Funding startups has today evolved into an extremely serious business vertical. Going by a recent investment report three out of four startup founders strongly believed that the fundraising environment will grow even more robust and positive in 2022.
Investors, with an eye on reaping dividends many times over the value of their investments, are ready to put down top dollar and ride the risk of investing in startups. But at the same time there is a subject matter termed as startup taxation or more specifically seed funding taxation which has to be taken into consideration.
The questions that every founder could have and that need to be addressed competently are-
• Is startup funding taxable?
• If yes, how are investments in startups taxed?
• Are you required to pay taxes on seed funding?
To make things a little easier let us first understand how this entity called a startup is legally defined. Because it is this definition that will ultimately form the basis of all current and future tax implications.
Who or what is recognised as a startup in India?
The Startup India Action Plan – G.S.R. 127(E) 19th February, 2019 – was formulated and is governed by the MINISTRY OF COMMERCE AND INDUSTRY (Department for Promotion of Industry and Internal Trade). The action plan put forth its objective to make bank financing easily accessible to start-up ventures, encourage entrepreneurship and in the process push up job creation. It has expressly laid down certain criteria mentioned ahead –
The eligibility criteria for an enterprise to be defined as a startup:
- The startup is incorporated as a private limited company or registered as a partnership firm or a limited liability partnership.
- The entity does not have an annual turnover exceeding INR 100 Crores in any of the financial years since incorporation/registration.
- This entity shall be considered as a startup for and only up to a period of 10 years from the date of its incorporation.
- The startup should be able to amply demonstrate that it is working towards creation, innovation or improvement of products, services and processes. It should also have the potential to generate a good number of employment opportunities and create wealth.
- It is not an entity formed by splitting up or reconstruction of an existing business.
If an enterprise meets all of the above criteria it is then completely eligible to be classified as a startup and can avail access to business capital and tax breaks.
So what tax breaks does a startup enjoy in India. Is seed funding that forms such an important component of every startup’s journey taxable? How are investments in startups taxed?
80 IAC Tax Exemption
This answers the question – is startup funding taxable. Any startup incorporated between the 1st of April 2016, till 31st of March 2021 is eligible for exemption. Budget 2021 has extended the period to 31st March 2022.
To answer do you have to pay taxes on seed funding:
Once approval is granted, the startup automatically becomes eligible for availing a 100% tax rebate on profit, for a period of three years in a block of seven years, provided that its annual turnover does not exceed Rs.25 crores in any financial year. This exemption helps startups use the profits generated to fund scaling up operations which would have otherwise gone to pay taxes.
New Section 54 EE of the Income Tax Act
This section grants eligible startups exemption on tax on a long-term capital gain. But this is only if the long-term capital gain or a part thereof is invested in a Central Government notified fund within a period of six months from the date of transfer of the asset. The maximum amount that can be invested is notified to be Rs. 50 lakh and any amount invested will have to remain invested in the specified fund for a period of 3 years. If the amount invested is withdrawn before 3 years, then the exemption will be revoked in the same year the money is withdrawn.
In a tax tweak announced in Budget 2022-23 the surcharge on long-term capital gains (LTCG) tax has been capped at 15% for all listed and unlisted companies. This bought in a long needed parity between the taxes on share sales of unlisted firms and the listed ones.
Exemption of Tax on investments above the average market value
To answer how are investments in startups taxed – Investments above the fair market value in eligible startups are tax exempt. These could be investments made by resident angel investors, family or such funds not registered as venture capital funds. Investments made by incubators too are exempt.
For a more detailed understanding and also expanding your knowledge horizons through other articles on the topic of startup funding taxation you can simply log on to www.coffeemug.ai
It is a space packed with genuine and easy to interpret information that offers startups guidelines on opportunities and challenges in the startup business vertical. It also will help you perhaps build a great connect with professionals and mentors who could assist you in taking your venture to the next level.
Q. How do startups get tax exempt?
A. Startups are eligible for tax exemption under Section 56 of the Income Tax Act, only if
- The company is DPIIT-approved
- The startup’s total paid-up share capital and share premium does not surpass Rs. 25 Crore after the planned shares are being issued
Q. Why seed funding is important?
A. Seed fundraising allows you to raise money before your company has started generating profits. It helps you meet your financial needs and compensates for any shortfalls. Seed funding also supplies you with operating cash to help you manage your business on a daily basis.
Q. What is the difference between pre-seed and seed funding?
A. In comparison to a pre-seed round, a seed round can include professional investors like early-stage venture capital firms. Pre-seed funding demonstrates that your product caters to the market need, whereas seed funding is raised to prove your product market fit.
Q. How much equity do you need for seed funding?
A. In the seed round, entrepreneurs should ideally give shares worth not more than 10% of the company’s total equity. In some cases, dilution up to 20% is acceptable, but anything above 25% could be a bad bargain for the founder.