Convertible note repayment and conversion — tax treatment for startups

• Convertible Note Repayment & Conversion — Tax Treatment for Startups in India

For early-stage startups, raising funds through a Convertible Note (CN) can provide flexibility between immediate debt funding and a future equity investment. Instead of issuing equity immediately, the investor provides funds that may later convert into equity shares when specified conditions are met. 🚀

For founders, however, the tax treatment of a Convertible Note should be considered at both stages:

Initial Investment → 🔄 Conversion into Equity / 💰 Repayment

The applicable tax and regulatory treatment can differ depending on the terms of the note, the investor’s residential status, the manner of conversion and the applicable tax year.

• Important: From Tax Year 2026–27 onwards, the Income-tax Act, 2025 applies to the relevant tax year. For earlier tax years, the Income-tax Act, 1961 continues to govern the relevant transactions.

What Is a Convertible Note?

A Convertible Note is an instrument through which a startup receives funds from an investor with an arrangement that the investment may be converted into equity shares upon specified events or conditions.

The conversion may be linked to:

Future funding round

Valuation event

Maturity

Investor option

Agreed conversion price

Discount or valuation cap

For eligible Indian startups, Convertible Notes are also recognised under the applicable foreign-exchange framework for investment by non-resident investors, subject to the prescribed conditions.

How Does a Convertible Note Work?

A typical transaction may look like this:

Step 1️⃣ — Investor Funds the Startup

The investor provides ₹50 lakh under a Convertible Note.

⬇️

Step 2️⃣ — Startup Records the Instrument

The amount is recorded according to the terms of the note and applicable accounting framework.

⬇️

Step 3️⃣ — Conversion Event Occurs

The startup raises a qualifying funding round.

⬇️

Step 4️⃣ — Note Converts into Equity

The agreed amount is converted into equity shares according to the terms of the Convertible Note.

OR

Step 4️⃣ — Note Is Repaid

If the conversion conditions are not met and the agreement provides for repayment, the startup repays the investor.

Tax Treatment at the Time of Investment

The receipt of money under a Convertible Note should not automatically be treated as ordinary business income merely because the startup receives cash.

The actual tax treatment depends on the legal character and terms of the instrument.

Startups should maintain:

• Convertible Note Agreement
• Board approvals
• Investor documentation
• Valuation documentation
• Bank records
• Accounting entries
• Relevant regulatory filings

Proper documentation becomes particularly important when the investor is a non-resident.

Tax Treatment on Conversion into Equity

Conversion is one of the most important stages.

Where the Convertible Note is converted into equity shares according to its contractual terms, the tax consequences should be analysed based on the specific structure and applicable provisions.

The startup should carefully examine:

Conversion price

Fair value

Valuation report

Investor category

Original issue price

Conversion terms

Whether any amount is recognised as income or gain

Applicable company-law and FEMA requirements

Key Point

Conversion should not be viewed simply as a normal sale of the note.

The legal terms of the Convertible Note and the applicable tax provisions determine the appropriate treatment.

What About Section 56 Tax Concerns?

Startups should pay particular attention to provisions dealing with amounts received in relation to the issue of shares.

Historically, Section 56(2)(viib) of the Income-tax Act, 1961 was an important consideration where closely held companies issued shares for consideration exceeding prescribed fair-market-value parameters.

For transactions governed by the earlier law, startups should therefore review whether the relevant provision applies to the transaction and whether any available exemption or startup-related relief is applicable.

For tax years beginning from 1 April 2026, the Income-tax Act, 2025 applies and the corresponding provisions should be reviewed under the new legislation.

What Happens When the Convertible Note Is Repaid?

If the Convertible Note does not convert and is instead repaid, the startup should examine:

Principal Amount

Repayment of the original principal generally represents settlement of the funding obligation rather than ordinary business expenditure.

Interest / Return

If the note carries interest or another return, the tax treatment of that component needs separate consideration.

Depending on the investor and transaction structure, TDS and withholding-tax requirements may also need to be examined.

The applicable tax law for TDS depends on the tax year in which the relevant payment or credit occurs. The Income Tax Department confirms that payments/credits on or after 1 April 2026 are governed by the applicable withholding provisions under the Income-tax Act, 2025.

Convertible Notes Issued to Foreign Investors

This is an especially important area for Indian startups.

Where the investor is a non-resident, the transaction can involve both:

🇮🇳 Indian tax law

FEMA regulations

RBI requirements

Foreign investment reporting

Withholding tax considerations

The startup should therefore not analyse the transaction purely from an income-tax perspective.

The Convertible Note must also satisfy the applicable foreign-exchange conditions relating to issue, conversion and repayment.

FEMA Considerations for Foreign Investors

For a foreign investor, the startup should verify:

Whether the investor is eligible to invest

Whether the startup qualifies under the applicable Convertible Note framework

Pricing requirements

Sectoral restrictions

Conversion conditions

Reporting requirements

Repatriation requirements

RBI/FEMA compliance

Important

A Convertible Note involving a foreign investor is not simply a private loan arrangement.

Its structure should be reviewed under the applicable FEMA framework before accepting funds.

Conversion vs Repayment — Basic Comparison

Particular	Conversion into Equity	Repayment
Investor receives	Equity shares	Money
Startup obligation	Converts instrument into shares	Settles liability
Valuation relevance	High	Depends on repayment terms
TDS consideration	Transaction-specific	Interest/return may trigger analysis
FEMA review	Important for non-resident	Important for non-resident
Documentation	Conversion documents	Repayment documentation
Accounting impact	Liability converted into equity	Liability settled

Simple Example

Suppose a startup receives:

₹1 crore Convertible Note

The agreement provides that the note will convert into equity during the next qualified funding round.

Scenario 1 — Conversion

The note converts into equity shares.

The startup should document:

• Conversion event
• Number of shares issued
• Conversion price
• Valuation
• Board/shareholder approvals where required
• Statutory filings
• Accounting treatment

The tax consequences should then be reviewed based on the specific transaction structure and applicable provisions.

Scenario 2 — Repayment

The startup does not meet the conversion conditions and repays ₹1 crore plus applicable contractual return.

The principal repayment and any interest/return should be analysed separately for tax and withholding purposes.

Accounting & Tax Documentation

Startups should maintain a complete audit trail from the date of investment until conversion or repayment.

Recommended documents:

• Convertible Note Agreement
• Term Sheet
• Board Resolution
• Investor KYC
• Valuation Report
• Bank Statement
• Shareholder approvals, where applicable
• Conversion calculation
• Share certificates / corporate records
• FEMA filings, where applicable
• TDS documentation, where applicable
• Repayment proof, where applicable

Good documentation can significantly reduce complications during:

Tax assessment

Investor due diligence

Banking review

Future funding rounds

Regulatory review

Common Mistakes Startups Should Avoid

Treating a Convertible Note Like an Ordinary Loan

Its legal and regulatory treatment depends on its structure.

Ignoring Conversion Terms

Conversion price, valuation cap, discount and trigger events can have significant commercial and tax implications.

Ignoring FEMA for Foreign Investors

Non-resident investment requires separate FEMA analysis.

Not Maintaining Valuation Documentation

Valuation becomes particularly important when the note converts into equity.

Ignoring TDS

Interest or other payments to investors may require withholding-tax analysis.

Mixing Principal and Return

Repayment of principal and payment of interest/return should be separately identified in accounting and tax records.

Using Outdated Tax Provisions

From Tax Year 2026–27 onwards, transactions are governed by the Income-tax Act, 2025, while earlier tax years continue to be dealt with under the previous legislation.

Convertible Note Compliance Checklist

Before issuing or repaying a Convertible Note, startups should review:

• Investor eligibility
• Startup eligibility
• Convertible Note terms
• Conversion mechanism
• Valuation methodology
• Tax implications
• TDS/withholding requirements
• FEMA compliance for foreign investors
• RBI reporting requirements, where applicable
• Accounting treatment
• Board and shareholder approvals
• Conversion documentation
• Repayment documentation
• Proper maintenance of investor records

Why Startups Prefer Convertible Notes

Convertible Notes can provide several practical advantages.

Faster Fundraising

They can allow startups and investors to defer detailed valuation negotiations to a future funding round.

Future Equity

Investors can potentially convert their investment into equity when the agreed trigger occurs.

Flexible Structuring

Discounts, valuation caps and conversion events can be negotiated contractually.

Lower Initial Complexity

Compared with an immediate priced equity round, the initial transaction may be structurally simpler in certain situations.

However, the legal, tax and regulatory implications should be assessed before signing the instrument.

Key Takeaways

A Convertible Note can be an effective fundraising instrument for an eligible startup, but conversion and repayment should not be treated as identical tax events.

The key areas to review are:

• Initial funding → 🔄 Conversion/Repayment → 🧾 Tax treatment → 💱 FEMA compliance → 📑 Reporting

For Indian investors, the focus is primarily on the applicable income-tax and corporate-law framework.

For foreign investors, the analysis additionally involves FEMA, RBI requirements and withholding-tax considerations.

Most importantly, startups should ensure that the Convertible Note Agreement, valuation, accounting entries and statutory filings all tell the same story.

Frequently Asked Questions

Is a Convertible Note taxable when received by a startup?

The receipt should be analysed based on the legal nature and terms of the instrument. It should not automatically be treated as business income merely because funds are received.

Is conversion of a Convertible Note into shares taxable?

The tax consequences depend on the structure, terms, valuation and applicable tax provisions. The conversion should therefore be reviewed before implementation.

What happens if a Convertible Note is repaid?

The repayment generally represents settlement of the funding obligation. Any interest or additional return should be separately examined for tax and withholding purposes.

Are Convertible Notes allowed for foreign investors?

Convertible Notes can be issued by eligible Indian startups to eligible non-resident investors subject to the applicable FEMA/RBI framework and conditions.

Is valuation required for Convertible Notes?

Valuation requirements depend on the transaction and applicable legal/regulatory framework. Valuation becomes particularly important when the note converts into equity.

Does TDS apply to Convertible Note repayment?

The principal repayment and any interest/return should be analysed separately. Applicable withholding requirements depend on the nature of the payment and the investor’s status.

Conclusion

Convertible Notes can give startups valuable flexibility while raising early-stage capital, but their tax treatment requires careful planning.

The startup should evaluate the transaction at three key stages:

1️⃣ Receipt of Funds

2️⃣ Conversion into Equity

3️⃣ Repayment, if Conversion Does Not Occur

For foreign investors, FEMA and RBI compliance must be considered alongside taxation.

With proper documentation, valuation, accounting and regulatory compliance, startups can use Convertible Notes as an effective fundraising tool while reducing the risk of tax and compliance disputes. 🚀💼