Tax Exemption for Startups in India | Section 80-IAC, 54GB, 56 2(VII B) Explained

Startups in India are experiencing rapid growth, fueled by individuals with unique ideas eager to address high-demand services. The Government of India has, through its Startup India Action Plan launched in 2016, implemented clear regulations to streamline the process of incorporating startups in the country. Additionally, tax regulations have been introduced to foster the growth of companies for whom a heavy tax burden in the early-growth stage can prove challenging. It’s essential for startups to familiarize themselves with these government regulations, as they can greatly benefit during income tax filing in India.

India offers a variety of appealing tax benefits aimed at encouraging and supporting startups. These benefits can substantially alleviate financial burdens, allowing startups to concentrate on their growth and innovation. Ranging from complete tax exemption for the initial 3 years to the recent 2024 abolishment of the angel tax, these incentives play a crucial role in promoting the financial stability and expansion of emerging businesses. The government consistently endeavors to provide tax benefits to entrepreneurs, particularly startups, recognizing their significant potential contribution to the Indian economy. This blog comprehensively deals with the intricacies of tax exemptions enumerated in contemporary legislations in India.

What is a Startup?

A startup is a fledgling business venture established with the aim of offering a single product or service deemed to be in demand by its founders. However, for the purpose of determining legal eligibility for taxation and to access government benefits, startups must meet the specific criteria set out in the Ministry of Commerce and Industry Gazette Notification No. G.S.R. 127(E) dated 19 February 2019 (“Startup Notification”). As outlined therein, an entity is recognised as a startup upon satisfaction of the following requirements:

• The entity’s age must be under 10 years, indicating that it has been in operation for less than a decade from its date of incorporation or registration.
• The entity must be registered as either a private limited company, limited liability partnership, or partnership firm to avail of startup-related advantages.
• Its annual turnover for any financial year since its incorporation/registration should not exceed ₹100 crores.
• The entity should actively engage in the innovation, development or improvement of products, processes or services; or if it is a scalable business, should have a high potential of employment generation or wealth creation.
• The entity must not be established through the reconstruction or division of an existing business. 

Once determined that an entity satisfies the relevant criteria above, an application is required to be made to the Department for Promotion of Industry and Internal Trade (“DPIIT”) to obtain recognition as a startup (“Eligible Startup”). It is crucial to note that if an entity completes 10 years from the date of its incorporation/registration or if the turnover in any previous year exceeds ₹100 crores, the entity will no longer be considered an Eligible Startup. 

Tax Exemptions for Startups in India

Tax exemptions for startups are a constantly evolving regulatory space in India. Once recognised as an Eligible Startup, the Startup Notification further prescribes the processes to be followed to avail certain tax exemptions under the Income Tax Act, 1961 (“IT Act”). For example, Eligible Startups could apply for and avail angel tax exemption under Section 56(2)(viib) of the IT Act until the angel tax itself was abolished in 2024. This evolution speaks to the government’s initiative to encourage entrepreneurship and foster the growth of new businesses under the Startup India Action Plan.

In India, a startup can avail the following tax exemptions:

Income Tax Exemption for the Initial Three Years

Eligible Startups can avail of a three-year income tax holiday under Section 80-IAC of the IT Act, which exempts them from paying income tax on profits for any 3 consecutive years out of their first 10 years from the year of incorporation. However, this is subject to certain further conditions:

• Business Type: The startup must be a limited liability partnership or a private limited company;
• Incorporation Date: The company or LLP must be incorporated between April 1, 2016, and April 1, 2025. We have seen past instances wherein the deadline for this sunset clause keeps extending with every budget; and
• Capacity Focus: The products, services or processes are undifferentiated, have potential for commercialisation and have significant incremental value for customers or workflow.
• Tax Calculation: When calculating the deduction under Section 80-IAC, only the profits from the eligible business (i.e., business carried out by an eligible startup engaged in innovation, development or improvement of products or processes or services, or a scalable business model with a high potential of employment generation or wealth creation) will be considered.
• Eligible Business Certificate: A certificate confirming the business as “eligible” issued by the Inter-Ministerial Board of Certification (IMBC) is necessary. This certificate will be published in the official government gazette.

Tax Exemption on Investment in Startups

Section 54GB has been amended to exempt tax on capital gains arising from sale of residential house or plot of land, if the net consideration amount is invested in prescribed stake of equity shares of eligible startups/companies to utilize the same for purchase of specified assets.

• Eligibility of Assessee: This exemption can be availed by Hindu Undivided Families or individuals. 
• Eligibility of Investee Company: The company is required to: (i) be incorporated in India; (ii) engaged in the business of manufacture of an article or thing or in an eligible business; (iii) ensure the assessee has more than 50% of the share capital/voting rights after subscription; (iv) be a small or medium enterprise or is an eligible startup.
• Timelines: The assessee claiming the exemption is required to subscribe to the equity shares before the due date for furnishing return of income; and the company has to utilize the subscription amount for purchase of an asset within 1 year from such subscription date. The assessee claiming exemption shall be required to hold onto the shares for a period of 5 years.

Tax Exemption on Long Term Capital Gains

There is a separate provision for startups and capital gains reinvestment under Section 54EE. This section allows any taxpayer  to claim exemption from tax on long-term capital gains (from any asset, not just residential property) if they reinvest the gains in a fund notified by the Central Government within 6 months from the sale. The government offers a tax break on long-term capital gains through Section 54EE of the IT Act. Following are the key requirements of for exemption under 54EE:

• Eligibility: All assessees may avail of this exemption if they invest in a specified fund notified by the Government. However, no such funds have been notified as on date.
• Tax Exemption: Startups can claim exemption on long-term capital gains from any asset (not just residential property).
• Investment Requirement: To be eligible for the exemption, capital gains from selling an asset must be reinvested in a government-approved fund within 6 months.
• Investment Limit: There’s a cap on the exempt amount – a maximum of ₹50 lakh can be invested.
• Holding Period: The funds must be held for at least 3 years. Early withdrawal cancels the exemption.

Tax Exemption for Eligible Incubators and Venture Capital Funds/Venture Capital Companies

Incubators recognized by the Government of India and registered Venture Capital Funds and Venture Capital Companies are eligible for tax exemptions on their income under Section 10(23FB) of the IT Act. The prescribed eligibility criteria for the exemption u/s 10(23FB) is expansive and involves stringent regulation through the Securities and Exchange Board of India (SEBI). This can include requirements that the entity cannot list their own shares on any public exchange and/or investment of at least two-thirds of its investible funds in unlisted equity-linked securities. Such VCF or VCC may also be subject to investment restrictions on sectors or asset classes, in accordance with the applicable regulations.

Conclusion

Conclusively, the tax exemption for startups in India serves as a vital catalyst for fostering innovation, entrepreneurship, and economic growth. By providing relief from certain tax burdens during the initial years of operation, the government encourages the emergence of new ventures, thereby stimulating job creation and technological advancement. However, it’s imperative for policymakers to continually evaluate and refine these provisions to ensure their effectiveness in nurturing a vibrant startup ecosystem. Overall, the tax exemptions for startups stand as a pivotal measure in propelling India towards becoming a global hub for innovation and entrepreneurship.

FAQs on Tax Exemptions for Startups in India

1. What is considered a startup for tax exemption purposes in India?
   A startup is defined as an entity that:
   Has been in operation for less than 10 years from its incorporation or registration date.
   Is registered as a private limited company, limited liability partnership, or partnership firm.
   Has an annual turnover not exceeding ₹100 crores for any financial year since incorporation.
   Engages in innovation, development, or improvement of products or services, or operates a scalable business model with high potential for job creation and wealth generation.
2. What are the key tax benefits available for startups in India?
   Startups can avail:
   A three-year income tax holiday under Section 80-IAC.
   Exemption on capital gains reinvestment under Sections 54GB and 54EE.
   Tax exemptions for eligible incubators and venture capital funds under Section 10(23FB).
3. How does a startup qualify for the income tax holiday under Section 80-IAC?
   To qualify, the startup must:
   Be a private limited company or an LLP.
   Have been incorporated between April 1, 2016, and April 1, 2025.
   Obtain certification from the Inter-Ministerial Board of Certification (IMBC).
4. What conditions must be met for the capital gains tax exemption under Section 54GB?
   Individuals or Hindu Undivided Families (HUFs) can claim this exemption if:
   The net consideration from the sale of a residential house or plot is invested in the equity shares of an eligible startup.
   The startup must use the funds to purchase assets within one year of the investment.
   The investor must hold the shares for at least 5 years.
5. Are there any limitations to claiming the long-term capital gains exemption under Section 54EE?
   Yes, the key conditions include:
   The exemption is capped at ₹50 lakh.
   The reinvestment must be made in a government-notified fund within 6 months of the asset sale.
   The investment must be held for at least 3 years to maintain the exemption.
6. Can all startups claim tax benefits under the Income Tax Act?
   No, only startups recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) as Eligible Startups can claim these benefits. Startups must meet specific criteria outlined in the Startup Notification and obtain necessary certification.
7. What happens if the turnover exceeds ₹100 crores or the startup completes 10 years?
   If a startup’s turnover exceeds ₹100 crores or it completes 10 years from the incorporation date, it will no longer be considered an Eligible Startup and will not qualify for the related tax exemptions.
8. What are the tax exemptions for venture capital funds and incubators?
   Registered venture capital funds and recognized incubators can claim tax exemptions on their income under Section 10(23FB), provided they meet stringent eligibility criteria set by the SEBI. 

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