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Economy

Startup Boost: Investments By Non-Residents in Private Companies Will See Only 10% Capital Gains Tax

Did you know that startup investments (from non-Indians) got a tax fillip from the Budget 2016? If they sell shares in a private company, they will get taxed at only 10% of the gains in FY17, compared to the 20% they currently pay.

From the Memorandum in the budget:

Clarification regarding the definition of the term ‘unlisted securities’ for the purpose of Section 112 (1) (c)

Existing provisions of clause (c) of sub-section (1) of section 112 provide tax rate of ten per cent for long-term capital gain arising from transfer of securities, whether listed or unlisted. The expression “securities” for the purpose of the said provision has the same meaning as in clause (h) of section 2 of the Securities Contracts (Regulations) Act, 1956 (32 of 1956)(‘SCRA’). A view has been taken by the courts that shares of a private company are not “securities”.

With a view to clarify the position so far as taxability is concerned, it is proposed to amend the provisions of clause (c) of sub-section (1) of section 112 of the Income- tax Act, so as to provide that long-term capital gains arising from the transfer of a capital asset being shares of a company not being a company in which the public are substantially interested, shall be chargeable to tax at the rate of 10 per cent.

And because some of you will be curious, here’s the Section 112 part that is being referred:

 (c)  in the case of a non-resident (not being a company) or a foreign company,—

 (i)  the amount of income-tax payable on the total income as reduced by the amount of such long-term capital gains, had the total income as so reduced been its total income; and

 (ii)  the amount of income-tax calculated on long-term capital gains [except where such gain arises from transfer of capital asset referred to in sub-clause (iii)] at the rate of twenty per cent; and

(iii) the amount of income-tax on long-term capital gains arising from the transfer of a capital asset, being unlisted securities, calculated at the rate of ten per cent on the capital gains in respect of such asset as computed without giving effect to the first and second proviso to section 48;

Wait, Wait. Cut Through The BS, No?

Ok, boss.

  • Assume you are a VC or a foreign investor, even an NRI in Dubai.
  • You bought shares of Indian company (private).
  • Flipkart acquired you. And paid money. And this was more than a year after you bought the shares. (So long term capital gains taxes apply)
  • You currently pay 20% of tax on the “gain” you make.
  • Why? Because this is a private unlisted company.
  • And because some courts had decided that shares of private unlisted companies were not “securities”. So the (iii) clause above does not apply.
  • So the new budget has said: Dude, they are securities. From April 1, 2016, any sales of private company shares will be treated as securities, so (iii) above will apply, and the investor has to pay only 10% of gains as tax.
  • What the F is “first and second proviso of section 48”? Glad you asked. You can offset the impact of inflation when you calculate long term capital gains. If you bought something at Rs. 10 and sold at Rs. 20, and inflation was say 20%, then your cost is assumed to have become Rs. 12, so your gain is Rs. 8. You pay 20% of Rs. 8. This is the section 48 thing. So basically, they’re saying, don’t offset inflation and pay 10%, or offset inflation and pay 20%.
  • Many of these investments are exited at 10x or 20x (okay, we wish). But even if not, the effective tax rate is the 10% upper barrier.

But Indian Investors Can’t Celebrate

If we are Indian residents, there’s no love for us. We pay 20% on unlisted securities gains. (Whether or not we care about inflation offsets) This applies to both Indian companies and individuals. Sad!

This is unfair. I hope they fix this. We lost all our energy on the silly EPF thing. Now we can only hope the finance minister listens. How do you make in India if you incentivize only foreign investors?

For most VCs coming through Mauritius or Singapore, this doesn’t matter. They don’t pay any capital gains taxes since we have a treaty in place. Individual investors who’ve sold shares and who aren’t resident in India will see a lower tax at exit. Indian residents who sell shares, no such luck!

If you’re going to sell a company, it’s perhaps better to leave India for six months, live in Dubai and then sell shares to get a lower tax incidence. This is however a stupid thing to do for the country, and lets hope the finmin keeps that in mind and equalizes the space for all Indian residents too.

Note: This doesn’t apply to “listed” securities. Even as an Indian resident, you either pay zero tax (if you sold in the stock market) or 10% upper limit (if you sold in an off-market transaction).

Our Take: Non-Resident investors get a fillip in terms of a lower tax rate when exiting private companies, so startups get helped to that extent. It would however make more sense, if they wanted to incentivise such investments, to extend the lower tax to Indian residents also.

  • Vishal Garg says:

    Hi Deepak,
    Great post! My query is regarding delisting of Essar oil. Will the above also apply to Essar oil as it is not a listed company anymore?
    I am an NRI share holder in Essar oil. I have some share with holding more than 3 years, some with holding period more than 2 years and less than 3 years. In the budget, long term holding period has been reduced from 3 years to 2 years. Is this change applicable to Essar oil shares also? Would you know when would this change of 3 to 2 years be applicable?
    Thanks,
    Vishal.