Updated on: October 20th, 2022 3:48 PM

Startup Tax Exemption under Startup India Initiative

Startup tax exemption is one of the major highlights of the Startup India Action Plan unveiled by The Prime Minister Shri. Narendra Modi at the Startup India event held in Delhi on 16th January 2016. Tax exemption for a startup is provided under three different schemes and in this article, we look at those tax exemptions for Startups in detail.

Three Year Tax Exemption for Startups

Startups in their initial years, struggle with cash flow as they work on turning ideas into commercially viable products or services. Bootstrapped startups incur expenditure in terms of rental, equipment, salaries, taxes and more, which are most often funded by savings of the Entrepreneur. To provide better chances for Startups to succeed and to increase the number of Entrepreneurs, it is important for the Government to reduce the burden on the Entrepreneur.

Thus, Startup India Action Plan has announced a three-year income-tax exemption for Startups to help them grow and meet their working capital requirements during the initial years of operations. The startup income tax exemption is subject to the non-distribution of dividend by the Startup.

Tax Exemption on Capital Gains

Equity funding for startups is limited in India as it is a new concept gaining traction just over the last few years. Also, due to the high-risk nature, startups find it hard to attract investment in its initial stage. Hence, to provide an impetus to investors to invest in Startups and to create a vibrant investor community, the Startup India Action plan has announced tax exemption on capital gains. Under this scheme, tax exemption will be given to persons who have capital gains during the year, if they have invested such capital gains in the Funds of Funds recognized by the Government. This is help increase the funds available with various VCs and Angel Funds, thereby providing better availability of capital for Startups.

In addition, existing capital gain tax exemption for investment in newly formed manufacturing MSMEs by individuals shall also be extended to all Startups. Currently, such an entity needs to purchase "new assets" with the capital gain received to avail such an exemption. Under the new tax exemption scheme for startups, investment in "Computer or Computer Software" would also consider as the purchase of "new assets" in order to promote technology-driven startups.

Tax Exemption on Investments above Fair Market Value

Under the Income Tax Act, 1961, if a startup or company receives any consideration (money) for issue of shares which exceed the fair market value of the shares of the company, then receiving such excess amount over the fair market value is taxable in the hands of the recipient (Startup) as Income from Other Sources.

However, in most cases, the fair market value of shares of a startup is hard to exactly calculate. Further, in most cases, the valuation at which investment in the Company is significantly higher than the fair market value of the shares, thereby resulting in tax being levied on the Startup.

Currently, investment by Venture Capital Funds in Startups which exempts from the above provision of the Income Tax Act. With the Startup India Initiative, the same has extended to investment made by incubators in Startups.

Startups Eligible for Tax Exemption

It is important to note that not all startups are eligible for the tax exemption announced under the Startup India initiative. To be eligible for the startup tax exemption, the Startup must conform to the eligibility criteria for Startups mentioned in the Startup India Action Plan.

Further, Startup would be eligible to obtain tax benefits only after it has obtained certification from the Inter-Ministerial Board, setup for such purpose. The Inter-Ministerial Board setup by DIPP would validate the innovative nature of the business for granting tax-related benefits. Hence, the process for obtaining tax exemption for Startups could be time-taking and cumbersome.