How startups should look at the Union Budget

When Finance Minister Arun Jaitley enters the Parliament on Monday, the briefcase in his hand will hold the economic fate of the nation for the coming year. A set of financial documents explaining revenue, taxes, and expenditure by the Central government, Union Budget 2016 is the centre of attention in the country, including the startup world. Of course, startup founders and investors got a major boost when Prime Minister Narendra Modi announced the ‘Startup India Stand up India’ campaign on January 16. The Budget can determine the growth of economy and support for startup ecosystem in the country. Ganesh Prasad, partner at Khaitan and Company, said: “Startups and investors are hopeful that further measures encouraging startups, and investments in startups, will be implemented by the Ministry of Finance in the upcoming budget.”

Startups: Look at the budget and watch for the following terms

• Taxation of consideration above Fair Market Value: The SIAP has improved on the erstwhile policy of the government by proposing that investments by incubators in startups are exempted from consideration paid above FMV of securities being treated as “income from other sources.” The exemption was previously available to venture capital funds. As startups are typically invested in by angel investors and other early-stage investors, this exemption should be made available to them as well.
• Taxation of unlisted securities: Startups are increasingly incorporating companies in tax havens to allow investors to avoid high taxation of capital gains on transfers of securities affected, less than three years, from the date of investment. Similar to taxation of capital gains on transfer of securities in listed companies, the rate of taxation of securities of unlisted companies should be lower than 15 percent or nil.
• Taxation on conversion: Presently, conversion of preference shares into equity shares is considered to be a transfer, and capital gains tax is payable on conversion, although monies are not realised at such time. This should be considered as a transfer and the calculation of holding period for categorisation into short-term or long-term capital gains should include the period of holding of the preference shares prior to conversion.
• Taxation of ESOPs as perquisite: ESOPs can be a useful tool to retain employees, but are not considered attractive as they are considered perquisites, and the holder is subject to tax at the time of exercise of the option. Therefore, tax is payable even before the employee has sold the shares. Consequently, the notional (but not realised) gain between the acquisition price of the share and the FMV of the shares at the time of exercise of the option is taxed. Tax should be payable only at the time of transfer of the shares by the employee, and not at the time of exercise of the option.
• Alignment of angel investment framework with global practices: Globally, angel investments are encouraged to invest in startups by being provided with tax incentives such as high tax credits and usage of LLPs as tax pass through investment vehicles. India should adopt these tax incentives too.
• Dividends from foreign subsidiaries: Holding companies are taxed on dividends although the subsidiary company is liable to pay dividend distribution tax, as a direct consequence of which startups are increasingly incorporating holding companies in tax havens. This double taxation of dividend should either be removed, or the rate of taxation on dividend payable by the holding company should be significantly reduced from the current rate of 15 percent.
• Pass through status: While the Finance Act 2015 provided 'pass through' status for Category-I, such as venture capital funds, and Category II (such as private equity funds), alternate investment funds do not enjoy the 'pass through' status. Category III alternative investment funds, having extremely high investing potential, should also be provided 'pass through' status to encourage investments.
• Taxation of entire consideration, although deferred: Existing shareholders pay tax on capital gains on the entire consideration, although a substantial portion of the consideration may be deferred. Tax on capital gains should be payable on consideration received from time to time and not on the entire consideration at the time of payment of the first tranche.
• Parity in treatment: Typically, startups raise monies from foreign investors, who are encouraged by favourable tax jurisdictions that provide certain tax exemptions. Domestic investors should also be encouraged to invest in startups by being provided with tax exceptions such as not being subject to tax on capital gains.
• No capital gains reinvestment: Domestic investors are taxed on capital gains on transfer of shares, irrespective of whether the realised monies are utilised for further investments in startups. Investors should be liable to tax on capital gains if the realised monies have been reinvented in startups within a certain short period.
• Reduction of withholding tax: Startups have significant cash outflows on account of the 10 percent withholding tax payable on payments and commissions received. The withholding tax is typically claimed as refund by the startups. There should be reduction in withholding tax payable on payments/commissions to startups for a period of at least three years.

YourStory asked our readers what they want from the Budget. Out of the 1,000 participants – which included entrepreneurs, startup employees, and investors – 79 per cent stated that reduction in capital gains tax will ensure more investments in startups. With goods and services tax (GST) having more significance than ever before, 71.3 percent of our respondents hoped that it will be introduced in this Budget session. In case GST is not passed, 74.4 percent said service tax should be reduced.

According to the economic survey, Indian GDP has been growing at a rate of 7-7.5 percent in 2015-16, and is expected to stay the same in 2016-17. However, it is essential that the government executes policies to bring in more workforces and thereby reduce unemployment, in order to create a stable economy.