Budget 2012: Startups Gain A Little But Lose A Hell Of A Lot

Finance minister Pranab Mukherjee has hammered a nail through the heart of startup business community in India while giving the plain old pain balm at the same time. This is unlikely to prove much of a palliative unless the nail is taken off.

In particular, startups are affected by four measures in the Budget that has direct(or close indirect) impact on them. These include taxation of funds raised for investment (Yes! you read it right); relaxation of rules for auditing for smaller sized entities (if you are really a tiny firm, you can skip the need for auditing and thereby, the cost); tax benefit to an investor who needs to park money after selling his real estate property and invests in a startup(but there are riders, more on that later) and last a proposal that would boost venture capital and private equity investments in general through extension of pass-through tax benefit across sectors.

Now, let's take a close look at them:

Devil In The Budget: Pay Tax On Funds Raised For Investment!

First thing first. The government has done what is probably unheard of in the annals of taxation. Private companies who raise funds from individuals against shares(mind you, not equity convertible instruments) over and above the face value(and or fair market value) of those securities will have to pay tax on the money raised from April 1, 2013 (no it's not a joke in advance, you can read the official note in page 8-9 here).

This, in effect, means if you are a startup and raise money from your well-to-do uncle or for that matter an established angel investor(see here for India's hottest angel investors), you will have to pay tax on it as 'income from other sources'. This can potentially kill angel investment in startups as we know it.

The measure is not aimed at killing early stage investment, but if it is indeed implemented it would end up doing precisely that. Atleast for all those who would like to follow the more conventional fund raising cycle starting with angel investment followed by a seed/venture capital round and later in the growth phase private equity investment.

There are ways for startups to get around the problem if they are not bootstrapped for a marathon. Startups can seek individual investors(after all angel investors also need to invest hoping to find the next big thing) who form entities through which they can invest; they can raise money from individual investors through equity convertible route(such as convertible debt); look for angel investors outside India (hello Dave McLure, Ashton Kutcher); chasing seed funds for early stage capital(after all not every startup gets an angel investor) besides trying to crack a tough cookie.

We mean convincing the tax authorities that the shares are not being issued above the fair market value. Try selling them the value of still-to-file patent on a breakthrough in augmented reality or NFC or cloud computing service (you get the point why we call it difficult).

The gem of an idea to tax growth capital from what we can gather is 'to prevent generation and circulation of unaccounted money'. But instead of simply assessing the individual investors who back such startups, the government has chosen to impose a tax on the investee.(Also read)

If you are pretty well bootstrapped, here's the good news:

Raising The Turnover Limit For Audit Compliance & Presumptive Taxation:

Under the existing provisions (of section 44AB), every person carrying on business is required to get his/her accounts audited if the total sales, turnover or gross receipts in the previous year exceed Rs 60 lakh(~$120,000). Similarly, a person carrying on a profession is required to get his accounts audited if the total sales, turnover or gross receipts in the previous year exceed Rs 15 lakh(~$30,000).

In order to reduce the compliance burden on small businesses and on professionals, the government has proposed to increase the threshold limit of total sales, turnover or gross receipts, for getting accounts audited, from Rs 60 lakh to Rs 1 crore in the case of persons carrying on business and from Rs 15 lakh to Rs 25 lakh in the case of persons carrying on profession.

It is also proposed that for the purposes of presumptive taxation (under section 44AD), the threshold limit of total turnover or gross receipts would be increased from Rs 60 lakh to Rs 1 crore. These amendments will take effect from April 1, 2013 and will, accordingly, apply to the assessment year 2013-14 and thereafter.

Tax Incentive For Individual Investors In Product Startups:

This one is for the product startups and by product we mean hardware firms who are into manufacturing. To boost SMEs in manufacturing sector, the government has proposed to provide rollover relief from long term capital gains tax to an individual or an HUF on sale of a residential property (house or plot of land) if they re-invest that money in the equity of a new SME in the manufacturing sector. Such relief to investors is valid only for re-investment in other property as of now.

But there are a bunch of riders which dilutes the usefulness of this measure.

For one, the money is to be utilised for the purchase of new plant and machinery within a period of one year from the date of subscription in the equity shares. So if you already have a small set-up and want some money to hire people, forget this.

More importantly, the amount is to be used for subscription in equity shares in the SME company in which he/she holds more than 50 per cent share capital or more than 50 per cent voting rights.

Safeguards to restrict the transfer of the shares of the company, and of the plant and machinery for a period of five years are proposed to be provided to prevent diversion of these funds.

The relief would be available in case of any transfer of residential property made on or before   March 31, 2017.

Tax Pass-through For VC/PE Firm Extended Across Sectors

This long pending demand of the investment community was met in the Budget and will have a positive indirect impact on early stage investment space as also more mature investments. More on this here.

What do you think about the small incentives and big disincentive for startup investments?