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Tax Alert: Relaxation of eligibility criteria to Start-ups

21 February 2019

In a bid to stir up investments in start-ups and to provide certainty on the burning issue of so-called angel tax, the Ministry of Commerce and Industry (the ministry) has yet again in a span of one month issued a notification easing the norms for availing exemption under section 56(2)(viib) of the Income-tax Act, 1961 (the Act). Section 56(2)(viib) of the Act provides for taxing closely-held companies on capital raised by it through issue of shares in excess of fair value to resident investors. The erstwhile notification issued by ministry dated 11 April 2018 amongst others had the requirement of obtaining valuation report from a merchant banker specifying the fair market value of shares issued. As a result, several startups had received notices from tax authorities to justify the manner in which premium is derived in valuation report.

In order to provide relief from this issue, the ministry issued a notification dated 16 January 2019 whereby the requirement of providing valuation report was done away and only justification of shares price was required. Besides this, a timeline of 45 days from the date of receipt of application for approval was set for CBDT to either grant or decline the approval. Having said so, the uncertainties on the issue still persisted and the Ministry has come out with new notification on 19 February 2019 which shall supersede both the earlier notifications.

The notification aims at reducing the hassles currently faced by several start-ups and further simplify the criteria for availing exemption under section 56(2)(viib) of the Act. Entities shall now be considered as start-ups for a period of 10 years (as against 7 years) subject to turnover of such entity not exceeding INR 100 crores (as against INR 25 crores) in any of the financial years.

Further, in order to increase the number of start-ups eligible to claim exemption, threshold for aggregate amount of paid up share capital and share premium post issue/ proposed issue of shares has been increased from INR 10 crores to INR 25 crores. Also, while computing the aggregate limit of INR 25 crores, funds received from non-residents, venture capital company or a venture capital fund shall not be included. While the erstwhile limit of INR 10 crores subsumed all investments, excluding non-residents and VCFs from the limit means that resident investors can now invest to the tune of INR 25 crores. Also, removing the requirement of accredited investors tag (returned income should be INR 50 lakhs or more and net worth exceeding INR 2 crores) will further enable start-ups to receive funds without any hassles from small individual investors.

The notification also excludes from aggregate limit the considerations received from listed companies (whose shares are frequently traded either having net worth exceeding INR 100 crores (last day of financial year preceding the year in which shares are issued) or turnover exceeding INR 250 crores ( for the financial year preceding the year in which shares are issued).

However, to avail the benefit of exemption, investment shall not be made in the any of the non-core business assets such land, building, shares and securities, etc. Investment is restricted for a period of seven years from the end of the financial year in which shares are issued at premium. While such restriction can be seen as a move to channelize funds received in the business and to reduce the gestation period of achieving break-even, it may also hamper the growth of start-ups looking to set-up subsidiaries.

The notification being progressive shall provide start-ups with a much-needed breather in terms of increased threshold limit of paid-up share capital and further to avail exemption by simplifying the conditions. However, with the notification coming into effect from 19 February 2019, it may not make good the issues of the past faced by start-ups. A unique situation may arise whereby start-ups may have to deal with 3 different notifications depending on the relevant period. Since start-ups raise funds in tranches, it may lead to instances where different set of compliances are required for same investors depending on the time of their investment. In order to avoid such dichotomy, the ministry should provide further clarity with respect to the applicability of notification on issues dealt in the past so that they don’t come haunting in the otherwise bright future of start-ups in India.