Start-Ups, Stood up?

On 16^th January 2016, “Start Up India, Stand-Up India” was announced as one of the Government’s flagship initiatives accompanied by a detailed 19 point action plan. The Department of Industrial Policy and Promotion (“DIPP”) followed up with a notification on 17^th February 2016 (“DIPP Notification”) to define the term ‘start up’ for availing benefits of proposed Government schemes and subsequently the Union Budget 2016 has announced certain tax incentives for “eligible start-ups” in the Finance Bill which will be incorporated into the Income Tax Act, 1961 (“ITA”).

The purported objective of this initiative is to bring clarity, simplicity, uniformity and provide ease of entry and exit into the start-up space. The Finance Bill has also introduced a number of tax benefits with a view to incentivize establishment of start-ups. The key Budget proposals and the provisions of the DIPP Notification are factually summarized below followed by a discussion on their interplay and areas for concern that need further clarity.

BUDGET PROPOSALS IN THE FINANCE BILL, 2016 AND THE MEMORANDUM:

The various start-up incentives introduced in the ITA are as follows:

1.Section 80-IAC of the Income Tax Act, 1961 : The Finance Bill has introduced a new Section 80-IAC whereby an ‘eligible start-up‘ is entitled to a deduction of 100% of the profits earned from an ‘eligible business’ for any three consecutive financial years out of 5 financial years from the date of its incorporation.

An eligible start – up has been defined as a ‘company’ engaged in eligible business which satisfies all the following conditions:

• It is incorporated on or after April 1, 2016 but before April 1, 2019;
• The  total turnover of its business does not exceed 25 Crore rupees in any financial year between April 1, 2016 and March 31, 2021; and
• It holds a certificate of eligible business from the Inter-Ministerial Board of Certification (“IMBC”) as notified by the Central Government.

An ‘eligible business’ is defined to mean a business involving innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.

The benefit is not available inter alia, if the start-up is formed by splitting-up or reconstruction of an existing business.  This condition does not apply in cases where a start-up is formed as a result of the re-establishment, reconstruction or revival of the business of any undertaking which got discontinued as a result of extensive damage or destruction of its building, plant, machinery etc.  from natural disasters, riots, civil disturbance, accidental fire, explosion, or enemy action. In such a case, the business must be revived, re-established or reconstructed within 3 years from the financial year in which the business got discontinued.

2.Section 54EE of the Income Tax Act, 1961: Effective from financial year 2016-17, any taxpayer who transfers a long-term capital asset (“Original asset”) and invests the whole or part of capital gains into units of a specified fund (“Units”) within 6 months from the date of transfer of the Original asset is exempt from paying capital gains tax on whatever sum is invested in the Units.  The amount of investment in the units must not exceed Rs. 50 lakh in any financial year and the benefit is also available in the subsequent financial year if the period of 6 months from the date of transfer spills over to the subsequent financial year. For example, if the original asset is transferred in December 2017 and the proceeds are invested in May 2018, then the taxpayer will be eligible to claim relief in financial years 2017-18 and 2018-19. The taxpayer must hold the Units for at least 3 years to avail this benefit and a transfer of the Units before that would lead to the exemption being revoked. This also includes situations where the taxpayer raises a loan or advance against the security of such Units within 3 years which is deemed to be a transfer with consequential loss of benefits under this section.

3.Section 54GB of the Income Tax Act, 1961: The existing exemption from tax on long term capital gains from sale of residential property when such gains are invested in small or medium enterprises as defined under the Micro, Small and Medium Enterprises Act, 2006 has been expanded to include gains invested in eligible start-ups. After the amendment, when an individual or a HUF sell residential property and invest the gains to subscribe to more than 50% of the shares of a company as mentioned above and such company uses the amount invested to purchase assets (which has now been expanded to include computers or computer software), then such gains are exempt. This benefit is lost if the company transfers the asset within 5 years of its purchase.

THE DIPP NOTIFICATION:

‘Start-up’:Start-up is defined as an ‘entity’ which is further elaborated in explanation 2 as:

a)      private limited company as defined under the Companies Act, 2013,

b)      partnership firm registered under Section 59 of the Partnership Act, 1932,

c)       limited liability partnership (“LLP”) under the LLP Act, 2002.

In addition to some of the conditions imposed under the Finance Bill, 2016, the notification states that any of the above entities will be considered a startup for five years from its date of incorporation or registration.

‘Eligible Business’:The notification states that an ‘Eligible Business’ must aim to develop or commercialize a new product, process or service, or a significantly improved one that will create or add value for customers or workflow. It further states, inter alia, that mere development of undifferentiated products, processes or services, or those which do not have a potential for commercialization would not qualify. 

ANALYSIS OF BUDGET PROPOSALS IN LIGHT OF THE DIPP NOTIFICATION AND STARTUP ACTION PLAN:

1.Who is a start-up? : To avail the tax benefits, an eligible start-up must necessarily be a company within the meaning of the Income Tax Act, 1961 (“ITA”). This is a clear deviation from the DIPP Notification which identified start-ups to be a private company, partnership firm or a LLP. This deviation excludes a number of start-ups registered as partnership firms or LLPs, restricting the flexibility of entrepreneurs to structure their businesses as a partnership firm or LLP which have significant advantages in terms of time taken to establish, as well as in respect of administration and associated costs. Further, LLPs are a very popular form of business for entrepreneurs owing to a single layer of tax at the LLP level, with no tax on the partner’s share of income received from the LLP, as opposed to a company which is taxed on its profits as well as on the dividends distributed. While the Government is on the one hand incentivizing Indian LLPs by opening up the FDI regime to LLPs, on the other hand it is disincentivizing LLPs as a business model for start-ups by excluding them from tax incentives. 

Further, ‘company’ under the ITA has been defined broadly to include an Indian or a foreign company, whether public or private. Hence, the use of the word ‘company’ may lead to unintended consequences.

Having said that, currently as the situation stands, the definition of start-up issued by DIPP read with the Start-up Action Plan gives the impression that such definition was meant to apply only to avail benefits of proposed government schemes targeted at start-ups and to bring about uniformity with respect to the same. The various proposed schemes in the Action Plan included:

1. Easing regulatory compliance for startups through self-certification with respect to several Labour and Environmental laws.
2. Simplification of registration process through the mobile app
3. To avail the benefits of the Start-up Intellectual Property Protection (SIPP) scheme which includes free help from government facilitators in the form of general advisory, filing assistance, prosecution and appearance at hearings.
4. Exemption from criteria of prior experience/turnover while applying for government bids.
5. To obtain venture debts and credit guarantees through National Credit Guarantee Trust Company
6. Assistance from BIRAC AcE Fund for biotech startups.

The DIPP Notification is an exercise of Executive power under the aegis of Art. 73 of the Constitution of India and therefore operates with the force of law unless overridden by statute. Therefore to the extent there is an inconsistency between the amendments to the ITA and the notification, the provision of the ITA will prevail. This means LLPs and partnerships will not be able to avail tax benefits under the ITA. However, they will still constitute start-ups for the purposes of availing other government scheme benefits whenever they are implemented. Nevertheless, the situation is less than satisfactory as only private companies fall within the scope of both the definitions and are therefore eligible to avail of all benefits. If left unamended, this creates two classes of startups (“eligible startups” under ITA and “start-up” under the DIPP Notification) with differing requirements for availing different benefits which does not contribute to making things simpler, easier or clearer for start-ups.

Further, it is pertinent to note that the main benefit under Sec. 80IAC is whittled down by the fact that Minimum Alternate Tax nevertheless applies for the years in which the benefit is claimed, although practically it may take many years for a startup to actually make profits.

2.Sec. 54EE of the Income Tax Act,1961 has used unnecessarily complicated language to achieve a simple end result. The amount of eligible relief is linked to whether the capital gains from sale of an asset is wholly or partly used to buy Units in the specified Government fund and if the whole amount is not used, then the remaining capital gains is not exempt from tax.

3.The definition of ‘eligible business’ in the  DIPP notification may lead to subjectivity in determining what business may be considered as ‘innovative’ in order to be considered eligible. For eg., where a business is based on a global model and is introduced for the first time in India by an eligible taxpayers, would the same be considered ‘innovative’? Similarly, if there are existing players in a business model and the local needs justify the entry of more such players, would that constitute as innovative? Clarity is required on such aspects as well.

4.The Finance Bill, 2016 has missed the opportunity to exempt tax on excess consideration on the issue of shares above the Fair Market Value in the hands of the Start-up under Sec. 56(2)(viib) as promised in the Start-up Action Plan. Similarly, even though investments from Venture Capital Funds in start-ups continue to be exempted, the same has not been extended to investments by incubators.