Startups Under I-T Dept Scanner, Get Tax Notices Over VC Funding

A number of startups, particularly in the fintech sector, have reportedly received tax notices from the Income Tax Department in recent weeks regarding the venture capital funding raised by them.

The notices, issued under Section 68 of the Income Tax Act, have combined the investments received by these startups with their earned income. Consequently, tax and penalties have been imposed on the total sum, ET reported.

One startup registered with the Department for Promotion of Industry and Internal Trade (DPIIT) has been instructed to settle a tax and penalty amounting to INR 37 Cr. This demand is based on venture capital funding totaling INR 40 Cr received by the startup.

Under Section 68 of the Income Tax Act, if a company fails to adequately explain the origin and nature of the funding it receives, tax authorities have the power to tax the capital raised in addition to the income earned by the startup during the relevant fiscal year. Conversely, such tax liabilities can be resolved if the company provides a satisfactory explanation and submits the necessary documentation.

Earlier this week, the founder of a fintech startup was served a notice demanding the submission of the balance sheets of investors who injected capital into his startup during the fiscal year 2023, the report said.

The founder claimed that the startup submitted all relevant documents, along with the Permanent Account Number cards of the investors but was still served with a tax demand.

If a startup affected by the tax demands chooses to appeal, it must initially deposit 20% of the total tax demand with the government. This will deplete cash reserves and adversely affect working capital needs, a startup founder said.

Meanwhile, a spokesperson of the Central Board of Direct Taxes (CBDT) told the publication, “The assessment is carried out in a faceless manner in scrutiny proceedings, with dynamic jurisdiction. Therefore, it is not possible to comment whether startups located in Bengaluru or in the fintech sector only have been served tax notices.”

Income tax notices have also been issued to Alternate Investment Funds (AIFs) regarding transactions conducted during the past few financial years.

It is pertinent to note that startups have often come under the radar of the tax authorities in the past, with angel tax being one of the biggest issues for startups.

Last year, the Income Tax Department said it had no data pertaining to the number of DPIIT-registered startups impacted by angel tax and Section 68 of the I-T Act, Inc42 reported.

The Central Public Information Officers (CPIO) of the I-T Department said that the department does not maintain the data for startups separately. Hence, none of the regional headquarters of the department have information about the number of startups that have been sent notices under Section 56(2)(viib) and Section 68.

The latest development also comes at a time when there are signs of funding picking up in the Indian startup ecosystem. Funding raised by Indian startups surged 43% month-on-month (MoM) to $734 Mn in February this year.

Moreover, the number of funding deals also saw an uptick, rising to 83 in February compared to 68 in January.