Indian startups under I-T department scanner; gets tax notices over VC funding

In recent weeks, a wave of tax notices has swept through the Indian startup ecosystem, particularly targeting the fintech sector.

The Income Tax Department, under Section 68 of the Income Tax Act, has issued notices to various startups regarding the venture capital funding they have amassed. These notices have not only questioned the nature and source of these funds but have also combined the investments received with the startups' earned income, leading to hefty tax and penalty demands.

The hefty demands

One fintech startup, duly registered with the Department for Promotion of Industry and Internal Trade (DPIIT), found itself facing a staggering demand of Rs 37 crore in taxes and penalties on venture capital funding of Rs 40 crore.

The move by the tax authorities underlines the stringent scrutiny being applied to the financial inflows of startups, where failure to adequately explain the origin and nature of the funding can result in significant financial liabilities.

Documentation and compliance hurdles

Startups are now scrambling to comply with the demands for extensive documentation. The founder of one such fintech startup disclosed that despite submitting all required documents, including the Permanent Account Number (PAN) cards of investors, his company was still slapped with a tax demand.

The situation highlights the challenges startups face in proving the legitimacy of their funding sources to the satisfaction of the tax authorities.

Startups facing these tax demands have a tough time if they decide to appeal. To do so, they must first pay 20% of the total tax bill to the government. This rule can really stretch their budgets and affect how they run their business.

Broader implications and responses

The issuance of these tax notices, while not confined to any specific geographic location due to the faceless assessment process, has raised concerns among startups and investors alike. The Central Board of Direct Taxes (CBDT) has stated that assessments are carried out in a faceless manner, making it difficult to ascertain a targeted focus on Bengaluru-based or fintech startups specifically.

Meanwhile, the startup ecosystem is witnessing signs of recovery, with funding surging 43% month-on-month to $734 Mn in February, indicating resilient optimism amidst regulatory challenges.