Tax Implications and Benefits every Indian start-up should know about
The Indian technological startup landscape has seen tremendous growth over the last decade with India becoming the 3rd fastest growing hub for technology startups globally. India has around 50,000 startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT). Startup India is a flagship initiative of the government of India, intended to build a strong eco-system for nurturing innovation and startups that will drive sustainable economic growth and generate extensive employment opportunities. The government has pushed for the use of digital technologies through initiatives such as the National Program on Artificial Intelligence (AI) and the establishment of nine centres of technological excellence.
Under the Income Tax Act, 1961 ("ITA"), startups have been provided with specific benefits and exemptions as below:
Income Tax exemption u/s 80-IAC for three years -
An eligible startup can avail a deduction of 100 per cent of its profits for three consecutive financial years out of its first ten years since incorporation. To avail of this exemption, an entity shall be considered as a startup if it meets the following eligibility criteria:
- Up to ten years from the date of incorporation/ registration (incorporated as a private limited company as per the Companies Act, 2013 or registered as a partnership firm under section 59 of the Partnership Act, 1932 or a limited liability partnership under the Limited Liability Partnership Act, 2008) in India.
- Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
- The entity is working towards innovation, development, or improvement of products, processes, or services or a scalable business model with a high potential for employment generation or wealth creation.
Capital Gain Tax exemption u/s 54EE and u/s 54GB
Section 54EE of the ITA provides an exemption of tax on a long-term capital gain (LTCG) to eligible startups if such LTCG or a part thereof is invested in a fund notified by the Central Government within six months from the date of transfer of the asset. The maximum amount that can be invested in the specified long-term asset is Rs. 50 lakhs and such amount should remain invested in the specified fund for 3 years.
Individuals or HUF can avail exemption u/s 54GB of the ITA in respect of LTCG arising from transfer of a residential property, if the amount of net consideration is invested, before the due date of furnishing of return of income, in equity shares of an eligible startup and ensure compliance with specified conditions.
Relief from Angel Tax u/s 56(2) (viib)
Examining the Angel Tax issue is crucial, a severe bone of contention for most startups funded by Angels and Venture Capital funds. It shows how the government was reactive instead of proactive concerning startup taxation. Being proactive and investor-friendly can make a world of difference in boosting investor confidence and firing up the entrepreneurial spirit in India.
Section 56(2)(viib) of the ITA provides that when a private company or closely held public company issues shares (equity and preference shares) to a resident at a price more than its face value and receives consideration, which is over the fair market value of such shares, then the amount received more than the fair market value of the shares is deemed as 'income' in the hands of such company under the head Income from Other Sources.
An exception has been provided if the funds have been received by:
- A venture capital undertaking from a venture capital company or a venture capital fund.
- By a company from a class or classes of persons as may be notified by the Central Government.
In 2018, in several scrutiny assessments of startups, assessing officers made additions under Section 56(2)(viib) of the ITA for receipt of security premium received on account of the issue of shares to financial investors. This issue was taken up very strongly by startups in the media and became a public relations nightmare for the government. After that, to mitigate this issue, a series of announcements provided that provisions of section 56(2)(viib) of the ITA would not apply to a recognized Startup that has filed a declaration under Form 2.
Relaxation for carrying forward and set off of losses
Section 79 stipulates that in case of a Company, not being a closely held company, shall be allowed to carry forward and set-off the losses, subject to the condition that 51 per cent of shareholders holding beneficial voting power remain the same as at the beginning and end of the year in which the loss was incurred. The restriction of holding 51 per cent of voting rights has been relaxed in the case of eligible startups.
- Access to INR 10,000 crore Fund of Funds – Government to provide equity funding support for the development and growth of innovation driven startups.
- Fast track exit for startups start-ups with simple debt structures can be wound up within 90 days of applying insolvency vis a vis 180 days for other companies.
- Start-ups would be provided with an 80 per cent rebate in the filing of patents.
Others important considerations:
Place of Effective Management (POEM): The concept of "Place of Effective Management" ("POEM") is an internationally recognized test for the determination of the residential status of any foreign company in the host country. POEM is the place where the key management and commercial decisions necessary for the conduct of an entity's business are, in substance, made. POEM's objective was to plug the loophole in earlier provisions that allowed companies to escape the status of Indian tax residency in case partial control and management were situated outside India. Seen as an anti-avoidance measure, the POEM concept targets foreign operations of Indian groups and foreign companies having operations controlled from India. The concept of POEM replaces the parameter of "control and management of affairs wholly in India" with "place of effective management in India." POEM guidelines issued by the CBDT are based on internationally prevalent practices, and while they do provide guidance on the test of POEM, it is highly subjective and fact-based.
Transfer Pricing: Several startups have also spread their footprints outside India, setting up subsidiaries outside India under the ODI route. Such start-ups need to be mindful of provisions of section 92A of the ITA. Two or more parties to the international transaction can be associated enterprises based on conditions such as voting power, loan transaction, the appointment of directors or executive director, supply of raw material, etc. Therefore, start-ups need to comply with Transfer Pricing regulations and have arm's length transactions with their Associated Enterprises. Transfer pricing disputes can range from more straightforward topics on comparability to more complex economic concepts on recharacterization, marketing intangibles, management charges, cost-sharing agreements, location savings, and financial transactions. Such entities must keep and maintain such documentation as prescribed in Rule 10D of Income Tax Rules, 1962, and file Form 3CEB.