Angel tax - Widening the ambit of Transfer Pricing

India is one of the biggest hubs of the 'Start-up' ecosystem in the world. It ranks third with over 90,000 start-ups and 107 unicorn companies worth 30 billion dollars1.

Angel tax was introduced in 2012 in the form of Section 56(2)(viib) of the Income-tax Act, 1961 (the Act) to potentially avoid money laundering practices (especially in the cases of start-ups) through the subscription of shares of a closely held company. Unlisted companies (usually start-ups) in receipt of any money in the form of investments over and above the fair value would be subject to income tax under the head ‘Income from other Sources’ for the relevant financial year.

The introduction of Angel Tax was not embraced by angel investors across the country in light of the potential ramifications for the ‘Start-up’ ecosystem.

Amendment in the Union Budget 20232

The provisions of Section 56(2)(viib) of the Act are amended whereby the government has also included foreign investors in the ambit of Angel Tax. This means when an unlisted company, such as a start-up, receives equity investment from a resident or a non-resident for the issue of shares that exceeds the face value of such shares, it will be counted as income for the start-up and be subject to income tax under the head ‘Income from other Sources’ for the relevant financial year in India.

The amendment shall be with effect from 1 April 2024.

Potential Transfer Pricing implications

Pursuant to the amendment, if the non-resident investor and the investee company in India are qualified as an ‘Associated Enterprises’ (AE) as per the provisions of Section 92A of the Act and if there is any income chargeable to tax in India for the investee company under Section 56(2)(viib) of the Act on account of AE investing in the shares of a closely held company (Indian investee in the instant case) at a value over and above the fair market value of the shares then the transaction would fall within the purview of ‘international transactions’ under Section 92B of the Act as per the provisions of the Indian Transfer Pricing (TP) Regulations and would therefore be required to be computed having regard to the principle of Arm’s Length Price (ALP).

Issue of equity shares by Indian investee - Reporting requirements and determination of ALP

Indian taxpayers have been reporting the international transaction relating to the issue of shares in the Accountant’s Report in Form 3CEB (Report) out of abundant caution, pursuant to the decision of Hon’ble Bombay HC in the case of Vodafone India Service Pvt. Ltd3. wherein it was held that the issue of share by an Indian company to non-resident company does not give rise to any income and thus provisions of Chapter X of the Act are not applicable to the said transaction.

It is evident from the decision that the non-applicability being referred to herein is in the context of the determination of ALP, i.e., when no income arises from an international transaction, the question of determining ALP does not arise. The HC has not specifically discussed reporting an international transaction in the absence of income arising therefrom.

With the amendment in the provisions of the Act, the transactions between Indian closely held companies and their AE could potentially lead to income chargeable to tax in India, thereby triggering TP compliance requirements (by reporting such transaction in Clause 16 of the Report) having regard to the ALP and documentation required for the transaction relating to the issue of shares for the relevant year under consideration.

For the purpose of determination of the ALP of the said transaction, the independent valuation report relied upon by the Indian investee for the determination of the fair market value for the purpose of Rule 11UA of the Income-tax Rules, 1962 (the Rules) could potentially act as a determinant factor. However, Revenue authorities potentially challenging the methodology, criteria and data points used for the valuation report to arrive at the fair market value by the Indian investee cannot be ruled out. Also, on the business front, domestic entrepreneurs and foreign investors would be indignant toward widening the coverage of Angel Tax to nonresidents. This may potentially cause a hindrance to the ‘Start-up’ ecosystem in India, wherein capital investors would potentially look out for other investment opportunities in different countries.

2. Finance Bill, 2023
3. Writ Petition no. 871 of 2014