To boost entrepreneurship and employment generation, the government had allowed a three-year tax holiday to eligible start-ups.

The Finance Act 2018 has proposed to expand the ambit of activities that can be undertaken by start-ups, thereby further widening the scope to include start-ups engaged in improvement of products, processes or services or in a scalable business model with a high potential of employment generation or wealth creation.

It is pertinent to note that, in spite of favourable tax incentives, few anti-abuse provisions in the Income-Tax Act, 1961, (the Act) have hampered investor sentiment and have resulted in unnecessary dispute and litigation.

One of the key issues is taxation on account of sale of shares by a start-up to domestic investors.

The Income Tax Act provides that where shares of an unlisted company are issued at a price more than its fair market value (FMV) to a resident, the excess receipt over FMV is considered as income of the firm issuing such shares. In this regard, FMV of the shares has to be determined on the basis of net asset value of the firm. Alternatively, FMV can also be determined by an account or a merchant banker as per discounted free cash flow method.

Owing to the novelty and market potential of the idea involved, the valuation of a start-up firm can be highly dynamic and may practically undergo major change over a short span of time, thus leading to disputes on this front.

Considering the significance of building a mature start-up ecosystem in the country, the Central Board of Direct Taxes (CBDT) in 2016 notified that the provision for taxation of investment made at more than FMV shall not apply for investments made in eligible start-ups fulfilling conditions prescribed by the Department of Industrial Policy and Promotion (DIPP).

According to DIPP regulations, an eligible start-up incorporated on or after 1 April 2016 is required to obtain an inter-ministerial board (IMB) certification for availing “tax benefits". The term “tax benefit" has not been defined under DIPP guidelines. Thus, there is a debate that whether “tax benefit" includes exclusion granted by the CBDT in 2016 to the start-ups from FMV valuation for issue of shares.

The above confusion on the eligibility of a start-up for claiming exclusion from the rigors of share valuation requirements impact investments received by start-ups prior to 1 April 2016 and by start-ups that have not obtained IMB certification. Thus, even though the government has provided an exclusion to some start-ups, it does not cover the entire start-up industry.

According to recent press reports, the government, in consultation with DIPP, is planning to accord the status of start-ups to firms incorporated prior to 1 April 2016. Also, the government is considering exempting investments made by individuals in certain start-ups from tax liabilities to encourage high net worth individuals to promote innovation.

Recently, CBDT has also directed its officers to not take any coercive action in cases where the tax demands have been raised on start-ups due to the above provisions and had directed the appellate authorities to decide on past orders by 31 March. While the government is trying to encourage start-ups by providing time-to-time relaxations, the stringent use of anti-abuse provisions by the revenue authorities is hampering investors’ confidence. It is imperative that a blanket exclusion is provided to start-ups and its investors from the applicability of anti-abuse provisions in relation to the valuation of shares for the first 10 years or by way of a monetary threshold below which the aforesaid anti-abuse provisions would not get triggered. In a case of gross abuse, the revenue authorities can always resort to general anti-avoidance rules (GAAR) to ensure that their interest is protected.

It’s high time to review the above provisions, make necessary changes and provide impetus to the start-ups. After all, some of today’s start-ups will be billion-dollar companies tomorrow. Therefore, they deserve a soft touch in their initial years.

FAQs:

What is a “start-up"?

According to a Department of Industrial Policy and Promotion (DIPP) notification dated 23 May 2017, an entity is considered as a “start-up"-

* If it is incorporated as a private limited company, or registered as a partnership firm or a limited liability partnership in India; and

* Up to 7 years from the date of incorporation (10 years in case of entities in the biotechnology sector);

* Turnover has not exceeded Rs25 crore for any of the financial years, and

* It is working towards innovation, development or improvement of products or processes or services, or if it is a scalable model with a high potential for employment generation or wealth creation.

Provided that any such entity formed by splitting up or reconstruction of a business already in existence shall not be considered a ‘start-up’.

What are the conditions for seeking “tax benefit" for a start-up?

In order to obtain tax benefits, a start-up should–

* Be a private limited company (as defined in the Companies Act, 2013) or a limited liability partnership (as defined under the Limited Liability Partnership Act, 2008) which is incorporated on or after the 1st day of April 2016 but before the 1st day of April 2019, and

* Be working towards innovation, development or improvement of products or processes or services, or should be a scalable business model with a high potential of employment generation or wealth creation, and

* Obtain a certificate of an eligible business from the inter-ministerial board of certification as constituted by the department of industrial policy and promotion from time to time.

What is “angel tax"?

Consideration for issue of shares received by an unlisted company in excess of the fair market value of the shares is taxable as it’s “income from other sources". In the context of a start-up, this taxation is referred to as “angel tax".

You can send your queries to vikas.vasal@in.gt.com

Gaurav Mittal & Vedika Kedia contributed to this story.

Vikas Vasal is national leader, tax, at Grant Thornton India LLP.

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