Start-Ups and Indian Income tax laws

As per Economic Survey 2020-21 (“the Survey”) tabled in Parliament of India, India currently houses 3rd largest start-up ecosystem in the world with 38 firms being valued at over $1 billion or having the coveted “Unicorn status”. In 2020 alone, 12 new unicorns were added by India^[5]. Further, another 38 start-ups entered the unicorn club in first 11 months of 2021^[6].

• a) Legal Constitution: Is a private limited company or registered as a partnership firm or a limited liability partnership;
• b) Age of Entity: Has not yet completed a period of ten years from the date of incorporation/registration;
• c) Turnover Ceiling: Has an annual turnover not exceeding Rs. 100 crores for any of the financial years since incorporation/registration;
• d) Innovation & Scalability: Is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation; and
• e) Organic Formation: It is not formed by splitting up or reconstructing a business already in existence.

a) Tax Holiday (Section 80-IAC)

100% profits of a start-up from eligible business are exempt from income-tax provided it is incorporated between 1 April 2016 till 31st March 2022. This exemption can be claimed for any 3 consecutive years out of a period of ten years from date of its incorporation. The option to choose 3 consecutive years out of 10 years has been provided given that generally start-ups take time to turn profitable.

b) Exemption from Angel Taxation (Section 56(2)(viib))

Under provisions of the Act, where any company receives any consideration for issuance of shares to resident investors which exceeded its fair market value (FMV) basis the mechanism prescribed under the Act, such excess amount is taxable in hands of such recipient company. These provisions were introduced as anti-abuse provisions to prevent malpractices like money laundering, use and investment of unaccounted money etc.

However, given that during initial phase of their life, the start-ups rarely earn profits commensurate to their size, traditional valuation methods like return on assets, return on capital employed, free cash flow-based models cannot be used and / or have lot of subjectivity around them and generally cannot be used straightaway for valuation of Start-Ups. Eventually hybrid models are generally used for computing their valuation wherein lot of weightage is given to the business idea of the start-up, its scalability and commercial feasibility.

Given the same and subjectivity around valuation methodology, it used to be a matter of intense litigation between the taxpayers and Indian tax authorities. Further, since in case of start-ups, these provisions used to impact investments received from angel investors (generally wealthy individuals), it came to be known as “Angel Tax”.

In the past years, a lot of notices were issued by Indian tax authorities to investigate valuation methodology and/ or FMV of shares issued. According to a report, nearly 73 per cent of the start-ups received one or more Angel Tax notices^[7]. Therefore, this matter received a lot of media attention and bought unwarranted adverse publicity to India as an investment destination.

Accordingly, the matter was taken up at the level of Prime Minister and Finance Minister and it was decided to provide relief to recognised start-ups from the provisions of “Angel Tax”. As a result of the same, investments received by such start-ups were taken out of the purview of “Angel Tax” subject to satisfaction of specified conditions.

c) Tax Exemption to Individual/HUF on Investment of Long-Term Capital Gains in Equity Shares of Start-ups (Section 54GB)

100% tax exemption is available to individuals/ HUF in relation to long term capital gains income on sale of residential property wherein subject to prescribed conditions, the net consideration received on sale is invested in equity shares of a start-up.

The start-up needs to use the amount invested to purchase assets and should not transfer such assets within 5 years from the date of its purchase. This exemption was provided to channelise and allow young entrepreneurs to utilise proceeds from sale of residential property to fund acquisition and capital needs of the start-up without worrying about income tax related consequences.

d) Relaxation in Relation to Set-off and Carry Forward of Losses Even in Case of Change of Shareholding (Section 79 Amendment)

As stated above, start-ups generally take time to break-even and turn profitable. Majority of the companies from start-up ecosystem that have made it big and have got their shares listed on stock exchanges in India are still not profitable (including Zomato, Paytm, Policybazaar etc.).

In the early phase of their life, start-ups generally incur losses and to carry on, sustain and scale-up their business operations, raise funding by diluting the stake of the promoters. Due to such change in shareholding, the losses incurred in previous years were not available for set-off in subsequent year(s) to start-ups due to application of section 79 of the Act.

In view of the same, the Act was amended to allow the start-ups to carry forward and set-off earlier year losses, if all the shareholders of such company who held shares carrying voting power on the last day of the year in which the loss was incurred continue to hold shares on the last day of the previous year in which such loss is to be carried forward/ set-off.

“Start-ups have been a focus area for the Government of India and lot of demands of the start-up industry have been considered and also been met. However, there is always scope for more and accordingly, few suggestions in this respect have been stated hereunder.”

Proposal A: Rationalisation of Section 194-O E-Commerce TDS

In the recent years, new provisions in relation to tax deduction have been included under the Act. Under provisions of section 194-O, an e-commerce operator is obliged to withhold tax at 1% on payments to be made to e-commerce participants (vendors) for the sale of goods/provisions of services facilitated through the portal. Such a deduction also needs to be made in cases where the purchaser directly makes payment to the e-commerce participant for sale of goods/ provision of services facilitated through e-commerce platform.

Although the stated objective has been to report the transactions and thus increase compliance by the taxpayers, however the same has adversely impacted ease of doing business for start-ups by increasing compliance burden. It has led to increase in administrative costs and puts e-commerce participants/ vendors in a disadvantageous position vis-à-vis traditional business given that TDS to be deducted by e-commerce platform creates working capital issues in terms of blocked TDS credit (which is akin to cash) for such vendors and thus increases cost of doing business.

To ease these problems being faced by businesses including start-ups, the Government of India should consider easing the rigours of this section and/ or compliance burden especially for start-up sector. To provide relief to start-up sector, here are some suggestions:

• Specific Circumstances & Extended Thresholds: Make these provisions applicable only in specified circumstances or with some thresholds in case complete withdrawal of these provisions is not an option (threshold of INR 500,000 already exists in relation to individuals and HUF and this may be extended to other forms of businesses like partnership, companies as well); or
• Direct Payment Exemption: The section should not be applicable in cases where the buyer makes the payment directly to e-commerce participants/ vendors for the sale of goods/ provisions of services facilitated through the portal given that it involves lot of administrative efforts to track such payments; or
• Periodic AIS Reporting in Lieu of TDS Withholding: Alternatively, introduce a reporting mechanism (wherein reporting needs to be made at adequate intervals say quarterly) instead of tax withholding provisions. Such data may be collected and reported in Annual Information Statement (AIS) being provided to taxpayers by the Income tax department. This would serve the purpose of collecting relevant information/ relevant data and at same time not have any working capital issues on the start-ups.

Proposal B: Incentives to Channelise Resources from General Public

As discussed above, start-ups are generally set-up by the people who possess the ideas, techniques, capabilities etc. but lack the necessary resources, to capitalise and commercialise them. Lack of resources is another factor why lot of people do not want to venture into this area. It is also been seen that lot of start-up entrepreneurs shelve their ideas mid-way for want of resources to fund the same.

To meet the funding requirements of start-ups, the Government of India has set-up various schemes/ funds and also allowed them to raise external commercial borrowings. Further, as already discussed above, provisions have been introduced under the Act whereby the long-term capital gains earned by individuals/ HUF are exempted from income tax on making investment in equity shares of start-ups.

However, more needs to be done specially to channelise resources from general public. In this respect, Government of India may evaluate following propositions to incentivise and channelise resources from general public towards start-ups:

• Upfront Tax Deduction on Investment: Providing upfront tax relief on making investments in start-ups directly or through some specialised investment funds set-up to fund start-ups with adequate lock-in period; and/ or
• Concessional Capital Gains Tax Rate: Taxing the capital gains earned by investors on sale of shares of such start-ups/ units of investment funds investing in start-ups at concessional rate of 5% or 10% like in case of sale of listed shares.

Proposal C: Dedicated Nodal Ministry for Start-ups

Government may also evaluate and create a separate nodal ministry to investigate the issues being faced by start-ups. This would streamline and fasten the process of resolution of issues being faced by the start-ups by reducing the time taken by various government departments.

“Start Up India Scheme provides several benefits to start-ups including simplification of compliances, self-certification, funding support, legal support and fast tracking of patent applications at lower costs, benefits under provisions of Income-tax Act, 1961 etc.”