How are start-ups taxed In India?

India has emerged as the third largest start-up ecosystem in the world, with over 61,000 recognized start-ups by the Department for Promotion of Industry and Internal Trade (DPIIT). The government has rationalized the tax and regulatory regime applicable to start-ups.

Here’s a list of all the tax benefits available to an eligible start-up. 

Income Tax Holiday for Start-ups 

Eligible start-ups can opt for and enjoy income tax exemption for any three consecutive years out of ten years, post incorporation. The said tax relief is subject to the fulfilment of the following conditions: 

• The eligible start-up is incorporated between April 2016 and March 2022. The Finance Bill 2022 has proposed to extend the last date of incorporation by one year to March 2023.
• Turnover should not exceed INR 100 crore in the year in which tax exemption is claimed.
• It must hold a certificate of eligible business, from the Inter-Ministerial Board of Certification (IMB).

It is pertinent to note that an eligible start-up can be a company or a limited liability partnership. It should be engaged in the business relating to innovation, development or improvement of products or processes or services, or a scalable business model with a high potential of employment generation or wealth creation.

No Tax on Share Issuance to Investors at a Premium

Start-ups are exempt from income tax on the amount received in excess of fair market value (FMV) of the shares issued to investors. 

It is pertinent to note that such start-up should be recognized by the DPIIT and total paid-up share capital and share premium, if any, post share issuance should not exceed INR 25 crore. There are certain other conditions which are also required to be fulfilled.

• Set-off of earlier year losses 

Generally, it is observed that newly incorporated companies find it difficult to make profit during their initial years of business operations. Accordingly, to support start-ups, it has been provided that in case of an eligible start up, such losses are eligible to be carried forward and set off in subsequent years against taxable profits upon satisfaction of the following conditions:

• All shareholders carrying voting power during the year in which the loss was incurred continue to remain shareholders in the year of set off; and
• losses must have been incurred within seven years from incorporation.

Tax Deferment on Exercise of Employee Stock Options (ESOPs)

ESOPs are an important tool employed by businesses to attract and retain talent, and help employees participate in the growth journey of the business. Currently, ESOPs are taxed at two stages in the hands of the employees. Firstly, at the point of exercise, when the difference between the FMV on the date of exercise and the exercise price is taxed as perquisite i.e. part of salary. Secondly, at the time of sale, when the difference between the sale price and the FMV on the date of exercise is taxed as capital gains 

In nutshell, there is tax pay out by the employees immediately upon exercise of the ESOPs. Practically, this could be a challenging scenario in case of employees as at that stage sufficient funds may not be available. 

To incentivise start-ups to hire and employ talent by granting ESOPs, an amendment was made by Finance Act, 2020 wherein the tax deduction at source (TDS) with respect to perquisite income on ESOPs of eligible start-ups was deferred. Thus, an option has been provided to ‘eligible start-ups’ to deduct tax on perquisite income on exercise of ESOPs within 14 days of the following events, whichever is earlier: 

• After the expiry of 48 months from the end of the relevant assessment year;
• From the date of sale of shares; or 
• From the date the taxpayer ceases to be an employee of the eligible start-up

Capital Gains on Sale of Shares 

When an entrepreneur sells his shareholding, the period of holding of such shares is an important factor in determining its taxability.

a. Tax on sale of unlisted shares: Unlisted shares should be held for more than 24 months (on the date of sale) for it to be qualified as long-term capital asset. Accordingly, such shares if sold before 24 months would qualify as a short-term capital asset. 

• The long-term capital gains (LTCG) on sale of unlisted shares is taxable at the rate of 20% (plus applicable surcharge and cess) in case of domestic investors and 10% (plus applicable surcharge and cess) in case of foreign investors. Recently, the Finance Bill 2022 has proposed to restrict the rate of surcharge to 15% in case of LTCG arising on transfer of any asset. 
• Short-term capital gains (STCG) is taxable at normal tax rates applicable to the particular class of persons.  

b. Tax on sale of listed shares: Listed shares if held for more than 12 months (on the date of sale) qualify as long-term capital assets.

• LTCG, in excess of INR 1,00,000, is taxable at the rate of 10% (plus applicable surcharge and cess). Indexation benefit cannot be availed in computing the cost of acquisition. Further, cost of acquisition of shares acquired prior to 1 February 2018 shall be higher of
  • Actual cost of shares
  • Fair Market Value as on January 31, 2018 or sale consideration, whichever is lower.
• STCG on sale of listed shares is taxed at a flat rate of 15% (plus applicable surcharge and cess)  

Bottom Line

If the developments seen in 2021 are an indicator of the future, Indian start-ups seem to be progressing on the right track. The Government has also shown its support towards the start-up culture by introducing timely reforms on the tax and regulatory front. 

However, stakeholders feel that Budget 2022 could have done just a little bit more to provide fillip to start-ups. Some changes such as extending the cut-off date for incorporation of start-ups for availing tax exemption by at least 5 years, as against a year’s extension and benefit of tax exemption on amounts received in excess of FMV of the shares issued to investors are still being sought.

This article was originally published on Forbes.