Startups that have been ordered to pay tax despite valuations being marked down in recent funding rounds are challenging the demands, complaining that the move runs counter to the government's campaign to encourage entrepreneurial spirit.

With startup fever having waned over the past year or so amid concerns over profitability and competition, valuations have declined sharply. Last month, the tax department challenged such reductions at about 100 startups and issued orders seeking 33% tax at the elevated levels that prevailed earlier. Some startups have moved the income-tax tribunal against the notices while others have approached their advisers and could seek legal recourse in the coming days.

LetsRecycle, an Ahmedabadbased and Aavishkaar Ventures-backed waste management startup, was among those to get the tax demand and has challenged it at the Income-Tax Appellate Tribunal.

I-T notices as they have to struggle daily to improvise business processes," said LetsRecycle founder Sandeep Patel. "When I-T (income tax) acts this way, investors will be sceptical to invest, entrepreneurship will never be born and startups will never become (large) enterprises." He said his startup directly or indirectly employs 1,650 waste pickers, among them 200 from the weaker sections of the society.

Prime Minister Narendra Modi launched the Startup India programme in January last year as part of a campaign to create a conducive ecosystem for such companies to boost job creation.

The tax demand has been made for the assessment years 2013-14 and 2014-15 under Section 56(2)(vii)(b) of the Income-Tax Act, 1961. Experts said the Section was actually introduced to curb money laundering and was being wrongly aimed at genuine investment in startups.

ET reported on June 2 that startups with marked-down valuations may face tax notices. The Central Board of Direct Taxes (CBDT) subsequently issued a notification exempting government-registered startups on June 14.

"As feared, the tax officers have started challenging all investments prior to this amendment," said Amit Maheshwari, partner, Ashok Maheshwary and Associates LLP. "Tax officers have challenged the valuation methodology, assumptions and projections duly certified by merchant bankers or chartered accountants and this could be the ground on which this would be challenged by the startups."

While some startups weren't inclined to seek legal recourse, their investors are said to be nudging them to do so, said experts. According to people aware of the matter, SAIF Partners, a venture capital fund, is seeking legal opinion after some of the startups in which it has invested faced tax demands. An email sent to SAIF Partners and an SMS to CEO Ravi Adusumalli did not elicit any response. Other investors are also likely to push companies to challenge the tax demands.

"The government had allowed three years' tax break for startups and you are defying your own Prime Minister's verdict on startups," said Sumit Mehrra, CEO, Green Umbrella Investment Advisory, and an angel investor. "The whole logic is defeated when you are taxing a startup on perceived valuation. Taxing actual profit or gain is practical; taxing on notional gain will be obviously challenged by the startups."

In some cases, startups are looking to set off losses against the tax demand. However, this could trigger a new set of problems for the startups, experts said.

"Setting off of accumulated tax losses could lead to the tax demand on perceived overvaluation in many cases and the startups may still be penalised for concealment of income," said Maheshwari.

The flip-flop in policy makes no sense having offered tax breaks to young companies. The tax department should rescind its move to levy the tax on startups whose valuations have fallen on the grounds that the first premium was higher than the firm's fair value. The valuation rules must be simple and clear. Arbitrariness must be eschewed as investors need stability and certainty in tax policy. More so, when they take risks.