Income Tax Notices to startups

For instance, one startup, registered with the Department for Promotion of Industry and Internal Trade (DPIIT), has been instructed to pay ₹37 crore in taxes and penalties on funding of ₹40 crore from venture capital investors, sources disclosed. Section 68 of the I-T Act allows authorities to tax capital raised by a company along with its income if the company fails to satisfactorily explain the nature and source of the funding received. However, such tax demands can be resolved if the company provides a satisfactory explanation and submits the required documentation.

Typically, DPIIT-recognized startups do not encounter such scrutiny. Nevertheless, recently, a fintech startup founder received a notice demanding the balance sheets of investors who injected capital into the company during the fiscal year 2023. Despite submitting all relevant documents along with the Permanent Account Number cards of the investors, the startup still faces a tax demand, the founder lamented.

The initial notice, issued under Section 142(1), requested evidence of identification, creditworthiness, genuineness of share capital, and the premium value over the face value of the shares. Despite some companies furnishing relevant shareholder agreements for assessment, they continue to face tax demands.

Furthermore, startups appealing against tax demands must first deposit 20% of the overall tax demand with the government, which adversely affects their cash reserves and working capital requirements, noted one startup founder who spoke anonymously.

Notably, tax notices have also been sent to Alternate Investment Funds (AIFs) regarding transactions in past fiscal years, according to a tax lawyer familiar with the cases. While some cases saw no tax demands after appropriate documents were submitted, startups find it challenging to provide confidential information about investing funds’ balance sheets, exacerbating the situation.

Income tax officials assert that inquiries are made under the relevant provisions of the Income Tax Act based on credible information and provide video conferencing facilities for further explanation before issuing assessment orders.

The government amended Section 68 of the IT Act through the Finance Act 2022 to include a provision mandating the department to seek information on the sources of venture fund infusion. Experts view this as an attempt to curb illegitimate transactions disguised as share issuance but stress the need for a balanced approach to ensure legitimate investments aren’t unfairly targeted.