Startup Taxation – A Reality Check

  • Blog|Income Tax|
  • 6 Min Read
  • By Taxmann
  • |
  • Last Updated on 10 May, 2021
With a vision to build a strong ecosystem for nurturing innovation and encouraging entrepreneurship in India and to facilitate the goal of sustainable economic growth, generate large-scale employment opportunities, promote foreign investment and enable ease in doing business for startups in the country, the Modi Government, in January 2016, launched its flagship initiative “Startup India”
In line with this initiative, the government launched a policy framework, Startup India Action Plan, primarily focusing on the following three pillars: Simplification and Handholding, Funding Support and Incentives, and Industry-Academia Partnership and Incubation.
Under this plan, eligible startups in India can avail of various regulatory and tax benefits, and have access to various funding options if they fulfill certain criteria. This article attempts to discuss the tax and regulatory incentives available to Startups and if such incentives are serving the targeted purpose.

Are you a Startup?

The first question, before we attempt to understand the tax and regulatory framework of a Startup is – What is a Startup?
The Indian government has been evolving the definition of an “Eligible Startup” for over a decade, i.e., a Startup that is eligible to claim regulatory and tax incentives. An entity is considered a “Startup” only if it is incorporated as a Private Limited company (under the Companies Act, 2013), or registered as a
Partnership Firm (under the Partnership Act) or a Limited Liability Partnership (under the Limited Liability Partnership Act) in India, and fulfills the following conditions:
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  • Not more than seven years have elapsed from its incorporation/ registration (for an entity in the biotechnology sector, this period is 10 years).
  • The turnover of the entity in any financial year since incorporation/ registration has not exceeded INR 250 million.
  • The entity is working towards innovation, development or improvement of products or processes or services, or is a scalable business model with a high potential of employment generation or wealth creation.
However, an entity formed by splitting up or reconstruction of an existing business is not considered a “Startup.” Thus, we need to ensure that an entity qualifies as a “Startup” in the first place to avail the various tax and regulatory benefits. 

Tax benefits – Soft Corner for Startups: 

1. Tax Holiday for three consecutive years: 

 For eligible Startups formed on or after 01 April, 2016, 100% deduction of profit is available. Further, eligible Startups are free to choose any three years out of a period of first seven years from their incorporation, in which they can avail the tax exemption.

2. Capital gains tax exemption:  

To boost the startup ecosystem in India, a long-term capital gains exemption up to INR 5 million is provided, if the amount equal to capital gain arising from the sale of capital assets is reinvested in the units of a notified fund set up for Startups for a period of at least three years.

3. Carry forward of losses despite the substantial change in ownership: 

The Indian tax regime allows the protection of unabsorbed tax losses of Startups incurred in the initial seven years of its operations, as long as all the shareholders in the year of incurrence of loss continue to be shareholders in the Startup company in the year of carry-forward and set-off. Therefore, such protection is available even if the change in shareholding is beyond 49% threshold applicable in other cases.

4. No Angel tax:  

In another welcome move by government authorities towards encouraging Startups in India, eligible Startups have been excluded from the ambit of angel or premium taxation under section 56(2)(viib) of the Income-tax Act, 1961. Therefore, where a Startup issues its shares to any angel investor in consideration of funding received from the investors at a price exceeding the fair market value of the shares of the Startup, any excess over the fair market value (i.e. premium) is not taxed in the hands of the Startup post this amendment.

A reality check – Are the incentives for real or just eyewash? 

While the incentives provided by the government to encourage entrepreneurship in India through Startups seems to have made the journey easier and thought-provoking for ignited young minds; however, it is still not a cakewalk. These incentives are available to specific eligible Startups and are subject to fulfilment of certain conditions. Some of the issues in claim of such benefits are enumerated below:

1. Subjectivity on “Innovation”:

How one defines and understands innovation may differ owing to different perspectives. This scope of subjectivity may deprive an entity of recognition as an eligible Startup. Per the guidelines, any entity that wishes to be recognised as an eligible Startup for tax and other benefits has to apply to the regulatory authority with a write up about the nature of its business, highlighting how it will help in fostering innovation, development or improvement of products and services. It is always a possibility that the regulator may have a different view and may reject such claim.

2. There “is” a tax deduction, but there “are” conditions: 

The golden incentive of 100% deduction of profits for tax purposes seems good; however, it comes with a set of conditions, some of which are as follows:

    • The exemption is only available to Startups that are private companies or LLP formed on or after 01 April 2016;
    • It holds a certificate of eligible business from the Inter-Ministerial Board of Certification;
    • Startups are not formed by split up or reconstruction of an existing business;
    • Plant and machinery used in the business should be new and have never been used in India before;
    • The total turnover of the Startup is not exceeding INR 250 million in the relevant financial year.

3. Angels fly a “little” high:

While the government recently exempted eligible Startups from taxation on premium received over and above the fair market value of their shares on its issue to eligible investors, a closer look may reveal this to be eyewash, as the horizon of such exemption is very limited. A Startup shall be eligible to claim such exemption only if the following conditions are fulfilled:

    • Startup being a private limited company;
    • The sum total of “paid-up capital and share premium” of the Startup after issue of shares to eligible investor does not exceed INR 100 million;
    • A valuation report has been obtained from the Merchant Banker specifying the fair market value of shares;
    • The investor has an average returned income of at least INR 2.5 million in the last three years or has a net worth of at least INR 20 million on the last day of the preceding financial year.

4. Investor exits, loss lapses: 

For eligible Startups to carry forward and set off their losses incurred in the initial seven years from incorporation, it is required that all the shareholders in the company as on the late day of the previous year in which the loss was incurred, continue to be shareholders in the year in which such loss is to be carried forward and set off. Typically, Startups raise seed/ initial funding from financial and private equity investors that have specific and in some cases, very limited time horizons on their investments. This could result in lapse of unabsorbed tax losses on their exit by breaching the aforementioned condition.
Way forward:
The revolutionary initiative to promote sustainable economic growth and encourage young innovative Indians to be an entrepreneur and create jobs (rather than seeking one) is a welcome step by the Indian government. Plus, the incentives and relaxation introduced over the time has provided a great push to the Indian Startups ecosystem.
However, considering the size of the vast Indian economy, the growing pace of Startups around the world and the needs of such Startups ecosystem, the incentives on offer may still feel like a drop in the ocean and a reality check is necessary to determine if they are even serving the purpose of their introduction.
The government may consider widening the scope of incentives provided to Startups by adopting various possible measures, such as increasing the amount of maximum yearly turnover from INR 250 million, uplifting the post-investment capital limit of INR 100 million for protection against angel taxation, relaxing the condition of continuous holdings by investors to claim the benefit of tax losses, etc.
It may be worthwhile to wait and watch how some of these much-needed incentives will actually take shape going forward. While all this is still a thing of the future, one may anticipate the greater tax incentives the government is planning to boost and revolutionize how Startups operate in India. Until then, hold your doors, because another Flipkart, Paytm or Ola may already be ringing doorbells.

AuthorsHiten Kotak, Leader – M&A Tax, PwC India and Amit Bahl, Partner – M&A Tax, PwC India

Disclaimer: Views are personal to the author. The article includes inputs from Nikhil Goenka, Director – M&A Tax, PwC India, and Shubham Aggarwal, Associate – M&A Tax, PwC India.

Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any.

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