TAXATION REGIME ON STARTUPS IN INDIA

1. Start-up Entity Forms Recognised under the Start-up India Scheme

The definition of start-up recognises three entity forms for start-ups for the purpose of benefits under Income-tax Act,1961 as well as other benefits:-

  • a partnership firm registered under section 59 of the Partnership Act, 1932
  • a limited liability partnership under the Limited Liability Partnership Act, 2008
  • a private limited company

The Tax Efficiency of different startup entity forms recognised for Startup India Scheme are as follows:-

Sr. No.Points of comparisonRegistered Partnership firmLimited Liability Partnership FirmPrivate Limited Company
1.Whether tax holiday available under section 80-IAC?No.Yes, subject to fulfilment of conditions stipulated in that sectionYes, subject to fulfilment of conditions stipulated in that section
2.54GB tax benefit to promoter selling his residential property and investing proceeds in capital of startup entityNo.No.Yes.
3.Effective Tax rates31.2% to 34.944% depending on total income size; Subject to AMT31.2% to 34.944% depending on total income size; Subject to AMT26% to 29.82% depending on total income size without foregoing exemptions but subject to MAT

 

25.17% [Section 115BAA]/ 17.16% [Section 115BAB] if certain exemptions including section 80-IAC tax holiday foregone; No MAT

4.First proviso to section 68 as regards capital raised from residents where resident investors have to satisfactorily explain their sourceNot applicableNot applicableApplicable
5.Angel Tax u/s 56(2)(viib)Not applicableNot applicableApplicable. However, exemption available subject to fulfilment of conditions specified in Para 4 of LSN.

2. Start-up Entity which is a Registered Partnership Firm:-

Para 1(f) of the LSN defines ‘partnership firm’ to mean a firm registered under section 59 of the Partnership Act, 1932.

A start-up which is a registered partnership can’t avail tax holiday under section 80-IAC not can its partners avail capital gains tax exemption under section 54GB if they sell their residential properties and invest in capital in start-up firm.

However, a registered partnership firm start-up can nevertheless avail other non-tax benefits under the start-up India scheme. An unregistered firm start-up cant avail any benefits under the Start-Up India scheme.

A partnership firm can be seamlessly converted into LLP under the Second Schedule of the LLP Act, 2008. It can also be seamlessly converted into a private limited company under Chapter XXI of the Companies Act, 2013.

The conversion of a firm into company or LLP is a one-way street. There is no provision for conversion/reconversion of LLP/company into firm.

The following are the tax consequences under the Act for a registered partnership firm:

  1. Partnership firms can avail presumptive tax regime under section 44AD whereby if turnover from business does not exceed Rs. 2 crores, firm can opt to be assessed on business income computed at the rate of 8% of turnover (6% if payment for turnover is received by cashless means) without maintaining books of account and without getting them audited under section 44AB. This facility is not available to LLPs and companies.
  2. Positive side is no ‘angel tax’ under section 56(2)(viib) of the Act and so no question of any exemption from angel tax. Negative side is that funding from angel investors will not be forthcoming as they want tag along rights and drag along rights which enable them to exit advantageously by selling their shares when start-up becomes profitable and valuable business.
  3. First proviso to Section 68 is not applicable to partnership firm. First proviso to section 68 of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. The resident investors from whom funds are received as share monies have also to satisfactorily by explain their source of investments. No such onus on firm as regards capital contributions from partners credited in its books. It is sufficient if firm explains source of the credit.
  4. No tax-holiday under section 80-IAC as Registered Partnership Firm is not an ‘eligible start-up’ within the meaning of clause (ii) of Explanation to section 80-IAC. Only start-ups which are LLPs and private limited companies are considered ‘eligible start-ups’ subject to fulfilment of conditions in that Explanation are ‘eligible start-ups’. Therefore, start-ups which are registered partnership firms are not eligible for three-year tax holiday (any 3 out of 10 years from the year of incorporation) under section 80-IAC in respect of profits from eligible business.
  5. No section 54GB benefit of capital gains exemption to promoters/partners who sell their residential properties and invest in start-up firm.
  6. Tax rate of 30% which compares unfavourably with 25% applicable to a start-up private limited company

     

    Firms attract 30% tax rate on total income irrespective of turnover. Start-ups which are private limited companies can avail the concessional rate of tax of 25% applicable to companies whose turnover do not exceed Rs. 400 cr as start-ups by definition have turnover of Rs. 100 cr or less.

    This 30% tax rate also compares unfavourably with the 25.17% tax rate that companies will enjoy under section 115BAA if they don’t claim certain specified tax reliefs and the 17.16% rate applicable to new manufacturing companies under section 115BAB provided they don’t claim certain deductions or exemptions.

  7. Reconstitution of firms [New Section 9B and new substituted sub-section (4) of section 45]:- When there is reconstitution of firm/LLP/AOP/BOI by way of retirement of partners or members and payment of retiring partner/member is made by the firm/LLP/AOP/BOI giving him a capital asset, there are two transfers of capital assets:-
  • One by the firm to the partner
  • The other by the partner to the firm i.e. partner relinquishes his interest in the firm

Section 9B inserted in the Act by the Finance Act, 2021 captures the first transfer of capital asset i.e. by firm to the partner and taxes it in the hands of the firm. Sub-section (4) of section 45 as substituted by the Finance Act, 2021 captures the second transfer but instead of taxing it in partner’s hands taxes it in the hands of the firm. Besides, payment to retiring partner of balance standing to his capital account will attract capital gains tax in the hands of the firm.

Any transfer of stock in trade to retiring partner will have to be valued at fair market value and profits and gains on it will be taxed as business income in the hands of the firm. Besides, there is no clarification whether such stock transfer by firm to retiring partner will be sale or purchase of goods for Tax Collected at Source provisions of section 206C(1H) and TDS Provision under Purchase of Goods U/S 194Q.

As it is, partnership firms are unattractive for startups due to higher taxes, no tax holiday under section 80-IAC, no section 54GB incentive to promoter who sells his residential property to invest in capital and higher tax rates than companies. Removal of Dividend distribution tax by Finance Act, 2020 has made companies more attractive. Now this tax in firm hands on reconstitution is one more thing that makes partnership firms unattractive.

3. Start-up Entity which is a Limited Liability Partnership:- According to para 1(e) of the LSN, ‘limited liability partnership’ ‘shall have the same meaning as assigned to it in clause (n) of sub-section (1) of section 2 of the Limited Liability Partnership Act, 2008’.

The said clause (n) defines ‘Limited Liability Partnership’ to mean a partnership formed and registered under this Act;’

This makes it clear that an LLP to be eligible to be regarded as ‘start-up’ must be formed and registered in India under the LLP Act, 2008. LLPs incorporated abroad shall not be regarded as ‘start-up’ under the LSN.

However, a foreign national can be a partner in an LLP registered in India. Such LLP can be got recognised as start-up by DPIIT.

3.1 Can foreigner be a partner in a startup LLP and can such startup be recognised by DPIIT? The following clarification to FAQ on Start Up India website may be noted:-

“Can a foreigner enter into partnership under the LLP Act and get that LLP registered with Startup India?

Yes, a foreign national can enter into partnership under the LLP Act and get that LLP registered on our website. It can even get recognised by the DIPP.”

3.2 What are the tax consequences for a startup LLP under the Income-tax Act?

The following are the tax consequences under the Act for a Limited Liability Partnership:

  • Tax-holiday under section 80-IAC available to a start-up LLP – Section 80-IAC(1) provides for a 100% tax holiday to an eligible start-up for 3 consecutive years in respect of any profits and gains derived from eligible business. The tax holiday may, at the option of the start-up LLP assessee, be claimed by him for any three consecutive assessment years out of sevenyears beginning from the year in which the eligible start-up is incorporated. Clause (ii) of Explanation to section 80-IAC defines ‘eligible start-up’ to mean a company or a limited liability partnership engaged in eligible business which fulfils the following conditions, namely:-
    1. it is incorporated on or after the 1st day of April, 2016 but before the 1st day of April, 2022[1];
    2. the total turnover of its business does not exceed Rs. 100 crores in the previous year relevant to the assessment year for which deduction under sub-section (1) is claimed; and

       

      Note : The turnover limit of Rs. 25 crores has been increased by the Finance Act, 2020 to Rs. 100 crores with effect from assessment year 2021-22.

    3. it holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government;
  • Section 80-IAC tax holiday for LLPs is like declaring holidays on February 29, 30 and 31in non-leap years in view of Alternate Minimum Tax under section 115JC which applies to it. Alternate Minimum Tax (AMT) under section 115JC is applicable to an LLP if it claims any deduction under any section included in Part C of Chapter VI-A of the Act under the heading ‘C-Deductions in respect of certain incomesSection 80-IAC falls under Part C of Chapter VI-A.
  • Therefore, LLP start-up is liable to AMT of 18.5% of adjusted total income  total income before claiming section 80-IAC and Section 80JJAA. Thus, AMT totally negates section 80-IAC/Section 80JJAA benefits for a start-up LLP.
  • Instead of ending up with zero tax on zero total income after sections 80-IAC and 80JJAA claims, these claims are added back to zero total income to get adjusted total income on which AMT is applicable. However, in the 3 consecutive years that a start-up LLP claims sections 80-IAC and/or 80JJAA, it ends up with a concessional tax rate of:-
  1. 5% plus surcharge 12% plus 4% Health and Education Cess which works out to 21.5488 % if ATI exceeds Rs. 1 cr and
  2. 24% if ATI is Rs. 1 crore or less.
  • No section 54GB benefit of capital gains exemptionto promoters/partners who sell their residential properties and invest in start-up LLP.
  • Positive side is no ‘angel tax’under section 56(2)(viib) of the Act and so no question of any exemption from angel tax. Negative side is that funding from angel investors will not be forthcoming as they want tag along rights and drag along rights which enables them to exit advantageously by selling their shares when start-up becomes profitable and valuable business.
  • First proviso to Section 68 is not applicable to LLP –First proviso to section 68 of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. No such onus on an LLP as regards capital contributions from partners credited in its books. It is sufficient if firm explains source of the credit.
  • Tax rate of 30% which compares unfavourably with 25% applicable to a start-up private limited company

LLPs are treated as ‘firms’ under Income-tax Act and attract 30% tax rate on total income irrespective of turnover. Start-ups which are private limited companies can avail the concessional rate of tax of 25% applicable to companies whose turnover do not exceed Rs. 400 cr [turnover limit revised upwards from Rs. 250 cr to Rs. 400 cr by the Finance (No. 2) Act, 2019 w.e.f. A.Y. 2020-21] as start-ups by definition have turnover of Rs. 100 cr or less.

This 30% tax rate also compares unfavourably with the 25.17% tax rate that companies will enjoy under section 115BAA if they don’t claim certain specified tax reliefs and the 17.16% rate applicable to new manufacturing companies under section 115BAB provided they don’t claim certain deductions or exemptions.

  • Presumptive tax scheme under section 44AD is not available to LLPs:

Partnership firms can avail presumptive tax regime under section 44AD whereby if turnover from business does not exceed Rs. 2 crores, firm can opt to be assessed on business income computed at the rate of 8% of turnover (6% if payment for turnover is received by cashless means) without maintaining books of account and without getting them audited under section 44AB. This facility is not available to LLPs and companies.

  • Tax on LLP’s transfer of capital asset/stock in trade payments in connection with reconstitution of LLP’s. These provisions apply to LLP as LLP is ‘firm’ as per section 2(23) of the Act.

4. Start-up Entity which is a Private Limited Company

Para 1(g) of the LSN provides that the term ‘private limited company’ shall have the same meaning as assigned to it in clause (68) of section 2 of the Companies Act, 2013. The word ‘company’ in the said clause (68) means company formed and registered in India under the Companies Act, 2013 (hereinafter referred to as ‘the 2013 Act’) or any previous Companies Act in force in India.

In terms of the said clause (68), a private company means a company

  • having a minimum paid-up share capital as may be prescribed, and
  • which by its articles,—
  • restricts the right to transfer its shares;
  • limits the number of its members to 200 to; and
  • prohibits any invitation to the public to subscribe for any securities of the company.

4.1 Minimum paid-up capital requirements for forming a private company:- The minimum paid up capital at the time of registration of a company shall be as follows:-

  • One Person Company: Re. 1
  • Private Limited Company: Rs. 2
  • Public Limited Company: Rs. 7 [FAQ No. 6 of e-filing FAQs on MCA website]

4.2 Tax consequences for a start-up entity which is a private limited company

The following are the tax consequences under the Act for a private limited company (PLC) start-up entity:

  • Tax-holiday under section 80-IAC available to a start-up PLC – Section 80-IAC(1) provides for a 100% tax holiday to an eligible start-up for 3 consecutive years in respect of any profits and gains derived from eligible business. The tax holiday may, at the option of the start-up private limited company assessee, be claimed by him for any three consecutive assessment years out of ten[2]years beginning from the year in which the eligible start-up is incorporated. Clause (ii) of Explanation to section 80-IAC defines ‘eligible start-up’ to mean a company or a limited liability partnership engaged in eligible business which fulfils the following conditions, namely:—

     

    1. it is incorporated on or after the 1st day of April, 2016 but before the 1st day of April, 2022[3];
    2. the total turnover of its business does not exceed Rs. 100 crores[4]in the previous year relevant to the assessment year for which deduction under sub-section (1) is claimed; and
    3. it holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government;
  • Tax holiday can become illusory for private company start-up if MAT under section 115JB applies – Section 115JB of the Act provides that if 18.5% on book profits of a company is more than tax on total income, book profits shall be total income and 18.5% of book profits shall be the minimum alternate tax payable. There is no exemption from MAT for start-up companies as no amendment has been made to section 115JB exempting profits of a start-up from MAT. Nevertheless, section 80-IAC certification helps promoter to claim section 54GB benefits. Where he sells his residential properties and invests in equity share capital of an eligible start-up private limited company.
  • Section 54GB benefit of capital gains exemption availableto promoters who sell their residential properties and invest in start-up private limited company provided they transfer the residential properties on or before 31.03.2022. Section 54GB inter alia provides that long-term capital gain on transfer of residential property (house or plot of land) shall not be charged in certain cases where:

     

    1. Transferor-assessee is an individual or HUF.
    2. Transfer of residential property is made on or before 31-3-2022
    3. The net consideration from transfer of residential property is utilized for subscription to equity shares of a company which is an eligible start-up as defined in Explanation below section 80-IAC(4).

       

      Such utilisation is made on or before the due date for furnishing return of income u/s 139(1) of the Act.

    4. The eligible start-up private limited company is incorporated in India during the period from 1st April of the previous assessment year in which the capital gain arises to the due date of filing ITR u/s 139(1).
    5. The start-up company is a company in which the assessee has more than 25% share capital or more than 25% voting rights after the subscription in the shares by the assessee.
    6. The eligible start-up has within one yea from the date of subscription in equity shares, utilised this amount for purchase of new asset including computers or computer software if it is a technology driven start-up so certified by the Inter-Ministerial Board of Certification notified by the Central Government in the Official Gazette.
  • ‘Angel tax’under section 56(2)(viib) of the Act is applicable to moneys received against equity shares issued by a start-up private limited company and issue price is in excess of fair market value. However, exemption available from angel tax to a DPIIT-recognised start-up private limited company in terms of Para 4 of the latest start-up notification (LSN) where aggregate amount of paid up share capital and share premium of the startup after issue or proposed issue of share, if any, does not exceed, twenty five crore rupees.
  • First proviso to Section 68 is applicable to private limited companies – First proviso to section 68 of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. There is no exemption from applicability of section 68 to start-up private limited companies in terms of the LSN.

However, the Finance Minister, in Para 113 of her Budget Speech on July 5, 2019, announced that “The issue of establishing identity of the investor and source of his funds will be resolved by putting in place a mechanism of e-verification. With this, funds raised by start-ups will not require any kind of scrutiny from the Income Tax Department.”

  • The Finance (No. 2) Act, 2019 has, with effect from assessment year 2020-21, amended section 79 of the Act to provide that loss incurred in any year prior to the previous year, in the case of closely held eligible start-up private limited company, shall be allowed to be carried forward and set off against the income of the previous year on satisfaction of either of the two conditions stipulated in (a) or (b) below:

     

    1. on the last day of the previous year, the shares of the company carrying not less than 51% of the voting power were beneficially held by persons who beneficially held shares of the company carrying not less than 51% of the voting power on the last day of the year or years in which the loss was incurred.
    2. all the shareholders of such company who held shares carrying voting power on the last day of the year or years in which the loss was incurred, continue to hold those shares on the last day of such previous year and such loss has been incurred during the period of seven years beginning from the year in which such company is incorporated.

The above provision has been enacted to facilitate ease of doing business in the case of an eligible start-up.