#TaxmannPPT | Recent Changes in Angel Tax Provisions

ASHUTOSH MOHAN RASTOGI

Partner, Amicus - Advocates & Solicitors

Founder and tax lawyer with to two decades of experience in Tax and Transfer Pricing Litigation, consulting and advisory space. Ashutosh heads the Tax Practice at Amicus with an impeccable track record of wins some of them being Landmark Rulings.

Tax Litigation

Ashutosh also regularly serves as tax counsel on Tax/ Transfer Pricing matters at higher appellate forums including Tax Tribunal and High Court. He has advised and represented in

landmark Tax Rulings such as Cinestaan Entertainment (on Angel Taxation) and Pyramid IT Consulting (on Transfer Pricing). Both Rulings have established landmark principles in taxation frequently referred to by Tax Practitioners.

International Taxation and Transfer Pricing

His forte has been International Tax Structuring and Transfer Pricing Planning for related party cross-border transactions. Ashutosh has successfully represented several multinational companies before tax authorities in Transfer Pricing/ International Tax audits and advised companies on several complex Transfer Pricing matters. His International Taxation experience encompasses all aspects of Transfer Pricing advisory, GAAR, POEM compliance and litigation services (including representation at higher appellate levels).

ASHUTOSH MOHAN RASTOGI Partner, Amicus - Advocates & Solicitors

GST and Customs (Special Valuation Branch)

Linked with the Transfer Pricing Practice is the expertise in Special Valuation Branch (SVB) Proceedings for related party imports. Leveraging on his understanding of valuation and Transfer Pricing principles, Ashutosh is currently providing end to end valuation and representation services before the SVB under customs regulations.

GST advisory services ranging from Training to in-depth planning and impact analysis. Assisted by a team of Lawyers, Ashutosh is assisting companies in evaluating implications of the new GST law, analysing the legal/financial impact, and devise systems, process and control framework for successful compliance with GST Regulations that are still in a nascent stage.

Awards & Recognition

 Under his leadership Amicus Tax Practice has been consistently recommended as a Leading Firm (Asia Pacific) for Tax (2014-2022) and Recommended Firm by Asia Law (2022)

 Ranked as ‘Leading Individual’ for Tax by Legal 500 (2022)

 Ranked as ‘Notable Practitioner’ for Tax by Asia Law (2021-2022)

 Recommended by International Tax Review (2022)

 Publications:He has authored dozens of articles for leading tax journals such as BNA Bloomberg, IBFD and Tax sutra (online portal)

 Background

 Objective of setion 56(2)(viib)

 Angel tax: Pre & Post Amendment - Snapshot

 Additional valuation methods (Draft Rules)

 Notified Entities & Specified Nations

 Price Matching Concept

 Safe Harbour Concept

 Impact on Foreign Investments and Planning Implications

Background

• Startups mostly receive funding from HNIs, private companies, or consortium of private equity investors commonly known as Angels Investors

• The term “Angel” originated from the Broadway theater, where affluent individuals provided money for theatrical productions

• Prof. William Wetzel of University of New Hampshire coined the term “Angel Investor” in 1978 after completing a study on how entrepreneurs raised capital for businesses

• Since, the investment is received from Angel Investors, its taxation came to be known as 'Angel Taxation’

Angel Tax in News – Terror in Start-up Camp

Section 56(2)(viib) – Snapshot (Old Law)

Section 56(2)(viib)

Issue of Shares to a private company.

Consideration exceeds Fair Market Value (‘FMV’)

Consideration – FMV = Deemed Income (‘Other Income’)

Not applicable on secondary sale of shares

FMV computed as per Rule 11UA

Not applicable if issued to non-resident

Not applicable to preference shares/debentures etc

How Section 56(2)(viib) works? - Illustration

• ‘X’ Co. issues equity shares to Mr. ‘A’ for a consideration of Rs. 1000/-

• FMV of the shares as computed under a valuation report is ascertained at Rs. 950/-

• Excess consideration received by ‘X’ Co. is Rs. 50/- (Rs. 1000 – Rs. 950)

• As per the provisions of Section 56(2)(viib) Rs. 50/- will be deemed to be income of X Co. from other sources and taxable at a rate of 30% (plus cess)

Objective of Section 56(2)(viib)

Memorandum to Finance Act 2023:

“Clause (viib) of sub section (2) of section 56 of the Act was inserted vide Finance Act, 2012 to prevent generation and circulation of unaccounted money through share premium received from resident investors in a closely held company in excess of its fair market value. However, the said section is not applicable for consideration (share application money/ share premium) received from non-resident investors. Accordingly, it is proposed to include the consideration received from a non- resident also under the ambit of clause (viib) by removing the phrase ‘being a resident’from the said clause. This will make the provision applicable for receipt of consideration for issue of shares from any person irrespective of his residency status.”

Pre vs Post Amendment – Snapshot

Only ‘resident’ investors covered

Both ‘resident’ and ‘non resident’ investors covered Rule 11UA - Only Two methods

Five Additional Valuation methods provided under Draft Rule 11UA for Non-residents

(i) DCF (Discounted Cash Flow)

(ii) NAV (Net Asset Value) method.

(Aligning with FEMA)

Exclusions : DPIIT registered Start-ups

(meeting specified conditions)

Amount of paid up capital does not include funds from Non-residents and Venture capital funds.

Exemption from Angel Tax extended to ‘notified entities’ from ‘Specified Nations’

Pre vs Post Amendment – Snapshot (cont)

Price Matching Method not available Price matching Method for both resident and non-resident investors

Safe Harbor not available

Safe harbor for both resident and non-resident investors

Contemporaneous valuation report required but no time period for validity specified

90 days specified as time period for validity of valuation report (at option of assessee)

Additional Methods

• Existing Methods – DCF (Merchant Banker) and NAV – Available for Resident Investors

• Additional Methods (Merchant Banker) available only for Non Resident Investors

 Comparable Company Multiple Method

 Probability Weighted Expected Return Method

 Option Pricing Method

 Milestone Analysis Method

 Replacement Cost Methods

 Objective to align with FEMA Rules which permit use of any internationally accepted valuation method

Notified Entities

Angel Tax Provision not to apply to following ‘Notified Entities’

1. Government and Government related investors (central banks, sovereign wealth funds, international/ multilateral organizations and entities controlled by Government etc);

2. Banks or regulated entities involved in insurance business; and

3. Following entities in ‘Specified Territories’ (21 countries)

(i) Entities registered with SEBI as Category-I FPI,

(ii) Endowment funds (associated with university, hospitals or charities)

(iii) Pension funds

(iv) Broad-based pooled investment vehicle or fund with more than 50 investors (not being a hedge fund or fund which employs diverse or complex trading strategies)

Specified Nations

United States

1. Australia

8. France

15. New Zealand

2. Austria

9. Germany

16. Norway

3. Belgium

10. Iceland

17. Russia

4. Canada

11. Israel

18. Spain

5. Czech Republic

12. Italy

19. Sweden

6. Denmark

13. Japan

20. United Kingdom

7. Finland

14. Korea

21.

Mauritius, Singapore, Netherlands and UAE left out

• Raises questions regarding the narrow scope of the exempted 21 nations. PE & VC funds from these countries contribute nearly 50% of foreign investment in India today.

• Interestingly, Mauritius has sought clarification regarding its exclusion from the list of exempted countries, even though the island nation complied with all 40 FATF recommendations on AML/CFT (anti-money laundering/countering financing of terrorism).

Price Matching Method

The price derived as ‘FMV’ by a ‘Notified’ entity can be taken (at option of the investee ) as ‘FMV for other investors (not ‘Notified’ entity) in another/ subsequent round, if:

 Amount invested in next round does exceed the ‘aggregate consideration’ received from notified entity; and

 the prior investment round is within a period of 90 days from next issue of shares

Price Matching (Illustration)

• Notified entity subscribes to 1,000 equity shares of an unlisted company at FMV of INR 50 per share

• Investee has option to take INR 50 per share as FMV for other investors (not ‘Notified Entity’)

• However, this FMV can be applied upto investment of Rs 50,000 only (‘Aggregate Consideration’ Received’); and

• The subsequent investment has to be within 90 days of the receipt of consideration from ‘Notified Entity’

‘Safe Harbour’ Concept

• Safe harbour of ‘not exceeding 10 percent’ made available - if issue price exceeds FMV by not more than 10 percent, issue price accepted as FMV

• Safe harbour available for both resident and non resident investors

• Available in case of DCF, NAV and additional methods

• Not available in case of ‘Price Matching’ Method

• Greater breathing room for start-ups

• Welcome move that recognizes valuation is not a science but a matter of perception

Sec 56(2)(viib)- Whether applicable to preference shares?

Following incomes, shall be chargeable to income-tax under the head "Income from other sources", namely :— where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:

• Express Language – ‘Issue of Shares’

• Term Used as ‘shares’ Not ‘preference shares’

• ‘Issue’ vs ‘Conversion’

• From hereon it’s a matter of interpretation

Judicial Precedents

(Mum.-Trib) the Mumbai tribunal held that-

“The appellant had issued 6,10,825 Non-cumulative, non-convertible redeemable preference share at a premium of Rs. 490/- and the AO while applying S. 56(2)(viib) of Income Tax Act 1961 sought to bring the premium amount in the ambit of income. Court while rejecting the argument of the AO held that preference shares stand on a totally different footing as compared to equity shares and thus the S.56(2)(viib) cannot be made to apply circumstances”.

Whether applicable on issue of CCDs?

• S 56(2)(viib) states – “any consideration for issue of shares”

• Deeming provision only applicable to

‘issuance of shares’

• ‘conversion of CCDs to equity shares’

- No fresh infusion of capital

- No consideration at the time of conversion

Judicial Precedents

In Bangalore v. M/s. CAE Flight Training (India) Pvt. Ltd., Bangalore tribunal held that –

• “CCDs are to be considered as Debt only and the interest thereon has to be allowed and it cannot be disallowed by saying CCDs are equity and not debt”

In Secure Meter Ltd. (CC 10548/2009), Supreme Court held that –

• “While confirming the order of Hon’ble High Court of Rajasthan confirmed the position that Compulsory Convertible Bonds represent the loan funds and this represent the debts. The issue of bonds gives rise to a debt loan and not share capital and the expenditure incurred towards bonds should be considered as revenue in nature”

Judicial Precedents

• “That debenture is nothing but just another form of loan on which interest is payable. The debentures cannot be equated with shares. As regards convertible debentures, the company may also issue other debentures in which case the option is given to the debenture holders to convert them into equity or preferential shares as stated rate of exchange after certain period. Thus, debenture conversion is also another form of loan for a specified period till they are converted into shares. Interest is payable on convertible debentures till they are converted into shares when dividend becomes payable”

Concerns for Investors and Start-ups

Must have tax efficient exit options

Get an investment price that matches perception

Start-up

Downward pressure on valuation

Fear of Tax Scrutiny on valuation (plus tax litigation cost)

FEMA Regulations require investment above FMV but tax regulations tax excess

Unreasonable Tax Demands from start-ups already cash strapped

Investment must be at FMV (subject to 10% safe harbour) to satisfy both FEMA and Tax Regulations

Double Whammy for loss making Start-ups – easy prey for Angel Tax Challenge

Planning Around Angel Tax

 DPIIT Registration - Over 80,000 DPIIT-registered start-ups will not come within the tax purview, according to Indian Revenue Secretary (Sanjay Malhotra)

 Choice of Entity and Jurisdiction

 Flip Structure – take investment outside India

 Notified entities in Specified Territories (full or part investment may be through Notified entity combined with Price Matching Method)

 Choice of Instrument

 CCPS – Technically not Shares but still risk of challenge

 CCDs – Debt is much safer option

 Maintain Robust Valuation Report

 Backup projections based on underlying facts,

 Using growth rates/ metrics that can be defended, and

 Realistic assumptions on revenue & costs

 Sanity check on Valuation Report Disclaimers

 Legal jurisprudence on valuation- Department cannot challenge expert’s valuation

Principles and Precedents

Principles

Valuation by an expert cannot be challenged

Valuation cannot be judged on hindsight

Precedents

G.L. Sultania and Anr. (AIR 2007 SC 2172)

Dr. Renuka Datla [2004] 265 ITR 435 (SC)

Miheer H. Mafatlal (AIR 1997 SC 506)

Cinestaan Entertainment Pvt Ltd

SEBI [2015(6) ABR 291]

DQ(International) Ltd. (ITA 151/HYD/2015)

S 56(2)(viib) not applicable on Bonafide transactions

Deeming Provisions afforded strict interpretation

Business decisions of Assessee cannot be challenged

K.P. Varghese (131 ITR 597)

Subhodh Menon (ITA 676/Mum/2015)

Dilip Kumar & Co (2018) 9 SCC 1

Cinestaan Entertainment P. Ltd. ITA 1007/2019

S.A. Builders (288 ITR 1)

Walchand and Co. P Ltd (AIR 1967 SC 1435)

Dalmia Cement (B.) Ltd.(ITR 543 1983)