Foreign private equity (PE) and venture capital (VC) funds are increasingly pushing for tax-related indemnity clauses in their investment agreements with Indian startups, according to legal experts. This shift comes in response to a surge in direct and indirect tax notices targeting startups, prompting a need for greater protection against potential revenue losses due to unforeseen tax liabilities.
Historically, investment contracts included broad indemnity clauses covering general risks. However, recent trends show a distinct move towards incorporating specific tax indemnity provisions. These clauses are designed to shield investors from the financial impact of unexpected tax demands, which can have significant repercussions for startups.
Legal experts highlight that these indemnity clauses are becoming more detailed and expansive, with higher cap sizes reflecting the growing concern over tax-related risks. Tax insurance is also gaining popularity in India as a means to bolster indemnity provisions while allowing sellers to exit transactions without lingering fears of future claims.
One key driver for these indemnity demands is the need to ensure that startups make accurate tax representations and maintain robust compliance. In recent years, numerous startups have faced tax notices related to goods and services tax (GST), angel tax, and other direct taxes, including capital gains tax. Although the Union Budget 2024 abolished the angel tax for future transactions, existing demands remain in effect.
Legal experts note that startups, particularly in the fintech sector, are receiving increasing scrutiny from tax authorities. This scrutiny often results in tax notices seeking detailed explanations of funding sources and other financial activities. The potential penalties from such demands can exceed a startup’s revenue or market capitalization, and in some cases, startups must deposit 20% of the total tax demand before an appeal can be filed.
From an investor's perspective, including specific indemnity clauses is a prudent step to protect against unforeseen tax liabilities. This is particularly crucial given the perception among foreign PE and VC funds that some Indian startups may not maintain clear tax positions, leading to unexpected future notices.
For secondary transactions, investors are also requesting tax indemnity coverage. This may involve direct claims against the investor or indirect losses if tax demands affect the company's value. Additionally, Indian promoters and companies are increasingly seeking indemnity from foreign investors regarding capital gains tax issues, ensuring that any tax liabilities related to the sale or valuation of shares are covered.
Overall, the growing focus on tax indemnity underscores the need for startups and investors to navigate the complex tax landscape carefully and proactively manage potential risks.
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