Dream Big, Start Small, Act Now - Start-ups
Published: Jul 10, 2018
"Growth is never by mere chance; it is the result of forces working together."
- James Cash Penney
On 16 January 2016, the Government of India launched the "Start-up India, Stand-up India" campaign with the intention to build a strong eco-system for nurturing innovation and generating employment. A 19-point action plan was unveiled to encourage and channel the growth of start-ups in India. Though the main purpose of this initiative is to bring clarity, simplicity, uniformity and provide ease of entry and exit into the start up space, the government also intends to provide funding support and tax incentives to eligible start-ups.
The Department of Industrial Policy and Promotion (DIPP) under the "Start-up India" scheme, defines an eligible start-up to mean a private limited company, a registered partnership firm or limited liability company in India, which has been incorporated or registered for less than seven years and has an annual turnover less than INR 250 million (~USD 3.80 million). The start-up should be working towards innovation, development or improvement of products, processes or services, or if it is a scalable business model, it should have a high potential of employment generation or wealth creation.
Over the years, start-ups have turned out to be a major source of employment as well as revenue. Thus,the government has granted a number of tax benefits to start-ups with a view to incentivize them. Some income tax incentives and reliefs available to eligible start-ups under the Income-tax Act, 1961 (IT Act) are as under:
1. Tax holiday for three years in a block of seven years [Section 80-IAC]
Section 80-IAC of the IT Act provides an incentive to start-ups and facilitates their growth in the initial phase of their business.Post Finance Act, 2018, 100% deduction shall be available of the profits and gains derived by an eligible start-up incorporated on or after 1 April 2016 but before 1 April 2021, from carrying on eligible business. The deduction shall be available for any three consecutive assessment years out of seven years from its incorporation, subject to fulfilment of prescribed conditions.
The tax holiday provides the much-needed relief to start-ups in their initial years of operations and thereby helps meet their tax cost.
2. Angel tax exemption on investments above the fair market value [Section 56(2)(viib)]
Angel tax is levied at the rate of 30% (plus applicable surcharge and cess), on investments made by external investors above fair valuations in a start-up or a closely held company. However, over the years, this tax has made many angel investors shy away from offering financial support to start-ups.
Thus, to prevent the incidence of angel tax on investment in start-ups, the DIPP and Central Board of Direct Taxes (CBDT), through a series of notifications, have provided relief to start-ups from such taxation. The CBDT notified that angel investors funding approved start-ups, shall be exempt from incidence of tax under section 56(2)(viib) of the IT Act 1. Similarly, as per the DIPP notification, an application in Form2 shall be filed by the start-up to claim exemption from the applicability of Section 56(2)(viib) of the IT Act 2. The start-up company shall be eligible to apply for the exemption, subject to following conditions:
(i) the aggregate amount of paid-up share capital and share premium of the start-up after the proposed issue of shares does not exceed INR 100million;
(ii) the investor/proposed investor, who proposed to subscribe to the issue of shares of the start-up has, -
(a) average returned income of INR 2.5 million or more for the preceding three financial years; or
(b) net worth of INR 20 million or more as on the last date of the preceding financial year, and
(iii) the start-up has obtained a report from a merchant banker specifying the fair market value of shares in accordance with Rule 11UA of the Income-tax Rules, 1962.
Generally, start-ups get high valuation because of their innovative ideas or business models. Application of Section 56(2)(viib) of the IT Act to recover the tax on such valuation is prejudicial to the interest of the start-ups. Thus, the relief from angel tax to approved start-ups makes them a more attractive investment option and also reduces their cost of funding.
3. Set off and carry forward of losses allowed in case of change in shareholding pattern [Section 79]
Section 79 of IT Act provides that carry forward and set off of losses in a closely held company shall be allowed only if there is continuity in the beneficial owner of the shares carrying not less than 51% of the voting power, on the last day of the year or years in which the loss was incurred. However, relief has been provided to start-ups from the provisions of this section by excluding a company which is an eligible start-up carrying on eligible business, if all shareholders of such company which held shares carrying voting power on the last day of the year or years in which the loss was incurred:
(i) continue to hold those shares on the last day of such previous year; and
(ii) such loss has been incurred during the period of seven years beginning for the year in which such company is incorporated.
Start-ups are on constant lookout for funds and raise them from a series of new investors joining their growth story, resulting in substantial dilution of equity and voting rights. The eligibility to carry forward and set-off of tax losses even after substantial change in shareholding, shall help them reduce their tax cost and manage their ETR.
4. Other tax benefits
(i) Union Budget 2018 reduced the income tax rate to 25% for domestic companies if the total turnover or gross receipts of the previous year 2016-17 did not exceed INR 2,500 million. The reduced rate helps start-ups in ploughing back the tax savings for the growth of their business. However, start-ups are liable to pay tax under MAT or under AMT provisions if the tax payable under normal provision is lower than MAT / AMT liability.
(ii) Start-ups not maintaining books of accounts in their initial years may opt for presumptive taxation under section 44AD of the IT Act. Under the said provisions,an assessee can offer 8% of total turnover or gross receipts as its income from profits and gains from business and profession for determination of tax liability. This benefit is subject to the condition that total turnover or gross receipts do not exceed INR 20 million per annum. Aneligible start-up selecting the presumptive taxation scheme must set up its business as an individual proprietor or registered partnership firm.
(iii) Under Section 80JJAA of the IT Act, an assessee liable for tax audit under section 44AB of the IT Act is entitled for a deduction of 30% of additional wages paid to new regular employees for three consecutive years,subject to prescribed conditions. The deduction for employee cost reduces the effective cost of hiring new talents by start-ups.
(iv) With a view to incentivise investments in start-ups, section 54EE of the IT Act provides exemption from capital gains tax if the long term capital gain proceeds are invested by an assessee in units of such specified fund, as may be notified by the central government in this behalf, subject to lock-in of three years. The investment in the units of the specified fund shall be allowed up to INR 5 million. One awaits the notification of such units for indirect participation in the growth story of start-ups.
(v) Section 54GB of the IT Act provides exemption of long-term capital gain arising from the sale of residential property by an individual or HUF, on investing the same in the shares of a start-up.This is subject to the start-up utilising the said proceeds towards purchase of a new asset within one year from date of subscription of equity shares.
Although start-ups may be small companies, they play a significant role in the economic growth of the country by not only creating new industries but also providing creative employment opportunities. Over the next few decades, start-ups through their innovation and new business models will play a major role in the manner we conduct our businesses. Thus, the initiations by the Government of India vis à vis the funding support and tax incentives, are welcome moves as they provide a business-friendly environment and reduce tax burden on the innovation drivers.
[Manish Jain is Senior Manager and Ritika Maheshwari is an Associate with Deloitte Haskins and Sells LLP. The views expressed are strictly personal.]
1 CBDT Notification No.45/2016 dated 14th June 2016; CBDT Notification No. 24/2018/F. No.370142/5/2018-TPL (Pt) dated 24th May 2018; DIPP - Notification No. GSR 501(E) [F.NO.5(91)/2015-BE-I], dated 23-5-2017; DIPP - Notification No. GSR 364(E) [F.NO.5(4)/2018-SI], dated 11-4-2018.
2 Notification No. GSR 364(E) [F.NO.5(4)/2018-SI], Dated 11-4-2018 - "Board" means the Inter-Ministerial Board of Certification comprising of the members from :- DIPP, Representative of Ministry of Corporate Affairs, Representative of Ministry of Electronics and Information Technology, Representative of Department of Biotechnology, Representative of Department of Science & Technology, Representative of CBDT, Representative of RBI, Representative of Securities and Exchange Board of India.