Rakesh Nangia & Neetu Singh
When we dream an idea, it’s a time to start-up and living that dream. The government launched Start-up India in January 2016 as an initiative that intends to fulfil millions such dreams of entrepreneurs. It aimed at promoting entrepreneurship by nurturing, mentoring and facilitating entrepreneurs. People have ideas, but the same need to be complimented with the right infrastructure, business plans and capital. Start-up India intends to build an ecosystem for nurturing such innovation to drive sustainable economic growth and generate large-scale employment opportunities. To foster the growth of start-ups, the government is taking visible steps by keeping it simple and easy to do business. To accelerate spreading of the start-up movement, the government has made a commitment in its action plan that it will handhold start-ups and provide funding support, incentives, necessary industry-academia partnership and incubation. To a large extend, start-ups have been released from the compliance burden; for instance, they are allowed to self-certify compliances under six labour laws, three environmental laws and several state adherences.
Mobile apps and portal have also been launched for interacting with the government and regulators directly. Not only this, in the event of business failure, swift and simple processes has been proposed for exit, which will encourage start-ups to experiment with new ideas without having a fear of facing a complex and long-drawn exit process.
To qualify as a start-up for availing benefits under the Start-up India plan, one has to meet the definition provided by the DIPP. This definition has been enlarged and now the age of a start-up has been raised from 5 years to 7. However, in biotechnology sector, this period extends to 10 years. This change has been made taking into account a long gestation period by start-ups to establish. The turnover criterion remains the same—annual turnover for any fiscal shall not exceed Rs 25 crore. Also, earlier the definition included start-ups working towards innovation, development or improvement of products or processes or services, but it now includes a scalable business model, with high potential of employment generation or wealth creation.
All this looks good, but is it enough. The key to survival lies in funding support and incentives. In initial days, entrepreneurs with new ideas struggle to evaluate feasibility and have limited sources of finance.
A significant number of start-ups fail due to lack of funds, collaterals and cash flows. To provide funding support, the government has set up a “fund of funds” with a corpus of `10,000 crore. This fund will not directly invest in start-ups, but will participate in the capital of Sebi-registered funds. But again, is it enough? Certainly not. Probably that is the reason the government also cannot undermine the need of foreign investment in start-ups.
For the first time, the consolidated FDI policy (released on August 28, 2017) lists start-ups as a separate section. This shows that start-ups are on the government’s top agenda. The policy allows start-ups to raise foreign money from VC funds and other investors through instruments such as convertible notes. Start-ups can issue equity or equity-linked instruments to foreign VC investors.
This will encourage more VC funds to invest in Indian start-ups. Foreign residents (except those in Pakistan and Bangladesh) will be permitted to purchase convertible notes issued by an Indian start-up for Rs 25 lakh or more in a single tranche. NRIs can acquire convertible notes on a non-repatriation basis, but there is a caveat that start-ups will have to take requisite government approval in sectors where FDI is not under automatic route to issue convertible notes. To provide financial support to start-ups from banks and financial institutions, the DIPP is likely to move a Cabinet Note on Credit Guarantee Fund.
With a view to promote growth of start-ups and address working capital requirement, tax concessions have been given. When Start-up India was launched, tax exemption was given for 3 years out of 5, but under the current regime the timeline for tax exemption has been enhanced to 7 years, meaning now profit-linked deductions are available for 3 years out of 7. This change has been made because most start-ups struggle to earn profits in initial years. This will create more space for growth, but exemption is available if there is non-distribution of dividend. The Finance Act 2017 has also relaxed provision for carry forward of losses for start-ups. As per tax provisions, the carry forward of losses in business is allowed for 8 years if the company has continuous holding of 51% voting rights. This condition has been relaxed for start-ups, and now to carry forward losses, only the founders need to hold shares. Thus, with increase in VC investments and buy-outs, start-ups were experiencing major changes in shareholding and getting denied of benefit of tax losses, so this measure is a welcome change.
Having said that, start-ups are still navigating through a tax maze when it comes to investment getting marked down. With start-up excitement going down due to increased competition and reduced profitability, valuations of many start-ups have fallen sharply. As per current tax laws, the government can levy tax on difference between high valuation and actual valuation on which shares should have been issued. This provision was introduced to curb unwanted and illegal transaction where black money hoarders used the technique of issuance of shares at a premium in sham companies, but there could be an instance where the said provision can hurt genuine case of start-ups where shares are marked down. To pluck this problem, the government issued a notification on June 14, 2016, stating that a ‘start-up’ company receiving monies as consideration for issue of shares in excess of fair market value would not be covered under the said provision and the term ‘start-up’ has been defined to mean a closely held company that fulfils conditions outlined by the DIPP.
The government clarified the issue, but this benefit has only been extended to government registered start-ups, so the fate of other start-ups is still not known. In our view, fair market value can go up or down over time and hence the idea of using marked down value as an opportunity to tax in genuine cases may hurt the sentiments of start-ups and should be dealt judiciously.
The start-up culture is booming. The government is extending support and encouraging the idea of entrepreneurship, and many successful entrepreneurs are becoming role models. Looking at the success stories, the world of start-ups looks glamorised, but young entrepreneurs need to keep in mind that they should be realistic, innovative and make an endeavour to create a sustainable business.
Rakesh Nangia is Managing Partner and Neetu Singh is Director, Direct Taxation, Nangia & Co.