Startups, VC & Investment Banking

Convertible notes issued to non-resident investors are permissible under Schedule I of FEMA Notification No. 20(R) — Foreign Exchange Management (Non-debt Instruments) Rules, 2019 — for startups that are DPIIT-recognised and receive a minimum investment of ₹25 lakh per investor in a single tranche. The note must be repayable or convertible into equity within 5 years from the date of issue. An FC-GPR filing is not required at the time of issuing the convertible note; however, once conversion happens, an FC-GPR must be filed with the RBI within 30 days of allotment of shares via the FIRMS portal using Form FC-GPR under FEMA Notification No. 20(R). All FEMA filings require a CA or CS certification, and any breach of the 5-year conversion timeline requires an RBI compounding application under the Foreign Exchange Management (Compounding Proceedings) Rules 2000.

Gains on transfer of unlisted shares by a founder to a VC fund are taxable as capital gains under Chapter IV-E of the Income Tax Act 1961. If the shares are held for more than 24 months, the gain is long-term and taxed at 12.5% under Section 112 of the Income Tax Act 1961 (as amended by Finance Act 2024, applicable from AY 2025-26); indexation benefit is no longer available for unlisted shares transferred on or after July 23, 2024. If held for 24 months or less, short-term capital gains apply at slab rates under Section 111A or the general provisions. Where the consideration received is less than the fair market value determined under Rule 11UA of the Income Tax Rules 1962, Section 50CA deems the FMV to be the full value of consideration for the seller, potentially creating a tax liability even on a below-FMV transfer. A CA valuation report prepared under the Discounted Cash Flow or Net Asset Value method per Rule 11UA is therefore essential before any secondary transfer.

Section 9A of the Income Tax Act 1961 provides a safe harbour for an eligible investment fund managed by an eligible fund manager in India, such that the mere presence or activity of the fund manager does not constitute a business connection of the fund in India under Section 9(1)(i). To qualify, the fund must be a resident of a country with which India has a tax treaty, have at least 25 members (with diversification conditions), not invest more than 20% of its corpus in a single entity, and have a corpus of at least ₹100 crore, as specified in Section 9A(3). The fund manager must not be entitled to more than 20% of profits as carried interest from that fund and must be registered with SEBI as a fund manager. Compliance certification from a CA is required annually along with Form 3CEJ under Rule 10V of the Income Tax Rules 1962, which must be filed by November 30 of the relevant assessment year.

ESOPs issued by a private limited company are governed by Section 62(1)(b) of the Companies Act 2013 read with Rule 12 of the Companies (Share Capital and Debentures) Rules 2014, which require a special resolution and an ESOP scheme document approved by shareholders. For tax purposes, the perquisite value — being the fair market value of the shares on the date of exercise less the exercise price — is taxable as salary income under Section 17(2)(vi) of the Income Tax Act 1961, with TDS applicable under Sec 192, IT Act 1961 (≡ §392, IT Act 2025). For DPIIT-recognised startups, Sec 192(1C), IT Act 1961 (≡ §392, IT Act 2025) of the Income Tax Act 1961 allows deferral of TDS on ESOP perquisites to the earlier of: 5 years from exercise, date of sale of shares, or date of cessation of employment, providing significant cash flow relief to employees. When shares are subsequently sold, capital gains arise and are taxed under Section 45 of the Income Tax Act 1961 with the holding period computed from the date of allotment.

A VC's financial and legal due diligence for a Series A or later round typically covers audited financial statements for the last 3 financial years, a cap-table with all share allotments traced to Board and shareholder resolutions, FEMA compliance records including all FC-GPR and FLA filings under the Foreign Exchange Management Act 1999, all direct and indirect tax returns including GST returns and transfer pricing documentation if applicable under Section 92 to 92F of the Income Tax Act 1961, and a review of related-party transactions under Section 188 of the Companies Act 2013. A CA prepares a financial due diligence report that reconciles management accounts to statutory accounts, quantifies contingent tax liabilities, and highlights any open assessment notices from the Income Tax Department. Unresolved demands under Section 156 of the Income Tax Act 1961 or pending TDS defaults under Section 201 are common deal-breakers that must be disclosed and quantified before term-sheet execution.