Well, I wrote earlier that hon’ble Finance Minister, perhaps, forgot the one change in the Income Tax Act that may hinder the progress of Startup Scheme – the flagship program for generating jobs by Modiji. Please read One Startup Taxation Problem Still Left to Be Solved! Now after I read the Economic Times news article wherein lots of comments have comeup, I decided to publish this article, which will bring two fresh idea for stratups for generating fund without a taxation problems, especially the provision u/s 56(2)(viib) under which the excess of premium, which cannot be justfied be added as income from other sources. In a nutshell, this article will deal with following issues:
- Startups can issue shares on premium without limit and without any botheration. How?
- What are the special tax benefits ( hidden from public glare) for a certain class of investors in startups?
I believe a majority of startups, can actually benefit from the above two tax planning ideas and overcome the issue of section 56(2)(viib) of the Income Tax Act at least until the government finally relaxes the norms for startups.
Tax Planning Idea 1: Get Non-Resident Invest in Your Startups
Section 56(2)(viib ) provides that if a closely held company ( read private companies -startups fall under this category) issues shares on premium, which is more than Fair Market Value, the difference may be added as its income under the head income from Other Source. Now this provision does not apply when the shares are issued to non-residents. It means that if you issue shares to non-resident individual or company, section 56(2)(viib) will not be applicable.
Read the Bold lines in the provision u/s 56(2)(viib)
(viib) Where a company, not being a company in which the publics are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares that exceeds the face value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares:
Provided that this clause shall not apply where the consideration for issue of shares is received—
(i) By a venture capital undertaking from a venture capital company or a venture capital fund; or
(ii) By a company from a class or classes of persons as may be notified by the Central Government in this behalf.
Now in most of the startup cases, these conditions of investment through a non-resident can easily and naturally be fulfilled. If yes, there is no reason about being concerned with the provision u/s 56(2)(viib) of the Income Tax Act.
Tax Planning 2 : Lower Rate of Tax on Long-Term Gains
This is also related to non-residents. The Finance Act 2016 has brought in two very good news for non-resident investors in private companies. Thease are:
The shares of private companies are now long ter in just 24 months. This is on account of changes in section 2(42A) of the Income Tax Act.
The changes made in meaning of the word “securities.” This part requires reference to amended section 112(1)(c) which is as under :
(c) In the case of a non-resident (not being a company) or a foreign company,—
(i) The amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been its total income; and
(ii) The amount of income-tax calculated on long-term capital gains except where such gain arises from transfer of a capital asset referred to in sub-clause (iii)] at the rate of twenty per cent; and
(iii) The amount of income-tax on long-term capital gains arising from the transfer of a capital asset, being unlisted securities or shares to a company not being a company in which the public are substantially interested, calculated at the rate of ten per cent on the capital gains in respect of such an asset as computed without giving effect to the first and second proviso to section 48;
The blue bold line was inserted by Finance Act 2016 and thus for non-residents, any sale of shares of private companies will be charegd to tax @ 10% , offcourse without taking the benefit of indexation.
As a parting note , it must also be borne in mind that the startups falling under the category of venture capital undertaking as defined under section 10(23F) also do not have to worry about the tax u/s 56(2)(viiib) as they are out of the pruview of the said provision. Here is the extract of Venture Capital Undertaking
“venture capital undertaking” means such domestic company whose shares are not listed in a recognised stock exchange in India and which is engaged in the business of generation or generation and distribution of electricity or any other form of power or engaged in the business of providing telecommunication services or in the business of developing, maintaining and operating any infrastructure facility or engaged in the manufacture or production of such articles or things (including computer software) as may be notified by the Central Government in this behalf;
Conclusion is that a startup can get investment from a non-resident without any fear of section 56(2)(viib) and the non-resident investor also gets the benefit if a very low tax rate of just 10% on the long-term capital gains.