Foreign investors demand tax indemnities for startup investments

PE and VC funds are increasingly seeking tax indemnity

Foreign private equity and venture capital funds are increasingly demanding indemnification from Indian startups against tax-related regulatory risks following a slew of direct and indirect tax notices to them, legal experts said.

The indemnity clauses are aimed at protecting investors from the fallout of tax demands on startups by requiring startups to compensate investors for revenue losses because of unanticipated tax notices, the experts said.

Until recently, investment contracts carried a general indemnity clause that applied to any unanticipated development in the company, but now PEs and VCs are insisting on tax-related indemnity, the experts said.

“Tax indemnity provisions are becoming increasingly comprehensive, with rising indemnity cap sizes,” said Abhay Sharma, a partner at Bombay Law Chambers. “Tax insurance is also gaining traction in the Indian market as deal parties aim to ensure robust indemnity provisions while allowing sellers to exit without concerns over future claims.”

One of the key reasons for funds seeking such a clause is to nudge the companies to make accurate tax representations to the investors and to ensure better compliance, legal experts said.

In the past few years, several startups have received notices pertaining to goods and services tax (GST), angel tax and other direct taxes, including capital gains tax, where the company is required to collect withholding tax from exiting non-resident investors.

In the Union Budget 2024, the government abolished the controversial angel tax with prospective effect, meaning existing tax demands have not been withdrawn. However, there will be no such tax demands in the future.

Legal experts said that on the income tax front, several startups, especially fintech companies, are receiving tax notices seeking explanations on the nature and source of funding.

“The penalties sought by the authorities may be more than the revenue or the market capitalisation of the startups. Additionally, in the event of an adverse decision, startups are required to deposit 20 percent of the total tax demand before an appeal can be admitted,” said Rashmi Deshpande, founder of Fountainhead Legal. “From an investor’s perspective, the inclusion of specific indemnity clauses is a prudent measure to safeguard their investments against such unforeseen tax liabilities.”

These measures have come at a time when there is a growing perception among the foreign PE and VC funds that some Indian startups were not taking clear tax positions, which could often lead to unexpected notices in the future, say legal experts.

“For secondary transactions also, investors ask for indemnity coverage related to tax demand, which may relate to a direct claim against the investor due to the company’s defaults or an indirect loss caused to the investor if the demand is made on the company for the decrease in value of the company in which they have invested,” said Akshat Pande, managing partner at Alpha Partners.

In some cases, the companies are also seeking tax indemnity from foreign funds in cases involving capital gains tax. “If there is a sale of shares of a foreign investor in a negotiated deal, the Indian promoters and the company (of which the shares are being traded) also have started asking for indemnity from the selling investor against a tax demand, which may be related to the sale price or valuation etc., for which the investor will have to indemnify the company/promoters in case the notice is sent to them, since they will be in India,” Pande added.