Start-Ups: The Struggle and the Triumph!

The Major Development for Start-Ups Came On February 19, 2019 Vide Notification No. G.S.R. 127(E) ("2019 Notification"), which finally Addressed A Majority of The Demands Raised by Start-Ups...

The Government of India in January 2016 launched a flagship initiative 'Startup India' with an intention of building a strong eco-system for nurturing innovation and promoting startups in the country in order to drive sustainable economic growth and generate large scale employment opportunities. The Government through this initiative aimed to empower start-ups to grow through innovation and design.

In furtherance of this initiative, notifications were issued in 2016¹, 2017² and 2018³ by the Department for Promotion of Industry and Internal Trade ("DPIIT") (erstwhile – Department of Industrial Policy and Promotion), explaining the eligibility conditions, procedure for getting recognized as a 'start-up' and conditions and procedure for availing benefits (including tax benefits).

However, the major development for start-ups came on February 19, 2019 vide Notification No. G.S.R. 127(E) ("2019 Notification"), which finally addressed a majority of the demands raised by start-ups. The 2019 Notification prescribed inter alia the following amendments:

• widened the scope of start-up definition;

• increased the permissible aggregate limit of share capital for seeking exemption;

• deleted the resident investor eligibility criteria, with respect to their net worth and income;

• broadened the list of exempted investments by specified categories of investors;

• did away with the requirement of making separate applications for exemption under Section 56(2)(viib) of the Income-tax Act, 1961 ("IT Act"); and

• most importantly, it removed the requirement of providing justification for valuation of shares, thereby setting to rest the debate about discrepancies in the

valuation methodologies used by the start-ups.

Eligible Start-Ups

The 2019 Notification has now broadened the scope of 'start-up' definition to include an entity:

(a) which is up to 10 years old, if it is incorporated as a private limited company or registered as a partnership firm or a limited liability partnership in India;

(b) which has a turnover not exceeding INR 100 Crore since

the date of incorporation/registration; and

(c) which is working towards innovation, development or

improvement of products or process etc. with a high potential of employment generation or wealth creation.

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a 'start-up'.

Exempted Investors

A start-up as defined above will be eligible to avail tax exemption on investments received under section 56(2)

(viib) of IT Act, if:

(a) it is DPIIT recognized; and

(b) the aggregate amount of paid up share capital and share premium of the start-up after the issue of shares does not exceed INR 25 Crore.

However, this limit of INR 25 Crore shall not be applicable in case the shares issued are subscribed to by:

• non-residents (including Non-resident Indians);

• a venture capital company or a venture capital fund; and

• frequently traded listed companies according to Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, with a net worth of INR 100 Crore as on the last day of preceding financial year or turnover of INR 250 Crore for the preceding financial year.

The above exemption, however, has not been extended to Category-II AIFs ("Cat-II AIFs"). Usually, private equity funds, debt funds etc. come under the purview of Cat-II AIFs. Furthermore, even though venture capital funds are

registered as Cat-I AIF, it has been observed that recently funds have started using Cat-II AIFs for making venture

capital investments.

Restrictions on Start-ups

To ensure that the exemption is restricted to bona fide cases having regard to anti-abuse intent of "Angel Tax"

provisions, the 2019 Notification prohibits the start-ups from investing in any of the following assets for a period of up to 7 years from the end of the latest financial year in which shares were issued at a premium:

(i) residential building or land appurtenant thereto, other than that used by the start-up for the purposes of renting or held by it as stock-in-trade, in the ordinary course of business;

(ii) non-residential land or building, or both, other than that occupied by the start-up for its business or used by it for purposes of

renting or held by it as stockin-trade, in the ordinary course of business;

(iii) loans and advances,

other than loans or advances extended in the ordinary course of business by the start-up where the lending of

money is a substantial part of its business;

iv) capital contribution made to any other entity;

(v) shares and securities;

(vi) a motor vehicle, aircraft, yacht or any other mode of transport, the actual cost of which exceeds INR 10 Lakhs, other than that held by the start-up for the purpose of plying, hiring, leasing or as stock-in-trade, in the ordinary course of business;

(vii) jewellery other than that held by the start-up as stockin-trade in the ordinary course of business; and

(viii) any other asset, whether in the nature of capital asset or otherwise, of the nature specified in sub-clauses (iv) to (ix) of clause (d) of explanation to Section 56(2)(vii) of the IT Act.⁴

Breach of the above end-use restrictions shall result in retrospective revocation of the exemption from "Angel Tax" provisions.

Benefits and exemptions for recognized Start-ups

Eligible Start-ups are entitled to the following benefits and exemptions:

(a) Tax Exemptions
• The start-ups are exempted from Income-tax for a period of 3 years in a block of 7 years provided that annual turnover of the start-up does not exceed INR 25 Crore in any financial year and such start-ups do not distribute any dividend to their shareholders.

• A new section 54 EE was inserted under the IT Act to exempt start-ups from any tax on capital gains arising from the transfer of long-term capital asset,

if such capital gains have been invested in whole or part in the long-term specified asset such as fund notified by Central Government not exceeding INR 50 Lakh, for a period of at least 3 years, within a period of 6 months after the date of such transfer.

(b) Foreign Exchange Management Act, 1999
• Start-ups are allowed to raise 100% funds from foreign venture capital investors, irrespective of the sector in which the start-up is engaged.

• Only start-ups are allowed to issue convertible notes to a person resident outside India.

• Start-ups are permitted to raise external commercial borrowings up to USD 3 million per financial year with a minimum average maturity period of 3 years under the automatic route for any expenditure connected to its business, allowing start-ups to access lowinterest foreign loans instead of going through the daunting task of finding a suitable investor.

(c) Companies Act, 2013
• Start-ups are exempted from preparing a cash flow statement and are not required to include the cash flow statement in their financial statement.

• Start-ups are not required to hold a minimum number

of 4 meetings of their board of directors in a year and are required to hold at least one meeting in each half of a calendar year.

• Start-ups can accept deposits from their members as clauses (a) to (e) of sub-section (2) of section 73 of the Companies Act, 2013 are not applicable to startups.

• Employee Stock Options can be issued to an employee of a start-up who is a promoter or a person belonging to the promoter group; or to a director who either himself or through his relative or through any body corporate, directly or indirectly, holds more than 10% of the outstanding equity shares of such start-up.

• Start-ups may issue sweat equity shares not exceeding 50% of their paid-up capital up to 5 years from the date of their incorporation or registration.

(d) Fast Track Process
• A start-up can be wound up within 90 days of filing an insolvency application under the Insolvency and Bankruptcy Code, 2016.

• Any application by a start-up for patents will be fast tracked along with 80% rebate in filing of patents visà-vis other companies.

(e) Compliance based on Self-Certification
• Compliance pertaining to 6 labor laws including the Contract Labour (Regulation and Abolition) Act, 1970, the Employees' Provident Funds and Miscellaneous Provisions Act, 1952, the Employees' State Insurance Act, 1948, the Payment of Gratuity Act, 1972 etc. and 3 environmental laws i.e. the Water (Prevention & Control of Pollution) Act, 1974, the Water (Prevention & Control of Pollution) Cess (Amendment) Act, 2003, and the Air (Prevention & Control of Pollution) Act, 1981, will be allowed to be self-certified through the start-up mobile application.

• No inspections will be carried out under labor laws for a 3-year period.

• Start-ups classified as White Category as defined by the Central Pollution Control Board will be allowed self-certification under environmental laws, with only random checks proposed.

Conclusion

India was once regarded as the land of red-tape and cumbersome bureaucratic hurdles. However, the Government's continuous determination to de-bunk such views has aggressively transformed the landscape by introduction of various regulatory relaxations coupled with a host of other initiatives, such as provision of funds with a total corpus of INR 10,000 Crore, to benefit the current entrepreneurs and technology-savvy customer base.

The Indian start-up ecosystem is gradually entering into a matured phase, with increasing number of sophisticated

investors entering the market widening the scope and potential of domestic markets. The Government's liberalization of various laws specifically for start-ups including the recent proposals to allow start-ups to issue 50% of their paid-up capital as sweat equity up to 10 years from the date of their incorporation and registration and permitting to raise deposits exceeding 100% of their paidup share capital for a period of 10 years, has continuously eased the entrepreneurs in doing business in India.

With the introduction of the above incentives and programs

and removal of the major hurdle such as 'Angel Tax', the intention of the Government is clearly established to

support the start-ups and accomplish its vision to make India the largest start-up destination in the world. While

these initiatives do take a step forward, the implementation and practical application still has to be tested in the coming times.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.