Is Taxing Capital Transactions In The Era Of Foreign Investment A Necessary Evil to Boost Tax Revenues?

It’s a catch 22 situation. On one hand, there is a continuous need to improve the overall business environment in India (including the approach of tax authorities towards investors), whereas the other arm requires the government to increase direct tax collections to fund the ambitious investment target of the government.

This, when combined with the challenge to curb malpractices resulting in tax evasion leads to an aggressive approach by the Tax Department. In the past, one such malpractice has been via capital infusion in companies. The Government introduced certain laws to curb such malpractices by amending the tax provisions but the way these provisions are being practiced by the tax department is creating a difficult situation for genuine investor/investments.

Hence, the question is that how do we strike a balance? After all, we believe that the investors shouldn’t get cold feet before entering the Indian market altogether, especially when there exist feasible solutions to deal with such issues.

We’re going to start with two scenarios which have come to the fore recently and require attention, following which we’ll trace their solutions:

  • The first is about Angel Tax which continues to haunt investors and start-ups. The tax department is alleging that excessive premiums being paid by investors is the investee companies’ income, in the case of investing in start-ups. To begin with, yes this seems to be in contradiction with the Government’s efforts to soothe the nerves of investors by directing the tax department to not levy Angel Tax, but the department appears to be proceeding with a different mandate.
  • The second is about how the tax department is trying to treat Foreign Direct Investment (FDI) as unexplained credit by invoking Section 68 of the Income Tax Act, 1961.

The Problem of Angel Tax

Coming to the issue of start-up investment, those few start-ups which are lucky to survive the lack of resources will end up being targeted by the tax department when they get the resources, or particularly capital.

Understandably, the issue again gets linked to certain malpractices observed in the Indian economy in the past. Companies would receive share capital at huge/unfair premiums, which would be subsequently be paid back in cash and the investor would only hold a nominal stake in the shell company.

However, currently the cases being tracked are those of companies which are built on innovative ideas, or genuine businesses with proven concepts. Also, it is a globally known fact that such technology-based businesses invest significantly in customer acquisition and business growth plans.

Typically, the promoters of these businesses start off as boot-strapped ventures and subsequently rely on external financial support to build their businesses. Such investments include transactions negotiated between two independent parties, where the promoter wants to dilute the least possible equity and the investor wants to acquire the maximum possible equity, assuming the funding amount is constant.

Therefore, this brings the issue of valuation into contention. Considering both parties are aware that if the business is successful, higher profits will be at stake and hence there’ll be clear motivation to acquire/hold as much stock as possible when the business is small. Famous exits of promoters/early-stage investors such as the WhatsApp-Facebook transaction or the Flipkart-Walmart transaction are constant inspirations for every promoter/investor.

In such a situation, where valuation is a critical decision variable between two independent parties and deals are aggressively negotiated, the tax department’s effort to compare future projections with actual performance is irrelevant to the transaction’s dynamics.

Going by the tax department’s approach, every investment will inevitably yield huge returns, and if the company fails to achieve its projected growth, the tax department will penalize them – as if losing the business was not a penalty enough for the promoters and investors.

Business risks, non-performance, industry dynamics, and other such factors affecting the non-achievement of goals are ignored and considered irrelevant. Mere analysis of cash-flow projections from the time of investment and actual data available with the tax department after 3 years of investment leads to a conclusion that there is excess premium. In a nutshell, the tax department has taken away any risk associated with risk capital, i.e., equity.

FDI Being ‘Unexplained Credit’

India has been at the forefront in the list of countries attracting foreign investment and it is true that India needs foreign capital. However, while receiving FDI at a large scale, it is also important that the color of money being flown as FDI is not wrong.

On similar lines, tax laws allow the tax department to seek explanation on money received as share capital and understand the identity, genuineness and creditworthiness of the overseas investor. Consequently, taxpayers are being asked to provide financial data of the non-resident investor(s) to assess the genuineness and credit-worthiness of the investor.

The main issue being raised in this article is to assess the fine balance between being protective enough to prevent misuse of easy FDI policies and aggressive enough to not scare away the genuine investors.

There are various regulations such Prevention of Money Laundering Act and certain processes under Foreign Exchange Management Act which require the transacting banks, Reserve Bank of India (RBI) and the concerned Indian investee company to provide documentation at the time any foreign investment is received in India.

The process requires filing of Form FC-GPR, which will invariably establish the identity of remitter as well as a confirmation from remitter bank regarding its relationship with remitter. In addition, if the remitter is the original shareholder of Indian company, it would have already submitted its legalized (including attestation by Indian embassy in the respective country) and notarized corporate documents with the Registrar of Companies (RoC).

A foreign investor, being outside the jurisdiction of the Indian Income Tax Act, is not obligated to provide financial information in India. Other information such as name of the investing entity, their basic corporate documents, etc. are included as part of RBI’s compliance documentation. Given the above, any request from the Income Tax Department for submission of financial data of the investor company is likely to put the Indian taxpayer in an awkward situation vis-a-vis tax department and its shareholder.

Considering that it is important to strike the right balance, we need to go back to the original purpose of the introduction of Section 68 of the Income Tax Act. One of the purposes of Section 68 is to probe any sort of money laundering and conversion of black money.

In an international scenario, such kind of malpractice is often carried out through round-tripping or hawala transactions. Since there are existing laws (such as treatment of difference between fair price and transaction price, where the resident buys the shares at less than market price, as income for the buyer) and regulations to check such malpractices to begin with, it would prove important to seek relevant documentation used in compliance of these laws such as the FC-GPR documents or the entity’s incorporation documents, in case the original investor is investing.

From the taxpayers’ point of view, one of the things that can be done is to seek notarized and apostilled corporate charter documents of the investors at the time the investment is done. Even though there may not be a statutory requirement considering the time limitation at the time of tax audits, having such documentation in place will prove beneficial in establishing the identity and genuineness (to an extent) of the investor. In addition, the documentation available on public registry in the respective countries can also be produced.

Hence, it’d be better to define certain parameters where the Government believes dubious transactions may have happened and the concerned field officers should dive deep only in those transactions. For example, the cases where investment is made by an overseas private equity fund or a listed public entity, those transactions can be considered for exemption from detailed scrutiny. Overall objective of investment and subsequent use of capital may be analyzed to see if there is any possible mala fide intention behind the investment at premium.

Submission of RBI and Registrar of Companies (ROC) compliance documents can be made mandatory, and if the perusal of those documents shows glaring gaps or non-compliance, further investigations can be conducted. Even in such situations, the matters may be referred to FT&TR for investigation so that appropriate information can be obtained through right channels. But applying the same process for every transaction will inevitably become a pain-point for genuine investors as well as the tax department.

Conclusion and Key Takeaways

It is a delicate balance but considering the administration’s continuous efforts to improve India’s Ease of Doing Business ranking, it is imperative to mandate that such capital transactions are not routinely brought into the tax net.

For this, understanding of new age businesses is a must for effective implementation of tax laws. Without this, India will continuously be looked down upon as an aggressive tax jurisdiction. Quest for growth in tax revenues cannot come at the cost of the investors’ convenience. From an economic perspective, the need for FDI and support capital for start-ups is much more than the need for protecting tax revenues.

There needs to be a more structured and risk-based approach towards the application of the above provisions or else, start-ups will inevitably start restructuring their operations and take their key functions outside India and keep the risk capital outside India, as well.

Training and transparency will play a huge role in this transformation. A great example of excellent collaboration between the Tax Department and the taxpayer has been the Advance Pricing Agreement (APA) for transfer pricing matters. I believe the critical thing for its success was the availability of the Tax Department to understand the business by visiting the business. This allowed them to have a better perspective while deciding complex transfer pricing matters. Similarly, it is imperative to get proper business insight to evaluate whether excess premium should be taken as income or not.

Hence, the question will always be to decide the priority. While it is the prerogative of each successive government, I believe promoting entrepreneurship and capital investment should always remain at the forefront.

Written by Nitin Garg

As one of the founding partners at Coinmen Consultants LLP, Nitin currently heads the Corporate and International Tax practice for the firm.

Note: Views presented in the article are of the author and not the firm.

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