A Comprehensive Guide for IT Startups Raising Funds: Convertible Note Tax Risks India

Raising capital fuels the growth of every startup. In India’s vibrant IT startup ecosystem, convertible notes have become a preferred tool for early-stage fundraising. They allow founders to secure capital quickly without fixing a company valuation right away. This flexibility benefits startups, but it also creates a web of convertible note tax risks in India. Founders and investors must manage these risks carefully, because ignoring them can lead to heavy tax liabilities and regulatory scrutiny.

A recent Inc42 report shows that Indian startups raised USD 25 billion in 2022, proving the strength of the ecosystem. While convertible notes simplify fundraising, they also bring unique challenges. This guide breaks down the convertible note tax risks in India and gives founders and business leaders clear, actionable strategies to stay compliant.

Why Tax Authorities Scrutinise Convertible Notes: Convertible Note Tax Risks India

Convertible notes act as hybrid instruments. They begin as debt but convert into equity later, usually during a new funding round. Because of this dual nature, tax authorities keep a close watch. Below are the major convertible note tax risks India poses.

The Angel Tax on Share Premium

The biggest concern is the ‘Angel Tax,’ under Section 56(2)(viib) of the Income Tax Act, 1961. This rule taxes any share premium that exceeds the fair market value (FMV) of the issued shares. Although convertible notes start as debt and remain exempt, problems appear at conversion.

The Problem: When conversion takes place, startups usually issue shares at a discount compared to their updated valuation. If the Income Tax Department decides those shares were priced below FMV, it can treat the difference as taxable income for the startup.

Expert Insight: “Founders often believe a valuation cap protects them from Angel Tax,” explains a senior partner at a leading tax advisory firm. “However, authorities may challenge the valuation method during conversion, especially in foreign investment cases, and demand reassessment. Careful documentation and expert valuation reports become essential in such cases.”

Capital Gains on Conversion and Sale

Conversion itself does not create tax liability. Yet, the subsequent sale of those shares by investors triggers capital gains tax.

Tax Treatment: The investor’s cost of acquisition equals the original note price. The holding period, which decides if gains are long-term or short-term, starts from the date of the convertible note, not the conversion date. This rule can benefit investors, but it also creates confusion for those unfamiliar with the law.

FEMA and RBI Compliance for Foreign Investments

Many IT startups raise funds from foreign investors. This step introduces strict compliance obligations under FEMA (Foreign Exchange Management Act).

Documentation and Reporting: RBI regulations require startups to report all foreign direct investments promptly. They must file Form FC-GPR within 30 days of issuing shares to a foreign investor. For convertible notes, this filing applies at the point of conversion. If a startup delays or makes errors, authorities may impose penalties of up to 300% of the transaction value. According to a Mondaq report, Udaan, a major B2B e-commerce startup, faced approval delays in 2022 because of incomplete FEMA filings.

Data Point: In 2023, a survey found that nearly 15% of Indian startups incurred FEMA-related penalties due to incorrect reporting of foreign investments. This number highlights the real financial risks of non-compliance.

Minimum Investment and Maturity Risks

Indian rules also set strict thresholds for convertible notes to avoid classifying them as deposits.

• Minimum Threshold: DPIIT-recognised startups must receive at least ₹25 lakh (or its foreign equivalent) from each investor in a single tranche. Investments below this level fall under deposit rules of the Companies Act, which most startups cannot meet.
• Maturity Period: A convertible note must either convert into equity or be repaid within 10 years. If no conversion event takes place, the startup has to repay the note. In 2021, more than 10% of Indian startups defaulted on such repayments, triggering legal disputes and tax scrutiny.

Actionable Strategies to Mitigate Convertible Note Tax Risks India

To manage these challenges effectively, startups should adopt a proactive approach.

• Engage Expert Valuators: Hire a chartered accountant or registered valuer to establish the fair market value of shares at conversion. A professional valuation report acts as strong evidence against future tax disputes.
• Draft Agreements with Precision: Use expert legal counsel to prepare a clear convertible note agreement. It should define valuation methods, conversion triggers, maturity dates, and investor rights. Ambiguity in these clauses often leads to disputes.
• Prioritise Regulatory Compliance: Obtain DPIIT recognition before fundraising. For foreign investments, create a process to ensure timely RBI and FEMA filings. Consistency in compliance builds investor trust.
• Maintain Meticulous Records: Keep detailed documentation of board resolutions, investor communications, and financial records. Strong evidence makes it easier to prove compliance during audits.

Future Outlook: A Shifting Landscape

The Indian government continues to refine startup policies. While we can expect a more streamlined regulatory system, authorities are also increasing transparency requirements. In the near future, tax departments will rely on data analytics and AI to monitor valuations and foreign investments more closely. Startups that plan their fundraising with tax risks in mind will have a clear advantage.

Convertible notes remain attractive because they are flexible, fast, and founder-friendly. Yet the convertible note tax risks in India demand careful attention. With proactive strategies and expert advice, startups can customise this tool to raise funds while staying compliant and resilient.

Conclusion: Stay Ahead of the Tax Curve

The allure of convertible notes for IT startups is undeniable flexible, fast, and founder-friendly. Yet, the convertible note tax risks in India demand vigilance. As India’s startup ecosystem continues to thrive, proactive compliance and strategic tax planning will separate successful IT startups from those bogged down by penalties. By addressing these risks head-on, you can unlock the full potential of convertible notes while securing your startup’s future.

About LawCrust

LawCrust Global Consulting Ltd. delivers cutting-edge Hybrid Consulting Solutions in Management, Finance, Technology, and Legal Consulting to ambitious businesses worldwide. Recognised for our cross-functional expertise and hybrid consulting approach, we empower startups, SMEs, and enterprises to scale efficiently, innovate boldly, and navigate complexity with confidence. Our services span key areas such as Investment Banking, Fundraising, Mergers & Acquisitions, Private Placement, and Debt Restructuring & Transformation, positioning us as a strategic partner for growth and resilience. With an integrated consulting model, fixed-cost engagements, and a virtual delivery framework, we make business transformation accessible, agile, and impactful.

For expert legal help, please contact us:

• Email: inquiry@lawcrustbusiness.com