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Regulatory Framework in India and the Startup Ecosystem: An Unresolved Conundrum

[Anushka and Amogh are students at Rajiv Gandhi National University of Law, Punjab.]


The recently released World Bank report on the Ease of Doing Business (EODB) hints at optimism; for India is currently ranked at 63 out of 190. However, an often-overlooked statistic is its position in starting a business, which is one of the indicators while calculating the EODB. India currently ranks 136 out 190 in starting a business and has only improved by one place over the last year.


In spite of ambitious projects undertaken by the Indian government such as 'Start-up India' and adopting a 'pro-entrepreneurship' attitude, a report by the IBM Institute for Business Value and Oxford Economics states that close to 90% of start-ups fail within the first five years. Why is that the number of new start-ups launched has decreased sharply since 2017, and such number has continued to decline in 2019? Or is the 'pro-start-up outlook' of the NDA government lucrative only on paper?


One of the dominant causes for new age start-ups to be deterred, as perceived by entrepreneurs, is the corporate governance structure in India and its complex regulatory compliance regime. In this article, we intend to examine the direct and the indirect impact of such structure and possible solutions to keep this start-up bubble afloat.


Start-ups in India: Growth and Challenges


The last 2 decades saw a dynamic evolution and growth of start-ups in India. These start-ups came to be recognized as effective business engines bringing forth dynamism, innovation and transformation into the corporate ecosystem. In 2018, start-ups accounted for 2.64% of the total jobs created in India and are projected to create between 200,000 and 250,000 jobs in 2019. However, the complicated framework of rules often proves to be a stumbling block for start-ups, baffling even the brilliant, innovative minds behind these start-ups, burying them in paperwork and huddling compliance costs. The authors intend to examine these challenges faced by start-ups under the current corporate regime, evaluating various regulations, in force as well as in the pipeline, that play spoilsport to growing businesses in the country.


Incorporation and Winding-up Formalities


Incorporation is generally defined as the legal process through which a corporate entity or a company comes into existence. Incorporation of any corporate entity in India is an unnecessarily tedious and multi-stage arduous task. It takes an average of 2 to 3 months to incorporate a company in India, a stark contrast to an average of 2 days required for any company to be incorporated in developed countries like Singapore. Moreover, budding start-ups face a plethora of other problems like rejection of names for the start-up and lack of a trusted database, combined with arbitrary and whimsical grounds for rejection of such names. While the process has been simplified to some extent with the introduction of SPICe, the procedural formalities require a further crop and consolidation.


Consider the example of the recently released draft rules on e-pharmacies, which require start-ups in this sector to mandatorily register themselves and warrant additional compliances. These rules mandate that the application for registration must be accompanied by a whopping sum of INR 50,000. Additionally, the rules prohibit advertisements of medicines and drugs, a major deterrent for start-ups in their nascent stages which naturally suffer from a capital crunch. Moreover, these rules provide for verification procedure and re-registration after a period of 3 years. This also reflects on the ‘one size fits all approach’ and ‘large company bias’ of the government, laying down a uniform set of compliances for companies – big or small.


Complex and tedious winding-up formalities is yet another deterrent for start-up founders. "Shutting down a company is hundred times more difficult than starting a company," has often been the complaint of entrepreneurs. The bureaucracy and the costs involved in closure are few of the main reasons why several companies continue to remain dormant without legally shutting operations. Even then, such companies have to bear costs for maintenance and compliance with annual filings, failing which would entail penal consequences by the relevant authorities. No wonder, entrepreneurs are viewing limited liability partnerships as a more viable option. In order to improve this situation, authorities must attempt to provide for a single window closure to conclude winding up formalities, avoiding harassment to the management.


Cumbersome Tax Compliances


Extensive and complicated tax compliances are yet another checkpoint for businesses. While the indirect taxation reform in the form of goods and services tax (GST) has helped in greater formalization and simplification of the Indian tax regime, the taxation slabs require further reform. A number of goods and services that are crucial for entrepreneurs are taxed in the highest brackets of 18% and 28%, which is counter-intuitive for economic growth. Start-ups in India have to pay an 18% GST reverse charge on foreign services such as hosting, database retrieval, pay-per-use services which, indeed, is an apparent hurdle.


Despite several tax exemptions ensured to start-ups, there still lies a hurdle to a simpler, single tier friendly tax regime. For instance, professional tax is one more of those inexplicable levies that consume the valuable time that could be invested by a business owner in much more constructive activities. Professional tax is payable to the state government, in addition to the income tax to the Central government, for indulging in any trade or profession. Moreover, the present tax regime mandates every company to file quarterly TDS returns – this could conveniently be simplified as an annual compliance.


Another major controversy involved is the levy of angel tax on start-ups. Introduced in 2012, angel tax is an 'income' tax (Section 56 (2) (vii) (b), Income Tax Act 1961) on super normal premium garnered by start-ups on the issuance of equity from resident investors. Although this tax has been done away with for start-ups registered with the Department for Promotion of Industry and Internal Trade (DPIIT), such exemption only comes with a number of terms and conditions. Moreover, the procedural compliance required to avail such exemption still offers an operational setback to the reform.


One of the conditions in DPIIT’s notification for exemption of angel tax was the end-use of the funds raised. Start-ups cannot invest the funds in certain assets, like 'shares and securities' or 'loans and advances'. The intent behind this is to restrict the flow of unaccounted money through the exemption carved out for start-ups. However, most start-ups park the funds they have raised from investors in mutual funds till the time they actually need the funds. Thus, the freedom is not unhindered. Additionally, while the requirement of obtaining an IMB certification (for recognition of start-ups) has recently been done away with, the tax holiday provisions under the Income Tax Act 1961 continue to require such certifications for eligible start-ups. If such certification process is not made on a real-time and fast-track basis, angel investors shall ultimately face the crunch, causing start-ups to suffer.


Conclusion


Clearly, despite the government’s ingenuity to rejuvenate and promote the existing start-up bubble, there is a need to invest some foresight into reforms. Given the slowdown of the economy, there is a need for the government to borrow inspiration from our counterparts in Singapore which boast of a much more attractive regulatory regime. Unfortunately, also in the pipeline are other regulations that seem regressive to start-ups in the near future.


The proposed Data Protection Bill, which incorporate government’s push for data localization, might act as a significant deterrent for start-ups. As suggested by IAMAI, Indian start-ups rely on data collection and processing users’ data, and by imposing limitations on purpose, storage and collection of data, it would be difficult for start-ups to operate. Creating trade barriers will curb their global expansion and initiative. Further, compliance costs for these companies will witness an exuberant rise, since data processing and handling will be another addition to their list of concerns.


There seems to be an urgent need to denounce some of the red-tapism in order to make room for innovation and new-age technology. This also includes a blanket ban on the use of cryptocurrencies in India. New era start-ups are synonymous to innovative technologies and ideas. This ban would inhibit new applications and solutions from being deployed and would discourage tech start-ups, as also remarked by NASSCOM. This shall deter legitimate operations and could cause India to lag behind in a world embracing disruptive technologies. Many budding startups fell prey to this ban including Koinex which had to shut down its operations in June 2019.


Simplicity in regulation, expanding the vision and toning down the regulatory discretion are important, considering the immense potential in budding Indian start-ups. Snap policy reforms, without or little public consultation with stakeholders, often hampers a predictable regulatory environment. This shall lead to a wider applicability and acceptability among the entrepreneurial class, furthering the government’s initiative to provide incentives.

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