting and base erosion of income and tax in India.
The arm’s length principle is the heart of the Indian TP code, which requires controlled transactions, i.e., transactions between/among Associated Enterprises (‘AEs’) to be computed having regard to the arm’s length price (‘ALP’), i.e., the price at which independent, unrelated third parties transact/would have transacted under similar economic circumstances and market conditions.
This indicates that after the proposed amendment if there is any income chargeable to tax in India under section 56(2)(viib) of the Act due to a non-resident investor investing in the shares of a closely held company at a value over and above the FMV of such shares and assuming that the company and the investor are AEs under section 92A of the Act, the transaction would be covered under the ambit of the Indian Transfer Pricing Regulations and would therefore require to be reported in the Annexures to Form 3CEB of the closely held company and the investor and further the income would require to be computed having regard to the ALP in accordance with the provisions of section 92(1) of the Act.
This is contrary to the principles of income and transfer pricing that was upheld in the Bombay High Court (HC) decision in the case of Vodafone India Services Private Limited. The moot point of the decision was the ‘arising of income’ from the transaction of ‘Issue of Shares’ and the consequential applicability of transfer pricing provisions, which was held as not applicable and in favour of the taxpayer.
The decision of the HC could be summarised as follows:
- “Income” arising from an International Transaction is a condition precedent for applying transfer pricing provisions. Hence, an income must arise in the transaction. In the transaction of the issue of shares, no income arises.
- ALP is meant to determine the real value of the transaction entered into between AEs. It was a re-computation exercise and not a separate charging section when no income arises.
- Any capital receipts are considered as income only when specifically included as income.
- The amount received on issue of shares was admittedly a capital account transaction not separately brought within the definition of Income, except in cases covered in section 56(2)(viib) of the Act. Therefore, absent express legislation, no amount received, accrued, or arising on capital account transaction could be subjected to tax as income.
- Parliament had consciously not brought to tax amounts received from a non-resident for the issue of shares, as it would discourage capital inflow from abroad.
- Receipts on the issue of equity shares to its AE, a non-resident entity, or the shortfall between the fair market price of its equity shares and the issue price of the equity shares, could be considered as “income”.
The judgement was widely accepted, and the issue of shares as a transaction became only a reporting mechanism in the transfer pricing study reports and the audits. It was widely expected that the Union Budget 2023 would throw additional clarity on such a transaction of issue of shares and take it off the transfer pricing radar. But what happened, in reality, was the contrary. As per the amendment, any excess amount per share over and above the FMV of the share would be treated as Income from Other Sources in the hands of the recipient company.
The question that arises is if this income i.e., the excess consideration received by a non-resident investor over and above the FMV of the shares of the closely held company, would require to be computed having regard to the arm’s length principle, what exactly would be the mechanism to evaluate the arm’s length nature of this transaction?
Since, the above-discussed TP implication gets triggered owing to the proposed amendment, the explanation to the same section could be relied upon for the determination of the ALP. As per the explanation to section 56(2)(viib), the FMV under this section shall be determined in accordance with Rule 11UA of the Income-tax Rules, 1962 (‘the Rules’). One of the positions could be to assume that once a fair market valuation exercise has been undertaken in accordance with Rule 11UA of the Rules, the said valuation report would also be acceptable for the purpose of the Indian TP Legislation. However, on the contrary, the other position could be that a transfer pricing regulation is an independent regulation; hence, a separate analysis needs to be undertaken. This could be true, especially while validating the Merchant Banker’s assumption while arriving at the valuation per the Discounted Cash Flow (DCF) method as per Section 11UA of the Rules. Having said that, it would be interesting to see how the Indian TP administration proceeds with the evaluation of the said transaction. Would the FMV exercise undertaken by the taxpayer as per Rule 11UA of the Rules be accepted? Would the parameters of the valuation report be challenged during the course of the TP Assessment proceedings? Would the department proceed with a new valuation exercise when such transactions are involved?
It could be a good idea to involve your transfer pricing advisor while determining the FMV of the Indian company raising investments from the foreign Associated Enterprises.
Concluding remarks
Before this proposed amendment, since section 56(2)(viib) covered a scenario where consideration was received from an Indian resident investor, the issue of shares by a closely held Indian resident company to a non-resident AE was not covered under this section owing to which there was no possibility of any income accruing in India.
Even the very famous Bombay High Court decision in the case of Vodafone India Services Private Limited laid this down as a fundamental principle that while the issue of shares to an AE is an international transaction, any premium on the same would still be outside the purview Transfer Pricing. The reason being securities premium does not satisfy the definition of the term income and therefore Transfer Pricing would not be triggered.
However, with this proposed introduction of angel tax, even transactions between Indian closely held companies and non-resident investors (assumingly AEs) could generate income chargeable to tax in India (not the entire securities premium but the excess over and above the FMV); therefore, triggering transfer pricing regulations and documentation requirements. In short, this means that the shelter of the Vodafone case may no longer be available to Indian taxpayers.
Indian companies with foreign investment falling under the transfer pricing regime should watch out for further clarity and enactment of such legislation in the near future.