Startups Vs Income Tax Department: A Battle That Seems To Have No End

Angel tax may have been abolished in principle but lingering tax-related challenges continue to haunt Indian startups in one way or another.

“It was not only about Section 56(2)(viib) of the Income Tax Act, commonly referred to as the angel tax but also about the way assessing officers scrutinise startups’ tax matters,” a startup founder, who had to shut his business due to angel tax issue in 2021, told Inc42.

Entrepreneurs confronted with this predicament usually find themselves stuck between a rock and a hard place – either embark on an exhaustive legal fight that could last 8-10 years to vindicate themselves or shut down their business, a step that many startup founders have reluctantly taken.

The taxation issue is back in the spotlight following a recent post on X (formerly Twitter) by Ashneer Grover, in which he spoke about many of his portfolio startups receiving notices from the Income Tax (I-T) Department.

Grover said I-T officers are demanding startups to provide information about their shareholders and their individual income tax returns (ITR) for the last three years. He raised valid questions:

• How and why would companies have access to their shareholders’ ITR?
• Why would a shareholder or individual share their ITR with a private company?
• Why can’t the IT department retrieve ITR data from its own system using PAN (Permanent Account Number)?

The post quickly caught the attention of the I-T Department, which promptly responded to it. In a lengthy post, the department explained that Section 68 of the Income Tax Act, 1961, under which the Assessing Officer (AO) conducts inquiries regarding the creditworthiness of shareholders/investors, places the initial burden on the company to prove the following things:

• The identity of the investor
• The creditworthiness of the investor
• The genuineness of the transaction

The department also noted, “In the present case, it appears that the AO has sought to examine the genuineness of the transaction and the source of investment by the shareholder-investor to verify if the amount invested aligns with the income reported in the ITRs of the investors. Alternatively, if the PANs of the investors are shared with the AO by the Company, he can verify the ITRs of the investors. This has been the practice, as reflected in various tweets in the thread.”

I-T Dept’s Response Sparks Further Debate

If the I-T Department’s response was intended to provide clarification and end the issue, it failed to do so. Many startups and investors Inc42 spoke to believe that the I-T Department’s response is misleading.

Mohandas Pai, partner of Aarin Capital and former CFO of Infosys, raised concerns, saying, “This is misleading. How can you ask for three years of tax returns from the investor through the startup? Does the law permit this?”

Pushpinder Singh, founder and CEO of Travelkhana, said, “The I-T Department’s reply is inaccurate. In our case, we provided PAN numbers but that wasn’t sufficient. The startup was required to provide ITRs. If PAN numbers were adequate, the issue wouldn’t have arisen in the first place.”

He claimed that his startup has been requesting a hearing since November 1, 2019 but to no avail.

“After Covid, the government came up with a faceless scheme. They kept sending us letters to settle in the Vishwas (Vivad Se Vishwas) scheme, which meant we acknowledge their charges and settle without interest. We declined as our case was clear and we had submitted the bonafide to the I-T Department. We haven’t heard since then despite several reminders to them. There is no SOP (standard operating procedure) or a SLA (Service level agreement) for the Department wherein we can get a timely response.”

Another startup founder, who didn’t want to be named, also said that the tax department wanted ITR of investors. “We did provide PAN numbers, but they specifically requested the submission of stakeholders’ ITRs under Section 68 of the Income Tax Act. Nothing less was accepted,” he said.

Another serial entrepreneur, Nikunj Bubna, who shut his previous startup amid angel tax issues, said his exemption from the angel tax issue is still pending. “Six years later, the exemption from angel tax is still pending. It’s been three years since we appealed to the Commissioner of Income Tax (CIT), and the appeal has yet to be listed for a hearing.”

So, Why Section 68 Remains The Biggest Problem?

According to Section 68 of the Income Tax Act, any amount credited in a taxpayer’s books, for which the explanations provided by the taxpayer are unsatisfactory in the opinion of the AO, will be treated as the taxpayer’s income.

Section 68 grants substantial power to AOs, which can become problematic for startups. As per founders, AOs often question why valuation predictions don’t match actual business results and argue that funding should be treated as income.

Commenting on this, Siddarth Pai, founding partner of 3one4 Capital, said, “AOs have the authority to request information they believe is important to make a decision. However, asking for shareholders’ ITRs from the companies and not the shareholders themselves is not appropriate.”

He pointed out that ITR details of investors are confidential, and they wouldn’t want to share them with a third-party company. Moreover, the tax department should be able to check the shareholders’ tax returns directly.

How Should Founders Deal With This Issue?

Finance minister Nirmala Sitharaman, during her budget speech earlier this year, proposed another amendment to Section 56(2) (viib) which brought non-resident investors under the ambit of the angel tax, impacting foreign investors. Amid a cold response from investors, the CBDT further proposed a set of amendments to Rule 11UA.

The latest notice has further created an outcry among the startups as none of the previous issues have been fully resolved to date.

Siddarth Pai suggested that startups which receive such notices from the I-T Department should not become an intermediary between the AO and investors. Instead, they should ask the AO to directly request this information from the investors under Section 133(6) of the Income Tax Act, 1961.

He suggested that the startups receiving such notice from the I-T Department should submit the following documents:

• PAN of the Investor
• Copy of the share certificate issued and the share application form filed by the investor. Share application forms are now required to include the bank details of the investor
• The contact information of the investor, such as phone number, address, and email ID. These are standard fields in any definitive agreement

Additionally, Pai said startups should clearly state the following in writing (in consultation with a lawyer or accountant, as this is merely indicative), “We, the undersigned company, have provided the details of our investors that are available with us. Upon asking them for the documents requested pursuant to the scrutiny notice dated [date], our investors have indicated that they will willingly comply with the request if it is made to them directly by the AO. Hence, we request the AO to obtain this information using the powers granted to them under Section 133(6) of the Income Tax Act, 1961.”

Will Indian Startups Get The Tax Breather As Promised? 

It’s been more than six years since the angel tax issue erupted and despite dozens of notifications and assurances, it still remains unresolved.

For instance, the exemption given to startups is also limited in numbers. Until February 2021, hardly 8% (3,612 startups) of then 44K recognised startups filed form 2 to avail exemptions under the angel tax.

There appears to be a gap between the I-T Department’s practices and the concerns of startups and investors when it comes to dealing with angel tax issues. The situation highlights the need for clearer and more equitable tax regulations and enforcement to support the growth of startups in India.

In the past, FM Sitharaman assured startups multiple times that they would not be harassed by AOs.

In August, 2019, when the angel tax issue dominated all discussions about the Indian startup ecosystem, Sitharaman told the press, “There won’t be any fishing expedition by officials. This is one way in which fears of harassment of assessee can be addressed. Unless a notice or document carries a DIN, it need not be taken seriously by the assessee at all.”

She said the government would continue to shift away from prosecution to monetary penalties for minor offences under the Companies Act and issue faster approvals to make life easier for businesses. “I want to assure that we are responsive and the reform process will continue. There is no intention to prosecute,” said Sitharaman.

She reiterated this in her FY21 Budget speech also.

However, there seems to be no change in the situation on the ground. “The way AOs ask questions about startups’ performance, not even investors ask that way,” a founder said.

“AOs need to be sensitised.” – This was the most common statement from founders and investors Inc42 spoke to. While they are prepared to tackle the business challenges head on, the never-ending battle with the I-T Department seems to have exhausted many in the Indian startup community.