Section 54EE of Income Tax Act: Addressing the Need for a Better LTCG Exemption for Startups
[Hrishikesh is a student at Jindal Global Law School.]
Startups majorly rely on external investments to survive and accordingly, a lucrative tax regime is essential in order to attract investments. Long-term investors that look to invest in startups aim to make the most of their initial investment and earn exponential capital gains on their investment when their stock is sold in the long run. LTCG tax is imposed on the profits that an investor makes on the liquidation of his stock that has been held over a period of time that qualifies as long-term. This tax is crucial in incentivizing investors to invest in promising startups and fund them over the long run as it determines the proportion of the profits investors could take back once the startup has taken off and possibly further invest the proceeds in other enterprises.
Startups in India are underperforming due to drops in investments each financial year as a result of which promising Indian startups with viable business ideas are failing to make their mark. While there exist other important factors that govern investments into startups, the Government should aim to formulate tax policies/exemptions that incentivize investing in promising Indian startups to ensure that they have funds to function efficiently. This article aims to argue that the exemption to long term capital gains (LTCG) tax given by Section 54EE of the Income-tax Act 1961 is unsuitable for Indian startups and addresses the need to introduce a better policy similar to the American Qualified Small Business Stock (QSBS) to reinvigorate them.
Deficiencies in Section 54EE
The LTCG tax imposed in India is 20% of the gains realised through the sale of unlisted securities. The Finance Ministry capped the maximum applicable surcharge at 15% along with a cess rate of 4%. Thus, the overall effective tax rate on long-term gains is 23.92%. While the above-mentioned tax rate is reasonable when compared to nations such as the UK, the US and Israel, the question that arises is, keeping in mind other important factors, why promising startups in these nations are attracting sufficient investments and why their Indian counterparts face a dearth of investments. The answer, as far as LTCG tax is concerned, lies in the exemption given to LTCG tax in each of the above-mentioned nations and the investor retention their startups enjoy as a consequence of the exemption.
Section 54EE(1) of the Income-tax Act states that LTCG shall not be charged on the capital gains from the transfer of a long-term capital asset provided that the whole or a part of the capital gains is invested in ‘long-term specified asset’, that is, a specified government bond within six months from the date of transfer of the capital asset. Clause (a) further notes that if the cost of the long-term specified asset is not less than the capital gains arising from the transfer of the asset, the whole of such gain shall not be charged, and clause (b) states that if the cost of the long-term specified asset is less than capital gains earned, the cost of the capital gains used to acquire the former asset shall not be charged while the rest of the capital gains shall be liable to be charged. Furthermore, the maximum amount that can be invested in a long-term specified asset is fifty lakhs during a financial year and the lock-in period of these assets is five years.
The amount of capital gains exempted under Section 54EE is limited to the amount invested in specified bonds. Therefore, if an investor wants to exempt the entirety of his LTCG from taxation, pursuant to Section 54EE, it can only be done if the entire sum is invested into a Government-notified fund. Even under clause (a), if the cost of such fund is more than the capital gains arising from the transfer of the asset, an investor would have to invest the entirety of the capital gains into the asset as any remaining un-invested capital gains amount would be liable to be taxed at the normal rate. Furthermore, if the LTCG earned by an investor from the liquidation of his equity exceed fifty lakhs, which it would for most investors, then he would have to invest a whole fifty lakhs into the notified Government asset and get the rest of the gains taxed in order to make the maximum out of the Section 54EE exemption. This defeats the entire purpose of an exemption policy. Moreover, the lock-in period for investing in government bonds is five years, thus the investors, in order to get their money back, would have to wait for five more years on top of the numerous years they locked in their money in startups. Therefore, the exemption given under Section 54EE does nothing to ensure that the investor circulates his profits/capital gains in the form of investments into other startups as it does not provide room/incentives for the same, which is exactly what policies in the US, UK, and also Israel, for instance, envisage.
UK’s Enterprise Investment Scheme
The UK’s Enterprise Investment Scheme (EIS) offers generous LTCG tax reliefs to startup investors under its capital gains tax (CGT) reliefs. Long-term gains tax on the sale of equity is 20% in the UK; however, gains realised from the liquidation of shares issued under EIS are not subject to the same provided that they were held for at least three years. Furthermore, EIS also has a deferral scheme wherein if the sum of an investor’s gains is reinvested into EIS shares between one year prior and up to three years after the gain is realised, the investor can defer capital gains tax on the sale of his initial EIS shares several years after it arises thereby giving increased options to the investor to fund budding startups and flexible tax planning. This process of sale of EIS shares and subsequent reinvestment of a part of the gains can be repeated and the capital gains tax bill can be deferred, if the investor so wishes, indefinitely.
QSBS: Balancing Investor Benefits and Incentives to Invest
USA’s QSBS scheme has been extremely useful in establishing a startup culture in the country. Established under section 1202 of Internal Revenue Code, this scheme fully exempts LTCG tax on the liquidation of QSBS provided it is held for at least 5 years. However, the exemption can only be allowed if QSBS was directly issued to the investor and does not apply if the same was bought from other shareholders. Furthermore, QSBS only applies to qualified small businesses, that is, companies with aggregate gross assets no greater than $50 million before issuance. The maximum gain exclusion under QSBS is limited to $10 million or 10 times the basis of the initial investment, whichever is greater. Post the 2008 recession, this scheme incentivized investors to invest their money into small high-risk but promising enterprises leading to the growth of successful startups and the beginning of the start-up wave across the US.
In addition to these incentives, the deferral scheme known as the “1045 rollover” provides great investor flexibility. Under this scheme, an investor can defer taxes on the sale of the original QSBS before the 5-year period by investing the sale proceeds into a replacement QSBS in another startup within 6 months of the sale. The tax on the sale of the original QSBS can be avoided when the aggregate time period of holding the original and replacement QSBS are 5 or more years. Thus, the 1045 rollover ensures investor benefits go hand-in-hand with encouraging investment in the startup ecosystem.
It is crucial to formulate tax exemption policies that ensure both investor benefits and incentivize investments in start-ups. Exemption under Section 54EE does not encourage investors to further invest in startups. Drafting a policy similar to QSBS will ensure both thereby leading to investor retention and increased investments in startups. Individual investors, and venture-capital funds, which can both be companies or trusts, can be brought within the ambit of the policy, and the definition of small company under Section 2(85) of the Companies Act 2013 can be adopted to set a higher threshold limit for the policy. Department for Promotion of Industry and Internal Trade (DPIIT) can be used as the administrative body which ensures compliance with all the criteria to be fulfilled before availing of exemption under the policy. Thus, there has to be a robust system which ensures the registration of start-ups with DPIIT, looks into the compliance aspect and then gives the exemption to investors.
The exemptions given by the policy, including the rollover benefit, will ensure that investors in startups not only avail the requisite capital gains tax exemptions but also ensure that they invest more into promising Indian startups as it will provide for both investor benefits as well as increased incentives/room to further invest into the Indian startup ecosystem leading to investor retention and sufficient funds for startups to function efficiently.