Start-ups eco system is always dynamic and volatile. They are always in search of the innovative funding and that also in a cost effective manner. In order to promote start-ups, government always comes out with innovative initiatives either they give exemption from regulatory requirements or provide cost effective funding. One of the step taken by government was the introduction of convertible notes under the Companies Act, 2013, specifically for start-ups. Ministry of Corporate Affairs vide notification[i] dated June 29, 2016, amended Companies (Acceptance of Deposits) Rules, 2014, which provides that “an amount of twenty five 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” is considered as exempted deposits. Further, Reserve Bank of India also amended Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2016, to introduce the concept of convertible notes under FEMA.

Herein, we have prepared a detailed note on convertible notes which can be issued by Start-ups Company to a person resident outside India. But, before going into the nitty-gritty of the topic, let’s see the current scenario of foreign funding coming into India. Herein, we have provided the total amount of foreign funding coming into India during January to March, 2020[ii].

  • Total FDI inflows into India (Equity inflows + ‘Re-invested earnings’ + ‘Other capital’)-  USD 18,325 million.
  • FDI Equity Inflows into India: INR 95,549 Crore
  • Top three investing countries (FDI Equity inflows) in F.Y. 2019-20: Singapore: INR 103,615 crore, Mauritius: INR 57,785 crore and the Netherlands: INR 46,071 crore.
  • Top three sectors attracting highest FDI Equity inflows in F.Y. 2019-20: Services Sector: INR 55,429 crore, Computer Software & Hardware: INR 54,250 crore and Telecommunications: INR 30,940.
  • Top three states attracting highest FDI equity inflows in F.Y. 2019-20: Maharashtra: INR 52,073 crore, Karnataka: INR 30,746 crore and Delhi: INR 28,487.

We have seen the total amount of foreign investors have invested in Reliance Jio i.e. INR 1,04,326.65 crore.

Application of Law

For issuing convertible notes, the following FEMA laws shall be applicable in addition to other laws:

1. Foreign Exchange Management Act, 1999 (hereinafter referred to as “FEMA”).

2. Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (hereinafter referred to as “NDI Rules”).

3. Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019 (hereinafter referred to as “Mode of Payment and Reporting Rules”).

Regulatory Provisions

1. What are Convertible notes?

Convertible note means an instrument issued by a start-up company acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into a such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon the occurrence of specified events as per other terms and conditions agreed and indicated in the instrument.

2. Who can issue convertible notes?

A convertible notes can be issued by an Indian Start-up company.

3. What is the meaning of Start-up company?

Start-up has been defined by Department of Industrial Policy and Promotion (hereinafter referred to as “DIPP”), Ministry of Commerce and Industry vide amended notification dated January 16, 2019.

An entity shall be considered as a Start-up:

  • Up to a period of ten years from the date of incorporation/ registration, if it is incorporated as a private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) in India.
  • Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
  • Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.

Provided that an entity formed by splitting up or reconstruction of an existing business shall not be considered a ‘Startup’.

4. To whom convertible note can be issued?

  • A convertible note can be issued to a person resident outside India (other than an individual who is a citizen of Pakistan or Bangladesh or an entity which is registered or incorporated in Pakistan or Bangladesh).
  • A NRI or an OCI may acquire convertible notes on the non-repatriation basis and subject to other terms and conditions as mentioned in the NDI Rules. [hereinafter referred to as “eligible subscriber”].

5. How much amount of convertible notes can be subscribed?

Eligible subscriber can subscribe or purchase convertible notes for an amount of twenty five lakh rupees or more in a single tranche.

6. Through which mode of payment convertible notes can be purchased?

A start-up company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to the NRE/FCNR(B)/Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

A start-up company issuing convertible notes to a NRI or OCI on non-repatriation basis shall receive the amount of consideration by inward remittance through banking channels or out of funds held in NRE/FCNR(B)/NRO account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

7. Through which mode repayment/sale proceeds of convertible notes can be remitted?

In case of issue of convertible notes to person resident outside India:

Repayment or sale proceeds may be remitted outside India or credited to NRE/FCNR(B) account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

In case of issue of convertible notes to a NRI or OCI on non-repatriation basis:

The sale/maturity proceeds (net of applicable taxes) of convertible notes shall be credited only to the NRO account of the investor, irrespective of the type of account from which the consideration was paid and the amount invested in convertible notes of an Indian company shall not be allowed to be repatriated abroad.

8. What are the reporting requirements for convertible notes?

  • In case of issue of convertible notes: The Indian start-up company issuing Convertible Notes to a person resident outside India shall file Form CN within 30 days of such issue.
  • In case of transfer of convertible notes: A person resident in India, who may be a transferor or transferee of Convertible Notes issued by an Indian start-up company shall report such transfers to or from a person resident outside India, as the case may be, in Form CN within 30 days of such transfer.
  • Annual Return on Foreign Liabilities and Assets (FLA): An Indian Company which has received FDI shall submit form FLA to the Reserve Bank on or before the 15th day of July of each year.

Conclusion

In current scenario, convertible note is one of the most common methods of funding for start-ups. If start-up takes the external commercial borrowing (“ECB”) route then it would be burdened with too much compliance like ECB-2 return every month, filing of ECB Form with any changes in ECB loan, etc.

Ministry of Finance (“MOF”) vide notification dated April 22, 2020, amended rule 6 (a) of the NDI Rules. The amended NDI rule provides that investment by a country which shares land border with India or beneficial owner from any such country shall invest only with the Government approval. Now, the question is whether an entity which shares land border with India can invest in an Indian entity by way of convertible notes without the government approval? As per my opinion, rule 6(a) is specifically for investment by person resident outside India in equity instruments of Indian company. If person resident outside India shares land border with India it requires the permission of Government of India. The question here arises whether investment in convertible notes by PROI who shares land border with India would be considered as investment in equity instruments and will it be covered under the amended proviso of rule 6 (a)? In order to answer that question we need to read the definition of the “equity instruments” as defined in NDI Rules means equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. Further, “Convertible Debentures” means fully, compulsorily and mandatorily convertible debentures. So, Convertible note doesn’t fit into the definition of equity instruments and more specifically convertible debentures. So, the amended proviso(s) of rule 6(a) doesn’t apply to an investment by PROI in convertible notes belonging to country which shares land border with India.

However, above is my personal opinion. What’s your opinion? Do share it on chirag@csahmedabad.com.

Please feel free to write to us with your suggestions and/or any queries that you may have. We’d be more than happy to assist you.

[i] Link of the notification:  https://taxguru.in/company-law/amendment-in-rules-for-acceptance-of-deposit-by-companies.html

[ii] QUATERLY FACT SHEET FACT SHEET ON FOREIGN DIRECT INVESTMENT (FDI) FROM APRIL, 2000 to MARCH, 2020 (Link: https://dipp.gov.in/sites/default/files/FDI_Factsheet_March20_28May_2020.pdf).

https://yourstory.com/2017/01/convertible-notes-finally-reality-indian-startups

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