venture capital: Domestic startups come under income tax glare for their recent funding

Several new economy ventures, primarily in the fintech sector, have received income tax notices in recent weeks with respect to venture capital raised by them, according to people in the know. The notices — served under Section 68 of the Income Tax Act — have clubbed the investments received by these startups with the income earned by them, and tax and penalties have been levied on the combined amount, the sources said.

So much so that one startup, registered with the Department for Promotion of Industry and Internal Trade (DPIIT) – has been asked to pay Rs 37 crore in tax and penalty on funding of Rs 40 crore by venture capital investors, they added.

To be sure, under Sec 68 of the I-T Act, if a company is unable to satisfactorily explain the nature and source of the funding it receives, authorities are permitted to tax the capital raised along with income earned by the startup in the relevant year. Equally, such tax demands are also closed if the company offers a satisfactory explanation and furnishes the requisite documentation.

Typically, a DPIIT-recognised startup does not face such scrutiny.

Balance Sheet of Investors Wanted

Earlier this week, the founder of a fintech startup received a notice requiring him to furnish the balance sheet of investors who invested capital into his company in the financial year 2023.

“We submitted all of these documents along with the Permanent Account Number cards (of the investors) but have still been served with a tax demand,” he said.

In this case, the initial notice, under Section 142(1), had sought evidence of identification, creditworthiness, genuineness of share capital, and the value of premium over the face value of the shares. He was asked to furnish “the identity, genuineness and credit worthiness of the shareholders”.

Some of the companies facing tax demands claim they have furnished relevant shareholder agreement for assessment.

Moreover, if an affected startup decides to appeal against the tax demands, it has to first deposit 20% of the overall tax demand with the government.

“This will eat into our cash reserves and will hurt our working capital requirements,” said one startup founder speaking on the condition of anonymity.

Venture Funds Also on Radar

A tax lawyer dealing with some of these cases said IT notices have also been sent out to AIFs (alternate investment funds) with regard to transactions in the past few financial years.

He pointed out that in a few cases, there has been no demand for tax once the appropriate documents were submitted.

“While companies are submitting documents like financial statements of their investors, it’s hard to show income on a standalone basis for these funds. They raise capital from their limited partners (sponsors in funds) and go on to deploy the monies” he said.

Further, it is difficult for startups to furnish confidential information about an investing fund’s balance sheet, rendering the situation even more difficult for them, he noted.

I-T officials are of the view that all such inquiries are being made under the relevant provisions of the Income Tax Act based on credible information. There are no roving inquiries that are carried out, officials told ET.

“The income tax department these days receives information from multiple sources and credible information is shared with the assessee to seek an explanation,” said one official. In addition, video conferencing facility is also provided if the assessee wishes to provide further explanation and assessment orders are issued only after that, he added.

The government had amended section 68 of the IT Act via Finance Act 2022 to include a provision that mandates the department to seek information on sources of venture fund infusion.

Experts said that while the provision “is intended to curb illegitimate transactions in the garb of share issuance, its application to investments made by Sebi-regulated funds and venture capitalists is unfortunate since there is more than adequate oversight on such investors.”

“It is crucial for regulatory authorities to strike a balance between tax compliance and fostering a conducive environment for entrepreneurship, ensuring that legitimate investments are not unjustly targeted,” said Hemanth Danda, a partner at Aeka Advisors, a tax advisory and consulting firm.