Angel Tax on Multinational Companies might trouble FDI

One of the most controversial items in the Union Budget 2023-24 was the reintroduction of the Angel Tax; or the tax on unfair profits in private unlisted companies. The idea of Angel Tax was first mooted in the Union Budget 2013-14 and had a good intent. The intent was to prevent money laundering. Here is how it worked. A private company would be created and then would be sold to a domestic or global entity at a price not connected to the basic fundamentals of the company (fair market value).

The excess funds were laundered; or that was supposed to be the modus operandi. In its original form, venture capital players were anyways exempt from the purview of Angel Tax. This angel tax was only applicable to resident investors. In Budget 2023-24, the angel tax has been extended to non-resident investors too. That has been the big shift. Currently, the government is seeking public feedback, but if it is introduced, it could be a major sentiment dampener to the FDI flows and start-up ecosystem.

What is the big change proposed by Finance Bill 2023?

The passage of the Finance Bill, 2023, has clearly proposed to bring issuance of unquoted shares to non-residents also within the ambit of angel tax. The idea is to eliminate the possibility of tax avoidance using tax havens. The government has now gone a step further. It has exempted FDI flows into start-ups from well-regulated and compliant sources like the US, UK, and France. However, if these flows into Indian unlisted start-ups come from markets that are not so well regulated like Ireland, the Netherlands, Singapore, or Mauritius, then the angel tax provisions would apply. This is likely to deeply impact the valuations of unlisted start-ups in primary market raising funds from offshore investors.

However, there are some clear exemptions. Firstly, investments from designated sources as stated above will continue to be exempt. Flows from VCs and VCs located in IFSC would also be exempt from these provisions. Above all, the investments by non-residents into eligible start-ups will also continue to be outside the purview of angel tax. These are exemptions. Barring these exceptions, all other foreign direct investments (FDI) into closely held private companies and larger start-ups shall be subjected to such angel tax provisions. The logic is whether the consideration paid for the private unlisted start-up is “SUBSTANTIALLY” more than the fair market value (FMV). The authorities have also given detailed guidelines and methodology for estimating the FMV in such cases. So, it looks like an attempt to plug loop holes in the tax system, but could have consequences for FDI. The good news is; it could divert more flows via AIFs, which are still exempt from angel tax.

Nuances of FMV and pricing

The real bone of contention here is whether the investor is paying substantially more than the fair market value (FMV) or not. Now comes the catch. On the face of it, all issuance of shares in Indian companies (listed or unlisted) to non-residents is subject to pricing guidelines under the Indian foreign exchange regulations. This anyways provides for the FMV as the floor price for the issuance of shares. The FMV, as in the case of any business valuation, would be again based on the discounted cash flow (DCF) method, to adhere to the floor price rules prescribed by the Indian foreign exchange regulations.

However, there are other considerations like convertibles, preferential exit, anti-dilution undertakings and substantial control, that determine the premium. Most non-residents are willing to pay a premium over the floor price. Apparently, the CBDT has a problem only in two areas. Firstly, where the price paid is at a substantial premium to the fair market value (FMV). The second area is about justifying the premium. If the premium can be justified based on covenants like convertibles, preferential exit, anti-dilution, or control premium; it is still OK. The problem is where the premiums are arbitrary and cannot be veritably justified and explained.

There are larger implications on the issue of convertible instruments. Here is why. For instance, stake in start-ups is often sold to non-residents using convertibles like convertible debt or convertible preferential shares. In all these cases, the conversion ratio is agreed upon at the time of the issue of convertibles itself. Now, if the conversion ratio is out of sync with the FMV logic as prescribed by the CBDT, then again there could be an issue of angel tax getting triggered. Since the Finance Bills is effective from April 01, 2023, it exempts all such deals closed up to March 31, 2023. However, this grandfathering clause would not be applicable in case of convertibles where the conversion happens after March 2023. So, there are going to be a plethora of contentious and open issues and it would apt for the CBDT to issue detailed clarifications on these items.

Will this cannibalize FDI flows into India?

That is a moot question, but let us play devil’s advocate to begin with. One concern is that the angel tax provisions may force a lot of Indian start-ups to shift their domicile or headquarters to investor-friendly jurisdictions. Many of the fast growing nations like Singapore and the UAE offer a very conducive environment for start-ups with very few questions being asked. That could trigger further debate on deemed Indian companies versus domiciled Indian companies and could become the setting for a lot of unnecessary litigation. We have seen such flipped structures in the past and it is likely to happen all over again, something that is best avoided.

Having played devil’s advocate, the bottom line is that sound and solid regulation has always been conducive to the orderly growth of markets. That has been the past experience. It may come with some teething problems, but most Western nations are generally very particular about compliance. India needs to have a robust start-up ecosystem but that does not mean becoming an open market for value trading. The government may have a tough point to sell, but it may be good in the long run. What India needs to be careful is that such provisions do not lead to unnecessary hounding of businesses.