The Govt. has recently announced a 3 year tax break for startups as part of DIPP Action Plan for startups. In this post, I point out the well-known landmines that the draftsmen need to avoid:
1. Will the income 'not be included in computation', or will it be 'deducted'?
Income Tax Act may codify a tax break as an exclusion or a deduction. A typical startup will suffer losses in the initial years. If income is excluded from computation, this means that the loss (which is negative income) will not be available for set off against future profits. In Section 10A (exemption for Software tech parks, etc), the law was amended to replace exclusions with 'deductions' which do not deny carry forward and set off.
2. Will income 'derived from' startup activity be eligible, or will it be income 'attributable to'?
If only income 'derived from' startup activity is eligible for tax benefits, startups will get sucked into vicious litigation on whether a particular income is eligible. For example, a startup charging users for a differentiated service may be augmenting its revenue with advertising or referrals (or selling customer data). The Assessing Officer (AO) may argue that income not directly received from core users is not 'derived from' startup activity but is 'attributable to' it. This potential litigation trap can be avoided by using the term 'income attributable to', a term with wider scope.
3. What activities will be hit by provisions against restructuring?
While the DIPP paper is silent, officials have stated in media briefings that there will be provisions against restructuring to avoid a case where existing business restructure themselves to claim startup benefits.
Safeguards are of course needed in this regard. However, there is a risk of overdoing it. The classic case study would be TCS. Originally a department of Tata Sons, the demerger had to wait for a change in law permitting restructuring.
4. Who decides whether it is a "new product or service or process"?
The DIPP Action Plan states:
"A business is covered under the definition if it aims to develop and commercialize
• a new product or service or process; or
• a significantly improved existing product or service or process,
that will create or add value for customers or workflow"
This is stringent requirement. It leaves unexplained who determines whether a product or service or process is new. Or is the improvement significant? Who decides whether it is adding value? What if a minor tweak adds significant value to the customer? Is significance of improvement to be determined by quantum of change or the perceived improvement felt by customer?
Will DIPP judge all this? Or will it accept the recommendations of Incubators? Will all startups recognized by DIPP be automatically granted the benefit, or will Assessing Officer have the authority to judge anew whether the product etc is new or significantly improved or adds value. If this definition is repeated in Income Tax Act, presumably AO will have the power to determine whether the definition is met.
Potential Google before Assessing Officer: Sirjee, yeh naya product hai.
AO: Isme naya kya hai? Yahoo ka search engine pehle se hai. Waisa hi toh hai
5. Who decides the 'potential for commercialization'?
The DIPP Action Plan further states:
"The mere act of developing
• products or services or processes which do not have potential for commercialization; or
• undifferentiated products or services or processes; or
• products or services or processes with no or limited incremental value for customers or workflow
would not be covered under this definition."
Suffice to say that no one is a good judge of 'potential for commercialization'. No one. The best names in VC industry have rejected startups that made it really big on this ground, while their chosen investments turned dud.
Let me say that again: there is no good judge for potential for commercialization.
Apart from the 3-year tax break, the Action Plan suggests exemption from Section 56(2)(viib), a crude tool which has made equity infusion difficult in small companies. It may be appropriate to just withdraw it, instead of excluding a small class of players from it.
All eyes now on how the Finance Bill, 2016 drafts the 3 year tax break!
1. Will the income 'not be included in computation', or will it be 'deducted'?
Income Tax Act may codify a tax break as an exclusion or a deduction. A typical startup will suffer losses in the initial years. If income is excluded from computation, this means that the loss (which is negative income) will not be available for set off against future profits. In Section 10A (exemption for Software tech parks, etc), the law was amended to replace exclusions with 'deductions' which do not deny carry forward and set off.
2. Will income 'derived from' startup activity be eligible, or will it be income 'attributable to'?
If only income 'derived from' startup activity is eligible for tax benefits, startups will get sucked into vicious litigation on whether a particular income is eligible. For example, a startup charging users for a differentiated service may be augmenting its revenue with advertising or referrals (or selling customer data). The Assessing Officer (AO) may argue that income not directly received from core users is not 'derived from' startup activity but is 'attributable to' it. This potential litigation trap can be avoided by using the term 'income attributable to', a term with wider scope.
3. What activities will be hit by provisions against restructuring?
While the DIPP paper is silent, officials have stated in media briefings that there will be provisions against restructuring to avoid a case where existing business restructure themselves to claim startup benefits.
Safeguards are of course needed in this regard. However, there is a risk of overdoing it. The classic case study would be TCS. Originally a department of Tata Sons, the demerger had to wait for a change in law permitting restructuring.
4. Who decides whether it is a "new product or service or process"?
The DIPP Action Plan states:
"A business is covered under the definition if it aims to develop and commercialize
• a new product or service or process; or
• a significantly improved existing product or service or process,
that will create or add value for customers or workflow"
This is stringent requirement. It leaves unexplained who determines whether a product or service or process is new. Or is the improvement significant? Who decides whether it is adding value? What if a minor tweak adds significant value to the customer? Is significance of improvement to be determined by quantum of change or the perceived improvement felt by customer?
Will DIPP judge all this? Or will it accept the recommendations of Incubators? Will all startups recognized by DIPP be automatically granted the benefit, or will Assessing Officer have the authority to judge anew whether the product etc is new or significantly improved or adds value. If this definition is repeated in Income Tax Act, presumably AO will have the power to determine whether the definition is met.
Potential Google before Assessing Officer: Sirjee, yeh naya product hai.
AO: Isme naya kya hai? Yahoo ka search engine pehle se hai. Waisa hi toh hai
5. Who decides the 'potential for commercialization'?
The DIPP Action Plan further states:
"The mere act of developing
• products or services or processes which do not have potential for commercialization; or
• undifferentiated products or services or processes; or
• products or services or processes with no or limited incremental value for customers or workflow
would not be covered under this definition."
Suffice to say that no one is a good judge of 'potential for commercialization'. No one. The best names in VC industry have rejected startups that made it really big on this ground, while their chosen investments turned dud.
Let me say that again: there is no good judge for potential for commercialization.
Apart from the 3-year tax break, the Action Plan suggests exemption from Section 56(2)(viib), a crude tool which has made equity infusion difficult in small companies. It may be appropriate to just withdraw it, instead of excluding a small class of players from it.
All eyes now on how the Finance Bill, 2016 drafts the 3 year tax break!
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