Incorporation and Tax Considerations for Start-ups in India
22 October 2012
One of the biggest considerations for an Entrepreneur while building a start-up is handling future tax issues. First things first, to figure out the taxability, the entrepreneur should first decide on the sort of legal structure that he or she would like to use for company incorporation.
There are three options for incorporation of start-ups. Tax considerations in India depend upon the incorporation option chosen for the Start-ups.
Let us understand the incorporation options and the related tax considerations:
A Proprietorship Concern – such a start-up very easy to incorporate. Need a personal PAN Card and a proposed name of the firm with which you open a bank account and start operations. All Income of the new firm is essentially that of the proprietor and is taxed as Business Income of the proprietor (entrepreneur in this case). The tax structure is the same as that for any Indian resident individual. So assuming that the entrepreneur has other personal income such as a salary from some other company and some interest and dividends, any profit that he makes from this new venture would be added to the other incomes and taxed together. In the case of start-ups, that may make a loss in the beginning, all losses from business cannot be simply adjusted against incomes from other various sources, rather these losses can be carried forward for a period of up to 8 years and adjusted with future profits that may arise out of the business.
A Partnership Firm – this type of start-up is relatively easy to incorporate. Need to execute a partnership deed between the proposed partners mentioning the name of the proposed firm. The Partnership deed has to include details of the ownership percentage of every partner and details of the capital that they bring into the company. The salaries and remuneration amounts of every partner can also be mentioned in this deed. The Partnership firm has its own identity. Once the partnership deed is executed, a PAN card in the name of the firm can be applied for. A Bank account in the name of the Firm can be opened after the PAN card has been procured. A Partnership firm probably holds a little more weight than a proprietorship firm in the credibility that the firm could have. The profits or losses of the firm are taxed separately and have no connection to the personal incomes of the individual partners. The firm may be subject to tax audit by a professional Chartered Accountant depending on the turnover of the firm. Net Profits are taxed at 30% + Education cess. Net Losses if any can be carried forward for a period of up to 8 years.
A Private Limited Company: It is harder to incorporate such a start-up. To incorporate a private limited company, you first need to think of a name for your company and then send it to the Registrar of Companies (R.O.C .) for approval. The Registrar of Companies then checks for the uniqueness of the name and then only sends the approval for the same. Once the name is approved, you can apply for the formation of the company along with a Memorandum of Association (MOA) and Articles of Association (AOA) of the proposed company and the details of the Directors, Shareholding pattern, Paid up capital and Authorized or Registered Capital of the company. Once the company is approved, the Ministry of Corporate Affairs (MCA) through the Registrar of Companies issued a Certificate of Incorporation which is the identity of the company. The company can then apply for a PAN Card and open bank accounts after that. The company also has to issue shares to the shareholders and print copies of the MOA and AOA and prepare a company seal which can be used to authorize official documents. All Private limited companies are subject to tax audit irrespective of whether they are in business or not, or whether they are making profits or not as per the Income Tax Act. All net profits of a private limited company are taxed at 30% + Surcharge + Education Cess. Private limited companies are the most recognized and credible out of the three forms of company incorporation. They tend to attract the most investors as well. A word of caution though, when you are trying to raise capital for your startup as of 1st April 2012, the Government of India introduced a new clause in section 56 (2) of the Indian Income Tax Act, which essentially says if a resident person purchases equity shares of an Indian company for a price that exceeds the fair market value of those shares, then the excess amount will be taxed by the income tax department as “Income from other sources”. Now in the case of most start-ups who receive funding from angel investors or family and friends for a stake in their company, obviously receive funding for an amount which far exceeds the value of the equity shares that they sell. This poses a large problem for such entrepreneurs as this excess amount is then deemed to be taxed by the Income Tax department. Though, as per this provision if the company receives funding from a Venture Capital Company or Fund, then this excess is not taxed. Another possible exclusion to this provision, could be that a Non Resident Individual could possibly invest in your company without the need to pay taxes on the excess amount as the rule only applies to “Residents”.