The Government of India is taking a lot of measures to create job opportunities which will lead to an increase in the overall growth of the country. In doing so, the Government is giving various monetary and non- monetary benefits to the eligible entities. One such eligible entity being ‘Startups’ for which the Government of India has launched various initiatives to give a boost to such entities. The Government of India as a part of this initiative had launched ‘Startup India’ program in the year 2016 to nurture innovative entrepreneurship and to create large scale job opportunities across all the sectors which will ultimately help in economic growth of the country.
A Startup is basically a newly emerged business venture that caters to meet the need, want or troubling issues of the society by developing an appropriate business model/platform which are suitable to cater to such needs or wants. As the entity is in its first stage of operations, funding of the business model and routine expenses always remain a big concern to the founders of the Startups. In order to ease the task of the founders of the Startups and to attract large investors in investing in Startups, the Government of India provides various incentives and exemptions to those Startups who fulfil the prescribed guidelines.
In order to take benefits of the incentives and exemptions provided by the Government of India, the Startup has to get itself registered with Inter Ministerial Board (‘IMB’ or ‘the board’) constituted by Department of Industrial Policy and Promotion (‘DIPP’). The board shall review the applications of the Startups and shall certify whether the particular Startup will be eligible for claiming the incentives. The incentives given to the Startups are in the form of:
a. Exemption from levy of income tax on share premium received by eligible Startups under section 56 of the Income Tax Act, 1961 (‘the Act’).
b. 100% deduction of the profits and gains from income of Startups under section 80 IAC of the Act for particular number of years.
Angel investor is an investor who invest their own funds in a Startup by way of debt or an equity. The angel investor by investing in the Startup help to propel the business model and to meet the initial expenses of the company. Angel investors are more focused on helping Startups to take their first steps, rather than focusing on the profit they may get from the business.
Income tax Scenario on shares issued by a company for a price exceeding its fair market value
According to section 56(2)(viib) of the Act, if a closely held company (excluding such companies as notified by the Government) receives from a resident any consideration for issue shares that exceeds its fair market value then, such additional consideration exceeding its fair market value shall be considered as taxable in the hands of the issuer.
Angel tax is basically the tax levied on such closely held companies which issue shares to the resident at a price higher than the face value. Such provisions of the Act has led to cause funding problems for the founder of Startups and some of really capable Startup have failed miserably due to lack of funds despite having good business model. The Angel tax was introduced in the Union Budget of 2012 and was listed as a “measure to prevent generation and circulation of unaccounted money” in the memorandum explaining the intent of introduction. It was one of those tax avoidance provisions introduced with an intention to bring an action against the money launderers who were using closely held shell companies to circulate unaccounted monies. However, over the last 6 years one cannot help but feel that the scenario has turned out to be reverse. For the Government to catch few money launderers/evaders, many genuine Startups who have raised capital by way of shares exceeding its fair market value have paid a heavy price already.
No classes of companies were sought to be exempt in the initial years and the tax administrators starting viewing this as a revenue garnering measure rather than a tax avoidance measure Tax Authorities in the recent past have been questioning all companies who have issued shares at a premium, on the validity of the valuation report to justify the manner in which the premium at which shares are issued is arrived, at the time of receipt of investment. After representations by some leading Angel investors and the start-up communities, the Central Board of Direct Taxes (‘CBDT’) instructed the Tax Authorities not to take coercive measures against start-ups and angel investors.
In order to exclude Startups from the section of 56(2)(viib) of the Act, the Government has been issuing timely notifications (Notification dt 12 April 2018 and 16 January 2019), providing with the conditions to be followed by such Startups in order to apply for an approval before CBDT for claiming exemption and to avoid getting the provision of section 56(2)(viib) attracted. By enforcing such conditions on the Startups, it actually doesn’t give any impetus to Angel Investors to invest their money in those Startups who cannot fulfil the conditions prescribed by the Government to claim the exemption. Thus, sometime such Startups end up giving not so desired results or fail due to lack of adequate funds.
The Department for Promotion of Industry and Internal Trade in super session of all earlier notification has issued notification dated 19 February 2019 simplifying the process of exemption to the Startups. According to the said notification, the entity shall be considered as Startup for a period of 10 years (earlier 7 years) subject to turnover not exceeding 100 crores (earlier 25 crores) and the entity should work towards innovation, development or improvement of products or services. The other conditions that should be followed by the entity in order to be eligible Startup are :
a. The threshold limit of paid up share capital and share premium post the issue/proposed issue of the shares shall not exceed 25 crores (earlier 10 crores).
However, in calculating the above limit of 25 crores non-residents, venture capital funds (‘VCFs’) and venture capital company, registered with SEBI are not to be included. Accordingly shares can be issued to such excluded investors without any limit and still the Startup will be eligible to claim exemption u/s 56(2)(viib) of the Act provided the shares beyond the threshold limit are issued to the excluded investors.
This condition has definitely turned out to be a breather to the Startups, as the earlier limit of INR 10 crores, which was with respect to total share capital and share premium, including for shares issued to non-residents and AIFs as well, is now increased to INR 25 crores only for investments made by resident investors.
b. Restriction on Investments
Further, to be eligible for the exemption, there are restrictions on investments made by the start-ups which are as below-
As a part of compliance, the start-up is also required to file a declaration in the prescribed form stating that above conditions are fulfilled. The notification also provides that, in case the start-up which has claimed an exemption under section 56(2)(viib) of the Act, makes an investment in any of the above specified investments before the end of seven years (from the end of the latest financial year in which the shares are issued at premium), the exemption availed under the said section shall be revoked retrospectively.
As the investment in securities is prohibited, the start-up will not be eligible to invest in mutual funds as well and investments would be restricted to other modes like fixed deposits, government bonds etc. Further, it is pertinent to note that the criteria of an investor having a specified return on income and net worth is done away with as provided in the earlier notifications.
Overall, the notification provides some relief (which was overdue from a long time) in terms of enhancing the limits to qualify as a start-up, and provides an additional incentive in the form of increase in aggregate amount of share capital and share premium post issue of shares (INR 25 crores for residents and no limit for non-residents), the restrictions on investments to be made by start-ups are quite stringent and impose challenges on the start-ups and their operations.