India has grown as a hub for start-up ventures in the last few years. Government initiatives have incentivized the functioning of start-up companies and have made a largely positive impact on the prospects for entrepreneurship in India. The Finance (No. 2) Bill, 2019 (“Bill”), incentivises fundraising for new-age start-ups and facilitates acquisitions.

I. Start-ups – Rationalisation Measures.
II. Limitations imposed on carry forward of loss.
III. Changes to Alternative Investment Funds (AIF) – Pass Through.
IV. Buy-back tax on listed securities.

  • The law as it stands states that a start-up company can apply for income tax exemption on investments above the fair market value (FMV) received under section 56 of the Income Tax Act, 1961 (the Act). A start-up shall be eligible for notification under clause (ii) of the proviso to Section 56 (2)(viib) of the Act, and consequent exemption from the provisions of that clause, if it fulfils the following conditions:

    (i) It has been recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) under para 2(iii)(a) or as per any earlier notification on the subject,
    (ii) Aggregate amount of paid up share capital and share premium of the start-up after issue or proposed issue of shares, if any, does not exceed, Indian Rupees Twenty Five crore .

    The proposed Bill, seeks to expand the exemptions and benefits available to eligible start-ups and their investors.

    Previously, investments by Cat-I AIFs in venture capital undertakings were exempted from taxation under Section 56(2)(viib) of the Act. Section 56(2)(viib) provided that, where a company, not being a company in which the public are substantially interested receives any consideration from a resident for issuance of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the FMV of the shares (share premium) shall be charged to tax.

    The definition of venture capital fund includes Cat-I AIFs. Accordingly, venture capital undertakings have been exempt from Section 56(2)(viib) only in respect of investments by Cat-I AIFs. With a view to facilitate venture capital undertakings to receive funds from Cat-II AIFs as well, the Bill proposes to amend Section 56(2)(viib) to exempt venture capital undertakings from its applicability in respect of investments received by Cat-II AIFs, as well.

    It means that capital-raised from Cat II AIFs by start-ups companies will no longer be subject to the provisions of Section 56(2)(viib), popularly called the angel tax. This move will likely

    To lift-up investments by Cat II AIFs in venture capital undertakings. Further, most AIFs are set up as Cat II AIFs and hence this amendment will effectively benefit most of them.

  • Another major change is an amendment to Section 79 of the Act, it restricts closely held companies in which the public are not substantially interested to carry forward and setoff losses. Section 79 of the Act which previously allowed eligible start-ups to carry forward losses from any year prior to the previous year to be set off in the previous year, subject to the continuation of the shareholders holding shares carrying voting power in such year prior to the previous year.

    Under the proviso of the proposed Bill, eligible start-ups would be able to avail the same benefit by satisfying that, 51% of the shares carrying voting power are held by the same persons as in the year prior to the previous year. Even if the above condition is not met, eligible start-ups are allowed to carry forward and set off the loss incurred in any year prior to the previous year, if the following two conditions are fulfilled.

    “(a) if all the equity shareholders carrying voting power on the last day of the previous year in which the loss was incurred continue to hold those shares on the last day of such previous year.
    (b) such loss has been incurred during the period of seven (7) years since the year in which the company was incorporated.”

    Both the above (a) and (b) needs to be satisfied by the eligible start-up companies to avail the benefits of carry forward and set off losses.

    In sum, if a start-up company, issues shares to Cat I & II AIFs, it is exempt under section 56 (2) (viib) of the Act. However, if a start-up, issues shares to individual and if any amount of premium is paid (exceeding the FMV) of shares, the premium received by the start-up company through the transaction shall be taxable to the start-up company, under the head income from other sources and the Company shall be liable to pay the corporate tax. Practically, the tax provision is boosting investments in start-up companies through AIFs. Eligible start-up should look for Cat I & II AIFs for investments and it does not encourage individuals to directly invest in the equity of the start-ups. This can reasonably be expected to encourage acquisitions in India of such eligible start-ups, by providing more ways to avail tax benefits to potential investors.

    The above amendments are facilitating start-up culture in India. However, the qualitative impact on the economy is not yet visible. The rationale being that, for a company to qualify as an eligible start up under relevant DPIIT notifications (supra) being too stringent. Unless the Government relaxes the norms for qualification, the benefits under the Act will only benefit a few.

    However, what matters most is that financial growth depends on how the start-up companies optimise the use of the funds invested by the AIFs.

  • Cat I & II AIFs already poses tax pass through status under section 115 UB of the Act. Tax pass through status means, any income specifically (excluding business income) earned by the AIF would be treated as exempt, and will be taxable to the unit holder as if such unit holder earned the income directly, and not through the AIF.

    Losses incurred by AIFs whether in form of business losses or otherwise can be set-off or carried forward. However, losses not being business losses of AIFs could not be passed through to the unit holders. As a result,unit holders could not claim set-off of such losses against the income earned. To overcome this incongruity, the Bill provides that the unit holders holding units for more than twelve (12) months would be able to set off or carry forward losses against the income earned through the investment in the AIF. On the flip side, if the unit holder holds the units in the AIF for a period of less than twelve (12) months, it will not be able to take advantage of set-off or carry forward of losses. The intention of the Government seems to be to make long-term investment in AIFs more beneficial.

  • The Bill seeks to provide a balanced treatment of taxation of listed and unlisted companies. It could be said that it is meant to be an anti-abuse measure. Currently, under Section 115 QA of the Act, unlisted companies are liable to pay tax on income from buy-back of shares (if there was any gain to the shareholder on the transaction). Under the proposed Bill, the scope of Section 115 QA of the Act has been increased to also include publicly listed companies, whereas initially it was applicable only to unlisted companies. That means, tax of 20% shall be levied on buy-back of shares from a shareholder by a company listed on a recognised stock exchange. Distribution of profits by listed companies will have to be analysed closely. The listed companies will have to efficaciously analyse and make a determination whether the profits of the company should be distributed to the shareholders in the form of dividends or through buy back of shares.

    To conclude, from an acquisition activity viewpoint, the Bill focuses on facilitating transactions, promising innovation and commercial activity. Efforts have been made to possibly pave the way for a favourable tax policy environment for transaction activity in the country.