India spurs start-up investment with tax reforms

25 September 2019

India has instituted key reforms this year to ease the tax burden on start-ups and make it easier for domestic and foreign investors to contribute to their success.

The government made changes to two sections of its tax code affecting start-ups. In February, it amended Section 80 of the Income Tax Act, which provides an income tax exemption for up to three years for qualified start-ups. The income limit for start-ups was raised from 250 million rupees to one billion rupees ($14 million). The definition of a start-up was also expanded to include companies up to 10 years old, instead of seven.

The government also loosened rules surrounding the payment of an unpopular “angel tax,” which required start-ups to pay a 30 percent fee on capital investments that exceeded a firm’s government-calculated fair market value. In August, the angel tax rules were amended further, and now any start-up that is registered with the Department of Industrial Policy and Promotion (DIPP) will automatically be exempted from the angel tax.

Companies may apply on a government website to register as a start-up. Once they have achieved start-up status, they will not be charged the angel tax. They may also apply on the same site for a Section 80 income tax exemption for up to three consecutive years.

To be eligible for start-up status, a company must:

  • Be a private firm, partnership or limited liability partnership that registered or incorporated within the past 10 years
  • Have annual income of less than $1 billion rupees
  • Have the potential to generate employment or create wealth. Companies formed as spinoffs or other reconstitutions of an existing business are not eligible to apply.

Pressure to reform

The changes represent a more business-friendly attitude toward start-ups, and came in response to widespread protests directed at the angel tax. Adopted in 2012 to prevent money laundering, the tax was viewed by many business groups and executives as unreasonable and excessive.

Criticism intensified in late 2018 after India’s tax department sent notices to a slew of start-ups, demanding that they pay the tax on funds they had received from investors along with penalties on amounts that were overdue. Many companies contested the government’s valuation of their firms, as well as the tax itself.

The tax made it tough for start-ups, which are not listed on exchanges, to raise needed money. Some shut down or left the country. Individual investors, who were required to submit an income-tax return, a certificate of net worth and other documentation each time they made a contribution, started looking outside of India for places to put their capital to work.

The tax was particularly hard on smaller start-ups. Those valued below the “unicorn” level of $1 billion in 2018 received 5 percent less in funding than they did the previous year and participated in fewer deals, though when the unicorns were added in, a record $10.5 billion was raised.

Bold economic goals

The Indian government, which had promised reforms for months, has made good on its word with this year’s tax changes. Business leaders praised the removal of the angel tax for qualified businesses, which, along with expanded income tax relief, will make it easier for the country’s 24,000 registered start-ups to thrive.

In addition, the government is now saying that it will not pursue the collection of previously-assessed angel tax and will settle all appeals by the end of the year.

It also promised that goods-and-services tax refunds, which small and midsized businesses have long complained take too long to process, will paid within 30 days. The tax department created a dedicated office to help small businesses with tax questions.

And in a nod to foreign investors, Finance Minister Nirmala Sitharaman agreed to revoke a recently-introduced surcharge on foreign companies investing in India.

The reforms are part of an ambitious plan to create more jobs and further elevate the country’s economic stature, which has risen dramatically in the past decade. India’s GDP this year is forecast to be nearly $1 trillion larger than it was in 2014, making it the world’s fifth-largest economy after the U.S., China, Japan and Germany. The ruling political party aspires to raise GDP another $5 trillion by 2025.

Start-ups, with their potential to attract capital and generate jobs and wealth, are a key part of the plan. With the current reforms in place, multinationals that were previously dissuaded by government bureaucracy may want to give India a second look when considering start-up investments or partnerships. This is particularly true in light of additional surprise tax reforms announced last week, including a significant reduction of India’s corporate tax rate. Vistra will provide more information on those changes soon.