Is the Startup India Action Plan really that startup-friendly?

I had the privilege of attending the Startup India event at Vigyan Bhawan on January 16, 2016. The event was landmark because, for starters, it was the first of its kind that encouraged and allowed dialogue between India’s startup community and the policy makers (aka the government). I don’t recall hearing of such an event even in the most sophisticated startup ecosystems like the US or Israel. There is no doubt that the Modi government should be applauded for this wonderful initiative. We are building another ecosystem along with conventional businesses and like Masayoshi Son, Chairman and CEO of Softbank said, this is the beginning of a Big Bang for India!

The event saw participation from various ecosystem partners with some interesting and meaningful discussions leading upto Prime Minister Narendra Modi’s address to the gathering. Imagine attending a Coldplay concert where, before its conclusion, free tickets for their next global tour would randomly be given to people from the crowd. That is how Vigyan Bhawan was when our Prime Minister arrived. After his encouraging speech (where he also joked about how as a chaiwala he should have gotten into the hospitality space like Ritesh, the founder of OYO), he released Startup India: Action Plan. His announcements were historic and extremely positive for the different players. A copy of the action plan was made available to us. Just before going to bed on a Sunday evening, I decided to open the action plan and understand the details of each scheme.

Let us look at some important steps:

1. Definition of a startup: This really is the most fundamental question that comes up. When such policies are announced for startups, it is important to know who would even fall within that definition. None of our present statutes define ‘startups’ and therefore, it was important that the government came up with a definition that was broad enough to avoid disappointments.

The action plan defines startups as:

“Startup means an entity, incorporated or registered in India not prior to five years, with annual turnover not exceeding INR 25 crore in any preceding financial year, working towards innovation, development, deployment or commercialisation of new products, processes or services driven by technology or intellectual property.

Provided that such entity is not formed by splitting up, or reconstruction, or a business already in existence.

Provided also that an entity shall cease to be a Startup if its turnover for the previous financial years has exceeded INR 25 crore or it has completed 5 years from the date of incorporation/registration.

Provided further that a Startup shall be eligible for tax benefits only after it has obtained certification from the Inter-Ministerial Board, setup for such purposes.”

Pay attention to the phrases that are underlined. If a startup has a revenue of Rs 25 crore in any preceding financial years, it should not be allowed to claim benefits under the action plan. This seems fair. However, to claim benefits, such startup should be working towards (i) innovation, (ii) development, (iii) deployment or (iv) commercialisation of new products, processes or services driven by technology or intellectual property.

Let us imagine a startup that is incorporated in 2016 and will be leasing furniture to customers on a minimum of a one-year lease. It is looking to solve a fundamental problem faced by young people who shift cities for a job and do not want to spend a lot of money upfront to purchase a new bed, dining table, couches, fridge, television, washing machine and air conditioners, and then worry about moving it when they have to shift cities again. This business, in my view, is innovative because it addresses a very practical problem. However, it is not really driven by technology or intellectual property, because all the furniture, though designed in-house, use very standard models which can be replicated easily. Would such a business not be entitled to benefits under the government’s action plan? Who will decide whether a startup is actually working towards innovation or development and whether it is heavily or marginally relying upon technology and IP?

It is important that when a formal notification or statute is passed, these questions are addressed else entrepreneurs would again be in a fix on whether they fall within the definition of startups or not. No doubt that the action plan is a positive step and we definitely do not want it to be counter-productive. Like the example above, there are multiple businesses that are marginally reliant on technology and/or IP but if they actually solve or aim to solve a problem, they should fall within the definition of a startup.

Additionally, I am also curious to see how the Inter-Ministerial Board is set up to give the necessary certification for tax benefits. The process of seeking these certifications should be made completely online and be time-bound. The need for physical interaction should only trigger if the Board rejects any application and the parties wish to make a detailed oral submission for the Board to reconsider its decision.

Finally, there seems to be some dichotomy on how the Rs 25 crore threshold is treated. The first paragraph of the definition implies Rs 25 crore in each financial year, whereas paragraph 3 goes ahead to state that a startup ceases to be a ‘startup’ if its turnover for the previous financial years has exceeded Rs 25 crore. The government should clarify this ambiguity in the definition.

2. Compliance regime based on self-certification: This is a very important move by the government, especially with respect to labour laws. However, the fundamental issue of compliance still persists. Startups still have to comply with the payment of gratuity, payment of provident fund, contract labour regulations etc. The only difference is that no labour inspector will come and conduct a suo moto

Dear early-stage startups, we all know how you treat regulations where there is no immediate threat of prosecution. Three years is a long window. However, please remember that once this three-year window is over, you could still be prosecuted for non-compliance for the first three years of operations. Therefore, ensure compliance and only once all the necessary filings, registrations and returns are in place, self-certify your compliance to the authorities.

3. Faster exits for startups: The expression ‘exits’ is used more in connection with winding-up as opposed to what most people in the startup system would understand. The government has relied on the Insolvency and Bankruptcy Bill, 2015, but we do not know when it is likely to receive Presidential assent. Even if the Bill takes its own sweet time to convert into a statute, the government ought to make the present process of voluntary winding up easy and efficient. It should float special schemes where winding up should not be (i) expensive and (ii) time consuming. It makes little sense for a company going through bankruptcy to pay more money in a long-drawn winding-up process. The Ministry of Corporate Affairs can release special schemes where companies that fall within the definition of ‘startups’ can make an application for winding up, and a liquidator is appointed to ensure closure of the business within 30 to 60 days. The process should be so seamless that no startup should require the assistance of a lawyer for this.

4. Tax exemption on capital gains: As this policy stands right now, once an investor exits a startup, he will not be liable to pay capital gains tax provided he has invested the gains in the fund of funds recognised by the government. So, in essence, the ‘gain’ does not reach the investor upfront and gets invested back in the fund of funds. However, this fund will not invest directly in startups but participate in the capital of SEBI-registered venture funds. Does this mean that the investor who generated the ‘gains’ pursuant to his exit in a startup will now become an investor in the fund of funds, almost like a limited partner? Does this mean that such investor has the likelihood of attracting a better return by putting his ‘gain’ in corpus of the fund of funds? What about the tax liability at this stage? These are all the multiple questions that come up when I read between the lines of this exemption. Hopefully, when the Finance Act, 2016 is passed, all these issues would be addressed.

5. Tax exemption to startups for three years: This was music to my ears at Vigyan Bhawan, and I do not even run a startup! So I can just imagine how excited it must have gotten all the founders. Even though most startups do not make any profit, such exemption for those who do is a very positive step. However, once again, the exemption does not clarify whether this three-year exemption will apply to startups once they have started earning profits or will apply to them for a period of three years from their incorporation. If the latter, the exemption is fairly redundant. In case it is the former, then the government should be given its due credit for such a positive reform. Also bear in mind that a company ceases to be a startup after five years from incorporation, so if it only makes profits in its sixth year, this exemption is not likely to apply. We definitely require the government to clarify its position on this.

6. Tax exemption on investments above fair market value: As the Income Tax Act, 1961 stands today, the difference in the fair market value arrived at by a chartered account and the value at which shares are allotted to an investor is treated as ‘income from other sources’ for the startup. However, investments by SEBI-registered venture capitalists are exempted from the operation of this provision and now the government intends to treat investments by incubators in the same manner. This is a positive step for all those companies that are incubated or assisted by incubators. However, most early-stage startups raise money from angels and HNIs at very high valuations and then require accountants to justify that valuation as much as possible using the discounted cash-flow method (as it is based on projections of future earnings). Since the fair market value so arrived is the minimum value at which shares should be allotted, startups try and make this value as close as possible to the value at which shares are allotted, so that the differential (e income from other sources) is as minimal as possible. This practice is unhealthy as it often inflates the fair market value. Had this exemption applied to all investments in startups, whether by VCs, angels, HNIs, incubators or accelerators, chances are that such a practice would have completed stopped. The regulators should take note of this and consider the possibility of expanding the scope of this specific exemption in view of the above.

To conclude, the action plan is largely optimistic since it shows a very positive intent by the government. However, going forward, it is critical that the government sets up a team of founders, investors, angels, lawyers and accountants who can ensure that the final policies surrounding startups are as flawless as possible and maintain the right balance between accountability, transparency and doing business. Kudos to the Modi government, but we expect a lot more in the coming months!