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In recent weeks, there has been a surge in tax notices affecting the Indian startup ecosystem, particularly in the fintech sector. Notices issued under Section 68 of the Income Tax Act have targeted several startups, probing into their venture capital funding. These notices delve into the origin and nature of the funds, often resulting in significant tax and penalty assessments when satisfactory explanations are not provided.

Section 68 of the Income Tax Act grants tax authorities the power to levy taxes on both the capital raised and the income earned by startups if the source and nature of their funding remain inadequately explained. Conversely, providing a satisfactory explanation, along with the necessary documentation, can resolve these tax obligations. The Finance Act of 2022 amended section 68 to mandate the department to acquire details regarding the origins of venture capital injections.

For example, a fintech startup registered with the Department for Promotion of Industry and Internal Trade (DPIIT) faced a formidable challenge when tax authorities demanded ₹37 crore in taxes and penalties for a ₹40 crore venture capital infusion. Similarly, the founder of another fintech startup received a notice requesting the balance sheets of investors who provided capital in fiscal year 2023. Despite submitting all requisite documents, including investors’ Permanent Account Number cards, a tax demand was issued. These incidents highlight the intensified scrutiny surrounding financial inflows into startups, underscoring the consequences of inadequate explanations regarding funding sources.

Anxiety Within Corporate Circles

The distribution of these tax notices, facilitated by the faceless assessment process, has triggered anxiety among startups and investors alike. This unease has permeated company circles, impeding startup activities and eroding investor confidence. Such measures are regressive and detrimental to the startup ecosystem.

Many companies receiving notices are being interrogated about the creditworthiness of investors and the valuation of startups, often involving a calculated premium. Notably, these notices were issued shortly before the close of FY24, adding pressure to companies to furnish investor details within a limited timeframe. Given the Income Tax Department’s access to investors’ PAN details, questions arise regarding the direct solicitation of information from them.

Institutional investors and individuals with stakes in the banking, financial services, and insurance (BFSI) sector have felt the repercussions of these decisions. Some investors are reluctant to disclose information, leading to challenges in obtaining necessary data promptly. Despite the government’s verbal support for startups, practical support seems lacking, particularly when navigating regulatory challenges.

Navigating Regulatory Challenges

Startups are now racing to comply with documentation requirements, highlighting the obstacles they face in validating the authenticity of their funding origins to meet tax authorities’ standards. When contesting tax requests, startups encounter significant financial strains, as appealing requires remitting 20% of the entire tax owed to the government. This regulation imposes financial burdens and can impact operational strategies.

While actions under the IT Act may be legally justified, they impose significant administrative burdens on all parties involved. Genuine investors who have diligently routed funds through proper channels are unfairly affected. Therefore, policymakers must devise solutions to create a stress-free investment environment for legitimate investments. With startups historically facing scrutiny from tax authorities, the issuance of fresh notices only compounds their challenges.