India’s Only Startup Investment Incentive Is More Red Tape Than Red Carpet

In no other situation is this partial break more evident than in the income tax benefits for startups and for investors into startups, Section 54GB of the Indian Income Tax Act, 1961. Touted before the budget as a tax break for investing into Indian startups, section 54GB can best be summed up from Macbeth, Act 5, Scene 5 – “full of sound and fury, signifying nothing.”

This paper tiger of a clause exudes the erstwhile License Raj of India – a byzantine series of needless complications which seem attractive in theory but are untenable in practice.

In principle, the clause gives a tax exemption of INR 50 lakhs (a small sum) for the investment of any capital gains into an eligible startup. But where it errs is in the compendium of conditions that dilute the effect this clause would have had in galvanising startup investment in India:

• Restriction on the type of gains eligible:
  • The proceeds that can be invested should arise only from the sale of residential property or land (not any other asset)
• Restriction on the company that can be invested into:
  • The investment needs to be made into an eligible startup, defined as any private limited company incorporated after April 1, 2016 and who has received IMB approval (so far, the success rate for this is around 1%)
• Restriction on the security issuable:
  • The investment can only be made into equity shares (not preference shares, which is the preferred instrument for all startup investments)
• Restriction on minimum ownership:
  • The investor should own 50% of the voting power of the start-up for the Rs 50 lakh invested! (no founder will ever part with 50% of their company for Rs 50 lakh)
• Restriction on the use of funds:
  • The amount invested should be utilised by the eligible startup to purchase a new asset (plant and machinery), but specifically excludes any and all computers and computer software (clearly technology startups, which constitutes the bulk of all Indian startups, were never meant to be covered by this)
  • Any portion of the investment not used within 1 year of the investment to purchase said asset will be treated as income in the hands of the investor
• Restriction on exits:
  • The tax exemption lapses if the Company or shares is sold within 5 years and the entire amount invested becomes taxable

Whereas the rest of the world has simple schemes without any of the associated red tape, such as:

• UK – Seed Enterprise Investment Scheme (SEIS)
• US – Section 1202
• Singapore – Angel Investment Tax Deduction Scheme (AITD Scheme)

If the government is serious about galvanising Startup investment, which has already declined 48% in terms of the number of unique investors from 2015 to 2018, it needs to cut through all the red tape:

• Remove the need for IMB Certification (its success rate is abysmal and shrinks the eligible pool)
• Remove the restriction on the type of securities (non-redeemable securities will suffice)
• Remove the restriction of minimum ownership (50% control for 50 lakhs is a complete non-starter)
• Remove the restriction of use of funds (no tech startup will buy plant and machinery and not computers or software)
• Have a carve out for the sale or merger of the entire company to an unrelated entity

The angel tax (section 56(2)(viib)) has hurt the confidence of Indian entrepreneurs and is leading to them shirking domestic investors for foreign ones, thus accelerating India’s descent into a digital colony where all our innovative companies are wholly owned by foreign investors. Measures such as Section 54GB, that are supposed to boost domestic investment, are mere lip-service, destined to fail from the get-go.

In India, startups and entrepreneurs have succeeded in spite of such inadequate policies, not because of it. But we all still live with the eternal hope that this gets reversed.