startupindia1

By Pallav Narang

Startup India: Catalyst or Catatonic?

At a glitzy event this Saturday the Prime Minster announced the launch of “StartupIndia”, with the aim of accelerating the country’s economic growth by providing the required impetus to entrepreneurship. The action plan as proposed by the government has been divided into three broad categories:

  • Measures aimed at simplification of procedures and handholding
  • Funding support and Tax incentives to startups
  • Industry academia partnerships and incubation

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Notably, the action plan also lays down the exact definition of a startup that would be eligible for such benefits and support measures from the government. Yours truly had the pleasure and honor of attending the said event where the energy levels and expectations from the government were both at pretty high levels. It is apparent that the government wants to encourage startups in not just the digital/ technology sectors, it wants to see greater private involvement in agriculture, manufacturing, education etc.

Do the announced measures match up to expectations? Will they actually benefit startups? Let’s examine the proposals in details to figure out if they do.

Startups Defined

The word/phrase Startups has been part of our lingua franca for a while now with no particular demarcation as to at what point of time a business ceases to be a startup. For all intents and purposes behemoths such as Flipkart and Snapdeal are still considered startups. It is only fair that incentives not be doled out on the basis of vague outlines and therefore a clear definition is certainly needed. For the purpose of the action and plan and the incentives contained therein a startup has been defined (for administrative purposes) as an entity that satisfies all of the following criterion:

  1. A private limited company, LLP, or a partnership firm
  2. Incorporated or registered in India
  3. Not older than 5 years
  4. With an annual turnover not exceeding Rs 25 crore in any preceding financial year
  5. Working towards Innovation, development, deployment or commercialization of new products, processes or services
  6. Driven by Technology or intellectual property
  7. Not formed by splitting up or reconstruction of a business already in place

As is clear above sole proprietorships and AOPs and HUFs cannot be considered startups, though barring the first they are not popular entity formats to do business for startups anyway. The key requirements however in our opinion are points 5 and 6 where the startup has to demonstrate that it is in fact developing new products, processes, or services and is driven by intellectual property and/or technology.

This definition is again not without ambiguities, for instance what constitutes a new or significantly improved product or service? Should the product be new to the startup or to the market? Can more than one startup work on a new product/ service? These questions still remain to be answered.

To be eligible for tax benefits as outlined in this plan (don’t worry, we shall discuss them in detail later) the startups must have certification from the inter-ministerial board set up by the DIPP. To obtain this certification the startup must satisfy any one of the following requirements:

  • Have a letter of support from a recognized incubator which has been either established in a post grad college, funded by the government, or recognized by government
  • Have obtained funding from a duly registered fund including an incubation fund, angel fund, PE fund, Accelerator, or an Angel network, or
  • Have funding from the government of India, or
  • Have a patent related to its business granted to it by the IPTO

While this certification does seem excessive, the practical reality is that without a gatekeeper this exemption is bound to be misused.  Therefore, to ensure that those seeking to avoid taxes by setting up new entities and calling those startups can no longer do so, some checks and balances are certainly required. However, this does create another hoop to jump through for startups who may need the tax break.

Our other concern is that these approvals may not necessarily be received in a time bound manner given previous experiences with similar government agencies. A defined service level is critical for such processes and we hope the government comes forward and lays down timelines to be adhered to by the DIPP while granting such approvals.

Lets also take a look at the action plan proposal now, starting with Measures aimed at simplification of procedures and handholding. Most of the proposals under this head revolve around a new Mobile App and Portal to provide services to startups. 

The app and a supporting portal shall serve as a gateway to services that shall include registration, compliance, clearances, and collaboration with partners and stakeholders. The app will also allow the startups to apply for the various schemes being undertaken as part of the action plan.

The government has launched such single window systems before (the EbiZ portal, though it does not have an app that we know of) one would have imagined that additional services that a startup may require could have been integrated into the existing framework that the EBiz portal provides. This would allow not just startups but existing businesses as well the benefit of improved access and faster government services.

The app shall also help ensure Self-certification based compliance for 9 labour and environmental laws. The laws covered include:

  • The Building and Other Constructions Workers’ (Regulation of Employment & Conditions of Service) Act, 1996
  • The Inter-State Migrant Workmen (Regulation of Employment & Conditions of Service) Act, 1979
  • The Payment of Gratuity Act, 1972
  • The Contract Labour (Regulation and Abolition) Act, 1970
  • The Employees’ Provident Funds and Miscellaneous Provisions Act, 1952
  • The Employees’ State Insurance Act, 1948
  • The Water (Prevention & Control of Pollution) Act, 1974
  • The Water (Prevention & Control of Pollution) Cess (Amendment) Act, 2003
  • The Air (Prevention & Control of Pollution) Act, 1981

This exemption from inspections shall be valid only for a period of three years, starting April 2016 for eligible startup. We think this will definitely reduce the amount of time and personal bandwidth that entrepreneurs have to expend while dealing with government inspectors who, more often than not, are only looking to score a quick buck and simultaneously also reduce corruption levels.  We hope that when the GST regime comes in, eventually, similar exemptions will be provided from inspector visits at the time of registration and thereon under that act as well.

The action plan talks of creating a single point of contact for startups who can exchange knowledge and obtain access to funding via startupindia hub. We assume this too shall be a functionality baked into the App/Portal. The hub shall also allow such startups to gain assistance with financing, mentorship and various other facilities

In other measures to help Startups protect and monetize their intellectual property, the government proposes to set up a panel of facilitators to assist startups in filing of patents as well as trademark and design. The government shall generously bear the facilitation costs and pay the empaneled law firms at its own expense. Further the government has also proposed to relax the fee payable for patent filing by 80%.

Many cash deprived startups may not be able to readily afford lawyers’ fees at the time of patent filing. The formation of the panel facilitators is therefore a great step and will also encourage innovators to come forward and file for protection of their intellectual property which they may have otherwise not protected.  Given that the eligibility criteria for tax benefits includes having a patent to their name, the government has also promised to fast track patent applications filed by eligible startups.

The most significant of these measures however are the relaxed norms for Public Procurement. The government has proposed to relax experience and turnover requirements for them in tenders floated by government entities and PSUs. This is as long as the startups can demonstrate capabilities to execute the projects as per requirements laid down in the tender.

Some relaxations for small entities have existed in the past. These included relaxation in fee, exemption from payment of earnest monies, waiver of security deposit, price preferences etc. However experience and turnover requirements have been in existence for almost forever. This move shall allow many startups to be able to work with the government at early stages of their life.

The government has also recognized that only a small fraction of startups are able to survive and flourish beyond their early years. Post this period promoters are often left hanging with unpaid creditors, and compliance costs for a company that no longer earns them anything. Procedures for winding up outlined under previous legislations have often been time consuming with proceedings taking anywhere between 18-60 months to complete.

The action plan makes reference to the Insolvency and Bankruptcy Bill 2015 which is pending before parliament for approval. The bill contains provisions which shall allow for speedier bankruptcy proceedings and allow entrepreneurs to exit failed businesses in 90 days. For surviving businesses the bill also has debt collection measures that we shall discuss in detail in a separate post here.

Moving on to measures for Funding Support and tax incentives:

The action plan proposes to set up a fund of funds with corpus of Rs 100 Billion that shall provide capital not to startups directly but to other registered venture capital funds, with a corpus of Rs. 25 billion per year over a period of four years.

The setting up of this fund shall ensure that venture capital funds in India will have adequate access to capital to then invest into deserving startups. Though the fund size is not very significant considering the huge investments that large VCs have already made in India. Amazon, for example, has vowed to spend a larger sum (Rs. 132 billion) on its Indian subsidiary alone. If intelligently invested, however this sum could contribute to the seeding of a wider startup ecosystem in India. The proof of the pudding however shall remain in the eating and we shall have to wait to see how this move pans out.

While raising funding against equity is difficult for startups, raising debt is a significantly more arduous task. Banks and other lending institutions often require collateral which fledgling startups have in short supply. To remedy this, the government has proposed to set up a credit guarantee fund with a corpus of Rs 5 billion which shall provide guarantees on behalf of startups to allow them to avail credit. We think that while the move is a welcome one, the limited fund size shall be a significant constraint.

Talking about Tax exemptions, it has been proposed in the action plan to provide exemption on capital gains to persons who invest capital gains earned by them in the fund of funds as created by the government. We imagine this would be executed by adding another exemption after section 54GB of the act. With reference to section 54GB, its own purview is being extended from individuals who could obtain capital gains exemption for investment in manufacturing companies to all startups. The range of assets that can be purchased using such capital gains is also being extended to include computers and computer software which were previously not eligible for such exemption.

The action plan also proposes extension of exemption under section 56(2) (viib) to incubators. The introduction of section 56(2) (viib) in the year 2012 caused much trepidation in the minds of investors and entrepreneurs alike. Introduced ostensibly to reduce money laundering, the provisions specified for the taxation of consideration received by the company in excess of the Fair market Value against sale of shares. Later, exemptions were provided to investments received from registered VCs and AIFs. This has now also been allowed for investments from incubators.

Now moving to the biggest announcement of the day, the government has proposed a HUGE exemption for eligible startups (those startups which have been certified by the special intra ministerial board set up by the DIPP) who will gain exemption from income tax for a period of 3 years. These startups however will have to forgo dividend distribution during this period. This will lead to reinvestment of a larger chunk of profits within the company and will hopefully contribute to its growth. This is going to be a major fillip to the startups that can obtain the required certification from the government and that is where the challenge will lie.

Despite the exemption from income tax, provisions of section 115JB (Minimum alternative Tax or MAT) shall still be applicable. The applicable rates for MAT is 18.5% plus surcharge and cess in contrast to the regular tax rate of 30% plus surcharge and cess representing a saving of around 11% in taxes. In addition, the total amount of MAT paid can be carried forward and set off against the regular tax liabilities of future years (such credit can be carried forward for 7 years), thereby providing future benefit to such startups.

The tax benefits shall all accrue post April 1, 2016. The government shall table them before the parliament as part of its budgetary proposals in the month of February and a lot of the finer details shall be clearer at that point of time.

The action plan also included proposals to encourage Industry academia partnerships and creation of incubation centers all over. The larger move here is to allow centers of higher education to emerge as hotbed for startups. Similar to how leading American universities have system to foster innovation and then provide the requisite support to allow that innovation to be converted into a legitimate business.

The government aims to accomplish this by several methods, beginning with the Atal Innovation Mission (AIM) which shall provide mentoring and support to startups. The mission also includes the establishment of startup incubators around the country using a Public Private Partnership (PPP) model. As per the plan, the government will provide part of the funding support for setting up of these incubators and then let private enterprises manage them.

There is also talk of setting up “tinkering labs”, providing seed funding to selected startups. Other proposals include setting up of programs to foster innovation among students, innovation centers to promote research and development at major engineering colleges, Bio Incubation centers and funds for biotech startups as well as seven new research parks to allow academia and industry to collaborate on R & D.

The government also aims to set up a platform for startups via “startup fests” so that they can come together, collaborate and showcase their products and services.  The idea is that these fests are going to be organized nationally as well as internationally.  We are not sure if we need the government to organize Hackathons and makerspaces or hand out startup awards. Though if the startup India launch event was the template then we think they may be able to pull this off.

Overall, we welcome the fact the government has taken steps to encourage entrepreneurship and is looking to foster a startup culture in the country. Similar measures have been taken by other countries such as the US, Singapore, Canada, and Australia. So it was imperative that the country with the largest population of young individuals should take steps to ensure that job creation and economic growth are accelerated. Tax sops and support are welcome but lasting impact in our opinion will be created by the innovation and incubation centers as proposed by the plan. Being ardent supporters and advisors to startups, we hope that this shall lead to a new wave of innovative startups in India.

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Pallav Narang is a partner with Arkay & Arkay Chartered Accountants.

Edit: The headline has been updated