TaxTMI 
TaxTMI 
A US angel investor wires money into an Indian startup. No equity is issued. No valuation is agreed. The investment sits as a promise - a legal instrument that will convert into shares at the startup's next funding round, at a discount to whatever price that round closes at.
This is what a convertible note is supposed to do. And in the United States, it does exactly that - cleanly, cheaply, and in a two-page document.
In India, the same outcome requires navigating three separate legal frameworks - the Companies Act, FEMA, and the Income Tax Act - each of which imposes conditions that have no equivalent in a US deal. Get any one of these wrong and the investment is either treated as an illegal deposit, a FEMA violation, or a transaction that cannot be reported to the RBI at all.
This blog explains the 2026 rules for convertible notes in Indian startups, who can issue them, what foreign investors must know before wiring money, and where the common mistakes happen - from a practical, compliance-first perspective.
WHAT A CONVERTIBLE NOTE IS UNDER INDIAN LAW
Under Indian law, a Convertible Note is defined in the Companies (Acceptance of Deposits) Rules, 2014. The definition is specific: it is an instrument evidencing receipt of money initially as debt, which is repayable at the option of the holder or convertible into equity shares of the startup company upon the occurrence of specified events and as per agreed terms.
Three words in that definition matter enormously: initially as debt. Unlike a US SAFE - which is not classified as debt and carries no interest or repayment obligation - an Indian convertible note is debt from the moment it is issued. It sits on the Indian startup's balance sheet as a liability. It must comply with the Companies Act's requirements for borrowing. If it carries interest, that interest is income for the foreign investor and withholding tax obligations for the startup.
This distinction between convertible notes and SAFEs is not semantic. It has real consequences for the startup's compliance obligations, the investor's tax position, and the RBI reporting requirements that attach to the investment.
THE FOUR NON-NEGOTIABLE CONDITIONS UNDER FEMA AND COMPANIES ACT
For a convertible note to be issued legally to a foreign investor - whether a US angel, a UK seed fund, or a Singapore family office - four conditions must all be satisfied simultaneously. If any one is missing, the instrument cannot be issued under the FEMA carve-out, and the money received may be treated as an illegal deposit under the Companies Act.
Condition 1: The Company Must Be a DPIIT-Recognised Startup
The single most important precondition. Only a startup that has been formally recognised by the Department for Promotion of Industry and Internal Trade (DPIIT) under the Startup India programme can issue convertible notes to foreign investors.
DPIIT recognition requires the company to be a Private Limited Company incorporated under the Companies Act, 2013, to have been incorporated within the last 10 years from the date of application, to have annual turnover not exceeding Rs. 100 crore in any financial year since incorporation, and to be working toward innovation, development, or commercialisation of a new product or process or scalable business model.
A company that does not have DPIIT recognition cannot issue convertible notes to anyone - resident or non-resident - under the FEMA carve-out. If it receives money under a convertible note without this recognition, the amount received is classified as a Deposit under the Companies Act, triggering compliance requirements that startups are explicitly trying to avoid.
Condition 2: Minimum Investment of Rs. 25 Lakh Per Tranche Per Investor
Every convertible note issued - to any investor, resident or foreign - must represent a minimum investment of Rs. 25 lakh (approximately USD 30,000) in a single tranche from a single investor.
This is not negotiable and cannot be aggregated across multiple smaller tranches from the same investor to reach the threshold. Each tranche independently must meet the Rs. 25 lakh floor. A US angel investor who wants to put in Rs. 15 lakh cannot use a convertible note - the available alternatives are a priced equity round or a CCPS-based iSAFE structure.
For early-stage rounds where multiple investors are writing small cheques, this threshold is a practical constraint. It means convertible notes in India are not the instrument for Rs. 5 to Rs. 10 lakh investments from friends and family - they are designed for structured angel rounds where each investor is putting in meaningful capital.
Condition 3: The Note Must Be Converted or Repaid Within 10 Years
Convertible notes issued to foreign investors must either convert into equity shares or be fully repaid within 10 years from the date of issuance. The 2023 amendment to the FEMA Non-Debt Instruments Rules extended this from the earlier 5-year maximum, giving startups significantly more runway before mandatory conversion or repayment.
If a note reaches its maturity date without having been converted and without being repaid, the company is in default. For FEMA purposes, an unconverted, unrepaid foreign convertible note that has crossed its tenor is a regulatory violation that may require RBI compounding.
Condition 4: The Company Must Operate in a Sector Open to 100% FDI Under the Automatic Route
Because convertible notes from foreign investors are classified as foreign direct investment under FEMA, they are subject to FDI sectoral policy. If the startup operates in a sector where foreign investment requires government approval or is capped below 100%, the convertible note cannot be issued without satisfying those sectoral conditions first.
For most technology, SaaS, e-commerce (B2B), and product companies - the sectors where the vast majority of convertible note deals occur - 100% FDI under the automatic route applies. There is no government approval required, and the FEMA carve-out for convertible notes applies cleanly.
WHAT HAPPENS AT CONVERSION - WHERE MOST FOUNDERS GET SURPRISED
The convertible note framework defers the valuation conversation. But it does not defer the FEMA pricing requirements - it just moves them to the conversion event.
Under FEMA, when a convertible note converts into equity shares, the conversion price cannot be lower than the Fair Market Value (FMV) of the shares at the time the note was originally issued - not at the time of conversion.
This is a critical distinction that many founders and investors overlook. In a US convertible note, the investor benefits from a discount or a valuation cap that may result in shares being issued at a price significantly below the current round's pricing. In India, FEMA's pricing floor means that if the FMV at the time the note was issued was Rs. 100 per share, the conversion price cannot go below Rs. 100 - regardless of any discount agreed in the term sheet.
The FEMA pricing requirement effectively limits the benefit that a valuation cap or discount can deliver to a foreign convertible note investor. If the startup's valuation has grown significantly between the note issuance and the next priced round, the investor's conversion at a heavy discount may run into the FMV floor - converting at the cap or discount rate might still satisfy FEMA's pricing requirement, but only if the FMV at the original issuance date was below the conversion price.
This is not theoretical. It is a live issue in most convertible note conversions involving foreign investors, and it requires a SEBI-registered Category I Merchant Banker or a Registered Valuer to issue an FMV certificate at the time the note is issued - so that the FMV floor is documented upfront, not reconstructed under audit pressure when conversion is being executed.
THE RBI REPORTING REQUIREMENT - FORM CN AND THE 30-DAY DEADLINE
Every issuance of a convertible note to a foreign investor triggers a mandatory reporting obligation to the RBI. This is handled through Form CN on the RBI's FIRMS (Foreign Investment Reporting and Management System) portal, and must be filed within 30 days of the date of issuance.
The Form CN filing requires:
- Details of the startup company (CIN, DPIIT recognition certificate number, sector)
- Details of the foreign investor (name, country of residence, PAN or equivalent)
- Amount received, date of receipt, and purpose code
- The Foreign Inward Remittance Certificate (FIRC) from the startup's Authorised Dealer bank
- KYC documentation of the foreign investor
Missing the 30-day deadline attracts a Late Submission Fee under FEMA. Failing to file Form CN at all - which happens when founders treat the convertible note as a simple loan and do not consult a FEMA advisor - creates a FEMA contravention that must be compounded with the RBI before any subsequent equity round can be regularised. Most institutional investors at Series A will require a clean FEMA compliance history as a condition of closing.
WHY US-STYLE SAFE NOTES DO NOT WORK FOR FOREIGN INVESTORS IN INDIA
The Y Combinator SAFE - Simple Agreement for Future Equity - is the dominant early-stage investment instrument in US startup deals. It is not debt. It carries no interest. It has no maturity date. It converts into equity at the next priced round automatically.
None of these features survive contact with Indian company law. A SAFE issued to a foreign investor in India is not recognised as a security under the Companies Act and is not classified as an FDI instrument under FEMA. An AD bank presented with a foreign inward remittance linked to a SAFE has no recognised reporting mechanism to process it - which means it either cannot be received legally, or it is treated as a deposit or loan, with entirely different compliance implications.
The market solution is the iSAFE - India SAFE - which preserves the economic intent of a US SAFE (deferred valuation, discount, cap) but implements it through Compulsorily Convertible Preference Shares (CCPS). The CCPS are a recognised FDI instrument under FEMA, the investment can be reported, and the automatic conversion at a qualifying event can be structured through the CCPS terms. The legal documentation is longer and more expensive than a US SAFE, but it is FEMA-compliant.
For foreign investors who are firmly committed to a SAFE structure, experienced Indian counsel will typically convert the SAFE economics into a convertible note structure - preserving the valuation cap and discount - and apply FEMA's convertible note framework. The economics remain similar; the legal instrument changes to comply with Indian law.
THE INTEREST ON CONVERTIBLE NOTES - A TAX TRAP MOST FOUNDERS MISS
Because a convertible note is classified as debt under Indian law until it converts, any interest accruing or payable on the note is subject to tax treatment.
For a foreign investor receiving interest on a convertible note issued by an Indian startup, the interest income is taxable in India through withholding tax. The Indian startup must deduct TDS on the interest at the applicable rate - 20% under domestic law, or a reduced rate under the applicable DTAA if the foreign investor provides a Tax Residency Certificate.
The interaction between convertible note interest and FEMA's External Commercial Borrowing framework also requires attention. While convertible notes are exempt from certain ECB regulations under the FEMA Non-Debt Instruments Rules, interest payments to foreign note holders are cross-border payments that require proper documentation and purpose coding through the AD bank.
Many early-stage startups issue convertible notes that accrue interest on paper but defer actual payment to conversion or repayment. This creates a deferred interest liability on the balance sheet. At conversion, if the accrued interest is capitalised and converted into additional equity shares, the FEMA pricing and TDS implications of that interest capitalisation must be addressed in the conversion documentation.
COUNTRY-SPECIFIC RESTRICTIONS - INVESTORS FROM LAND-BORDER NATIONS
FEMA imposes an additional layer of restriction for investors from countries that share a land border with India: China, Pakistan, Bangladesh, Nepal, Myanmar, Bhutan, and Afghanistan. Direct and indirect investment from investors in these countries - including through convertible notes - requires prior government approval under the government route, regardless of the sector.
This restriction applies to beneficial ownership, not just the nominal investor. A convertible note issued to a Cayman Islands SPV that is beneficially owned by a Chinese investor triggers the land-border country restriction. Founders running angel rounds that include investors from these jurisdictions - or from funds with exposure to investors from these jurisdictions - must flag this before accepting the investment.