In the early stages, startups often go through long periods of losses before breaking even. Many of them raise equity instead of debt, and every time new funding comes in, the ownership structure changes. But there’s a hidden tax problem buried in all this: when your cap table changes, you could lose the ability to carry forward your losses.
This blog — Part 5 of the M2K Startup Series — explains the rules that apply when a startup wants to carry forward and set off business losses. We’ll look at what Section 79 of the Income Tax Act says, what’s different for eligible startups, and how one small exception can actually make a big difference.
General provisions for carry forward & set off of losses
Under Section 79 of the Income Tax Act, 1961, a closely held company (that is, not widely held or listed) can lose the right to carry forward business losses if there’s a significant change in who owns the company.
The rule is simple but strict:
The people who collectively held at least 51% of the voting power in the company at the end of the year when the loss occurred — must continue to hold at least 51% of the voting rights in the year the company wants to set off that loss.
If this condition isn’t met, the company loses the right to use those losses — even if the business is still the same.
This rule doesn’t apply to unabsorbed depreciation, but it does apply to business losses — and that’s where startups get stuck.
The reason for this provision is to prevent tax avoidance — like acquiring a loss-making company just to use its past losses to reduce tax. But in the case of startups, the rule creates a problem even when there’s no intent to misuse anything.
Provisions in case of Start-ups
Startups often raise equity in multiple rounds. Every time new investors come in, the shareholding structure shifts, and sometimes quite drastically. In a normal company, this would mean that the losses from previous years would lapse — even though the business is still being run by the same founders.
To solve this, the Finance Act, 2017 made a much-needed amendment. It relaxed the Section 79 condition — but only for eligible startups.
Here’s how it works:
Even if there’s a substantial change in shareholding (i.e., more than 51%), eligible startups can still carry forward their losses as long as they meet two conditions:
- All the shareholders who held shares at the end of the year in which the loss occurred must continue to hold shares in the year the losses are being set off.
It doesn’t matter if their percentage of holding changes, as long as they still hold some shares. - The losses being carried forward must have been incurred within 7 years from the year of incorporation.
If both these are satisfied, the startup gets to keep and use its losses, even if its cap table has changed completely.
This is a significant relaxation — it recognises how startups actually operate, and removes a big tax risk that used to get triggered just because of routine fundraising.
Illustration on Carry forward & Set off of losses
Let’s look at how this works through a real example.
Scenario 1 – I Co. is not an Eligible Startup
In Year 1, I Co. incurs losses. It has three shareholders: A (50%), B (25%), and C (25%).
In Year 2, these shareholders no longer hold 51% of the shares collectively — a new shareholder D has come in and taken 65% of the company.
Result: Losses from Year 1 cannot be set off in Year 2. The ownership condition is broken.
Scenario 2 – I Co. is an Eligible Startup
Same situation. Year 1 has shareholders A (50%), B (25%), and C (25%).
In Year 2, their shareholding changes drastically: A drops to 1%, B jumps to 33%, and C drops to 1%. A new investor D comes in and takes 65%.
But the key point? A, B, and C still hold some shares, even if small.
Result: Since all original shareholders still hold shares, and I Co. is an eligible startup, the losses from Year 1 can be set off in Year 2.
So even though there’s a more than 51% change in shareholding, the condition is saved — because the original shareholders didn’t fully exit.
Final thoughts
This is one of those lesser-known provisions that can quietly eat into a startup’s tax planning if ignored.
In a startup, fundraising changes everything — including the ownership pattern. And if you’re not an eligible startup, even a small change can wipe out your ability to carry forward losses.
But thanks to the Finance Act 2017, eligible startups don’t have to be restricted by the 51% voting condition. As long as the original shareholders stay on the cap table — even with reduced stakes — and the loss is within 7 years from incorporation, the benefit stays.
So here’s what startup founders and CFOs should do:
- Keep track of who held shares in the year of loss
- Maintain at least some shareholding for all original investors or founders until losses are used
- Ensure the company remains within the 7-year limit
- And most importantly, ensure your startup qualifies as ‘eligible’ under DPIIT and IMB norms
If you’re planning to raise funds and you’ve got losses on your books, don’t wait till the last minute. Review your shareholding pattern, talk to your advisors, and make sure the relief under the relaxed Section 79 still applies.
One missed detail, and your past losses could become a paper trail with no value.
