Double whammy! Investors and startups beware, the taxman is back

Since the SIDBI Fund-of-Funds is not a SEBI-recognised AIF and with Section 54EE of the Income Tax Act not being notified by the government, investors must brace themselves for the taxman’s axe for any capital gains invested in a startup.

Sometimes the fine print and a ton of announcements made by the Centre about startups can confuse even the taxman. But, the taxman has nothing to lose because he only has to collect and the startup or the investor has everything to lose.

So, while every investor thinks that their investment in Fund of Funds (FOF) is exempt under Section 54EE of the Income Tax Act, they may be in for a big surprise. The Section does not offer any protection unless ‘’notified’’ by the government.

This Section was introduced in 2016 after the Budget speech by the late Finance Minister Arun Jaitley and still does not offer any tax exemption to investors. It was touted as a big-ticket measure to galvanise rupee investment into startup funds by exempting capital gains upto Rs 50 lakh if invested into 'long-term specified assets' issued before April 1, 2019. But even by September 1, 2019, no such 'long-term specified assets' have been notified.

Section 54EE was introduced under the Finance Act, 2016, which provides for exemption of capital gain arising out of transfer of long-term capital asset (not exceeding Rs 50 lakh in a financial year) invested in a class of funds which will be notified by the government.

This was supposed to protect any investor. But, there is a bigger blunder here as the Rs 10,000 crore SIDBI Fund of Funds is not recognised as a notified fund and investing in that Fund of Funds does not entitle anyone any tax exemption under Section 54EE.

According to a source, "The issue is that nobody can avail of the exemption because the government hasn’t notified any eligible investment. The only Fund of Funds in India by the government is SIDBI – which nobody can invest into since its not a 'CAT II AIF'."

It’s a measure to promote investment, but due to the lack of any notification this Section hasn’t been used and has even lapsed without benefiting a single Indian investor, fund, or downstream startup.

Investor fears

Rupee capital is less than 10 percent of all capital going into startups and measures such as these are required to boost domestic investment. But such half-measures are detrimental to the industry.

“The government has made lots of announcements for startups. But, it has not made any progress in making startups an investment-friendly asset class,” says a highly-placed source in the government.

To gain exemption under Section 54EE, there must be a sale or transfer of a long-term capital asset and this whole amount should be invested in notified Fund of Funds by April 1, 2019. The maximum exemption limit is Rs 50 lakh.

So, the time has elapsed for those who want to claim exemption if they have already invested in the Fund of Funds, because the Section has not been “notified’’ and the government does not want to notify this any sooner than you want it to be notified.

Now these investors fear that they will be found under the axe of the taxman for following a government directive. Nobody has been able to claim this exemption.

According to data available with YourStory, for the last four years, the Indian startup ecosystem has raised $49 billion, most of that money going to the 24 unicorns which have been created in the country.

“For the startup ecosystem to grow, domestic investors have to be protected. What is the use in government announcements when we cannot claim exemptions while investing in funds,” says an investor, who did not want to be named.

Recently, YourStory reported that Angel Tax has really not gone away.

Finance Minister Nirmala Sitharaman’s announcement on August 23 that the Angel Tax is inapplicable to startups registered with the Department for Promotion of Industry and Internal Trade (DPIIT) may have come as a big relief for the ecosystem, but the fine print reveals that unresolved issues still persist.

While the Angel Tax, which was introduced in 2012 under Section 56(2)(viib) of the Income Tax Act, 1961, may be set aside for DPIIT-registered firms, other Income Tax (I-T) ambiguities have the startup ecosystem reeling.

Critical aspects like long-term Capital Gain Tax, exemption from negative list of investments, high penalty on a transaction where share premium is involved, and protection from investigation of the I-T department officials are still bothering India’s entrepreneurs.

Sections 111A and 112A of the Income Tax Act, for example, clearly grant exemptions for listed stock only. This means that gains from startup investments will be taxed at 28.5 percent while those from listed equity investments are taxed at 11.9 percent.

This comes as a big dampener for the investors in the startup ecosystem as it would slow down the exit process given the high tax they would have to pay. It may also discourage angel investors from putting their money into startups.

Then there is a third conundrum: Indian domestic investors get taxed at 37 percent, the same as the foreign portfolio investors. Thus, it is imperative that the government notify Section 54EE and show its true support for startups.

(Edited by Dipti Nair)