Issuance of Convertible Notes in India

Mudit Handa

12 Nov, 2020

The Government of India had announced the Consolidated FDI Policy during FY 2017-18. The main motive behind this new FDI policy is to make India a favorable place for investment by foreign investors. This Policy has eased provisions for issuing convertible notes.

One of the key aspects of the Consolidated FDI Policy was been to encourage more fundraising for the indigenous start-ups by empowering them to raise capital outside their business environment. One way of doing this is by the issuance of debt instruments called Convertible Notes, something which was hitherto restricted without SEBI approval.

As a result, the Indian Government had introduced the Companies Acceptance of Deposits (Amendment) Rules, 2017 in line with the Consolidated FDI Policy of 2017. Under these rules, the start-up companies were allowed to raise the capital by accepting deposits of up to ₹25 lakhs by the issue of convertible notes. However, these Rules were also amended in 2019, wherein the above threshold for raising capital by issue of convertible notes has been maintained.

Since then, the Convertible Notes have become quite popular investment instruments among the investors and the start-ups. Moreover, these have been quite handy in the advancement of the start-up ecosystem in places like Silicon Valley of California or in Singapore. So, let us first understand the concept of the Convertible Notes and the current legal framework of issuing the same in India.

What are the Convertible Notes?

Convertible notes are basically debt instruments that can be converted into equity shares either by the preference of the investor or during certain events, mostly related to a start-up company’s next level of raising equity capital.

Accordng to the Foreign Exchange Management (Transfer or Issue of Security by Person Resident outside India) Regulations 2017, the convertible note that is issued by any eligible start-up to any non-resident investor is firstly a debt instrument. However, it may be, by the preference of that investor, either repaid or can be capitalized as equity shares within the period of 5 years from the date of their issuance.

These Notes can also be redeemed upon their maturity, in case the start-up suffers loss or does not operate as expected.

In this regard, as per the Companies Acceptance of Deposits (Amendment) Rules, 2017 the definition of the Convertible Notes is as follows –

“Any amount of 25 lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person”

Issuance of Convertible notes in India before 2017

Prior to the amendment of the Companies (Acceptance of Deposits) Rules, the issuance of Convertible Notes to the foreign investors was restricted in India.

Reserve Bank of India (RBI) had opened gateway for the FDI through only equity instruments or those only instruments which are compulsory convertible into equity shares such as:

• Compulsorily Convertible Preference Shares (CCPS);
• Compulsorily Convertible Debentures (CCD).

Apart from the above, all other sorts of instruments, such as the Optionally Fully Convertible Debentures (OFCD), were considered as debt instruments only. These were supposed to comply with the External Commercial Borrowings (ECB).

Here, we must briefly go through the case study of the Sahara Group.

Sahara Group case study

One of the most notorious instances of financial misappropriations in India is of the Sahara Group.

• The reason behind the Sahara India Pariwar investor scam and the resulting downfall of the business empire was issuance of the Optionally Fully Convertible Debentures (OFCD) issued by 2 companies of Sahara Group.
• The Securities and Exchange Board of India (SEBI) had made its claim of jurisdiction over such instruments and raised objection on failure of Sahara to take SEBI approval before issuing them. Hence, SEBI ordered 2 companies of Sahara to stop issuing OFCDs and return all money to the investors.

The case was contested in Supreme Court, which ordered 2 Sahara companies:- Sahara India Real Estate Corporation Ltd. (SIRECL) and Sahara Housing Investment Corporation Ltd. (SHICL) to refund above ₹24,400 crores to its investors.

Need for legal provision for Convertible Notes                          

We can observe from the above case study that the absence of concrete legislation covering these types of financial instruments issuance has not only resulted in the violation of the norms by some well-known business conglomerates.

• Moreover, in such situation some genuine start-up companies with noble intent found it very difficult to raise capital from the foreign investors. Mostly such investors were habitual to invest in the start-ups through convertible notes.
• Besides, such notes were restricted to be issued for the reason they are considered as ‘Deposits’ under the Companies Act, 2013. Only the listed companies are eligible to raise deposits.

Hence, the government had come up with a solution to serve dual objective – to assist the fundraising in start-ups and to regulate the issuing of debt raising instruments by larger companies – by introducing the Companies Acceptance of Deposits (Amendment) Rules, 2017.

As per these rules the start-ups can now easily raise capital by accepting deposits of up to ₹25 lakhs the issue of convertible notes that are convertible as equity within the period of 5 years from the date of their issuance.

Eligible Start-ups for Convertible Notes issuance

In order to promote Ease of Doing Business and to boost FDI in start-ups, the RBI has allowed only “recognized start-ups” to raise capital through such convertible debt instruments.

For this, the RBI had also amended the Foreign Exchange (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, in 2017, to permit “recognized start-ups” to issue convertible notes to the foreign investors.

Recognized start-ups are those companies that are certified under the Start-up India Stand up India initiative for a period of 10 years since their inception.

Valuation Requirements for convertible notes

As such there is no need for the compliance of the valuation guidelines during the issuance of the convertible notes. This is a requirement only for other types of FDI instruments such as Equity Shares or the compulsorily convertible preference shares (CCPS).

However, while the conversion of such a note into the equity share or while its transfer from a non-resident to a resident investor, the pricing guidelines are mandatory to be followed. The pricing of such equity shares issued after conversion must be at or above the fair market value, which is to be determined by a certified chartered accountant or a merchant banker.

Taxability on issue of convertible notes

During the time of issuance of the Convertible Notes, there is no tax implication at the time of such issuance, since the Convertible Notes are initially considered as debt.

However, during the time of the conversion of these Convertible Notes, since the conversion price of these notes shall be set at fair market price. Automatically, there will be no tax liability.

However, in case the conversion price is beyond the fair market value, the difference between the conversion price &fair market price may be taxable on the company’s end u/s 56 (2) (vii-b) of the Income Tax Act, 1961^[1].

Fortunately, this is also tax exempt in case the company is recognized start-up and has also availed the tax exemption approval till first 10 years, from the Income Tax department at the time of the conversion.

Conclusion

Read our article:Guidelines for Compulsorily Convertible Preference Shares under FEMA