Taxation of Start-ups – An Emerging Sector in India
CA. G Lakshmi Priyadarshini
The author is a member of the Institute. She can be reached at priyaa.darshini12@gmail.com and eboard@icai.in.
“In today’s context where the Prime Minister of India emphasised the concept of ‘Aatmanirbhar Bharat’ (Self-reliant India) in order to boost the economy after the Covid-19 pandemic, the necessity to make more local businesses successful, especially in the MSME sector has gained momentum. The ‘Start-Up India’ is an initiative by the Government, introduced in 2016, ‘to build a strong eco-system for nurturing innovation and start-ups in the country that will drive sustainable economic growth and generate large scale employment opportunities’. The taxation of start-ups has been in the limelight for some time now, due to the issues that are unique to the sector and the subject has evolved over a period of time. Therefore, it is important to take note of the same and advise the start-ups on the tax incentives available in order to provide a holistic solution and thereby save taxes and other costs. Read on…”
What is a Start-Up?
A start-up, in general terms means, an entity formed by a group of entrepreneurs (called “Founder/(s)”) with the idea of introducing a new product/service, a new innovative idea or a big improvement of something already existing in the market. A typical start-up is a brainchild of the founder who needs financial backing to launch the product/service in the market.
Definition under Government Schemes (GSR 127(E))
Having briefly understood what a start-up is, now it is critical to see the definition of the term for the purpose of Government Schemes. Following are the key conditions for an entity to be a ‘Start-up’ as per the notification issued by the Ministry of Commerce & Industry, GSR 127(E) dated 19-Feb-2019:
In case the entity completes ten years from the date of incorporation/registration, it will cease to be a start-up. Also, if the turnover exceeds Rupees 100 Crores in any previous financial years, the entity will lose the start-up identity.
Recognition of a Start-up (DPIIT)
Under the ‘Start-Up India’ initiative, The Department for Promotion of Industry and Internal Trade (DPIIT) is authorized to recognize an entity as start-up in order to avail the various tax benefits, IPR fast tracking etc.
The process of getting recognition from DPIIT is a simple process, focused on getting information about business of the start-up, to check whether the idea is unique, is it a scalable business model, will it create employment opportunities in the future, wealth creation etc. After due verification of documents and information submitted, the DPIIT will issue a certificate recognizing the entity as a Start-up.
“It should be noted that only a private limited company incorporated under Companies Act, 2013 is covered under the definition of start-up. Further, both Limited Liability Partnership (LLP) and a partnership firm (registered under the partnership Act) is included in the definition of Start-up.”
There are currently more than 32,000 startups recognized by the DPIIT all over India.
State-wise Distribution of Recognized Startups (as on 4th December 2019):
Source: Ministry of Commerce & Industry Press Release dated 11-12-2019 / www.startupindia.gov.in
Income Tax Incentive: Section 80-IAC (100% Tax Holiday)
In order to provide tax incentive to start-ups, Section 80IAC was introduced by Finance Act, 2016, whereby 100 percent deduction of profits from the business of an ‘eligible start-up’ is allowed for three consecutive years. An option is given to the entity to choose any consecutive period of three years within seven years from incorporation.
Definition of ‘Eligible Start-up’ under the Income-tax Act
The definition of the term ‘Eligible Start-up’ under the Income tax act is significantly different from that of the DPIIT in respect of the criteria to be satisfied by an entity to qualify for tax deductions. The aspects of the definition are as follows:
- The start-up should have been incorporated on or after 01-04-2016 but before 01-04-2021.
- The turnover doesn’t exceed Rupees 25 Crores for the year in which the deduction is claimed.
- It holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government.
- Further, the benefit is available only for an eligible start-up being a Company incorporated under Companies Act, 2013 or a Limited Liability Partnership (LLP).
Procedure to get Certificate from Inter-Ministerial Board
The Inter-Ministerial Board of Certification is a Board set up by the Department for Promotion of Industry and Internal Trade (DPIIT) which validates Startups for granting tax related benefits. A startup can make an application in Form-1 along with required documents specified therein to get the certificate for claiming deduction under Section 80IAC. Following documents are required to be submitted along with the application:
- Copy of Memorandum of Association or LLP/Partnership Deed etc.
- Annual accounts for last three financial years (as applicable).
- Copies of Income tax returns for the last three financial years (as applicable).
Conditions to Claim Deduction under Section 80-IAC(3):
This deduction is subject to various conditions laid out under section 80 IAC (3) as follows:
- The start-up is not formed by splitting up, or the reconstruction, of a business already in existence.
- It is not formed by the transfer to a new business of machinery or plant previously used for any purpose.
Imported Machinery Exception: Any plant or machinery which was used outside India by any person other than the start-up is allowed, provided such machinery is imported into India and it is not used by any person in India prior to its installation. No depreciation should have been claimed in respect of the machinery or plant under the Income Tax Act earlier.
20% Relaxation Rule: There is a relaxation from condition (2) above, allowed in respect of cases, where the plant or machinery transferred to the new business of the start-up doesn’t exceed 20 percent of the total value of machinery used in the business.
Apart from the specific conditions under section 80IAC, certain conditions as mentioned under sub sections (5) and sub sections (7) to (11) of section 80IA also apply for claiming deduction under this section.
Angel Tax and Its Implications on a Start-up
Though, the term ‘Angel Tax’ is not mentioned anywhere in Income Tax Act, it has been widely discussed in many tax forums in the recent times mainly due to the adverse effect on the startup ecosystem. In order to understand the term, it is pertinent to note the circumstances that led to the angel tax regime.
In 2012, when the Finance Bill was introduced in the Parliament, a new Section 56(2)(viib) was introduced to tax the amount received by a closely-held company by way of issue of shares at premium to a resident, if it exceeds the Fair Market value (FMV) of the shares. This amendment was classified under the heading “Measures to Prevent Generation and Circulation of Unaccounted Money” in the Memorandum to the Finance Bill, 2012 at that time. Due to this amendment, the amount received as consideration for issue of shares in excess of the FMV will be taxed under the head ‘Income from other Sources’ of the Company issuing shares.
The intention was to curb money laundering activities which used issuing shares with ‘exorbitant/unjustified premium’ as a tool to bring the unaccounted money into the system. But this amendment, started to have adverse effect in one of the emerging sectors of the country, the Indian start-up ecosystem. Many start-ups raise funds from Venture capital fund or angel investors by issuing shares at a premium, which is mainly due to the fact that it may be a new company which doesn’t have books assets to back the issue of shares at premium. The share value is derived from the future potential of the business, market conditions, brand value etc., backed by projected cash flows. In some cases, the value is derived from intangible value of the Intellectual Property Rights (IPR) held by the start-up.
Investors/Venture capital funds were afraid of investing in start-ups resulting in significant reduction in investments in start-ups after the amendment was made. The IT department started issuing notices to many start-ups under the Section 56 (2) (viib) resulting in lot of disputed cases pending at various stages of the judiciary. This came to be known, infamously, as the “Angel tax” with respect to the taxation of start-ups.
After many representations from the start-up community and various changes made from time to time, finally the CBDT issued Notification No. 13/2019/F. No. 370142/5/2018-TPL (Pt.) on 05th March, 2019 to exempt start-ups recognised by DPIIT from the clutches of Section 56 (2) (viib), namely ‘angel tax’, applicable retrospectively from 19th Feb, 2019.
“After many representations from the start-up community and various changes made from time to time, finally the CBDT issued notification to exempt start-ups recognised by DPIIT from the clutches of Section 56 (2) (viib), namely ‘angel tax’ on 05th March, 2019 and the notification is applicable from 19th Feb, 2019.”
Conditions for Exemption from ‘Angel Tax’ (GSR 127(E)):
- DPIIT Recognition: First and foremost condition is that the start-up should be recognized by the DPIIT.
- ₹ 25 Crore Paid-up Capital & Premium Cap: The aggregate of Paid-up capital and share premium (post-issue) shouldn’t exceed Rupees 25 crores. Angel-tax is applicable only when shares are issued to a resident. Accordingly, any shares held by non-resident need not be considered for calculating the limit of Rupees 25 crores. Any shares held by a venture capital company or a venture capital fund will also be excluded from calculating the limit.
Restrictions on Investment in Specified Assets (7-Year Lock-in):
The start-up cannot invest in any of the specified assets for a period of seven years from the end of the latest financial year in which shares are issued at premium:
- Investment in land or building being a residential property;
- Motor vehicle, aircraft, yacht where cost exceeds ₹ 10 lakhs;
- Jewellery;
- Loans or advances or investments in another entity;
- Shares and securities (except in the ordinary course of business).
Self-Declaration in Form 2
A start-up fulfilling the conditions should make a self-declaration in Form 2 and submit the same to DIPP, which will in turn forward the same to CBDT after due consideration.
Withdrawal of Exemption
If found that the certificate is obtained based on false information or the start-up invests in restricted assets before seven years, the certificate will be revoked and exemption withdrawn with retrospective effect.
Capital Gains Incentives for Start-ups
Section 54EE: Exemption on Investment in Specified Long-Term Funds
This section provides exemption from capital gains tax if the long term capital gains are invested by an assessee in units of such specified fund, as may be notified by the Central Government in this behalf, subject to the condition that the amount remains invested for three years failing which the exemption shall be withdrawn. The investment in the units of the specified fund shall be allowed up to ₹ 50 lakh.
Section 54GB: Capital Gains on Transfer of Residential Property Invested in Start-ups
Long term capital gains arising on account of transfer of a residential property (a house or plot of land) shall not be charged to tax if such capital gains are invested in subscription of shares of a company which qualifies to be an eligible start-up subject to the following conditions:
- The assessee should invest the amount in the equity shares of an eligible company before due date for filing return of income under Section 139.
- The company has, within one year from the date of subscription in equity shares by the assessee, utilised this amount for purchase of new asset as prescribed.
- The assessee should hold more than 50 percent of the equity share capital after the subscription of shares.
- The company in which amount is invested should be a small or medium enterprise or an eligible start-up.
“Section 54GB was introduced to provide tax exemption to entrepreneurs or promoters of a startup selling their residential property in order to raise funds to invest in the company.”