This article is written by Prabhat B Shetty, pursuing a Certificate Course in Advanced Corporate Taxation from LawSikho.

Introduction

A start-up company is an entrepreneurial venture which is typically an emerging, fast-growing business that aims to solve an unmet need by developing a viable business model around an innovative product or a service. It is a newly established business usually small in size. A start-up is usually a company designed to effectively develop and validate a scalable business model.

The Government of India has announced an initiative for creating a conducive environment for start-ups in India. Various Ministries of Government of India have initiated a number of activities for this purpose. In this article I have tried to explain the various tax implications which the start-ups need to have an adequate knowledge of, as this information will form a part of effective business structuring. 

Under the Start-up India Action Plan, start-ups that meet the definition as prescribed under G.S.R. notification 127 (E)  is eligible to apply for recognition under the program. This definition is similar to the explanations and conditions provided in eligible start-ups and eligible businesses which is discussed in brief in the later part of this article.

An inevitable question that may follow now is how start-ups recognized and what is the process involved for this. Let us read on to find out more. 

Process of recognition of start-ups

The tax benefits and also other benefits provided to start-ups are only provided to Department of Industrial Policy and Promotion (DIPP) recognised start-ups.

Start-ups can be recognised by submitting a simple application through a mobile app or through the portal (https://www.startupindia.gov.in) to the Department of Industrial Policy and Promotion (DIPP). The following steps need to be followed:

1. Application must be made by an incorporated entity or a registered LLP which fulfils the definition of start-up. A copy of registration or incorporation must be submitted;
2. A write-up must be submitted regarding the nature of business, its development and improvement of product, process or services;
3. Additional documents providing website link, pitch deck, details if patent etc. must also be attached;
4. Information about any award received by the entity;
5. Documents related to funding as follows:

• Recommendation with regard to innovative nature of business in a format specified by DIPP from:

• Any Incubator established in post-graduate college in India; or
• Any Incubator recognised by the Government of India; or

• A letter of funding:

• By Government of India or any State Government as part of any specified scheme to promote innovation; or
• by any Incubation Fund/ Angel Fund/ Private Equity Fund/ Accelerator/ Angel Network duly registered with SEBI that endorses innovative nature of business; or

• A Patent filed and published in the journal by the Indian Patent Office in areas affiliated with the nature of business being promoted; or
• A letter of support by any incubator which is funded in relation to the project by Government of India or any State Government as part of any specified scheme to promote innovation.

It is also extremely pertinent to note what falls within the purview of eligible start ups. Let us read on to find out more.

What are eligible start-ups?

Under section 80-IAC of the Income Tax Act, 1961, eligible start-up means a company or a limited liability partnership (LLP) which is engaged in the eligible business, subject to the following conditions:

1. The start-up must be incorporated or registered on or after 1st April, 2016 but before 1st April, 2021;
2. The Turnover of the start-up must not exceed Rs. 25 crores (this limit has exceeded to Rs. 100 crores as per clause 36 of Finance Act, 2020);
3. The start-up must hold the certificate of eligible business from the Inter-Ministerial Board of Certification.

 The Inter-Ministerial Board of Certification consists of following members:

• Joint Secretary, Department for Promotion of Industry and Internal Trade;
• Representative of Department of science and Technology; and
• Representative of the Department of Biotechnology.

What are eligible businesses?

Under section 80-IAC of the Income Tax Act, 1961, eligible businesses are:

1. Those businesses that are carried out by  eligible start-ups;
2. Those businesses that are engaged in innovation, development or improvement of products or processes or services;
3. Those businesses which have a scalable business model with a huge potential of wealth and employment generation.

Tax benefits for start-ups

• Tax holiday for start-ups

Tax holiday means total exemption from paying the requisite amount of Tax for a particular period.

Benefits:

100% tax exemption for any of the 3 consecutive financial years out of the first 10 years since incorporation. The start-ups can actually choose 3 continuous years from the 1st decade of their start-up in which they do not want to pay tax.

Conditions:

Applicable only for eligible start-ups as specified under section 80-IAC of the Income Tax Act, 1961.

Purpose:

This allows the new business the flexibility to expand their operations, enhance their productivity and concentrate on developing a sustainable growth model instead of rushing things and aiming for short term profits. 

• Tax exemption for angel investors

Angel investors are usually individuals looking for best investment opportunities or a group of industry professionals who are willing to fund the venture in return for equity stake in the business.

Benefits: 

Earlier, angel tax was levied by the Government under section 56(2)(viib) @30% from the angel investor on funds invested at a share price above the fair market value. Now an amendment was made in which 100% exemption is allowed on tax being levied on investment above FMV. 

Let us understand it with the help of an example:

X is a company and Y is an Angel investor in that company. Y has invested Rs 100 in X Co. in return for shares which has a market value of Rs. 60

In this scenario, Rs. 40 (100-60) is the capital raised for X Co. 

Earlier 30% tax was charged by the Government i.e Rs. 12 (30% of Rs.40) was taxed by the government and the company could raise only Rs. 28 as capital. Now with the help of the much needed amendment, the entire capital of Rs.40 is exempt from tax.

Conditions:

In order to be claim exemption from section 56(2)(viib) following conditions must be satisfied:

1. It must be a recognised start-up.
2. After the proposed issue of shares, the aggregate amount of paid up share capital and share premium must not exceed Rs. 25 Crores.

Purpose:

The relief in Angel tax has encouraged Indian investors to invest in domestic start-ups as the fundamental problem with this tax was that it was imposed only if a resident investor were making the investments in Indian start-ups as the investments from non-resident investors and venture capitalist funds did not fall under the ambit of angel tax.

• Capital gains tax for start-ups

Any profits or gains arising from a sale or transfer of a capital asset will be considered as capital gains. The Government of India has allowed certain exemptions or reliefs on tax which are charged on such capital gains.

Section 54GB:

Benefits: 

As per this section tax on Long Term Capital Gains (LTCG) will be exempt if the net consideration (amount gained) from the transfer of residential property is invested in a new start-up by subscribing to its shares.

Conditions: 

1. The LTCG must arise to an individual/HUF in case of transfer of residential property.
2. The amount of net considerations must be used in subscribing equity shares of a new start-up before the due date of filing the income tax returns under section 139(1).
3. If the entire amount of net consideration has not been used then exemption will be allowed on a proportionate basis.
4. The new start-up must utilize the share capital in purchase of new assets within 1 year of such subscription.
5. The equity shares acquired by the Individual or HUF and the new assets acquired by the new start-up must not be sold or transferred within a period of 5 years.

Purpose: 

There are many new start-ups who are in need of urgent funds and in order to sustain their business and keep it running they have to sell their residential property. With the implementation of this section the government has made an attempt to not burden the investor and the start-ups by collecting taxes on the profits made on such sale.

Section 54EE:

Benefits:

Under this section LTCG of eligible start-ups are totally exempt from tax if such gains or part of it are invested in funds notified by the Government.

Conditions:

1. It must be a Long term Capital Gain;
2. Whole or part of the Capital Gain must be invested in long term specified assets as notified by the Government;
3. Such investment must be made within a period of 6 months from the date of transfer;
4. The amount of investments in such specified assets must not exceed Rs. 50 lakhs during the financial year;
5. The assessee must not transfer or convert the specified assets within 3 years of such investments. (Lock-in-period)

• Set-off and carry forward of losses in a start-up

Section 79 of the Income Tax Act, 1961 as amended through Finance Act, 2017 allows set-off and carry forward of losses in a start-up subject to certain conditions.

Benefits:

Start-ups incurring losses in the early stages of their businesses can carry forward their losses for a maximum of 8 assessment years and can set it off in the year in which profits were earned. As the total income in the profitable year will reduce significantly because of setting-off of previous year’s losses, the tax liability will be lower.

Conditions:

1. It must be an eligible start-up;
2. The original shareholders voting power and shareholding must be unchanged from the year in which the start-up was registered upto the year in which set off provisions were implemented.

Impact: This requirement of maintaining the original shareholders is impractical and difficult to maintain. Let’s say if one investor sells his stakes or the start-up decides to raise more funds then the start-up will have to forego the benefit of carry forward and set off losses.

Parul Jain, Partner at Deloitte had stated that start-ups can only carry forward the losses if all of the shareholders, who were shareholders in the year in which losses were incurred continue to be the ones when the start-up wants to utilise the loss. As per her analysis, the requirement to have all the shareholders as it is doesn’t work.                        

Conclusion

The Government of India is trying to become a regime which permits businesses to operate autonomously without compromising on the interests of the stakeholders. Each and every step taken by the Government of India seems to be towards removing regulatory bottlenecks which affects the smooth functioning of an enterprise.  

As the Start-Up India Action Plan is concerned, it is expected that the government’s vision to provide support to ambitious entrepreneurs will encourage innovators and investors alike.  The major tax implications which every start-up will go through have been covered in this article. I hope the tax(ing) struggle of a start-up will be a bit easier to navigate.

References

• https://taxguru.in/corporate-law/simple-steps-recognition-register-startup-startup-india-portal.html#:~:text=2.-,Process%20Of%20Reco gnition%20Of %20Start % 2 D U p,of%20Industrial%20Policy%20and%20Promotion
• https://www.moneycontrol.com/news/business/budget-2020-tax-incentives-to-startups-expanded-4864551.html
• https://cleartax.in/s/startup-india-tax-exemptions-eligibility
• https://www.icsi.edu/media/webmodules/SBEC_BOOK_2020.pdf
• http://www.lawstreetindia.com/experts/column?sid=156

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