Introduction

In the dynamic startup ecosystem, raising funds at the earliest stage is always a challenge. Entrepreneurs often resort to pre-seed funding instruments that balance investor interest with company growth. One such instrument gaining traction is the Pre-Seed Convertible Debenture (PSCD). It acts as a bridge between debt and equity, providing flexibility to both startups and investors. However, the tax implications of PSCDs are critical to understand for compliance, investor confidence, and future fund-raising.

What are Pre-Seed Convertible Debentures (PSCDs)?

• Definition: A pre-seed convertible debenture is a debt instrument issued by startups that later converts into equity shares, usually during a subsequent funding round.

• Purpose: Startups issue PSCDs when valuation is uncertain at the early stage. This allows investors to inject capital without fixing equity valuation immediately.

• Key Features:

  • No fixed valuation upfront

  • Conversion at a discount or valuation cap

  • Hybrid nature: starts as debt, converts to equity

Tax Implications for Startups

1. At the Time of Issuance

• Treated as a loan/debt instrument initially.

• Not considered income in the hands of the startup.

• Stamp duty may apply depending on state regulations.

2. Interest on Debentures

• If the PSCD carries an interest component, the interest expense is deductible for the company under the Income Tax Act, 1961.

• However, TDS under Section 194A applies on interest payments (if applicable).

3. Conversion into Equity

• On conversion, the debenture holder exchanges debt for equity.

• As per Section 47(xb) of the Income Tax Act, conversion of debentures into shares is not regarded as a transfer, hence no capital gains tax is triggered at the time of conversion.

• The cost of acquisition of shares = proportionate cost of debentures.

Tax Implications for Investors

1. During Holding Period

• Interest income received on PSCDs (if any) is taxable under “Income from Other Sources” or Business Income depending on investor profile.

2. On Conversion

• Conversion is not treated as a taxable event.

• Holding period of equity shares is reckoned from the date of allotment of shares post-conversion.

3. On Sale of Shares Post-Conversion

• Capital gains tax applies:

  • Short-term capital gains (STCG) if held < 24 months

  • Long-term capital gains (LTCG) if held ≥ 24 months

• Tax rates:

  • Listed shares: 10% LTCG (above ₹1 lakh) or 15% STCG

  • Unlisted shares: 20% with indexation (LTCG)

Tax Risks & Grey Areas

• Angel Tax (Section 56(2)(viib)): If PSCDs convert into shares at a premium higher than FMV, tax may apply on the company.

• GAAR Concerns: Aggressive structuring to avoid taxes may attract anti-avoidance provisions.

• Cross-Border Investments: FEMA and RBI guidelines play a significant role in case of foreign investors.

Best Practices for Startups & Investors

✔ Draft clear terms of conversion in agreements
✔ Obtain a valuation report from a registered valuer
✔ Maintain compliance with RBI FEMA rules for foreign investors
✔ Deduct and deposit TDS on interest (if applicable)
✔ Maintain proper accounting of debenture liability and its conversion

Conclusion

Pre-seed convertible debentures are a strategic funding tool for early-stage startups, offering flexibility in valuation while protecting investor interests. From a taxation standpoint, while initial issuance and conversion are tax-neutral, interest and post-conversion capital gains remain taxable events. Both startups and investors must adopt a compliance-first approach to avoid disputes with tax authorities. Consulting with tax professionals ensures smoother fundraising and regulatory adherence.

Intern at TAXAJ

TAXAJ is a consortium of CA, CS, Advocates & Professionals from specific fields to provide you a One Stop Solution for all your Business, Financial, Taxation & Legal Matters under One Roof. Some of them are: Launch Your Start-Up Company/Business, Trademark & Brand Registration, Digital Marketing, E-Stamp Paper Online, Closure of Business, Legal Services, Payroll Services, etc. For any further queries related to this or anything else visit TAXAJ

Watch all the Informational Videos here: YouTube Channel                                                                                               

TAXAJ Corporate Services LLP

Address: 1/3, UGF, Sulahkul Vihar, Old Palam Road, Dwarka, New Delhi-110078