Mumbai Income tax authorities have issued notices to several startups in connection with the share premium money they received a couple of years ago, said two people in the know.

The tax department has asked for details of the nature and the source of the investments and the credit worthiness of the investors. It has also questioned the valuation and pricing of the shares issued to the investors by the startups, and asked for a justification for the said valuation.

Experts said that these actions of the tax department could be detrimental to the growth of the startup ecosystem and foreign direct investment in the country.

“Almost in all such cases, the funds received by the startups are from reputed investors, who have made substantial FDI investments in India over several years,” said Punit Shah, Partner, Dhruva Advisors.

Angel tax provisions

“Even foreign investments, which were earlier exempt from angel tax, have now come under its ambit under section 56. Fresh notices under section 68 are now adding to the woes of startups. All this doesn’t augur well for an ecosystem that’s supposed to be a key job creation engine,” added Nikunj Bubna, CEO of TheWowBox India.

The Finance Act, 2023, brought investments by non-residents in unlisted Indian companies at a price more than the fair market value within the ambit of angel tax provisions.

Investment valuation

According to Shah, section 56(2)(viib) or section 68 are essentially anti-abuse provisions and should be used by the tax department only in the suspected cases of tax evasion or avoidance and not in cases where capital is received from credible investors. In the past, CBDT has instructed to the tax department not to unnecessarily question the share capital or premium infusion in startups and their valuation, said Shah.

To justify the high share premium, investors may need to furnish the valuation report for the issuance of securities at a premium and audited financials of the company during and after the fundraising . Documents required to establish investors’ creditworthiness may include the last three years’ tax returns, bank statements, and financials.

To be sure, registered startups that fulfil certain conditions as per the notification issued by DPIIT are exempt from angel tax provisions. A CBDT notification has clarified that assessment in relation to provisions of the angel tax shall not be carried out in the case of such start-ups.

“We have observed income tax officers honouring the notification in the assessment of eligible cases. The section 68 provisions relating to cash credits, however, operate independently of the angel tax provisions,” said Yashesh Ashar, Partner, Illume Advisory.

He added that providing the relevant source of money belonging to resident investors (as a part of the assessment) will require the cooperation of the concerned investors.

Section 56(2)(viib) deals with matters related to “high share premium” and “valuation” of investments in startups. Section 68 pertains to the creditworthiness or bonafide of the investors in such startups.