Explained: Why tax is a dilemma for start-up founders in India

After the abolition of the dividend distribution tax, the taxability of salaries and dividends in the hands of a founder of a bootstrapped start-up will be broadly similar, says Ritesh Kumar, IndusLaw

Zerodha Co-founder and CEO Nithin Kamath recently hit the headlines when he highlighted the tax arbitrage that start-up promoters face “between trying to earn by chasing growth and selling a stake in the business over trying to earn profits and taking out dividends”. In a social media post, Kamath went on to explain why most start-up promoters don’t like to take out profits from their venture through salaries, but prefer the share buy-back or share sale route, largely to save on taxes.

Experts explain the dilemma that start-up founders face on the tax front, and how some reform measures could give a boost to the start-up ecosystem.

Between salary compensation and dividend pay-outs, which is a more tax efficient way for start-up founders?

Experts point out that salary is a compensation for effort and time incurred in earning profits, whereas a dividend is the distribution of profits itself. The term salary encompasses not only monetary compensation, but also perquisites that could be both monetary and non-monetary in nature, such as ESOPs.

In India, salary pay-outs in the highest bracket are taxed at the rate of 42.7 per cent (including surcharge and cess). However, in case of dividends the overall tax incidence could become as high as 57 per cent (corporate tax 25.17 per cent plus, tax on dividends up-to 42.7 per cent).

“Compared to dividends, salary can be more tax efficient as first of all it is tax deductible to the company, and secondly, it enables the employee to take advantage of various deduct­ions, exemptions provided to salaried persons under the income tax law,” says Amit Maheshwari, partner and In­dia tax leader at Ashok Mahesh­wary & Associates. After the abolition of the dividend distribution tax, the taxability of salaries and dividends in the hands of a founder of a bootstra­p­ped start-up will be broadly similar, points out Ritesh Kumar, partner, IndusLaw.

However, another popular form of taking liquidity out from the company is carrying out share buy-back or through share sale to investors. Experts say the tax consequence of this route is rather attractive. The buy-back gain (namely, the difference between the price at which shares are bought back and the price at which they are acquired) is taxed at 20 per cent (plus applicable surcharge and cess).

What are the limitations of the share buy-back route?

In a buy-back route the company may not be able to pay out the entire profit given that the maximum permissible buy-back limit is 25 per cent of the paid-up capital and free reserves of the company. While the buy-back may be tax attractive, it comes with its own limitations, say experts.

How different is the tax incidence on start-up founders in developed markets, such as the UK, US or Singapore?

Tax experts point out that the whole ecosystem supporting start-ups in those countries is quite different. “Availability of different classes of shares, ability to give shares without any payment, different tax treatment for issuance of shares to employees/founders, ability to issue derivative instruments with minimum tax impact are some of the flexible features that result in different tax incidence in these countries,” says Daksha Baxi, founder, SRI Solutions.

There is broad uniformity in taxation in major developed countries worldwide. For instance, in the UK, dividends above the threshold of £2,000, or the personal allowance (basic exemption limit) is taxed at applicable slab rates, the highest being 38.1 per cent, points out Chirag Nangia, director, Nangia Andersen. In the US, ordinary dividends and salary are taxable at applicable slab rates which may range up to 37 per cent. On the other hand, Singapore practises a single-tier corporate income tax system, experts add. “Tax paid by a company on its income is the final tax, and all dividends are exempt in the hands of shareholders from further taxation,” says Nangia. In Singapore, salary is taxed progressively at slab rates, the highest rate being 22 per cent.

What is the message in this for tax administrators?

The big takeaway for tax administrators is that differential tax rates promote tax structuring and planning. “Hence, a uniform taxability of income under various provisions of the Income Tax Act is desirable,” says Nangia.

According to Sridhar R, partner at Grant Thornton Bharat, lowering the tax rate on salary (perquisite value that applies today on an exercise of ESOP grants to promoters/ employees) could be a good way to encourage the start-up environment. “This will encourage use of long-term incentive plans for start-ups, and for employees and promoters to get compensated through this mechanism,” he adds.