Tax Exemptions for Startups

Tax Exemptions for Startups
05 June 2020

Tax Exemptions for Startups

To give impetus to entrepreneurship and increase participation in the development of the country, the STARTUP INDIA campaign was launched in India in 2016. This campaign has enabled many budding entrepreneurs around the country to live their long aspired dreams. After all, being your own boss is a thing anyone would ask for. The main idea behind this innovative step taken up by the government was to promote bank financing for startups, simplify the process, and grant various helpful tax exemptions to make the journey less complicated for beginners.

Since the announcement of this plan until now, several rounds of discussions have been held by the Department of Industry and Internal Trade (DPIIT) with the entrepreneurs to scrutinize their issues. Tax exemptions have always been an issue with the starters as the inflow of money into their new ventures is very indefinite. When the Start-Up India program was launched, it was aimed at providing tax benefits to them for a period of five years. But the rules were eased as the investors were complaining that investing in many companies may not be very profitable during this phase. 

Startup India is a flagship initiative of the Government of India, intended to catalyze startup culture and build a strong and inclusive ecosystem for innovation and entrepreneurship in India. Since the launch of the initiative on 16th January 2016, Startup India has rolled out several programs with the objective of supporting entrepreneurs, and transforming India into a country of job creators instead of job seekers. Vide the various campaign, various benefits, and facilities were provided to the Startups.

Eligibility for a Startup

As per the Startup India Action plan, the followings conditions must be fulfilled in order to be eligible as a Startup :

  1. Being incorporated or registered in India for less than 7 years and for biotechnology startups up to 10 years from its date of incorporation.
  2. Annual turnover not exceeding Rs 25 crores in any of the preceding financial years.
  3. Aims to work towards innovation, development, deployment, or commercialization of new products, processes, or services driven by technology or intellectual property.
  4. It is not formed by splitting up or reconstruction of a business already in existence.
  5. It must obtain certification from the Inter-Ministerial Board set up for such a purpose.
  6. It can be incorporated as a private limited company, a registered partnership firm, or a limited liability partnership.
Various Benefits to Startups (Tax benefits)
  1. Tax holiday for three consecutive years: For eligible Startups formed on or after 01 April 2016, a 100% deduction of profit is available. Further, eligible Startups are free to choose any three years out of a period of the first ten 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. If withdrawn before 3 years, then the exemption will be revoked in the year in which money is withdrawn.
  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 an 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.

While the government 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:

  1. The startup is a private limited company;
  2. The sum total of “paid-up capital and share premium” of the Startup after issue of shares to an eligible investor does not exceed INR 100 million;
  3. A valuation report has been obtained from the Merchant Banker specifying the fair market value of shares;
  4. 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.
Fund of Funds for Startups

A ‘fund of funds’ of INR 10,000 crores to support innovation-driven Startups has been established which is being managed by SIDBI. The corpus shall be released over two Finance Commission cycles, by 2025. FFS invests in SEBI registered Alternative Investment Funds (AIFs) which, in turn, will invest in Startups. INR 600 crore has been released to SIDBI. Further, a letter of comfort for INR 1600 crore has been provided to SIDBI.

Faster Exit for Startups

The Insolvency and Bankruptcy Board of India has been constituted and the provisions regarding corporate insolvency resolution have been implemented on 1st December 2016. The provisions related to liquidation have been notified on 9th December 2016. The Ministry of Corporate Affairs (MCA) has notified the relevant sections 55 to 58 of Insolvency and Bankruptcy Code, 2016 pertaining to the Fast Track process, and has notified that the process shall apply to Startup (other than the partnership firm) as defined by DIPP. With the help of this notification, Startups shall now be able to wind up their business within a period of 90 days from making an application for the same as compared to the 180 day period for other firms.

The initiative taken for promoting the start-ups has pushed various entrepreneurs to start new ventures.

Tax exemptions allowable to eligible startups

1. 3 year tax holiday in a block of seven years: The Startup incorporated after April 1, 2016, is eligible for getting 100% tax rebate on profit for a period of three years in a block of seven years provided that annual turnover does not exceed Rs 25 crores in any financial year. This will help the startups to meet their working capital requirements during their initial years of operation.

2. Exemption from tax on Long-term capital gains: A new section 54 EE has been inserted in the Income Tax Act for the eligible startups to exempt their tax on a long-term capital gain if such a long-term capital gain or a part thereof is invested in a fund notified by Central Government within a period of six months from the date of transfer of the asset. The maximum amount that can be invested in the long-term specified asset is Rs 50 lakh. Such amount shall be remain invested in the specified fund for a period of 3 years. If withdrawn before 3 years, then the exemption will be revoked in the year in which money is withdrawn.

3. Tax exemption on investments above the fair market value: The government has exempted the tax being levied on investments above the fair market value in eligible startups. Such investments include investments made by resident angel investors, family, or funds which are not registered as venture capital funds. Also, the investments made by incubators above fair market value is exempt.

4. Tax exemption to Individual/HUF on investment of long-term capital gain in equity shares of Eligible Startups u/s 54GB. The existing provisions u/s 54GB allows the exemption from tax on long-term capital gains on the sale of a residential property if such gains are invested in the small or medium enterprises as defined under the Micro, Small and Medium Enterprises Act, 2006. But now this section has been amended to include exemption on capital gains invested in eligible start-ups also.

Thus, if an individual or HUF sells a residential property and invests the capital gains to subscribe the 50% or more equity shares of the eligible startups, then tax on long term capital will be exempt provided that such shares are not sold or transferred within 5 years from the date of its acquisition. The startups shall also use the amount invested to purchase assets and should not transfer the asset purchased within 5 years from the date of its purchase.

This exemption will boost the investment in eligible startups and will promote their growth and expansion.

5. Set off of carrying forward losses and capital gains allowed in case of a change in Shareholding pattern. The carryforward of losses in respect of eligible start-ups is allowed 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. The restriction of holding of 51 percent of voting rights to be remaining unchanged u/s 79 has been relaxed in the case of eligible startups.