To assess whether basis differences in financial instruments are temporary differences for which deferred taxes should be recognized, a reporting entity should determine the classification of the instrument for both financial reporting and tax purposes.

Instruments may be classified as debt (or another liability) for financial reporting purposes but as equity under the applicable tax law; the opposite—equity for financial reporting purposes, debt for tax purposes—may also occur. Also, hybrid instruments may be separated into a host contract and an embedded derivative under the guidance in ASC 815, Derivatives and Hedging, but remain as one instrument for tax purposes. Refer to PwC’s guide to Financing transactions for more discussion of accounting classification for financial reporting purposes.

The separation and classification guidance under US GAAP frequently differs from the applicable treatment for tax purposes; this may result in a book-tax basis difference for which deferred taxes should be recognized. To determine whether there is a temporary difference resulting from the issuance of a debt or equity instrument, including equity-linked instruments such as convertible debt and warrants, a reporting entity should consider the following questions.

A basis difference related to a financial instrument that has no tax effect upon reversal is not a temporary difference for which deferred taxes should be recognized. For example, a hybrid financial instrument classified as equity for tax purposes generally does not result in any tax consequences during its term or upon redemption. Consequently, if the instrument is classified as a liability for financial reporting purposes, any changes in fair value or interest expense recognized for financial reporting purposes would not have a corresponding tax consequence.