3one4 Capital's Siddarth Pai explains all a startup needs to know about tax compliance

In an interview with YourStory, 3one4 Capital Founding Partner Siddarth Pai gets into the nitty-gritty of tax regulations, and explains their implications for startups in India.

It is known that companies run from pillar to post to ensure their business is run in compliance with all the tax regulations of the land, and startups are no exception. The devil is in the detail, and startups would do well to read the fine-print to avoid any last-minute surprises.

Siddarth Pai, Founding Partner of 3one4 Capital, explains the impact of certain tax laws in the country on startups, and the importance of taking steps to be tax-compliant from the very beginning.

YourStory: How has angel tax impacted the startup ecosystem in the country?

Siddarth Pai: The lightning rod in terms of taxation has been the angel tax. Under Section 56 (2) (viib) of the Income Tax (I-T) Act, if you are a privately-held company, and issue shares at an amount that is higher than the face value, and the price at which you issue is higher than the fair market value, the difference between the issue price and fair market price is taxed as income in the hands of the startup.

How this plays out, for example, for financial year 2017-18 is that a startup would get a notice from the I-T Department under this section for the assessment year 2014-15, seeking information about the fair value certificate and audited financials from the date the startup raised funding to the latest date.

The I-T Department started comparing the projections with actual performance, which was surprising given that nowhere in the Act does it state that an I-T officer has the right to do this particular comparison when a validly issued and signed certificate by a practising CA or a Category I merchant banker has been given.

One does not get penalised for not meeting their numbers. Startups are constantly raising funding, sometimes they exceed their numbers, sometimes they miss. The I-T Department started looking at the actual performance, saying that your fair market value based on actual performance was lesser than the price at which the startup raised capital, thereby taxing the difference between the calculated fair market value and the one stated in the certificate.

Startups that invest all their capital in building their business are short on cash, and had to pay that 20 percent of the tax amount upfront when the matter went into litigation. This means they would have to raise that amount, thus running the risk of going through the whole cycle again.

The Act was introduced in 2012 to prevent money laundering, but pushing this onto startups gave the early stage a totally new dimension of challenges. No startup receives money in the form of hard cash, and they go through proper banking channels as mandated under the Companies Act of India.

However, a key area that has been missed many has been Section 68, which is about Unexplained Cash Credit. Here, the startup has to establish the source of the funding of the investors since this section is directly linked to Section 56 (2) (viib) mentioned earlier.

The I-T Department has the right to question a particular investor’s bank statement and balance sheet. No investor is comfortable giving out sensitive information such as bank statements for an angel investment. The tax rate on this is 86 percent, including penalties and fines. This has not been remedied or addressed yet, which is a point of grave concern.

The taxation principle should be applied to capital gains, not capital receipts like investments, and India shouldn’t have the tag of having a tax on raising capital.

Thankfully, the government and the I-T Department have taken cognisance of this, and have taken steps to rectify this. In February, the Central Board of Direct Taxation (CBDT) sent out a circular to its officers asking them to refrain from using ‘coercive measures’ to recover any outstanding demands. This was followed up by the creation of the Angel Fund structure under the existing Alternative Investment Funds (AIF) Regulations for funds, thus formalising angel investing and bringing this activity under the regulatory ambit.

YS: How is the delay in claiming refunds affecting startups?

SP: Most of the startups are not profitable for at least three to four years. In the current situation, if they raise an invoice for professional services, there is a tax deducted at source (TDS) under Section 194 j (Income from Profession) at 10 percent for services companies at the time of payment of the invoice, with the TDS being remitted to the government.

A startup will have to file the I-T return to claim refund, if they are under a loss as per standard practice. The problem for startups is that 10 percent of all the revenue goes to the government and they have to wait for over nine months from the end of the financial year in order to get the refund, which only comes in after the tax returns have been filed by the respective company by September 30 of each year.

Now, to ease this cash crunch, startups recognised by the Department of Industrial Policy and Promotion (DIPP) get to waive off the TDS clause till they achieve profitability or are able to get a universal lower deduction certificate from the I-T Department instead of the current one linked to specific paying clients. The option of getting a lower deduction certificate is also not widely known, and it is important for investors and professionals to advise startups on this.

YS: Have the startups been benefitting from the capital gains exemption law introduced in Budget 2015?

SP: Union Finance Minister Arun Jaitley, in the 2015 budget, inserted a Section under 54 (G)(B) to avail benefits of capital gains exemption through investing in a startup. Under this, an individual who has capital gains in terms of selling property or capital asset can invest up to Rs 50 lakh in a startup that is recognised by DIPP.

However, if one goes through the actual provision, to receive this capital gain exemption of up to Rs 50 lakh, the individual has to get up to 50 percent stake in the startup, which means that the enterprise value of the firm is Rs 1 crore. No startup has raised money at a valuation of Rs 1 crore since the dilution is far too high for such an early-stage venture.

Even the market places a minimum threshold of Rs 5 crore to Rs 6 crore for the first round of investments with dilution rarely exceeding 20 percent to 25 percent. Further, the individual will have to remain invested for a period of five years. In case the company gets sold after, say, three years, the individual will lose all the tax exemptions and any untaxed amount will be subject to tax under Capital Gains.

In order for this to be made more effective, it is essential to remove these restrictions of ownership of 50 percent, and allow for a genuine acquisition or merger of the startups so as to not to negate the tax benefit given.

Until then, it would be very hard for this section to create a positive effect for the startups funding ecosystem in the country. As of today, none of the professionals or investors I have come across have been able to avail of this benefit.

YS: What challenges do startups face while applying for government recognition as an innovative company?

SP: There are two sets of rules for recognition of startups by the government. One is the DIPP regulations, which is relatively straightforward to apply to and get approved. However, the critical part is to be recognised as a startup by I-T Department to avail the benefit of tax holiday.

To be recognised as a startup by the I-T Department, there is a special Inter-Ministerial Board (IMB) that actually vets the application over a long period of time. What has put startups in a state of confusion is the questions raised by IMB regarding the innovation behind the idea - a notion that has not been defined and is hard to quantify.

Some startups are even being compared to listed companies around the world with an observation that there are ‘similar services already available in the market’, followed by a list of entities in the same market as the startup. This demoralises startups as their innovation is being sidelined, and they are effectively being barred because of existing competition in different markets, areas, target customers and even industries.

For example, a startup in the vernacular video content space would not be recognised as being as innovative as Google when YouTube already exists, regardless of the fact that the underlying IP may be substantially different.

As per reports released in February 2018, only 82 startups have received this approval from the IMB for the tax benefits. It is imperative that a time-bound process with clarity on what constitutes innovation would help the startups gauge their ability to get recognised and obtain the necessary benefits, since this tax incentive is a strong signalling issue.

The IMB has taken some of these industry recommendations on board and at its last meeting, (on April 27, 2018) it proposed the disposing of the applications in a time-bound manner, stating that the first Tuesday of every month would be reserved for the IMB meeting to consider all the open cases received until the fifth of the previous month.

They have also stated that the minutes shall be uploaded every month. Unfortunately, the last update to the site was the April 27, 2018 meeting.

YS: What are tax burdens while receiving employee stock ownership plan (ESOP)?

SP: ESOPs have been a chronic problem for a long period of time from a taxation perspective. The way ESOPs work is that there is a vesting period, and when the employee fulfils certain criteria, the individual has the right to exercise the options.

These ESOP shares are then taxed twice, first as salary and then as capital gains.

1) As salary: Salary for the difference between the Fair Market Value and the Exercise Price upon exercise of the ESOPs (under Section 17 of the Income Tax Act, 1961, and Rule 3 of the Income Tax Rules, 1962).

2) Capital Gains: When the shares are sold, on the difference between the sale price and the fair market value as above.

This would be fine in a listed company wherein there’s an active and liquid market for the shares. But for a privately held startup, this translates into an immediate cash outflow for the employee whereas the ultimate cash realisation may only be five to seven years down the line, if at all.

In fact, a significant number of startup unicorns like Flipkart, Paytm and Swiggy have announced ESOP buyback schemes after getting funded to help their employees unlock the value in these options. Some startups even have loan schemes for their employees for this.

Imagine taking a loan to actually pay that tax, and all this without the guarantee of seeing any gain in the future.

Some of the startups that have shut shop have seen their employees suffer a dead loss of lakhs of rupees for the taxes paid on the ESOPs exercised, which end up becoming worthless.

A more employee-friendly ESOP regime considering the uncertainty on exit and the issue of the lack of liquidity of startup and unlisted shares is essential as this taxation regime demoralises many employees who would like to exercise their options and become co-owners of the companies they’ve helped to build.

YS: How do you view the new regulations governing angel fund investments?

SP: This is a step forward in the right direction, but there is a need for further concrete measures to get this going. Under the current regulation, an accredited angel investor should have a minimum net worth of Rs 2 crore, and income of Rs 25 lakh in order to invest in a SEBI-registered angel fund.

The angel fund concept came out of the need to regulate angel investing in India and requires an accredited angel investor to invest at least Rs 25 lakh across five years through an angel fund as per AIF regulations.

The drawback of this is that it places an unnecessary onus on friends and family, who are usually the first cheque into startups, as they may not meet the minimum income or net-worth requirements for them to invest into these angel funds, thus exposing the startup to the Angel Tax provision (Section 56 (2)(viib))

YS: Has the tax holiday scheme benefitted startups?

SP: Under the current regulations, if a firm is an innovative startup that is recognised by IMB, it gets a tax holiday for three out of seven years. One can choose any three of seven years where one does not have to pay any income tax. However, there is a caveat, if a startup is more than seven years old, or has revenue more than Rs 25 crore in any previous year, then one does not get any benefit of income tax holiday. This is a kind of an artificial ceiling imposed on startups wherein a revenue Rs 25 crore per annum is a low amount.

Even so, everybody was very enthused about it but got deflated when they realised that to receive such benefit, startups have to be incorporated after April 1, 2016 as per the Income Tax Act (Section 80-IAC).

YS: What else would be of note to startups and investors from an I-T perspective?

SP: With mergers and acquisitions along with large buyouts being among the top exit routes for Indian investors, the tax benefits of the carried-forward losses of the startups becomes a key driver of the exit value during this process of acquiring a company’s arithmetic.

But Section 79 prohibits this from occurring in any privately held company if the shareholding percentage in terms of voting power changes by 49 percent between the year of merger and the previous year.

Startups recognised by the IMB, which are only entities incorporated after April 1, 2016, and have the IMB certificate, can carry this forward for the seven years that they’re a startup, provided that all the shareholders who held voting shares as of the last day of the year in which the losses incurred continue to hold shares in the startup.

Given how the shareholding of a company changes with every investment and secondary sale, this carry forward of losses, which becomes crucial during a merger or a buyout of the existing shareholders, ends up getting lost due to the current regulations. In India, exits to domestic companies and listed entities would become more attractive if there is carry forward of loss that allows startups the flexibility they deserve.