Indian Startups Ecosystem: Compliance Mishaps
On 3rd June the headlines read, “Government recognizes 50,000 startups across India” and we all clapped our hands. In a short span of 5+ years, the Startup India initiative, executed by the Department for Promotion of Industry and Internal Trade (DPIIT), has become successful in creating a vibrant ecosystem of new-age businesses. This being done by recognizing startups, creating engagement, easing compliances, introducing benefits, and iterating. Consequently, in the same timeframe, India’s ranking in World Bank’s ease of doing business index improved from 130 to 63 out of 190 nations. Also, its unofficial startups capital, Bengaluru got the tag of ‘the World’s fastest-growing tech-hub from a UK-based research firm.
In spite of all this glitter, there also lurks the rising asymmetry between the headline policies and their practical application at ground level.
Let’s take a look at some of the compliance mishaps in the Indian Startups Ecosystem:
1. Tax Holiday for Startups: Too good to be true.
a. What is it?:
Under section 80-IAC of the Income Tax Act, startups that have received a tax exemption certificate from the Inter-Ministerial Board (IMB) enjoy tax exemption on profits for 3 consecutive years out of the 1st 10 years of its operations. Amazing!
b. The catch:
i. If your turnover exceeds INR 100 Crore, you cannot claim exemption.
ii. Obtaining the certification is a long-drawn process.
iii. Out of the 50,000 Startups recognized by DPIIT, only 266 startups have received the tax exemption certificate from the IMB till date. That’s less than 1% of the entire lot!
iv. This tells us that only the most innovative and the most scalable startups will get IMB certification. Ironically, these are the very startups that hit the turnover threshold of INR 100 Crore the fastest.
2. Capital Gains exemption for Startups: No practical application.
a. Did you know?
If a person sells her/his residential property to start a Tech Startup, her/his Capital Gains arising out of the sale of such property can be exempted under section 54GB of the Income tax Act.
b. Did you also know?
The exemption comes with a loooong list of conditions that you can read HERE.
c. The catch:
The exemption is only available for IMB certified startups. This means that entrepreneurs of only 266 Companies in this country can claim benefits under section 54GB as of today.
3. ESOP tax deferment scheme for startups: Well thought of but you can’t take benefit.
a. What is it?
ESOPs are a great way to reduce cash flows in early-stage Startups and also for retaining the top quality employees. They’re offered to the
employees at a discount to the fair value of the shares.
b. The problem:
When employees purchase these shares, they’re supposed to pay tax on the differential amount between fair value and the discounted price they actually pay. This means they’re dishing out cash to buy shares and then also paying tax on it. Their fleeting moment only comes when they finally get to sell these shares which often takes 1-3 years at the least.
c. The solution:
In 2020, the GoI finally took cognizance of this problem and decided that employees of Eligible Startups can defer the payment of tax on
ESOPs until they sell their shares or on expiry of 5 years or when they leave the startup, whichever is the earliest. Wow, right?
d. The catch:
Employees of Startups having turnover exceeding INR 25 Crore cannot avail this benefit. That’s a tiny threshold!
e. The bigger catch:
Eligible Startups refer to IMB certified startups only. Which is a coveted group of only 266 Startups as of today.
4. Carve out for carry forward of startups losses: But you again can’t take benefit.
a. You should know:
If there is a significant change in ownership of a company (more than 49% shareholding change) then the losses cannot be carried forward.
Here’s a fact: Most startups incur losses to blitz-scale and most startups issue shares and sell stakes to raise funds. Without the brought forward losses, these startups will have to pay taxes as soon as they make a profit.
b. The solution:
The GoI introduced a carve-out in Section 79 of the Income-tax Act for Eligible Startups, allowing them to carry forward losses as long as all the shareholders continue to hold at least 1 share in the startup.
c. The catch:
By now you know too well. Eligible Startups refer to IMB certified startups only. Which means that most of the startups continue to surrender their losses every time there is a major stake sale. Sigh!
5. Angel Tax exemption for startups: Only good for early stages.
a. You should know:
If a company issues shares at a price more than its fair value, it attracts taxes under section 56(2)(viib) of the Income-tax Act, which is dubbed as ‘Angel tax’.
b. What’s fair value?:
For Income tax purposes, fair value is determined from a Merchant Banker report which conducts a Discounted Cash Flow (DCF)
valuation of the company. This valuation drill comes at a considerable price which is the problem for early-stage Startups who have little cash to spare.
c. The solution:
DPIIT recognized startups can fill up a simple declaration form at the Startup India portal to exempt themselves from Angel tax. This basically means that these Startups can raise funds by issuing shares in excess of their fair value or basically without bothering a merchant banker for a report.
d. The catch:
While this scheme has clear cash flow benefits for early-stage startups, those that are raising funds in excess of INR 25 Crore (i.e. appx.
$3.5Mil) cannot take advantage of this.
So now you’ll agree that although the GoI has done commendable work in identifying areas where it could extend monetary benefits to startups. These benefits still remain parked in theory books without having any meaningful impact on the startup ecosystem. Carefully structuring your entity and planning your transactions in a way that you can become eligible for the benefits can be a time-consuming process and only adds to the complexities that are already existing.
Article by:
Ritwik Khator, Partner-Chunder Khator Associates