Rule 2 explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
Rule 2 of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 fixes what can be called an "equity instrument", a "convertible note", a "depository receipt", a "unit" and a "non-debt instrument". Everything else in the Rules turns on these meanings: a security that falls outside them is a debt instrument and is not governed by these Rules.
This article reads the definitions as per the Rules notified on 17 October 2019 (S.O. 3732(E)) as amended by the notifications named in this article; the latest amendment consulted is S.O. 4870(E) dated 2 September 2026. Amendments after that date should be checked in the Gazette. There is no official consolidated text, so each clause was read from the 2019 notification with the amendments applied.
"Equity instruments" are equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. Since S.O. 1802(E) of 12 April 2022, convertible debentures and preference shares count only if they are fully and mandatorily convertible and fully paid. A convertible note may convert within ten years, not five. Partly paid shares must be fully called up within twelve months of issue, with twenty-five per cent upfront, and share warrants need at least twenty-five per cent upfront and the balance within eighteen months. Equity instruments may carry an optionality clause only with a one-year minimum lock-in and no option or right to exit at an assured price.
Equity instruments: rule 2(k)
Rule 2(k) says "equity instruments" means equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. The Explanation gives the content of each term. Explanation (i) was substituted by S.O. 1802(E), the Foreign Exchange Management (Non-debt Instruments) (Amendment) Rules, 2022 (12 April 2022). As substituted it reads, in substance:
- Equity shares issued by an Indian company in accordance with the Companies Act, 2013 or any other applicable law include equity shares that have been partly paid.
- "Convertible debentures" means fully and mandatorily convertible debentures which are fully paid.
- "Preference shares" means fully and mandatorily convertible preference shares which are fully paid.
- "Share Warrants" are those issued by an Indian company in accordance with the regulations made by the Securities and Exchange Board of India, the Companies Act, 2013 or any other applicable law.
- Equity instruments can contain an optionality clause, subject to a minimum lock-in period of one year or as prescribed for the specific sector, whichever is higher, but without any option or right to exit at an assured price.
The 2019 text said "fully, compulsorily and mandatorily convertible" and had no "fully paid" requirement; that wording is now history.
Explanations (ii) and (iii) stand as notified on 17 October 2019; none of the later notifications changes them:
| Instrument | Condition printed in Explanation (ii) or (iii) |
|---|---|
| Partly paid shares issued to a person resident outside India | Fully called up within twelve months of issue, or as specified by the Reserve Bank from time to time |
| Partly paid shares | Twenty-five per cent of the total consideration (including share premium, if any) received upfront |
| Share warrants | At least twenty-five per cent of the consideration received upfront and the balance within eighteen months of issue |
The Reserve Bank's Master Direction - Foreign Investment in India, updated up to June 15, 2026, repeats these in paragraphs 4.3 and 4.4 and adds, as its own statement and not as part of the Rules, that the balance on partly paid shares need not come in within twelve months where a monitoring agency is appointed, and that the same conditions apply where a non-resident acquires partly paid shares or warrants by transfer. The issue is reported through the Reserve Bank's reporting regulations; see our FC-GPR reporting service page. Pricing is explained in our article on pricing under rule 21.
Convertible debentures or preference shares that are not fully, compulsorily and mandatorily convertible are, according to the Master Direction (paragraphs 4.6.2 and 4.7.2), debt instruments under a separate notification of the Central Government which the Master Direction cites as S.O. 3722 (E) of 16 October 2019. That notification is not in the texts consulted; it should not be confused with S.O. 3732(E).
Debt and non-debt instruments: rule 2(f) and rule 2(ai)
Rule 2(f) defines "debt instruments" as all instruments other than non-debt instruments. Rule 2(ai) lists the non-debt instruments:
- all investments in equity instruments in incorporated entities: public, private, listed and unlisted;
- capital participation in an LLP;
- all instruments of investment recognised in the FDI policy notified from time to time;
- investment in units of Alternative Investment Funds, Real Estate Investment Trusts and Infrastructure Investment Trusts;
- investment in units of mutual funds or Exchange-Traded Funds which invest more than fifty per cent in equity;
- the junior-most layer (equity tranche) of a securitisation structure;
- acquisition, sale or dealing directly in immovable property;
- contribution to trusts; and
- depository receipts issued against equity instruments.
None of the nineteen amending notifications changes clause (f) or clause (ai). The scope of the Rules, and therefore the reach of the restrictions in rules 3 and 4 explained in our article on rules 1 to 5, depends on this list. The Master Direction prints the same nine items in its paragraph 2.22.
Convertible note: rule 2(e)
A "convertible note" is an instrument issued by a startup company acknowledging receipt of money initially as debt, repayable at the option of the holder, or convertible into such number of equity shares of that company, within a period not exceeding ten years from the date of issue, upon occurrence of specified events as per other terms agreed and indicated in the instrument. As notified, the period was five years; S.O. 1802(E) (12 April 2022) substituted "ten years" for "five years". "Startup company" is explained in our article on Indian company, control, startup and investor classes, and the conditions for a non-resident buying such notes in rule 18 are in our article on convertible notes of startups. For the commercial background, see our guide to convertible notes and SAFE notes.
Depository receipts, IDRs, FCCBs and hybrid securities
- Depository receipt (rule 2(g)): a foreign currency denominated instrument, whether listed on an international exchange or not, issued by a foreign depository in a permissible jurisdiction on the back of eligible securities issued or transferred to that foreign depository and deposited with a domestic custodian; it includes a global depository receipt as defined in the Companies Act, 2013.
- IDR (rule 2(z)): an instrument in the form of a depository receipt created by a domestic depository in India and authorised by a company incorporated outside India making an issue of such receipts.
- FCCB (rule 2(q)): a bond issued under the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993. The Rules quote the 1993 Scheme as printed; the reader should check whether it has been replaced.
- Hybrid securities (rule 2(x)): instruments such as optionally or partially convertible preference shares or debentures and other instruments the Central Government specifies from time to time, which an Indian company or trust can issue to a person resident outside India.
Rule 2(h) and (i) define domestic custodian and domestic depository by reference to SEBI registration. Depository receipt investment is dealt with in our article on Schedules IX and X.
ESOP, sweat equity and Share Based Employee Benefits
- ESOP (rule 2(j)): "Employees' stock option" as defined under the Companies Act, 2013 and issued under the regulations of the Securities and Exchange Board of India.
- Sweat equity shares (rule 2(ao)): as defined under the Companies Act, 2013.
- Share Based Employee Benefits (rule 2(ama)), inserted by S.O. 1802(E): issue of equity instruments to employees or directors, or employees or directors of the holding company, joint venture or wholly owned overseas subsidiary or subsidiaries, who are resident outside India, under schemes formulated by an Indian company.
The conditions on issuing these to non-residents sit in rule 8, explained in our article on ESOPs, sweat equity and share based employee benefits.
Unit: rule 2(aq)
A "unit" is a beneficial interest of an investor in an investment vehicle. S.O. 1361(E), the Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2024 (14 March 2024), added an Explanation: for this clause, a unit includes a unit that has been partly paid up, which is permitted under the regulations framed by the Securities and Exchange Board of India in consultation with the Government of India. Our article on Schedule VIII deals with investment vehicles.
A worked example
Lakshya Components Private Limited, an Indian company, issues preference shares to Nordvik Holdings, a non-resident, that convert into equity only if Nordvik chooses. Under rule 2(k) as amended, preference shares are equity instruments only if fully and mandatorily convertible and fully paid, so these shares are not equity instruments; under the Master Direction they would be debt instruments outside these Rules. Had the shares been fully paid and mandatorily convertible, the issue would be within the Rules, and the cap, route and pricing conditions would then apply. A put option giving Nordvik an exit at an assured price would also breach the optionality limit in Explanation (i).
Need help with foreign investment reporting?
When a company receives money from abroad against these instruments, the issue has to be reported in the form the Reserve Bank specifies. Our FC-GPR filing team can check the instrument, the pricing and the report together.
Key takeaways
- Equity instruments are equity shares, convertible debentures, preference shares and share warrants issued by an Indian company; debentures and preference shares must be fully and mandatorily convertible and fully paid (S.O. 1802(E), 12 April 2022).
- Partly paid shares: fully called up within twelve months, twenty-five per cent upfront; share warrants: twenty-five per cent upfront, balance within eighteen months.
- An optionality clause needs a lock-in of one year (or the sector period, if higher) and no assured exit price.
- A convertible note may run for up to ten years since 12 April 2022.
- Non-debt instruments are the nine items in rule 2(ai); everything else is a debt instrument.
Read next
- Rule 2 of the FEM (Non-debt Instruments) Rules, 2019: FDI, foreign portfolio investment and the sectoral cap
- Rule 18 of the FEM (Non-debt Instruments) Rules, 2019: convertible notes of startups
- Rules 1 to 5 of the FEM (Non-debt Instruments) Rules, 2019: scope and general conditions
- Issue of shares to non-residents: FEMA compliance
Disclaimer: Based on the Gazette text of the instrument this article names, as notified and as amended by the notifications named in the article (for the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 the latest amendment consulted is S.O. 4870(E) dated 2 September 2026), as consulted on 2 October 2026. There is no official consolidated text; the provisions were read with each amendment applied. Sectoral caps, entry routes, conditions, forms and time limits change by notification, press note and circular; later changes should be checked on the Gazette, DPIIT and Reserve Bank sites. This article is general information, not legal advice; check the official text before acting.