Convertible Note (FEMA NDI Rules, Rule 2(1)(d))

By Sneha Iyer | Updated March 2026

What Is a Convertible Note?

A convertible note is an instrument evidencing receipt of money initially as debt, which is either repayable at the option of the holder or convertible into equity shares of the issuing startup upon the occurrence of specified events. The instrument is defined under Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014 and separately under Rule 2(1)(d) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) for foreign investment purposes. Only companies recognised as startups by the Department for Promotion of Industry and Internal Trade (DPIIT) can issue convertible notes.

For foreign investors, convertible notes offer a way to invest in Indian startups without needing an immediate equity valuation. Instead of negotiating a share price upfront, the investor lends money that automatically converts into equity at the next priced funding round — typically at a discount or with a valuation cap that rewards early risk. This makes convertible notes the fastest instrument to close a cross-border angel deal in India, often requiring less documentation than Compulsorily Convertible Preference Shares (CCPS) or equity rounds.

Convertible notes were introduced into Indian law through a notification dated 29 June 2016 that amended the Companies (Acceptance of Deposits) Rules, 2014. Prior to this, Indian startups had no simple debt-to-equity conversion instrument comparable to the convertible notes widely used in Silicon Valley. The 2016 amendment, followed by the FEMA NDI Rules 2019, created a structured legal pathway for both domestic and foreign investors to use convertible notes in India.

Legal Basis

The convertible note framework sits at the intersection of company law and foreign exchange law:

• Rule 2(1)(c)(xvii) of the Companies (Acceptance of Deposits) Rules, 2014 — Defines "convertible note" and exempts amounts of INR 25 lakh or more received by a startup company via convertible notes from the definition of "deposits," provided the note is convertible or repayable within 10 years from the date of issue (amended from 5 years by MCA Notification dated 22 January 2019).
• Rule 2(1)(d) of the FEMA (Non-debt Instruments) Rules, 2019 — Defines convertible note for foreign investment purposes as an instrument issued by a startup company evidencing receipt of money initially as debt, repayable at the holder's option or convertible into equity shares within a period not exceeding 5 years (the FEMA timeline has not been extended to 10 years).
• Schedule I, Paragraph 4 of the NDI Rules, 2019 — Permits a person resident outside India (excluding citizens of Pakistan and Bangladesh) to purchase convertible notes issued by an Indian startup company for an amount of INR 25 lakh or more in a single tranche.
• Section 62(3) of the Companies Act, 2013 — Governs the issuance of debt instruments convertible into shares, requiring a special resolution. Form MGT-14 must be filed with the Registrar of Companies within 30 days.
• FEMA Notification No. FEMA 20(R)/2017-RB — The master regulation governing foreign investment in India, under which convertible note provisions were originally introduced before being consolidated into the NDI Rules.

How Convertible Notes Work: Mechanics and Structure

A convertible note in India operates through a straightforward lifecycle:

Step 1: Issuance

The startup issues the convertible note to the investor. The investor transfers funds — for non-residents, via inward remittance or debit to an NRE or FCNR account. The minimum investment from a non-resident investor is INR 25 lakh (approximately USD 30,000) in a single tranche. There is no maximum cap — the amount is governed by FDI sectoral caps applicable to the startup's sector.

Step 2: Interim Period

The note accrues interest (typically 4%–8% per annum, negotiated between parties). The startup uses the funds for operations. The investor holds debt, not equity — no voting rights, no board seat, no cap table entry yet.

Step 3: Conversion or Repayment

Upon a specified trigger event (usually a qualified financing round), the note converts into equity shares at a pre-agreed formula — typically the lower of (a) a valuation cap or (b) a discount (15%–25%) to the price paid by new investors. If no trigger event occurs within the note's tenure, the investor can demand repayment of principal plus accrued interest.

Key Terms in a Convertible Note Agreement

FDI Rules for Convertible Notes

Foreign investment in convertible notes is subject to specific conditions under the NDI Rules that do not apply to domestic investors:

Eligibility Requirements

• The issuing company must be a DPIIT-recognised startup — not merely a private limited company
• The non-resident investor must invest a minimum of INR 25 lakh in a single tranche
• Citizens of Pakistan and Bangladesh, and entities incorporated in those countries, are prohibited from investing in convertible notes
• The investment must comply with FDI sectoral caps and conditions applicable to the startup's sector of activity
• The note must convert or be repaid within 5 years from the date of issuance (under FEMA — note the divergence from the 10-year Companies Act timeline)

Payment Channels

The consideration must be received through:

• Inward remittance through banking channels, or
• Debit to NRE or FCNR(B) account of the non-resident investor maintained with an Authorised Dealer bank in India

Transfer of Convertible Notes

A non-resident investor can transfer convertible notes to another person resident in or outside India, subject to:

• Compliance with RBI pricing guidelines
• Reporting the transfer within 30 days
• The transferee meeting all eligibility conditions (DPIIT startup, minimum INR 25 lakh, etc.)

Convertible Note vs. CCPS vs. SAFE: Which Instrument to Use?

Foreign investors evaluating Indian startup deals frequently compare three instruments. Here is how they stack up:

Conversion Triggers and Pricing

The convertible note agreement specifies events that trigger conversion. Common triggers include:

• Qualified Financing Round: The most common trigger — typically defined as a priced equity round above a threshold (e.g., INR 1 crore or more). The note converts at the lower of the valuation cap or the discounted price.
• Maturity Date: If no qualifying round occurs within the tenure, the note may convert at a pre-agreed valuation (often the valuation cap) or be repaid with interest.
• Change of Control / Acquisition: If the startup is acquired, the note typically converts immediately before the acquisition closes, so the investor participates in the exit proceeds.
• IPO: The note converts into shares at the IPO price (minus any agreed discount).

On conversion, the startup must issue equity shares at fair market value to comply with FEMA pricing norms. The conversion price cannot be lower than the FMV determined in accordance with internationally accepted pricing methodologies on an arm's length basis, as required for any FDI transaction.

Tax Treatment

During the Note's Tenure

Interest accrued on the convertible note is taxable income for the investor. If the investor is a non-resident, the startup must deduct TDS at the applicable rate (typically 5% for interest under most DTAAs, or 20% without a DTAA) when crediting or paying the interest.

On Conversion

The conversion of a convertible note into equity shares is generally not treated as a "transfer" under the Income Tax Act, 1961, and therefore does not trigger capital gains tax at the time of conversion. The investor's cost of acquisition for the newly issued shares is the original note amount plus any accrued interest that has already been subjected to tax.

On Sale of Converted Shares

When the investor eventually sells the equity shares received on conversion, capital gains tax applies based on the holding period calculated from the date of conversion (not the date of the original note investment). For unlisted shares: short-term if held for 24 months or less (taxed at the applicable slab rate for non-residents, or 30% for domestic companies), and long-term if held beyond 24 months (taxed at 20% with indexation benefits, or 12.5% without indexation under Section 112 post-Budget 2024 amendments).

On Repayment

If the note is repaid instead of converted, the principal repayment is not taxable. However, the interest component is taxable as income from other sources for the investor, with TDS obligations on the startup.

Reporting Requirements

Convertible notes involving foreign investors trigger multiple reporting obligations:

Late filing of Form CN or FC-GPR is a contravention under FEMA, 1999. The penalty under Section 13 of FEMA can be up to three times the amount involved or INR 2 lakh where the amount is not quantifiable. However, following the April 2025 amendment, RBI has capped compounding amounts at INR 2,00,000 for certain reporting contraventions, provided the company voluntarily approaches RBI and files overdue forms.

How This Affects Foreign Investors in India

Convertible notes are one of the most investor-friendly instruments available for early-stage cross-border deals into India, but they come with unique constraints:

• INR 25 lakh minimum: Unlike in the US where a convertible note can be for any amount, India mandates a minimum of INR 25 lakh (~USD 30,000) per tranche for non-resident investors. This effectively excludes micro-angel checks.
• DPIIT recognition is mandatory: The startup must have valid DPIIT recognition. If recognition lapses or is not obtained, the convertible note issuance to a non-resident is not permissible under FEMA — making it a potential FEMA contravention.
• 5-year FEMA deadline vs. 10-year Companies Act limit: Foreign investors face a stricter 5-year conversion/repayment window under FEMA, even though the Companies Act allows 10 years. This mismatch means a note issued to a domestic investor can remain outstanding for 10 years, but a note held by a foreign investor must convert or be repaid within 5 years.
• No direct equity rights: Until conversion, the foreign investor holds debt, not equity. This means no voting rights, no anti-dilution protection, and no board representation unless separately negotiated in a side letter.
• FEMA reporting burden falls on the company: The Indian startup (not the foreign investor) is responsible for filing Form CN and FC-GPR. If the startup fails to file, the investor's capital is at regulatory risk.

Common Mistakes

• Issuing convertible notes without valid DPIIT startup recognition. DPIIT recognition is a prerequisite, not an optional benefit. If the startup's recognition has lapsed (it must be renewed if the entity is over 10 years old) or was never obtained, issuing a convertible note to a non-resident is a FEMA contravention — potentially attracting penalties up to three times the investment amount.
• Confusing the 5-year FEMA deadline with the 10-year Companies Act limit. Many founders assume the 10-year tenure (introduced by the January 2019 MCA amendment) applies universally. It does not. For non-resident investors, the NDI Rules cap conversion/repayment at 5 years. Breaching this deadline means the note is non-compliant under FEMA from day one.
• Failing to file Form CN within 30 days of receiving funds. Startups focused on product development often overlook FEMA reporting. The 30-day clock starts from the date funds hit the bank account, not the date of executing the note agreement. Late filing requires a voluntary compounding application to RBI, adding cost (INR 50,000–2,00,000) and months of delay.
• Not obtaining a valuation report at conversion. While no valuation is needed when issuing the note, conversion into equity shares triggers FEMA pricing norms. The company must obtain a valuation from a SEBI-registered merchant banker or a chartered accountant confirming FMV. Issuing shares below FMV to a non-resident is a pricing violation under FEMA.
• Structuring a SAFE agreement and calling it a convertible note. SAFEs and iSAFE instruments lack explicit FEMA recognition. Some startups draft what is functionally a SAFE (no interest, no maturity date, no repayment right) but label it a "convertible note" to fit within the FEMA framework. RBI can look through the label to the substance — and a mislabeled SAFE may be treated as an unrecognised instrument.

Practical Example

NovaBridge Pte Ltd, a Singapore-based angel investor, wants to invest USD 50,000 (approximately INR 42 lakh) in FinSolve Pvt Ltd, a DPIIT-recognised fintech startup based in Bengaluru. The parties agree on a convertible note with the following terms:

• Principal: INR 42,00,000
• Interest: 6% per annum, simple interest
• Valuation cap: INR 15 crore
• Discount: 20% to the next qualified financing round price
• Conversion trigger: Equity round of INR 2 crore or more
• Maturity: 3 years (well within the 5-year FEMA limit)

Compliance steps at issuance: FinSolve passes a special resolution under Section 62(3) of the Companies Act and files MGT-14 with the ROC. NovaBridge remits USD 50,000 via banking channels. FinSolve files Form CN on the FIRMS portal within 30 days of receiving the funds.

18 months later: FinSolve raises a Series A at a pre-money valuation of INR 25 crore. The conversion price is the lower of:

• Valuation cap price: INR 15 crore / fully diluted shares = INR 150 per share
• Discount price: Series A price of INR 250 per share × (1 – 20%) = INR 200 per share

The note converts at INR 150 per share (the valuation cap applies). By this time, the note has accrued 18 months of interest: INR 42,00,000 × 6% × 1.5 = INR 3,78,000. Total conversion amount = INR 45,78,000.

Shares issued to NovaBridge: INR 45,78,000 ÷ INR 150 = 30,520 equity shares.

Had NovaBridge invested directly in the Series A at INR 250 per share, it would have received only 16,800 shares. The convertible note's valuation cap and accrued interest gave NovaBridge 82% more shares — the reward for taking early-stage risk.

Post-conversion reporting: FinSolve files FC-GPR within 30 days of allotting the 30,520 shares. TDS at 5% (under the India-Singapore DTAA) is deducted on the interest component of INR 3,78,000 before conversion — INR 18,900 is deposited with the government.

Key Takeaways

• A convertible note is a debt instrument that converts into equity shares upon a trigger event — it is the fastest way for a foreign angel investor to fund an Indian startup without an upfront valuation
• Only DPIIT-recognised startups can issue convertible notes; non-resident investors must invest a minimum of INR 25 lakh per tranche
• The conversion/repayment deadline is 5 years under FEMA (for NR investors) and 10 years under the Companies Act (for domestic investors) — a critical distinction that founders often miss
• Form CN must be filed within 30 days of receiving funds; FC-GPR must be filed within 30 days of allotting shares on conversion — late filing is a FEMA contravention
• Conversion into equity is not a taxable event, but interest is taxable and TDS must be deducted for non-resident investors
• Convertible notes offer simpler documentation than CCPS but have stronger legal standing than SAFEs under Indian law

Structuring a convertible note round with foreign investors or need help with DPIIT recognition and FEMA reporting? Beacon Filing provides end-to-end fundraising compliance services covering note documentation, Form CN filing, valuation coordination, and FC-GPR reporting on conversion.