1. INTRODUCTION

The Finance Bill, 2023 (the "Bill") introduced a significant amendment to the provision which has popularly been known as 'Angel Tax'. As per the Bill, the words 'being a resident' are to be omitted from clause (vii-b) of sub-section (2) of Section 56 of the Income Tax, 1961 (the "Amended Section 56"). Once this amendment takes effect in relation to the assessment year 2024-25, unlisted, privately held companies (not the ones in which the public are substantially interested), will need to watch out for the Amended Section 56 being also applicable in relation to share issuances to or funding from persons resident outside India (the "Non-residents"). We have discussed some key consequences and the impact it may have on the Indian investee companies and its Non-resident investors, below.

2. BACKGROUND

The extant Section 56(2)(vii-b) the Income Tax, 1961 ("IT Act") provides that if companies (not being a company in which the public are substantially interested) issue shares to a person being a resident1 at a premium exceeding the face value of such shares, and if the aggregate consideration received from resident exceeds the fair market value2 of the said shares, then such excess amount received over the fair market value of the shares as determined in accordance with Rule 11UA(2) of Income Tax Rules, 19623 (the "IT Act FMV") is taxable as 'income from other sources' under Section 56(2)(vii-b) of the Income Tax, 1961. Currently, the applicability of the sub- section is limited to residents only (excluding the Exempted Categories as mentioned below).

The government's focus on Foreign Direct Investment ("FDI") and campaign on ease of doing business in India is well known to all. Historically, companies have raised substantial FDI from Non-resident investors (on a repatriation basis) at a premium (above the IT Act FMV (as mentioned above)) without being worried about creating any tax impact on itself. Non-residents undertaking a FDI transaction are subject to the pricing guidelines as specified in Foreign Exchange Management (Non- debt Instruments) Rules, 2019 ("FDI Norms"), which mandate companies to issue equity securities to a Non-resident at a price not less than the fair valuation of such equity instruments (as per internationally accepted pricing methodology) arrived at on an arm's length basis duly certified by a chartered accountant or a SEBI registered merchant banker ("FMV")4 .

Given the volatility in markets and valuation wars in many sectors, investors prefer to take convertible instruments, whose ability to convert into a greater number of equity shares, come handy for valuation adjustments, anti-dilution, giving effect to liquidation preference, or agreed adjustments in case of indemnity claims, among other things. While a resident investment has more flexibility in such matters, under the current FDI Norms, in case of convertible equity instruments subscribed by the Non-residents, the conversion price cannot be less than FMV5 . To counter balance this requirement under law and the need to protect their economic rights, the Non-residents have traditionally subscribed to convertible equity instruments at a premium and paid subscription prices which are higher than the FMV. This ensures a buffer which can be used in case the relevant equity instruments are required to convert to a greater number of shares to give effect to any of the economic rights of the Non-resident subscriber. Unfortunately, the Amended Section 56 will lead to such difference in issue price and IT Act FMV of shares subscribed by a Non-resident, being subject to tax as 'income from other sources' in the hand of the investee company. It may also be pertinent to note that while FMV requirement is prescribed for FDI Norms as mentioned above, under the IT Act, the applicable taxes under Section 56 are to be determined based on the IT Act FMV, which in effect means that such valuation ought to be undertaken using net asset or the book value or discounted cash flow method and be duly certified by a merchant banker.

Other exemptions under Section 56(2)(vii-b) unaffected

Currently, Section 56(2)(vii-b) is not applicable if the funds are being raised from the following (the "Exempted Categories") (i) a venture capital company or a venture capital fund by a venture capital undertaking6 ; or (ii) Category I or Category II Alternative Investment Fund, registered and regulated under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 by a venture capital undertaking; or (iii) any person by a 'start-up' as recognised by the Department for Promotion of Industry and Internal Trade ("DPIIT")7 under and subject to notification number G.S.R. 127(E), dated the 19th February, 2019 ("Exemption Notification")8 .

As per the Exemption Notification, the exemption shall be available only to a 'start-up' (i) which is recognised by the DPIIT, and (ii) whose aggregate amount of paid-up share capital and share premium after issue or proposed issue of shares, if any, does not exceed INR 25,00,00,000 (Indian Rupees Twenty Five Crores). This is qualified by the condition that funds received from a Non-resident investor, shall not be included in computing the aforesaid threshold and the start-up shall not have invested or invest in such class of assets as specified in paragraph 4(iii) of the Exemption Notification, which includes immovable properties, loans and advances, capital contribution to another entity, shares and securities, motor vehicles or any other mode of transport, jewellery, or any other asset, whether in the nature of capital asset or otherwise.

It is pertinent to highlight that none of the exemptions mentioned hereinabove have been modified yet. However, it would be prudent to watch out for any forthcoming amendments to the Exempted Categories (including under the Exemption Notification), especially to align such existing exemptions with the Amended Section 56.

Given that Section 56 of the IT Act is currently only applicable to residents (with the exemptions as mentioned above), certain investee companies while raising substantial funds from resident investors (not falling within the Exempted Categories) have either (a) issued convertible equity instruments without any premium, at a high face value, or (b) have issued a larger number of convertible equity instruments at nominal face value, but convertible to a lesser number of equity shares, subject to meeting applicable valuation requirements, if any. This approach generally nullifies or mitigates the tax exposure on such companies under the extant Section 56(2)(vii-b). However, it may well be noted that such issuances may lead to additional costs to the investee company such as in terms of additional stamp duty and filing fees, depending on the state of its domicile.

3. INDUSLAW VIEW

With the Amended Section 56 being effective from assessment year 2024-25, it would pose challenges for the investee companies to give effect to and for investors (specially the Non-resident investors) to avail the valuation protection rights (such as anti-dilution or liquidation preference by way of adjusting the conversion ratio and conversion price of such convertible security), without creating a tax exposure for the investee company. As was already in prevalence, in case of issuances being made to resident investors earlier, investee companies may now in case of all persons (not from Exempted Categories) have to consider some of the measures mentioned in paragraph 2 above in order to mitigate tax exposure which may arise pursuant to Amended Section 56 including on account of its interplay with FDI Norms.

Since the Exempted Categories remain intact for now, (i) the Non-resident investors may start considering setting up funds in India in the Exempted Categories, and (ii) early stage companies may consider procuring registration as a 'start-up' with DPIIT and avail the benefits of an Exempted Category by meeting the requirements prescribed for the same.

Footnotes

1 Section 2(42) of the Income Tax Act, 1961 defines 'resident' as 'a person who is resident in India within the meaning of Section 6'. For ease of reference, the word 'person' under Section 2(31) 'includes (i) an individual, (ii) a Hindu undivided family, (iii) a company, (iv) a firm, (v) an association of persons or a body of individuals, whether incorporated or not, (vi) a local authority, and (vii) every artificial juridical person, not falling within any of the preceding sub-clauses'. Please also refer to Section 6 of the Income Tax Act, 1961 which prescribes the conditions to qualify as a 'resident'.

2 For the purposes of the clause 56(2)(viib) of the Income Tax Act, 1961, the 'fair market value' of the shares shall be the value-

  1. as may be determined in accordance with such method as may be prescribed; or
  2. as may be substantiated by the company to the satisfaction of the Assessing Officer, based on the value, on the date of issue of shares, of its assets, including intangible assets being goodwill, know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature, whichever is higher.

3 Rule 11UA(2) under Income Tax Rules, 1962, prescribes that-

'(2) Notwithstanding anything contained in sub-clause (b) of clause (c) of sub-rule (1), the fair market value of unquoted equity shares for the purposes of sub-clause (i) of clause (a) of Explanation to clause (viib) of sub-section (2) of section 56 shall be the value, on the valuation date, of such unquoted equity shares as determined in the following manner under clause (a) or clause (b), at the option of the assessee, namely:-

(a)....

(b) the fair market value of the unquoted equity shares determined by a merchant banker as per the Discounted Free Cash Flow method.

4 Rule 21(2)(ii) of Foreign Exchange Management (Non-debt Instruments) Rules, 2019 prescribes that-

'21 Pricing-

(1)...

(2) Unless otherwise prescribed in the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, the price of equity instruments of an Indian company-

(a) issued by such company to a person resident outside India shall not be less than:

(i) ...

(ii) the valuation of equity instruments done as per any internationally accepted pricing methodology for valuation on an arm's length basis duly certified by a Chartered Accountant or a Merchant Banker registered with the Securities and Exchange Board of India or a practising Cost Accountant, in case of an unlisted Indian Company.'

5 Explanation to Rule 21(2) of Foreign Exchange Management (Non-debt Instruments) Rules, 2019 states that-

'In case of convertible equity instruments, the price or conversion formula of the instrument should be determined upfront at the time of issue of the instrument. The price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with these rules.

6 The terms 'venture capital company', 'venture capital fund', and 'venture capital undertaking' shall have the meanings respectively assigned to them in clause (a), clause (b) and clause (c) of the explanation to clause (23FB) of Section 10 of the Income Tax Act, 1961.

For ease of reference, "Venture Capital Undertaking" under Section 10(23-FB)(c) has been defined in '(i) clause (n) of Regulation 2 of the Venture Capital Funds Regulations; or (ii) a venture capital undertaking as defined in clause (za) of sub-regulation (1) of Regulation 2 of the Alternative Investment Funds Regulations'

7 For the purposes of notification number G.S.R. 127(E), dated the 19th February, 2019 issued by Ministry of Commerce and Industry (Department for Promotion of Industry and Internal Trade),

'An entity shall be considered as a Startup:

  1. Upto a period of ten years from the date of incorporation/ registration, if it is as a private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) in India.
  2. Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
  3. Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a 'Startup'. Explanation: An entity shall cease to be a Startup on completion of ten years from the date of its incorporation/ registration or if its turnover for any previous year exceeds one hundred crore rupees.'

8 Start-up Exemption Notification can be accessed at https://www.startupindia.gov.in/content/dam/invest-india/Templates/public/198117.pdf

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.