Can the “source of funds” rule in the budget hinder non-venture capital investments in start-ups?

The 2022 Union budget, which had the digital theme emblazoned throughout, received a mixed response from the start-up community. While capping long-term capital gains at 15% is seen as a good move that will benefit startup founders, investors, and ESOP holders, there is an amendment to Section 68 of income tax law in the finance bill. , 2022 which imposes an additional compliance burden on start-ups to declare the source of funds “whether in the form of a loan or a borrowing”. The rule amendment does not apply to the venture capital fund/company registered with the Securities Exchange Board of India (SEBI).

The nature of the borrower/non-regulated businesses or the source of the sum in the form of credit/commitment will be considered explained if only the source of the funds is explained.

According to legal experts, this translates into the fact that unlisted companies have to prove the authenticity/solvency of the creditor. This is gaining importance as many start-ups raise funds from high net worth individuals and family offices in India and abroad.

Darshan Bora, Partner, Economic Laws Practice, said that under Section 68 of the Income Tax Act, the IT department is empowered to impose tax on any amount credited in the books of accounts if the credit recipient is unable to satisfactorily explain the nature and source of such sum.

“The proposed amendment makes this provision more onerous. Once the proposed amendment is effective, in addition to the beneficiary of a loan or borrowing, even the lender may be called upon to provide justification on the nature and source of the funds lent by him,” Bora said. .

“If the lender is unable to provide a satisfactory explanation, the amounts may be taxed as income in the hands of the loan recipient. This will increase the compliance burden for start-ups that receive loans or borrowings. This provision does not apply to sums received from a venture capital fund or a venture capital company. A similar provision exists for the issuance of registered capital and tax authorities have imposed a tax on registered capital receipts, which has led to disputes in the past,” he added.

According to Paras Nath, Partner, Tax and Regulatory Services, TR Chadha and CO LLP, this will also effectively address the issue of funding source which remains unexamined.

“There are many cases where the appraised person receives money in the form of loan, advance, share request money, etc. Explain. However, with regard to loans and advances of other kinds, they are not covered by the mentioned clarification,” said Nath.

“It has been held in various court decisions that to prove the authenticity of these loans and advances, the assessee must prove the identity and creditworthiness of the creditor. As a result, assessees were ridding themselves of liability by simply providing the lender’s PAN and ITR to establish these credits (loans and advances, etc.) on the books,” he noted.

“It has not always been possible for Revenue to review creditors’ books with reference to these credit transactions due to multiple challenges such as difference in jurisdiction, inability to review due to different years of involved, etc. Therefore, to strengthen the system and to verify the authenticity of the source of funds received by the assessee, the proposed amendment to Article 68 maintaining the assessee must also prove the source of funds in the hands of the creditor,” he added.

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