Explained: Legal hacks start-up founders can use to save on tax

When you sell a long-term capital asset (like stocks or gold, held for more than 24 months), you typically owe capital gains tax. But Section 54F gives you a chance to avoid that tax altogether

If you are a start-up founder and have secured an exit for your business, then the prospect of paying capital gains taxes on the proceeds for  the share sale can no doubt  daunting. Thankfully, if you held on to shares in your company for a period exceeding two years, you can invest the  gains into residential real estate one year before or two years after the share sale. The catch is that you should not own more than one residential property in your name and the entire amount invested shall be exempt from taxes up to a limit of Rs 10 crore.

Business Standard explains in detail some ways startup founders exiting their companies in India can reinvest their money to potentially save on capital gains tax:

Section 54F of the Income Tax Act: This section offers complete exemption from capital gains tax if the sale proceeds are invested in a new residential property in India. However, there are conditions:

1. The property must be for self-occupation or for a close relative.
2. The sale proceeds must be used to fully purchase the new property, or a significant portion (specified by the act).
3. You should not own more than one residential property in your name
4. Entire amount invested shall be exempt from taxes up to a limit of Rs 10 crore

"To qualify for exemption under Section 54F, the capital gains from the sale of the asset must be invested in a new residential property either one year before the sale or two years after the sale. Alternatively, if you're constructing a property, you have three years from the date of sale to complete the construction. It’s crucial to note that this exemption is only available if you do not own more than one residential house, other than the new one, on the date of transfer. It is also important to know that if the net amount received on sale of shares is more than Rs 10 crores, the deduction will be allowed taking the net amount as Rs 10 crore only," said Ankit Jain, Partner, Ved Jain & Associates.

Point to note: This is applicable only if you  have held on to shares in your company for a period exceeding two years, following which you can invest the  gains into residential real estate one year before or two years after the share sale.  Pallav Pradyumn Narang, Partner, CNK explains this further: For example if Mr Grover sells his company for Rs 15 crore where the cost of acquisition was zero ( he is the founder) and he subsequently buys a property worth Rs 12 crore then he will have to pay capital gains tax on Rs 5 crore only. This is because the relief under the section is capped at Rs 10 crore.

Other important points to note are as follows. 

1. Asset Type: The exemption applies to the sale of long-term assets other than residential properties. This includes land, bonds, gold, etc.

2. Time Frame: The purchase or construction of the new property must be completed within the stipulated time.

Jain lays down steps to take advantage of Section 54F

1. Plan Ahead: Begin planning for the purchase or construction of the new property as soon as you decide to sell the asset. Many miss out on exemption since they could not finalise or complete the purchase within the prescribed time. 

2. Reinvestment: Reinvest the entire net sale consideration into the new residential property. The exemption is proportionate to the amount reinvested relative to the total sale consideration.

3. Booking: One can also opt to book in an under construction project. However, one should ensure that the project is completed well within the period of 3 years. Letter of possession is usually sufficient to demonstrate completion. 

4. Documentation: Keep all documents related to the sale of the asset and the purchase or construction of the new property well-organized. This includes sale deeds, purchase agreements, construction receipts, and bank statements.

5. Temporary Investment: If you are unable to invest the amount immediately, you have the option to deposit the capital gains into the Capital Gains Account Scheme (CGAS) before the due date of filing your income tax return. This will allow you to claim the exemption and give you time to plan your investment.

If a founder invested Rs 50 lakh of his own money. When he exited, he received Rs 5 crore, leaving him with a capital gain of Rs 4.5 crore. Now, if the founder invests this money in residential house of Rs 3 crore, which will give him a deduction of Rs 2.7 crore. However, ifhe  buys the house for Rs 5 Crores or more, he will get the complete deduction of Rs. 4.5 crore from his capital gain.

"Another way could be to benefit under Sec 54EE, which helps specified startup founders in India in saving tax on capital gains. If they sell a long-term asset (over 24 months) and reinvest the entire gain (up to Rs 50 lakh) in a government fund within 6 months,  hold the investment for 3 years, then they get exemption from tax on long term capital gains under this section," said Ritika Nayyar, Partner, Singhania & Co.

Founders can also use the Startup India Scheme to save on taxes: This scheme povides tax benefits to entrepreneurs over five years provided the annual turnover of the venture does not exceed Rs 25 crore. Alay Razvi, Partner, Accord Juris LLP explains this 

Three Years Tax Benefit: Eligible start ups are granted a three year tax benefit on their profit wherein they are exempted from paying income tax on their profits for the first three consecutive years from the date of incorporation. It allows Founders to stay invested and reinvest the profits.

There's a catch, though. Your startup must be recognized by the Department for Promotion of Industry and Internal Trade (DPIIT). Only Private Limited Companies or Limited Liability Partnerships (LLPs) qualify for this tax exemption under Section 80 IAC.

Angel Tax Exemption:  The tax on investments above fair market value is exempt from tax for startups. These investments include investments by angel investors, investments by incubators, and investments by funds and individuals not registered as venture capital (VC) funds. In simple terms, investments made by angel investors by paying more than the company's fair value is exempt from tax. This helps startups have more funds for running their operations.