How India’s Income Tax Department is reshaping startup funding with stricter scrutiny and what founders and investors must do to stay compliant
A New Era of Tax Scrutiny for Indian Startups
India’s booming startup ecosystem, once celebrated for its innovation and rapid growth, is now facing a wave of intense scrutiny from the Income Tax Department. In April 2025, hundreds of startups and their investors received notices demanding detailed disclosures about the origins of their funds, especially where investments appeared to be routed through tax havens or complex financial structures. This marks a significant shift in how authorities are policing the flow of capital into India’s high-growth companies.
What Is Fund Round-Tripping—and Why Is It Under the Scanner?
Fund round-tripping is a practice where money is sent from India to foreign jurisdictions (often tax havens) and then brought back as foreign direct investment (FDI) into Indian companies, sometimes the same ones that sent the money out in the first place. While some cross-border investments are legitimate, round-tripping can be a cover for money laundering, tax evasion, or masking the true source of funds.
Authorities are particularly concerned about startups not recognized by the Department for Promotion of Industry and Internal Trade (DPIIT), as these companies do not benefit from certain tax exemptions and may fall outside standard regulatory oversight.
The Latest Crackdown: What’s Happening Now?
In the first two weeks of April 2025, the Income Tax Department issued a wave of notices under Section 68 of the Income Tax Act. This section empowers tax officials to question any unexplained credits in a taxpayer’s accounts. Startups and their backers were asked to provide:
- Income tax returns for the three years preceding the investment
- Bank account statements
- Proof of income for investors and promoters
A senior tax official explained, “In most cases, the investment came from tax havens and there were multiple transactions just to mask the real source of funds”. Where satisfactory explanations were not provided, investigations continued. However, DPIIT-recognized startups that file the necessary Form 2 declaration remain eligible for exemptions and are not subject to this level of scrutiny.
High-Profile Cases and Sector Impact
The crackdown has already ensnared notable startups. Gensol, linked with the ride-hailing platform BluSmart, and Medikabazaar, a B2B health-tech company, have both faced allegations of fund diversion and fraudulent disclosures. In March 2025, about 300 private equity firms and startup promoters received similar notices related to capital gains tax, with estimated tax evasion reaching Rs 4,500 crore.
These high-profile cases have rattled investor confidence and raised questions about governance and transparency in the startup sector. For instance, the removal of Medikabazaar’s CEO amid allegations of “malicious and fraudulent activities” highlights the governance risks when financial flows are not transparent.
Why This Matters: Risks and Compliance Challenges
The risks of fund round-tripping are significant:
- Legal Exposure: Startups and investors found violating the Foreign Exchange Management Act (FEMA) or the Prevention of Money Laundering Act (PMLA) can face penalties, asset freezes, or prosecution.
- Investor Reluctance: Many investors are hesitant to share personal tax records or sources of funds, especially for small investments, complicating compliance for startups seeking capital.
- Missed Opportunities: Non-compliance can lead to missed funding opportunities, as investors increasingly scrutinize tax and regulatory compliance before committing capital.
New Regulatory Measures: Tighter Controls and Reporting
Recent updates from the Reserve Bank of India (RBI) and Enforcement Directorate (ED) have introduced stricter reporting requirements for startups receiving foreign funds. Key measures include:
- Mandatory detailed documentation of the source and destination of foreign investments
- More rigorous scrutiny of cross-border transactions, especially those involving multiple layers of foreign entities or shell companies
- Real-time compliance checks on foreign direct investment (FDI) limits and sectoral caps
Practical Steps for Startups and Investors
To navigate this new environment, startups and their backers should:
- Conduct thorough due diligence on all investors, especially those based in or routing funds through tax havens.
- Maintain transparent ownership structures and avoid complex, opaque arrangements that raise regulatory red flags.
- Ensure timely and accurate reporting of all foreign investments, using prescribed forms and documentation.
- Stay updated on the latest legal and regulatory changes, working closely with legal and financial advisors.
The Road Ahead: Toward a Culture of Transparency
India’s startup ecosystem is at a crossroads. While the current crackdown may feel disruptive, it also offers an opportunity for genuine entrepreneurs to build stronger, more transparent businesses. As regulatory expectations rise, transparency, accountability, and compliance are no longer optional—they are essential for long-term success.
Startups that embrace these principles will not only avoid legal trouble but also build greater trust with investors, customers, and partners, laying the foundation for sustainable growth in the years ahead.
Summary Table: Recent Startup Tax Scrutiny in India
| Aspect | Details/Statistics |
|---|---|
| Notices Issued | Hundreds in April 2025; 300 PE firms in March |
| Estimated Tax Evasion | Rs 4,500 crore (capital gains-related) |
| DPIIT Recognition | Exempts startups from scrutiny if compliant |
| High-Profile Cases | Gensol, Medikabazaar |
| Key Laws | Income Tax Act (Section 68), FEMA, PMLA |
Stay compliant. Stay transparent. Build for the long term.
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