If we ran a poll on the most oft-quoted reactions by tax professionals to the Finance Minister’s Union Budget Speech each year, the adage ‘the devil is in the detail’ is likely to figure high. While this year’s budget overall appears to be well-balanced though walking a tight rope between continuing an economic stimulus through capex spends and fiscal prudence, after going through the fine print of the tax proposals, we found the inevitable devil in the proposed amendment to the so-called ‘Angel tax’ provisions.
The deemed income provisions (under Section 56(2)(viib) of the Income-tax Act, 1961) require Indian companies to offer to tax, any consideration received on allotment of shares with share premium in excess of the fair value of the shares (as per prescribed tax rules). As they currently stand, the provisions can apply to Indian companies raising funds only from resident investors, but the budget proposes that their application should be tested irrespective of whether the investor is a resident or a non-resident. The provisions were introduced as anti-abuse rules that were meant to curb money laundering arrangements. Raising of capital from some categories of investors was purposely excluded in testing these provisions, such as venture capital funds, AIFs and non-resident investors. Moreover, Government companies, listed companies and their subsidiaries as well as certain eligible start-ups remain outside the purview of these provisions.
Time and again, there have been calls to abrogate this tax as it entices the taxman for passing commercial judgement on matters dictated by fluid market forces. There have been instances where companies have been questioned by tax authorities on valuations in a fund-raise from resident investors, even where such valuations were adopted consistently by a group of investors, including non-resident investors. Quite the opposite of the general expectation that a level playing field would be given to domestic investors by repealing ‘Angel tax’, a parity has instead been proposed through an unanticipated measure to bring transactions involving non-resident investors into the tax net. In fact, unless the Government clarifies specifically, non-resident investor community would be worse off in a comparison to resident investors, because unlike resident AIFs, regulated offshore entities are not excluded from these provisions.
Taking a closer look at the potential implications on transactions and deal making, one obvious outcome would be the difficulty in concluding concurrent transactions with differential pricing. For instance, if the primary infusion by a non-resident into a company happens at a higher premium compared to price it pays on purchase of shares from residents, the lower valuation benchmark set by share transfers may become the cause for questioning the higher premium received by the investee company.
Unlike resident investors, non-resident investors are prohibited from investing into companies at a price below the fair market value as per an internationally accepted valuation methodology (‘FDI norms’). Therefore, the only tax-free option would be for them to invest at exactly the fair value price. However, that leaves no flexibility for the parties to entertain their own perceptions of valuations, which can widely vary. If the company management believes that the company price per share should be no less than 100, but the investor believes that the current fundamentals of the company support a price of 80, then provided that the fair market value of the share under FDI norms is not more than 80, they may mutually agree to structure a deal through a convertible instrument which allows the investor to exercise a conversion price of 80 if the company is unable to demonstrate its performance on agreed parameters.
Conversely, if the agreed performance criteria are met, the strike price is set at 100. Now it needs to be seen if this difference of 20 in the perception of the actual valuation between parties could be taxed in the hands of the Company. Another nuance, connected to the inter-play with the floor price set by foreign exchange regulations for foreign investors, is the potential impact on contractual anti-dilution mechanisms.
We know that several new age companies have successfully managed multiple fund-raises from sophisticated investors, providing impetus to the capital starved ecosystem, by demonstrating futuristic valuations that may not have been supported by conventional valuation methodologies at the time. In particular, early-stage investors have found confidence in founders and their vision in order to adopt seemingly rich valuations that can reap richer rewards down the line. These are pure market forces at play, where unrelated parties put a premium on what they believe the company’s potential is worth.
As a core principle, receipt of money on allotment of shares is a ‘capital receipt’ by the company for deployment in its business activities. This should not constitute a tax triggering event for the company as arguably no ‘benefit’ or ‘income’ has arisen to the Company. While there may be justifiable grounds to invoke deeming fiction for taxation of funds received by a company in certain situations, such transactions may be targeted under the other existing anti-abuse provisions, such as provisions requiring furnishing of satisfactory explanation for sources of funds.
In conclusion, it is hoped that the Government will reconsider this proposed amendment in view of its problematic ramifications on the ease of making investments. At a time that India is trying to position itself as bright spot in the world economy and a preferred destination for foreign capital, these provisions will create unwelcome uncertainties that disturb the accepted framework for foreign investment.
(By Kalpesh Desai, Partner – M&A and PE Tax, KPMG in India, and Amisha Singal, Partner – M&A and PE Tax, KPMG in India)