In a landmark decision, priority sector lending (PSL) status was granted by the Reserve Bank of India (RBI) to the startup sector in the country. By bringing startups within the ambit of banking finance, the central bank has helped several fledgling startups in the country gain access to institutional credit and created an enabling environment for the raising of easy working capital.

Till date PSL status was specifically accorded to reserved sectors such as micro, small and medium enterprises (MSMEs), education, agriculture and housing. PSL guidelines stipulate banks to set aside a portion of their funds for lending to sectors deemed important by RBI. Scheduled commercial banks and foreign banks having a significant operational presence in the country are required to set aside 40 per cent of their adjusted net bank credit for lending to such sectors.

The move reiterates the Indian government’s firm commitment to roll out a comprehensive roadmap to create a robust startup ecosystem, nurture entrepreneurship and incentivize innovation among the youth of the country. With a firm emphasis on promoting the ease of doing business and giving India a distinct competitive edge vis-a-vis other emerging economies, the government is aiming at making India a global startup destination. According to the Hurun Global Unicorn List 2019, India had the third largest startup ecosystem in the world with 21 unicorns (privately held startup companies with a value over $1 billion).

Over the years, big-ticket Chinese investors such as Alibaba Group and its affiliate Ant Financial, Tencent Holdings and Fosun RZ Capital have been instrumental in bankrolling thousands of startup ventures in the country including unicorns such as Paytm, Zomato, Delhivery, BigBasket and PolicyBazaar. Chinese investors have poured around $6 billion in the Indian startup sector over the last two years. With the government amending its foreign direct investment policy in the wake of the COVID-19 outbreak to prevent hostile/opportunistic takeovers of Indian companies from countries sharing a common geographical border with India, potential investments from Chinese investors have been subject to greater scrutiny. By bringing startups under the PSL umbrella, the government has provided the Indian startup environment with a sustainable alternative funding pipeline ensuring its operational momentum and continuity.

Since 2016, the government has announced several tax exemption measures under the Startup India programme to help small startup businesses raise funds and have access to easy working capital in their initial working years. Startup ventures incorporated after April 1, 2016 but before April 1, 2021 would be eligible for 100 per cent tax rebate on profit for three consecutive financial years out of its first 10 years since incorporation under section 80IAC of the Income Tax Act, 1961 (Act) if their annual turnover does not exceed INR 100 crore in a given financial year. Only private limited companies or limited liability partnerships recognized by the department for promotion of industry and internal trade (DPIIT) as startups can claim exemption under the aforesaid section.

Accepting the long-standing demand of the startup fraternity in India, the government of India has given a complete exemption to angel investors on funds invested in startups under Section 56(2)(viib) of the Act subject to the fulfilment of certain conditions by DPIIT. Angel funding is a major source of working capital funding for startups in early phases of their operations when they are trying to establish their market and brand presence. Till the announcement, investors were burdened with an angel tax levy of 30 per cent on funds invested by them in unlisted startup firms.

Section 54GB of the Act contains a provision which provides for tax exemptions from long-term capital gains on sale of property if they are invested into small or medium enterprises as defined by the Micro, Small and Medium Enterprises Act, 2006. Eligible startups have been brought within the gambit of this provision through a suitable amendment. If a property is sold by an individual and HUF and resultant financial gains from the sale are invested to buy 50 per cent of more shares in an existing startup, they are eligible for tax exemption from long-term capital gains. However, the tax exemption stands to be revoked if the shares are resold within five years or transferred to another person/enterprise. With the invested amount, startups are mandated to purchase assets. They cannot transfer the asset purchased to another party for a period of at least five years. Further, it has also been proposed that the condition of minimum holding of 50 per cent shares in the startups be relaxed to 25 per cent.

Till now traditional banks don’t have the requisite expertise to successfully navigate a startup funding round, which a VC or PE firm has. Considering the rapid innovation in the startup space, it would be crucial that RBI issues restructuring guidelines in lending to startups as the lack of collateral is likely to emerge as a significant point of concern for banks when they will consider lending to startups as many startups are digital platforms, and therefore, have little or nothing in the form of physical assets nor do they have sufficient free cash flow generation to cover interest payments.

The startup ecosystem in the country is scaling an exponential growth trajectory. Startups, though small in operational scale and size, will generate large-scale employment in the country. With a keen understanding of emerging market dynamics and leveraging new-age technologies, next-gen entrepreneurs are setting up ventures which bear testimony to their ingenuity and innovative vision. Going ahead, Indian startups will have a pivotal role to play in positioning India as a global economic powerhouse.

*Rajesh Narain Gupta, Managing Partner, SNG & Partners, Advocates and Solicitors; Soumyajit Mitra Principal Associate, SNG & Partners, Advocates and Solicitors