Tax Efficacy of Different Startup Entity Forms | Pros & Cons

The following are the tax consequences under the Income Tax Act for a registered partnership firm:

Pros

(i) Partnership firms can avail presumptive tax regime under section 44AD whereby if turnover from business does not exceed Rs. 2 crores, firm can opt to be assessed on business income computed at the rate of 8% of turnover (6% if payment for turnover is received by cashless means)without maintaining books of account and without getting them audited under section 44AB. This facility is not available to LLPs and companies.

(ii) Positive side is no ‘angel tax’ under section 56(2)(viib) of the Act and so no question of any exemption from angel tax. Negative side is that funding from angel investors will not be forthcoming as they want tag along rights and drag along rights which enables them to exit advantageously by selling their shares when start-up becomes profitable and valuable business.

(iii) First proviso* to Section 68 is not applicable to partnership firm. First proviso  to section 68* of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. The resident investors from whom funds are received as share monies have also to satisfactorily by explain their source of investments. No such additional onus on firm as regards capital contributions from partners credited in its books. It is sufficient if firm explains source of the credit.

Cons

(iv) No tax-holiday under section 80-IAC as Registered Partnership Firm is not an ‘eligible start-up’ within the meaning of clause (ii) of Explanation to section 80-IAC. Only start-ups which are LLPs and private limited companies are considered ‘eligible start-ups’ subject to fulfilment of conditions in that Explanation are ‘eligible start-ups’. Therefore, start-ups which are registered partnership firms are not eligible for three-year tax holiday (any 3 out of 10 years from the year of incorporation) under section 80-IAC in respect of profits from eligible business.

(v) No section 54GB benefit of capital gains exemption to promoters/partners who sell their residential properties and invest in start-up firm.

(vi) Tax rate of 30% which compares unfavourably with 25% applicable to a start-up private limited company

Firms attract 30% tax rate on total income irrespective of turnover. Start-ups which are private limited companies can avail the concessional rate of tax of 25% applicable to companies whose turnover do not exceed Rs. 400 cr as start-ups by definition have turnover of Rs. 100 cr or less.

This 30% tax rate also compares unfavourably with the 25.17% tax rate that companies will enjoy under section 115BAA if they don’t claim certain specified tax reliefs and the 17.16% rate applicable to new manufacturing companies under section 115BAB provided they don’t claim certain deductions or exemptions.

The following are the tax consequences under the Act for a Limited Liability Partnership:

Pros

(i) Tax-holiday under section 80-IAC available to a start-up LLP – Section 80-IAC(1) provides for a 100% tax holiday to an eligible start-up for 3 consecutive years in respect of any profits and gains derived from eligible business. The tax holiday may, at the option of the start-up LLP assessee, be claimed by him for any three consecutive assessment years out of seven years beginning from the year in which the eligible start-up is incorporated. Clause (ii) of Explanation to section 80-IAC defines ‘eligible start-up’ to mean a company or a limited liability partnership engaged in eligible business which fulfils the following conditions, namely:—

(a) it is incorporated on or after the 1st day of April, 2016 but before the 1st day of April, 2023¹;

(b) the total turnover of its business does not exceed ` 100 crores in the previous year relevant to the assessment year for which deduction under sub-section (1) is claimed; and

Note: The turnover limit of ` 25 crores has been increased by the Finance Act, 2020 to ` 100 crores with effect from assessment year 2021-22.

(c) it holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government;

(ii) Section 80-IAC tax holiday for LLPs is like declaring holidays on February 30 and 31 in view of Alternate Minimum Tax under section 115JC which applies to it. Alternate Minimum Tax (AMT) under section 115JC is applicable to an LLP if it claims any deduction under any section included in Part C of Chapter VI-A of the Act under the heading ‘C-Deductions in respect of certain incomes’. Section 80-IAC falls under Part C of Chapter VI-A. Therefore, LLP start-up is liable to AMT of 18.5% of adjusted total income i.e. total income before claiming section 80-IAC and Section 80JJAA. Thus, AMT totally negates section 80-IAC/Section 80JJAA benefits for a start-up LLP. Instead of ending up with zero tax on zero total income after sections 80-IAC and 80JJAA claims, these claims are added back to zero total income to get adjusted total income on which AMT is applicable. However, in the 3 consecutive years that a start-up LLP claims sections 80-IAC and/or 80JJAA, it ends up with a concessional tax rate of:

• • • 18.5% plus surcharge 12% plus 4% Health and Education Cess which works out to 21.5488 % if ATI exceeds Rs. 1 cr and
    • 19.24% if ATI is Rs. 1 crore or less.

(iii) Positive side is no ‘angel tax’ under section 56(2)(viib) of the Act and so no question of any exemption from angel tax. Negative side is that funding from angel investors will not be forthcoming as they want tag along rights and drag along rights which enables them to exit advantageously by selling their shares when start-up becomes profitable and valuable business.

(iv) First proviso* to Section 68 is not applicable to LLP – First proviso* to section 68 of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. No such onus on an LLP as regards capital contributions from partners credited in its books. It is sufficient if firm explains source of the credit.

Cons

(v) No section 54GB benefit of capital gains exemption to promoters/partners who sell their residential properties and invest in start-up LLP.

(vi) Tax rate of 30% which compares unfavourably with 25% applicable to a start-up private limited company

LLPs are treated as ‘firms’ under Income-tax Act and attract 30% tax rate on total income irrespective of turnover. Start-ups which are private limited companies can avail the concessional rate of tax of 25% applicable to companies whose turnover do not exceed Rs. 400 cr [turnover limit revised upwards from Rs. 250 cr to Rs. 400 cr by the Finance (No. 2) Act, 2019 w.e.f. A.Y. 2020-21] as start-ups by definition have turnover of Rs. 100 cr or less.

This 30% tax rate also compares unfavourably with the 25.17% tax rate that companies will enjoy under section 115BAA if they don’t claim certain specified tax reliefs and the 17.16% rate applicable to new manufacturing companies under section 115BAB provided they don’t claim certain deductions or exemptions.

(vii) Presumptive tax scheme under section 44AD is not available to LLPs:

Partnership firms can avail presumptive tax regime under section 44AD whereby if turnover from business does not exceed Rs. 2 crores, firm can opt to be assessed on business income computed at the rate of 8% of turnover (6% if payment for turnover is received by cashless means) without maintaining books of account and without getting them audited under section 44AB. This facility is not available to LLPs and companies.

The following are the tax consequences under the Act for a private limited company (PLC) start-up entity:

Pros

(i) Tax-holiday under section 80-IAC available to a start-up PLC – Section 80-IAC(1) provides for a 100% tax holiday to an eligible start-up for 3 consecutive years in respect of any profits and gains derived from eligible business. The tax holiday may, at the option of the start-up private limited company assessee, be claimed by him for any three consecutive assessment years out of ten years beginning from the year in which the eligible start-up is incorporated. Clause (ii) of Explanation to section 80-IAC defines ‘eligible start-up’ to mean a company or a limited liability partnership engaged in eligible business which fulfils the following conditions, namely:—

(a) it is incorporated on or after the 1st day of April, 2016 but before the 1st day of April, 2023;

(b) the total turnover of its business does not exceed ` 100 crores in the previous year relevant to the assessment year for which deduction under sub-section (1) is claimed; and

(c) it holds a certificate of eligible business from the Inter-Ministerial Board of Certification as notified in the Official Gazette by the Central Government;

(ii) Tax holiday may become illusory for private company start-up if MAT under section 115JB applies – Section 115JB of the Act provides that if 15% on book profits of a company is more than tax on total income, book profits shall be total income and 15% of book profits shall be the minimum alternate tax payable. There is no exemption from MAT for start-up companies as no amendment has been made to section 115JB exempting profits of a start-up from MAT. In Neha Home Builders (P.) Ltd. v. CIT [2018] 92 taxmann.com102 (Mumbai – Trib.), it was held, in the context of deduction under section 80-IB(10), that in section 115JC the legislature clearly mentions that ‘deduction claimed’ if any, under the heading ‘C.-Deductions in respect of certain incomes’ will be added to total income for determining Adjusted Total income for AMT(Alternate Minimum Tax) for non-corporate assessees. Since section 115JB dealing with MAT for companies does not contain any such provision like section 115JC, Chapter VIA-Part C deductions will have to be allowed for computing book profit for MAT purposes. If the legislature’s intention was not give benefit of section 8O-IB(10) for the purpose of MAT calculation, then legislature would have provided same type of provision in section 115JB which is currently absent. This shows that legislature wants to give benefit of deduction under section 80-IB(10) for the purpose of section 115JB calculation.

Since section 80-IAC also falls in Part C of Chapter VI-A like section 80-IB, a view can be taken that above ratio in Neha Home Builders (P.) Ltd will apply to section 80-IAC and that deduction under section 80-IAC should be considered for computing book profits for MAT purposes under section 115JB. Irrespective of the view one may take on applicability of MAT to section 80-IAC profits, section 80-IAC certification helps promoter to claim section 54GB benefits. Where he sells his residential properties and invests in equity share capital of an eligible start-up private limited company. Section 80-IAC certification also helps in employees of startups availing the benefits under section 192(1C) for deferal of tax liability on perquisites on the term of ESOPs.

(iii) Section 54GB benefit of capital gains exemption available to promoters who sell their residential properties and invest in start-up private limited company provided they transfer the residential properties on or before 31.03.2022. Section 54GB inter alia provides that long-term capital gain on transfer of residential property (house or plot of land) shall not be charged in certain cases where:

• • • Transferor-assessee is an individual or HUF.
    • Transfer of residential property is made on or before 31-3-2022.
    • The net consideration from transfer of residential property is utilized for subscription to equity shares of a company which is an eligible start-up as defined in Explanation below section 80-IAC(4).

Such utilisation is made on or before the due date for furnishing return of income u/s 139(1) of the Act.

• • • The eligible start-up private limited company is incorporated in India during the period from 1st April of the previous assessment year in which the capital gain arises to the due date of filing ITR u/s 139(1).
    • The start-up company is a company in which the assessee has more than 25% share capital or more than 25% voting rights after the subscription in the shares by the assessee.
    • The eligible start-up has within one year from the date of subscription in equity shares, utilised this amount for purchase of new asset including computers or computer software if it is a technology driven start-up so certified by the Inter-Ministerial Board of Certification notified by the Central Government in the Official Gazette.

(iv) ‘Angel tax’ under section 56(2)(viib) of the Act is applicable to moneys received against equity shares issued by a start-up private limited company and issue price is in excess of fair market value. However, exemption available from angel tax to a DPIIT-recognised start-up private limited company in terms of Para 4 of the latest start-up notification (LSN) where aggregate amount of paid up share capital and share premium of the startup after issue or proposed issue of share, if any, does not exceed, twenty five crore rupees.

(v) The Finance (No. 2) Act, 2019 has, with effect from assessment year 2020-21, amended section 79 of the Act to provide that loss incurred in any year prior to the previous year, in the case of closely held eligible start-up private limited company, shall be allowed to be carried forward and set off against the income of the previous year on satisfaction of either of the two conditions stipulated in (a) or (b) below:

(a) on the last day of the previous year, the shares of the company carrying not less than 51% of the voting power were beneficially held by persons who beneficially held shares of the company carrying not less than 51% of the voting power on the last day of the year or years in which the loss was incurred.

(b) all the shareholders of such company who held shares carrying voting power on the last day of the year or years in which the loss was incurred, continue to hold those shares on the last day of such previous year and such loss has been incurred during the period of seven years beginning from the year in which such company is incorporated.

The above provision has been enacted to facilitate ease of doing business in the case of an eligible start-up.

(vi) Concessional rate of tax of 25% for companies with turnover upto Rs. 400 crores

In case of a domestic company, for assessment year 2021-22, concessional rate of tax of 25% will apply if gross receipts or turnover does not exceed Rs. 400 crores in the previous year 2018-19. Surcharge shall be payable in the case of every domestic company,— (a) having a total income exceeding one crore rupees but not exceeding ten crore rupees, at the rate of seven per cent of such income-tax; and (b) having a total income exceeding ten crore rupees, at the rate of twelve per cent of such Income-tax. For Assessment Year 2022-23, concessional rate of tax of 25% shall apply if gross receipts or turnover does not exceed ` 400 crores in the previous year 2019-20. Surcharge as above shall be applicable. For assessment year 2023-24, concessional rate of 25% will apply if total turnover on gross receipt in previous year 2020-21 did not exceed ` 400 crores. Start-ups which are private limited companies will have turnover not more than Rs. 100 crores, so they can avail the concessional rate of tax of 25% companies. This compares very favourably with start-ups which are firms/LLPs with comparable turnover as LLPs/firms attract 30% tax on their total income regardless of turnover.

(vii) A start-up private limited company or a start-up public limited company can avail:

• • • the turnover-linked lower tax rates available to MSME companies with turnover upto INR 400 crores which can be claimed without foregoing any deductions or exemptions or reliefs
    • Lower tax rates under sections 115BAA and 115BAB which can be availed by opting for those sections and foregoing specified deductions/exemptions/reliefs and by satisfying conditions under those sections

The concessional tax rates as above are available to startup companies irrespective of satisfaction of definition of startup in the LSN and irrespective of recognition by DPIIT.

(viii) Dividend Distribution Tax not applicable w.e.f. 01-04-2020.

Abolition of DDT w.e.f. 01-04-2020 by the Finance Act, 2020 has made private limited companies more tax competitive and even more attractive option as a startup duly compared to Registered partnership firms and Limited Liability Partnerships (LLPs).

Cons

(i) First proviso to Section 68 [second proviso w.e.f. A.Y. 2023-24] is applicable to private limited companies

First proviso [second proviso w.e.f. A.Y. 2023-24] to section 68 of the Act requires a private limited company (closely held company) to explain ‘source of the source’ of funds raised from residents by way of share capital or share premium. There is no exemption from applicability of section 68 to start-up private limited companies in terms of the LSN.

However, the Finance Minister, in Para 113 of her Budget Speech on July 5, 2019, announced that “The issue of establishing identity of the investor and source of his funds will be resolved by putting in place a mechanism of e-verification. With this, funds raised by start-ups will not require any kind of scrutiny from the Income Tax Department.”

The following Table summarises the provisions of section 115BAA and section 115BAB and their comparative features: