Startups in India qualify for a host of benefits including exemption from certain taxes. However, in order to qualify for such exemptions, a startup needs to be covered under the definition of an `eligible startup’ as per the Startup India Action Plan launched in 2016.
Startups need to meet the following criteria to be eligible for exemptions:
- Registered as a private company; a partnership firm or a LLP
- Has been in existence for not more than 7 years
- Annual turnover does not exceed INR 25 Crores in any of the previous years.
- Aims to work for innovation and development.
An eligible startup qualifies for the following exemptions:
a) Three year tax holiday in a block of seven years
Startups incorporated after April 1, 2016, are entitled for a 100% tax rebate on their profits for a total period of three years over a block of seven years. However, if during this time period, the annual turnover the startup exceeds INR 25 Crores, then the tax rebate shall not be considered valid.
b) Exemption from tax on Long Term Capital Gains
Section 54EE of the Income Tax Act exempts startups from long-term capital gains tax, on the fulfilment of certain conditions. In order to avail this exemption, the capital gains investment should be a part of the fund notified by the Central Government within a total period of 6 months from the date of the actual transfer of asset. Further, there is a limit of INR 50 Lakhs on investment in long term capital gains in order to avail this exemption. Additionally, a lock-in period of three years is also prescribed. If the amount is withdrawn before the lock-in period of three years, then it will become taxable.
c) Exemptions on investments above the fair market value
Typically, eligible startups’ investments which exceed their fair market value are exempt from taxes. Earlier, any amount in excess of the fair market value was taxable. This tax, known as angel tax, has now been removed, subject to certain conditions.
d) Exemption to individuals/HUF on investment in startups
Any individual or HUF who invests the proceeds of sale of property to subscribe to at least 50% of shares of eligible startups shall not be required to pay long term capital gains tax. These shares are locked-in for a period of five years.
Taxation Regime for Startups
Startups are also required to pay the Dividends Distribution tax (DDT) at around 15%. Dividend Distribution Tax is levied on dividends which are paid out to shareholders. Currently, it is taxable in the hands of the company as well as the shareholders. Proposals are being put forth to scrap DDT for companies and make it taxable only in the hands of shareholders.
Recently, the government announced the reduction in corporate tax rates from 30% to 22%. This benefit can be availed by domestic companies who do not avail any other exemption or incentives. Startups may be registered as proprietorships, partnership firms or companies. If a startup is registered as a domestic company, then it is liable to pay corporate tax. Earlier the amount of corporate tax payable was dependent upon the turnover of a company. In wake of the recent changes, a domestic company which does not avail of any other exemptions/incentives is liable to pay 22% corporate tax or 25.17% inclusive of all surcharges and cess. A number of exemptions and incentives including tax holidays are granted to startups. If a startup company avails of these exemptions, it cannot take advantage of the reduced corporate tax rate till the exemption subsists. However, once the exemption period is over, it may opt to pay reduced corporate tax rate.
Angel or Devil Tax
Angel Tax has been a hotly contested issue. It is levied on the capital which Indian unlisted companies raise via off-market share transactions. If the entity is valued above its fair market valuation, then the excess amount is considered as income and is taxable accordingly. The rate of angel tax is 30.9%, which is inordinately high.
- Angel tax is levied only on investments by resident investors. This placed domestic investors at a substantial disadvantage compared to international investors.
- Startups as they have to pay tax on any additional funding that they get over and above their market valuation.
Startups had been protesting against angel tax for long. One of their major concerns was that while calculating fair market valuation of the entity, its future growth prospects were ignored and hence, majority of their funding became taxable.
Implications of removal of angel tax
The government recently relaxed the provisions pertaining to angel tax on startups which are registered with the Department for Promotion of Industry and Internal trade (DPIIT). It announced that Section 56(2)(viib) of the Income Tax Act, which dealt with fair market valuation of startups will be inapplicable to startups registered with DPIIT. This would in effect make angel tax a nullity for such startups.
Angel tax has been viewed as `everything evil with the tax regime’ by the startups. Its removal for companies registered with the DPIIT is being viewed favorably by the startup ecosystem. It has myriad implications both for the startups and for the economy.
- Firstly, being exempt from paying a tax which was as high as 30.9%, will increase cash flow to startups. They would no longer be wary of receiving additional funding for the fear of taxation.
- Secondly, this step is also a welcome step in terms of curbing ‘tax terrorism’ or the over-enthusiasm of tax authorities while taxing startups.
This move provides more clarity to taxation with regard to startups. The only criteria required here is registration with DPIIT. In order to be registered with DPIIT, the only condition is that the turnover should not have exceeded INR 100 Crores in any previous year.
Removal of angel tax is a growth-promoting strategy. This move will lead to more funds in the hands of startups and will incentivize their growth. This move of the government is laudable and will go a long way in promoting the startup ecosystem in the country.
Written by Soumya Shekhar, legal writer @ Riverus