BACKGROUND
What do you
generally mean by a startup? The Collins English Dictionary defines it in this
way: “A startup company is a small business that has recently been started by
someone.” But the Oxford English Dictionary calls it “a company that is just
beginning to operate”. The Merriam-Webster Dictionary, on the other hand,
describes it as “a fledgling business enterprise”. Therefore, any new business
in its infancy is a startup.
In India, the information
technology (IT) industry has been a significant driver of growth, employment
and exports. Using technology effectively, startups can ramp up scale and grow
significantly within a short period of time. The government, through the
Ministry of Commerce, has therefore been seeking to encourage startups through
initiatives such as Start-up India.
Initially, and with
effect from February, 2016 under the Start-up India initiative an entity was
considered a startup:
a. Up to five years
from the date of its incorporation / registration;
b. If its turnover for any of the financial years
has not exceeded Rs. 25 crores; and
c. It is working towards
innovation, development, deployment or commercialisation of new products,
processes or services driven by technology or intellectual property.
However, an entity
formed by splitting up or reconstruction of an existing business is not to be
considered a ‘startup’.
On 23rd May,
2017, the definition was amended by:
i. Increasing the period from five to seven years
and, in case of startups in the biotechnology sector, from five to ten years;
and
ii. Amending the nature of
activity to “working towards innovation, development or improvement of products
or processes or services, or if it is a scalable business model with a high
potential of employment-generation or wealth-creation”.
The definition was further amended on 19th February, 2019
under Start-up India; now, an entity is considered a start-up:
a. Up to a period of ten years from the date of
incorporation / registration, if it is incorporated as a private limited
company (as defined in the Companies Act, 2013), or registered as a partnership
firm (registered u/s. 59 of the Partnership Act, 1932), or a limited liability
partnership (under the Limited Liability Partnership Act, 2008) in India;
b. The turnover of the entity for any of the
financial years since incorporation / registration has not exceeded
Rs. 100 crores; and
c. The entity is working towards innovation,
development or improvement of products or processes or services, or if it is a
scalable business model with a high potential of employment-generation or
wealth-creation.
One of the
categories of incentives offered to startups is of certain income tax benefits.
There are, however, other tax provisions which have been a source of harassment
to startups. What are these tax benefits and tax provisions and how well have
they achieved their purpose?
TAX BENEFITS
1. Lower rate of tax –
section 115BA
One of the benefits
which was supposedly meant for startups has been section 115BA, which provides
for a lower rate of tax of 25% for eligible domestic companies with effect from
assessment year (AY) 2017-18. These eligible domestic companies are those that:
a. are set up or registered on or after 1st
March, 2016;
b. engaged only in the business of manufacture or
production of any article or thing, and research in relation to, and
distribution of such manufactured / produced articles / things; and
c. the total income is computed without certain
incentive provisions, including additional depreciation, and deduction u/s.
80-IAC.
Given the fact that today most mid-sized and small companies (those
whose turnover in 2016-17 did not exceed Rs. 250 crores) are liable to pay tax
at only 25%, the tax rate of 25% u/s. 115BA is no longer an incentive rate.
Further, the restrictions for claiming a benefit under that section meant that
it was restricted only to manufacturing companies and most startups, which
provide services, were not able to avail of the benefit of this provision at
all.
In any case, today
most startups would qualify for the normal lower corporate tax rate of 25% of
their profits (provided, of course, if they have any taxable profits).
2. Deduction of 100%
profits – section 80-IAC
This incentive
provision, meant specifically for startups, was introduced with effect from AY
2017-18. The objective of this provision, as explained in the Explanatory
Memorandum to the Finance Bill, 2016, was to provide an impetus to startups and
facilitate their growth in the initial phase of their business.
Under this section, an eligible startup can claim deduction for 100% of
profits and gains of eligible business for three consecutive assessment years
out of the first seven (increased from the first five, with effect from AY
2018-19) assessment years beginning from the year of its incorporation.
An eligible startup
is one which meets the following requirements:
(a) It is a company or a Limited Liability
Partnership (LLP);
(b) It carries on eligible business;
(c) It is incorporated on or after 1st April,
2016 but before 1st April, 2021;
(d) The total turnover of its business does not
exceed Rs. 25 crores in the relevant previous year;
(e) It holds a certificate of eligible business
from the Inter-Ministerial Board of Certification as notified in the Official
Gazette by the Central Government;
(f) It is not formed by the splitting up or
reconstruction of a business already in existence; and
(g) It is not formed by transfer of
used plant or machinery to a new business. Used plant and machinery can,
however, constitute up to 20% of the total value of the plant and machinery
used in the business without it being regarded as a violation of this
condition. Further, plant and machinery used outside India is not regarded as used
plant and machinery if it is imported into India, was not previously used in
India before installation by the eligible startup, and no depreciation has been
allowed / was allowable in India on such plant and machinery for any period
prior to the date of installation by the eligible startup.
Till AY 2017-18, the definition of “eligible business” was comparatively
narrow and restrictive – “a business which involves innovation, development,
deployment or commercialisation of new products, processes or services driven
by technology or intellectual property”. From AY 2018-19, the amended
definition is “a business carried out by an eligible startup engaged in
innovation, development or improvement of products or processes or services or
a scalable business model with a high potential of employment-generation or
wealth-creation”. This wide definition has the potential of encompassing a
large number of businesses and not just those engaged in the IT sector or
providing services using technology as a disruptor.
Till the third week
of November, 2018, out of a total 14,036 (19,287 as of 20th June,
2019) startups registered with the Department for Promotion of Industry &
Internal Trade (DPIIT), Ministry of Commerce, Government of India under the
Startup India programme, 91 (94 till 20th June, 2019) startups had
received approval for the tax exemption. The procedure for applying for
approval is quite simple – Form 1 (which is a fairly simple form) has to be
filed along with the Memorandum of Association / LLP Agreement, board
resolution, copies of accounts and income-tax returns for the last three years.
The Board can call for further documents or information, and make enquiries,
before granting or refusing registration.
A partnership firm,
although it may be registered as a startup with DPIIT, is not eligible for the
benefit of deduction u/s. 80-IAC, even though an LLP, which is also taxed as a
partnership firm, qualifies for the benefit of such deduction.
Since this is a
deduction of profits and under Chapter VI-A such deduction may not really be of
much use to most startups which require five or more years to attain
profitability, and then, once they attain profitability, would first be setting
off their brought-forward losses before being eligible to claim exemption under
Chapter VI-A. Further, such deduction is not allowable for MAT / AMT purposes
and hence a startup would end up paying MAT / AMT at 18.5% of its profits while
claiming deduction u/s. 80-IAC in its normal computation of taxable income.
Ideally, to be really effective and meaningful, the benefit should have been
provided for any three out of the first ten years beginning from the year of
commencement of business and not from the year of incorporation, and such
deduction should have been excluded from book profits or adjusted total income.
The turnover limit of Rs. 25 crores is also too low for most startups to
be profitable and be eligible to claim the deduction – it should have been kept
at the same level as in the definition of “startup” in Startup India of Rs. 100
crores.
3. Taxation of share
premium u/s. 56(2)(viib)
Section 56(2)(viib)
was introduced with effect from AY 2013-14. It seeks to tax amounts received by
a company in which the public are not substantially interested (a closely-held
company) from a resident as consideration for issue of shares at a premium, to
the extent that the consideration exceeds the fair market value of the shares.
If one looks at the intention behind the introduction of section
56(2)(viib), the Explanatory Memorandum to the Finance Bill 2012 lists this
amendment under “Measures to Prevent Generation and Circulation of Unaccounted
Money”.
The fair market
value of the shares is the higher of:
a. the value determined as per Rule 11U read with
Rule 11UA, or
b. the value as substantiated by the company to
the satisfaction of the Assessing Officer, based on the value, on the date of
issue of the shares, of its assets, including intangible assets, being
goodwill, know-how, patents, copyrights, trademarks, licences, franchises or
any other business or commercial rights of similar nature.
Rule 11UA(2)
permits the company to adopt either the book value (break-up value) method, or
the Discounted Free Cash Flow Method for determining the fair market value of
unquoted equity shares of the company.
An exemption is provided for consideration received by a venture capital
undertaking from a venture capital fund (VCF). There is also a provision for
notification of a class or classes of persons (investors) by the Central
Government for exemption. Two notifications have been issued under this clause
– Notification No. 45/2016 dated 18th February, 2016 and
Notification No. 24/2018 dated 24th May, 2018. Notification No.
45/2016 granted exemption for subscription by a resident person to a startup
company, which fulfilled the conditions of a startup as per the DIPP
Notification dated 17th February, 2016. Notification No. 24/2018
granted exemption to consideration received for issue of shares from an
investor in accordance with the approval granted by the Inter-Ministerial Board
of Certification as per DIPP Notification dated 11th April, 2018.
Again, so far as
investments by non-resident investors are concerned, the provisions of section
56(2)(viib) do not get attracted, since they apply only to investments by
resident investors.
Grant of approval for exemption
The procedure for
grant of approval is contained in DIPP Notification No. 364 of 11th
April, 2018 as modified by Notification No. 34 of 16th January,
2019, and further modified by DPIIT Notification No. 127 dated 19th
February, 2019.
Initially, the
conditions for approval were as follows:
i. the aggregate amount of paid-up share capital
and share premium of the startup after the proposed issue of shares does not
exceed Rs. 10 crores;
ii. the investor / proposed investor, who
proposed to subscribe to the issue of shares of the startup has,
(a) the average
returned income of Rs. 25 lakhs or more for the preceding three financial
years; or
(b) the net worth
of Rs. 2 crores or more as on the last date of the preceding financial year;
and
iii. the startup has obtained a
report from a merchant banker specifying the fair market value of shares in
accordance with Rule 11UA of the Income-tax Rules, 1962.
The amendments
brought about by DIPP Notification No. 34 of 16th January, 2019 were
that:
a. The average returned income of Rs. 25 lakhs
over the preceding three years was replaced by a returned income of Rs. 50
lakhs or more during the financial year preceding the year of investment; and
b. The requirement of a report from a merchant
banker under Rule 11UA was done away with.
Significant
amendments were carried out to the conditions vide DPIIT Notification No. 127
dated 19th February, 2019 as under:
(1) The upper limit
for the aggregate amount of paid-up share capital and share premium of the
startup after the proposed issue of shares was increased from Rs. 10 crores to Rs. 25 crores. Further, in counting this amount
of Rs. 25 crores, amounts received from non-residents, venture capital
funds and frequently traded listed companies (whose net worth on the last date
of the financial year preceding the year in which shares are issued exceeds Rs.
100 crores or turnover for the financial year preceding the year in which
shares are issued exceeds Rs. 250 crores) are to be excluded;
(2) Further,
amounts received for subscription from such listed companies are to be exempt
from section 56(2)(viib);
(3) The requirements of investor returned
minimum income and minimum net worth were deleted; and
(4) An additional condition was inserted to the effect that the company
should not have invested in the following assets, and shall not invest in such
assets for a period of seven years from the end of the financial year in which
the approved share issue at a premium takes place:
a. building or land appurtenant thereto, being a
residential house, other than that used by the startup for the purposes of
renting or held by it as stock-in-trade, in the ordinary course of business;
b. land or building, or both, not being a
residential house, other than that occupied by the startup for its business or
used by it for purposes of renting or held by it as stock-in-trade, in the
ordinary course of business;
c. loans and advances, other than loans or
advances extended in the ordinary course of business by the startup where the
lending of money is substantial part of its business;
d. capital contribution made to any other entity;
e. shares and securities;
f. a motor vehicle, aircraft, yacht or any other
mode of transport, the actual cost of which exceeds Rs. 10 lakhs, other than
that held by the startup for the purpose of plying, hiring, leasing or as
stock-in-trade, in the ordinary course of business;
g. jewellery other than that held by the startup
as stock-in-trade in the ordinary course of business;
h. asset, whether in the nature of capital asset
or otherwise, specified in sub-clauses (iv) to (ix) of clause (d) of
Explanation to 56(2)(vii), viz., archaeological collections, drawings,
paintings, sculptures, works of art and bullion.
The Inter-Ministerial Board of Certification (IMBC), which is the
authority to grant the approval, has taken certain positive decisions in this
regard. At its meeting on 16th May, 2019 the following decisions
were taken, inter alia:
i. It was observed that a large number of
applications were being rejected for availability of similar products /
services. The applications should not be rejected merely on the basis of
similar products / services as it could mean higher demand and competition.
ii. Startups from remote / rural areas and women
entrepreneurs should be encouraged to apply.
iii. IMBC may ask for video presentation of a
defined duration with specific areas to be covered by a startup for applying
for the tax exemption.
iv. IMBC may also hold video conference with the
startup, if required.
The objective of
IMBC, therefore, clearly seems to be to encourage genuine startups to apply for
and to grant the exemption from section 56(2)(viib). One understands from press
reports that so far 672 startups have been given approval u/s. 56(2)(viib).
Difficulties faced by startups
So far as most
startups which are innovating are concerned, their business is based on a
novel, untested concept. Their future business projections are based on hope
that their business concept or model will succeed. Investors place faith in the
startup founders’ ability and invest in the company based on such rosy
projections, knowing full well that the business model or concept is untested
and untried and that there is a high risk that the business may not succeed.
The investor investment at high valuations is based on the small chance that
the start-up may succeed and do so well that the consequent appreciation in
value of investment may more than compensate for the loss suffered on
investment in other startups. That is why investors spread their risks by
investing across various start-ups.
It is quite common
for a startup investor to invest in a company at the seed stage at a premium,
when the business is yet to commence, and all that is in existence is the idea
and a business concept in the mind of the startup founder. Similarly, most such
investments are made at premium valuations when the startups are still
incurring huge losses, with no profits in sight for the next few years. The
investment and its valuation is therefore more of an expression of confidence
by the investor in the founder and his business plan and not based on the
accuracy of the future numbers.
The problem faced by startups was that from AY 2013-14 till almost AY
2016-17, the provisions of section 56(2)(viib) applied without the benefit of
any exemption notification being available to them. Even from February, 2016,
many startups could not meet the DIPP criteria to qualify as a startup and
hence could not avail the benefit of exemption u/s. 56(2)(viib). The April,
2018 Notification and procedure did apply to more issues by startups, but was
still comparatively restrictive. It is only with effect from 2019 that startups
really started getting the benefit of exemption. Therefore, startups faced
serious problems of large demands in assessments for earlier years, due to
additions made in respect of premiums received on share subscriptions.
Since a vast majority of startups do not succeed in their business, when
the assessments for the year of investment came up for scrutiny, the numbers
actually achieved by the startups came nowhere close to the numbers that they
had presented to investors at the time of investment. The valuation based on
the actual numbers was thus a fraction of the valuation at which the investment
was made a few years ago. As a result, AOs sought to use the benefit of
hindsight to reject the pre-investment valuation provided by the company based
on projected financials and substitute it with a far lower post-investment
valuation based on actual financials. Since the investments were made at a far
higher premium, the provisions of section 56(2)(viib) were invoked to tax the
startups on such alleged “excess premium”.
At times, where
resident investors had invested along with venture capital funds or
non-resident investors at the same valuations, it led to an absurd situation.
While the investments by the VCFs or the non-resident investors were spared
from the provisions of section 56(2)(viib), the provisions were invoked for the
similar investments by resident investors. Indeed a very peculiar situation,
given that the valuation of the resident investment was validated by the
valuation of the VCF or non-resident investment!
Further, the stated
purpose of section 56(2)(viib) was almost completely ignored by the AOs. Even
cases where the investments were being made out of known sources of income of
the resident they were being taxed as income of the issuer company, even though
this could in no way be regarded as generation or circulation of unaccounted
money. Therefore, such action was contrary to the purpose of the provision.
Pending issues
The DPIIT Notification No. 127 of 19th February, 2019 states
that the notification for exemption would apply irrespective of the dates on
which shares are issued by the startup from the date of its incorporation,
except for the shares issued in respect of which an addition u/s. 56(2)(viib) has
been made in an assessment order before the date of issue of the notification
(i.e., 19th February, 2019). Therefore, if a startup has made any
issue of shares for which assessment is pending or has not been completed prior
to 19th February, 2019, it is advisable for it to obtain such
approval from the DPIIT, with consequent approval from the IMBC. In fact, even
startups whose case has not been selected for scrutiny in the year of such
issue of shares may find it beneficial to obtain such approval, to protect
themselves from any possible reassessment proceedings.
The most common
issue that many startups face is the fate of pending assessments and appeals,
where large demands have already been raised. There is no express provision in
such cases and the matters would have to be decided independently in appeal in
such cases. It would have been far better if a resolution process had been laid
down in such cases, which the appellate authority could have followed. For
instance, any startup fulfilling the conditions of exemption could have been
granted relief after verification of compliance with the conditions.
The other issue
faced by startups is the restriction on acquiring certain specified types of
assets, before and for seven financial years after the end of the year of share
issue, which could result in loss of the exemption. There is no minimum value
for such assets. Take a few situations: A startup buys a painting for its
office, costing Rs. 2,000; a startup gives a loan of Rs. 10,000 to its
employee; a startup buys a delivery vehicle for Rs. 11 lakhs; a startup invests
Rs. 1 lakh in a subsidiary. Any of these could result in a possible loss of
exemption! Perhaps, such interpretations were not intended. The objective of
the condition of investment in assets is to ensure that under the guise of
raising capital for the business, a startup does not become an investment
vehicle, and not to prohibit such normal business transactions.
A startup is merely
required to file a declaration that it has not invested in such assets and
shall not invest in such assets for seven years, in Form 2 with the DPIIT,
which will forward it to the IMBC. The IMBC will then grant the exemption. The
withdrawal of exemption will also be by the IMBC. In order to avoid unnecessary
loss of exemption for certain common business transactions, it is essential
that clarifications are issued by the DPIIT, clarifying that certain normal
transactions would not attract withdrawal of exemption. So also, a minimum
limit of, say, Rs. 5 lakhs, should be prescribed, below which limit,
acquisition of the specified types of assets would not invite withdrawal of
exemption.
Further, no procedure has been laid down for cancellation of the
exemption notification. However, before any cancellation of exemption is
resorted to, the basic principles of natural justice would have to be followed
by IMBC. This would require that the startup would have to be given a show
cause notice for that purpose, in response to which it would have a right to be
heard.
4. Set-off of Losses
under Section 79
Under section 79,
where there is a change in beneficial ownership of 51% of voting power of a
closely-held company from the end of the year in which a loss was incurred to
the end of the year in which the set-off of the loss is claimed, the benefit of
set-off and carry forward of loss is not available. The objective behind this
provision is to prevent transfer of loss-making companies for sale of losses,
where the benefit of the set-off of losses can be availed of by the acquirers.
In startups, such
change in beneficial ownership of voting rights is quite common on account of
dilution by the founders in each round of funding, and not by transfer of
shares. A concession has therefore been provided to startups in section 79(2)
with effect from Assessment Year 2018-19. A startup which is eligible for
deduction u/s 80-IAC can continue to obtain the benefit of carry forward and
set off of losses of the first seven years from the date of incorporation,
provided all the shareholders holding shares of the company in the year in
which the loss was incurred continue to be shareholders of the company as at
the end of the previous year in which the set-off of the loss is being claimed.
From the language of the section, it appears that in case of a startup
even if one shareholder transfers his nominal shareholding before set-off of
the loss, the benefit of carry forward of the first seven year losses will be
lost, as opposed to a less stringent 49% permissible transfer in case of other
closely-held companies. Also, there is a lack of clarity as to losses incurred
by startups after the first seven years – whether the
provisions of section 79(1) would apply or whether there would be no
restrictions at all.
CONCLUSION
Startups which have
raised funds at high valuations in recent years have faced a torrid time in the
past few years. Fortunately, the government has responded to their request for
relief and laid down a procedure which, by and large, excludes such startups
from the rigours of section 56(2)(viib). One only wishes that other businesses
were also spared from the unnecessary litigation that section 56(2)(viib) has
generated.
The government has spared startups from a nuisance provision. But has it
really provided enough tax incentives? The provision u/s. 80-IAC for tax
deduction of profits is not really a significant incentive. Today, compliance
involves a significant cost for most businesses, having become fairly onerous.
What startups would perhaps better appreciate is a tax regime with lesser
compliance hassles – exemption from tax deduction requirements as well as
having tax deducted at source from their incomes, exemption from scrutiny
assessment u/s. 143(3), etc. This would allow startups to focus on their
business, instead of having a part of their energies diverted towards
compliance, and definitely result in an improvement of productivity of the
startups.
The above provisions are based on their
legal status as on 23rd June, 2019.
