The Tax(ing) Struggles of an Indian Startup
Updated: Feb 15
If you are a freshly minted entrepreneur or still a dreaming "wantrepreneur", you are probably too busy trying to crack the funding code! While funds are imperative to get your start-up up and running, a whole new world of hassle ensues after you have actually started out on this long, and frankly arduous journey.
My intention in bringing this up is not to discourage the ingeniously innovative entrepreneurs of India, but to prepare them for the good, bad and the ugly that will come their way as they pave their path to a rewarding end.
One of the most taxing (pun intended) struggles of an Indian startup is to figure out all the tax provisions that apply to them, and navigate their ways out of this puzzling maze of rules and regulations!
If understood and used correctly, the Indian startups can enjoy some great tax benefits, but if they are less than perfectly cautious, they might just end up being tangled in one of its many complications.
What Makes you an Eligible Startup?
Although concepts such as SMEs and startups are broadly similar across the world, every region has varying specifications to determine what criteria should be used to identify a particular type of organisation.
In 2015, the Indian Government announced its plans for the Startup India programme, establishing the basic guidelines for identifying eligible startups. While the government has only recently moved to take the programme from a tagline to something more tangible, laying down a clear definition was a step forward for the startup ecosystem.
According to the Startup India Action Plan,
a startup is an organisation that has been incorporated under Indian jurisdiction for less than seven years (ten years in case of biotechnology firms).
Since this definition determines the tax holidays these businesses are entitled to get, the latest Union Budget included a proposal to extend this from seven to ten years for all firms. Designed to account for the fact that startups can often take a while to start being profitable enough to avail of tax exemptions, this decision was clearly symptomatic of the government's desire to finally implement a programme of startup empowerment.
About time, I'd say!
Another determinant of a firm's startup status is its annual turnover, which was previously defined as being 25 crores at most. However, Mrs. Nirmala Sitharaman sought to change this too, as she proposed to increase this limit to 100 crores in her Budget 2020 speech.
The role and purpose of a startup is defined as being geared towards developing and innovating novel products, processes or services.
This process involves the utilisation of technological tools and intellectual property to commercialise unique value propositions being offered to the market.
It is important to remember that a firm that has been created by splitting or restructuring a previously existing organisation can never be deemed a startup.
If all of these stipulated criteria are adequately met, a firm can seek a certificate from the Inter Ministerial Board, establishing itself as either a private limited company, a partnership firm or a LLP.
Tax Holiday for Startups in India
Finance Minister Mrs. Nirmala Sitharaman delivered some unexpected holiday cheer to newly established businesses recently, as she sought to extend the honeymoon period of ordinary startups from seven to ten years.
The startups are now given the opportunity to choose any three consecutive years out of the first ten years of their existence, and enjoy a tax exemption on their profits for these periods.
As the Minister explained, this allows the new businesses greater flexibility in expanding their operations and enhancing their productivity, before they can finally earn some tax-free profits.
With the extra three years in hand, it is likely that these startups will be able to adopt a slightly more sustainable model for growth: one that is founded on ground realities rather than a heedless rush for making a quick buck!
Capital Gains Tax for Startups
A capital gain tax refers to the amount charged by the government on any income that is generated from the sale of any form of capital asset. The capital gain can be short-term or long-term, and under Section 54 EE introduced in the Income Tax Act by former Finance Minister Arun Jaitley, the long-term capital gains of startups are deemed to be exempted from taxation. While this may sound like a dream on paper, the reality is not as exciting.
In fact, this is one of the many aspects where the government's efforts to implement real change have fallen far too short of the publicised goals of taking the ecosystem forward.
This section specifies that the capital gain tax exemption is applicable only if the capital gain in question has been invested in a Fund of Funds (FOF)
What is an FOF, you ask? Well, it is a fund that is clearly notified by the Central Government as being part of this exemption mechanism.
The catch in this issue is that the government has so far not bothered to notify any funds that will be eligible for such an exemption to be implemented. Therefore, while a dazzling provision does exist for startups to enjoy the benefits of, no one really knows the way to actually get there!
Angel Tax Eased
If there is anything that can soothe the wounds from the unfulfilled aspirations of being exempted from long term capital gains tax, it has to be the long-awaited easing of the Angel Tax. An angel investment can often infuse the startup ecosystem with domestic funds, and also bring in international investors to fuel innovation in the Indian market. However, since much of such investments are raised above the fair market value of startups, they were previously taxed at a rate of 30% on this cash inflow.
The angel tax provision was introduced back in 2012 to curb prospects of money laundering through small companies. While the premise of it was not completely unwarranted, it made it extremely difficult for startups to give away a part of their highly coveted investment amount before they had even managed to break even.
Section 56(2) was responsible for this seemingly draconian provision and the Finance Minister moved to do away with it in the later part of September 2019 when she decided on an exemption scheme.
This effectively did away with the angel tax for startups, and an allied move also cut existing corporate taxes from 30% to 22% for existing businesses.
ESOP Taxes for Startups
The recent decision to relaxat the rules applicable on Employee Stock Ownership Plan (ESOP) Taxes was one of the cornerstones of this year's Union Budget to provide relief to startups. Startups are known to recruit highly skilled and talented employees, and frequently try to retain their services by incentivising them with stock owning options. This form of compensation allows employees a higher stake in the business, and subtly urges them to stay in the startup. This effectively keeps attrition rates low and operational efficiencies high.
Earlier, a system of dual taxation was established to regulate this aspect, thereby affecting the implementability of this compensation tactic. In order to fix this issue, Mrs. Sitharaman introduced a new policy that allows employees to defer tax payments for five years, till they sell their shares or leave the company (whichever is earlier).
This will allow the employees holding stocks to feel more reassured about their stock position and bring down the possibility of losses if the startup is unable to succeed.
Under the existing scheme before this modification, the employees are required to pay a tax whenever they accept an ESOP, or clear the dues of a capital gains tax if they choose to redeem it.
Once the new regulation is put into effect, the employees will enjoy greater flexibility and lower losses.
The Flip Side of Startup Taxes
As if the issues with capital gain exemptions were not enough, Indian startups have to face some more taxing situations that further complete their tryst with taxation.
For starters, the eligible startups, in order to carry forward and write off the losses incurred in the first ten years since inception, have to establish that their original shareholders have not exited since the organisation was registered.
Although ten years is not exactly a long time, it is quite likely that some private equity investors may sell off their equity slice and leave the business before the first decade lapses.
This could potentially result in losses remaining unabsorbed, and startups facing significant issues. One of my pet peeves with the Indian startup ecosystem has always been the alarming lack of major exits in the market.
Now, however, it seems that I have something to be glad about, at least in the case of brand new startups, with regard to the dismal exit scenario in India.
Moreover, the relatively recent Goods and Services Tax or GST seems to have caused a fair bit of complications for the startups as well, as they scramble to calculate their dues to the state and the centre. Although the idea of this tax format is to simplify indirect taxes, some startups have had some trouble in adjusting to the new scheme of clearing tax dues. This has ended up adding a complicated step to their tax situation.
My advice would be to get the details hammered out by a competent chartered accountant, as once understood and incorporated, GST can be a rather beneficial system to work with.
Another concern that continues to pervade the startup space is the mad rush to register startups abroad, especially in places like the UK and Singapore, which are known to offer remarkable tax incentives. Add that to India's red tape issues, GST complications, and a myriad of murky regulations to tackle investments in Indian firms, and you've got a winning case for registering firms abroad.
While this may be a beneficial move for individual firms in the short run, they can effectively spell doom for the Indian economy in the long term. As the supposed "growth engines" of our emerging economy whistle away instead of taking us along for the ride, I wonder what more we would have to see by way of an economic crisis.
In essence, the startup ecosystem of India has a tough nut to crack in the taxation system, with occasional bouts of relief and rejoicing. However, if the government does not implement more lucrative incentives soon, it won't be long before Start Up India becomes fossilised under the combined weight of governmental inaction and complex taxation!