Income tax notices lead to stress among startups, executives and investors

This report has been updated

At a time when many startups, especially in the fintech industry, have received income tax notices recently, industry executives and investors said this has created anxiety in company circles.
 

They said such an action is regressive and poses significant challenges to startup operations and investor confidence.

The notices were served under Section 68 of the Income Tax Act. They have clubbed the investments made in the startups, along with the revenue, to calculate the tax, according to the sources.
 

Gouri Puri, partner, Shardul Amarchand Mangaldas & Co. shared that while angel tax continues to be a concern for several Indian start-ups raising capital, there have also been a parallel spate of cases where additions have been made in the taxable income of Indian companies receiving substantial share premium under Section 68 (unexplained cash credits)of the Income-tax Act, 1961. 

"In several of these matters, inquiries have been made in respect of source of funds in the hands of the investors. Often these details are not available with the investee company or are impracticable to procure especially where investments are made by PE funds. The Government should consider issuing necessary guidelines under Section 68 to shield genuine cases as this adversely impacts capital inflows," she added. 
 

Many companies that have been served the notices are being asked about the creditworthiness of investors, who put in money, according to fintech industry executives.
 

“There is another concern about the valuation of many of these startups, for which a particular premium has been calculated,” said a person familiar with the development. 

The person quoted above added that income tax notices were served only a few weeks before the closure of the financial year (FY24). These notices were related to FY22 and FY23.
 

Companies were required to furnish details about investors on a notice as short as three or four days. 
 

“People also felt that since the income tax department has the PAN details of these investors, why did it not seek information from them directly?” the person above asked.
 

Meanwhile, people in the know said that institutional investors and those with investments in the banking, financial services, and insurance (BFSI) sector were also affected by the move.
 

“Investors resist sharing information since they are not obliged to share details. As a result, companies may not have immediate access to some of this information requested,” the person added.
 

A fintech industry player said companies will have to figure out the root cause of the action taken by the authorities.
 

“There is no denial that the government has supported startups. However, with all these things, there is support only in terms of words and it doesn’t translate into practice,” the person added.
 

Yeeshu Sehgal, head of tax market, AKM Global, a tax and consulting firm said that it is increasingly common for startups to receive notices requiring clarification regarding the source of their investments and to verify the legitimacy of their investors.

He further added that "This regulatory demand poses significant challenges for startups especially in genuine cases and startups find it difficult to comply with. Clubbing the investments received by them along with their own income is unduly burdensome as it entails huge penalties as well. However, it is pertinent to note that venture capitalists and funds are already subject to regulations by SEBI. Hence, imposing additional tax obligations on the startups with respect to their investments and their own income appears undue hardship for the startup ecosystem.”
 

Executives said such action occupies too much time during normal operations. This is taking place at a time when getting access to capital is also difficult.
 

Anil Joshi, managing partner, Unicorn India Ventures, said while the action is justified under the IT Act, it is causing a lot of back-end work for all concerned. This includes investors who have put money through proper banking channels.
 

Joshi said though the reason is to control dubious transactions, it is putting everyone in hardship to justify the genuine investment. “I am sure the policymakers will find some solution to the situation and make it a stress-free investment environment for genuine investments,” said Joshi.
 

Rahul Charkha, partner at Economic Laws Practice (ELP), said that startups have often come under the radar of the tax authorities in the past. Angel tax is one of the biggest issues for startups. He said that fresh notices under Section 68 of the Income Tax Act, 1961 (‘the Act’) will only add to the woes of the startups.
 

“The Indian startup ecosystem has seen tremendous growth in recent years, becoming one of the most vibrant in the world. However, tax issues can pose significant challenges to startup operations and investor confidence,” said Charkha. He said that to sustain this growth trajectory and attract more investment, tax authorities need to address these issues effectively.
 

The government may issue guidelines and instructions exempting genuine transactions from the purview of Section 68 of the Act. 
 

“Further, clarification may be provided regarding the details and documents that may be relied on to prove the genuineness of the transaction and identification and creditworthiness of the investors,” said Charkha.
 

Ashish Aggarwal, director, Acube Ventures, said the situation can be very difficult and stressful for small businesses to be dealing with Section 68 notices. He said that fintech startups, including those that are rapidly growing, normally are in an environment where high speed can be practised and the fundraising process should not be delayed. 
 

“The complex taxing and penalties on the unexplained assets can adversely affect their financial situation as well as damage the chances for their development,” said Aggarwal.
 

Additionally, Aggarwal said the directives may provoke the loss of investors' confidence as well. “This makes investors feel cautious when they invest in startups which are monitored by tax authorities,” said Aggarwal.
 

Anirudh A Damani, managing partner, Artha Venture Fund, said the imposition of income tax notices under Section 68 has a significant and unsettling impact on the Indian startup ecosystem.
 

“It’s crucial to recognise that Indian startups compete on a global stage, not in isolation,” said Damani. “This procedural red tape not only sours the climate for innovation in India but also signals a misalignment between our ambition for home-grown innovation and the operational realities startups face,” he added.

Damani said that the emerging pattern of income tax notices poses substantial challenges for startups seeking venture capital in India. The fear of subsequent financial entanglements can divert resources from growth, innovation, and talent acquisition to dealing with tax obligations. This necessitates additional protective measures for startups and investors, complicating the investment process.
 

“Given the recurrent nature of this issue and ongoing discussions without resolution, the government and regulatory bodies must intervene decisively,” said Damani.
 

He added, “A collaborative and permanent solution is essential to remove this persistent obstacle, enabling startups to thrive and contribute meaningfully to the economy.”
 

Rajesh Gandhi, partner, Deloitte India said, "It is important to document the credit worthiness and genuineness of shareholders failing which tax can be demanded from the issuer company as unexplained credit. The tax law deems share subscription money to be unexplained credit unless the issuer company is able to explain the nature and source of such share subscription to the satisfaction of the tax officer."