A reporting entity will generally incur costs in connection with issuing a debt instrument. See FG 1.2.2 for information on the treatment of debt issuance costs for financial reporting purposes.

To determine the applicable tax treatment of debt issuance costs, a reporting entity should analyze which costs are deductible, as well as the relevant period and methodology for deducting the costs. For tax purposes, debt issuance costs are typically categorized as an ordinary and necessary business expense. Debt issuance costs are generally not classified as interest or OID for tax purposes even though the timing of deductions is often determined by reference to the tax OID rules. This is an important distinction for tax purposes because interest limitation provisions, which could defer or permanently disallow interest expense, generally do not apply to debt issuance costs.

Temporary differences may arise from a mismatch between the period in which debt issuance costs are deductible under the applicable tax law and the period in which they are recognized as interest expense for financial reporting purposes; these differences may result in the recognition of deferred taxes under ASC 740.

A permanent difference relating to debt issuance costs is unusual since debt issuance costs are generally considered deductible for federal income tax purposes.

When an embedded conversion option is bifurcated from a convertible debt instrument, deferred taxes would generally be established for both the debt host and the bifurcated derivative. Bifurcation of an embedded derivative results in the allocation of proceeds to two separate instruments for financial reporting purposes (i.e., the host contract and the bifurcated derivative). For tax purposes, the convertible debt typically remains one instrument. Accordingly, deferred taxes should be established for the temporary differences related to both the host contract (compared to its tax basis) and the derivative (generally zero tax basis). While those deferred tax balances will typically offset at issuance, they will not remain equal because the derivative will be measured at fair value each period while the premium or discount on the host contract (debt component) will be amortized over time. See FG 6.5 for information on the accounting for convertible debt with a separated conversion option.

In situations in which there is no future tax effect associated with the settlement of the hybrid financial instrument, we would not expect deferred taxes to be recognized. This may be the case, for example, when a mandatorily redeemable preferred stock is accounted for as a liability under ASC 480, Distinguishing Liabilities From Equity, and includes an embedded derivative (e.g., payment indexed to the price of oil) that requires separate accounting as a derivative under ASC 815. For tax purposes, however, the instrument may be treated entirely as an equity instrument, meaning that there would be no tax consequences during its term or upon redemption. Therefore, no deferred taxes would be recognized for the host contract or the derivative. This would be consistent with the guidance in ASC 740-10-25-30, which describes certain basis differences that are not considered temporary differences and therefore deferred taxes are not recognized.

There may be situations when the settlement of a hybrid financial instrument for an amount greater than its tax basis does not result in a tax deduction (or in a deduction less than the full amount of the excess), but settlement at an amount less than its tax basis would result in a taxable gain. In these situations, we would generally not expect a net deferred tax asset (combined deferred tax effect of host and derivative) to be recognized for the hybrid instrument. However, a net deferred tax liability should be recognized when the combined financial reporting basis of the host contract and separated derivative is less than the tax basis. A thorough understanding of the applicable tax treatment for the settlement of a hybrid financial instrument is essential to understanding the potential deferred tax implications.

Detachable warrants issued in a bundled transaction with debt are accounted for separate from the debt instrument. The allocation of the issuance proceeds between the debt instrument and the warrants depends on whether the warrants will be equity or liability classified. See FG 8.4.1 for information on warrants issued in connection with debt and FG 5.2 for information on the classification of equity-linked instruments. Allocation of the proceeds to both instruments creates a discount in the debt instrument that reduces the carrying amount of the debt for financial reporting purposes. When debt is issued together with other instruments (including warrants) as an investment unit, the non-debt components generally result in the issue price (i.e., the tax carrying value of the debt on issuance) being allocated away from the debt component based on relative fair market value, resulting in OID for federal income tax purposes. Allocation of the proceeds for financial reporting purposes may differ from the allocation for tax purposes; in that case, differences between the financial reporting carrying amount of the debt and the tax basis of the debt may result in a temporary difference for which deferred taxes should be recognized.

If the warrants are classified as equity, the initial recognition of deferred taxes on debt due to a book-tax basis difference created by the allocation of proceeds to warrants would be charged or credited to shareholders’ equity in accordance with ASC 740-20-45-11(c).

No deferred taxes should be recognized for the difference between the financial reporting carrying amount and the tax basis of the warrants if the warrants represent a right to convert the instrument into equity of the issuer. This is because the basis difference in the warrants will not have a tax effect upon reversal. However, the value attributed to the warrants under US GAAP may cause a temporary basis difference in the debt for which deferred taxes may need to be accrued.

If the warrants are classified as a liability, the initial recognition of deferred taxes on debt due to a book-tax basis difference created by the allocation of proceeds to the warrants should be recorded in the income statement through the provision for income taxes. Deferred taxes should also be recognized for the difference between the financial reporting carrying amount and the tax basis of the warrants if there is a possible future tax consequence related to the exercise of the warrants. Typically, however, the reversal of a warrant liability either through exercise, expiration, or cash payment does not result in a current or future tax consequence if the warrant is convertible into stock of the issuer or certain affiliates; in that case, consistent with the guidance in ASC 740-10-25-30, no deferred taxes should be recorded when the warrant liability is initially recognized or when subsequently marked to fair value through the income statement.

Subsequent to initial recognition, the temporary difference underlying the deferred tax asset or (more typically) liability associated with the debt reverses through the income tax line as the debt discount is amortized. This is the case regardless of whether the deferred taxes were initially recognized as an adjustment to shareholders’ equity or through the provision for income taxes.

Example TX 9-1 illustrates the accounting for deferred taxes when a reporting entity issues debt with detachable warrants that are accounted for as a liability.

EXAMPLE TX 9-1
Accounting for tax effects of issuing debt with detachable warrants

Company A issued 5-year term debt with a par value of $1 million with detachable warrants to purchase 100,000 shares of Company A stock for total proceeds of $1 million. The debt bears interest at a stated rate of 2%. The warrants are puttable back to Company A. It was determined that the warrants would create OID for tax purposes.

As a result of the put feature, the warrants will be classified as a liability; thus, the $1 million proceeds are allocated first to the warrants based on their fair value with the residual allocated to the debt instrument. (Note that this allocation would be different if the warrants were equity classified. See FG 8.4.1.) The fair value of the warrants is determined to be $400,000 with the residual $600,000 of the proceeds allocated to the debt instrument.

For purposes of this example, assume the amount allocated to the warrants was determined to be $300,000 for tax purposes, which is treated as OID, and that the warrants are treated as a position in the issuer’s equity. Thus, the reversal of the warrant liability recognized for financial reporting purposes, either through exercise, expiration, or cash payment will not result in a current or future tax consequence.

Company A is subject to a 25% tax rate and interest expense is deductible currently for tax purposes.

What are the deferred tax implications, if any, upon issuance of the debt with detachable warrants?

Upon issuance, Company A would recognize deferred taxes for the temporary difference on the debt. No deferred taxes, however, would be recognized for the difference between the financial reporting carrying amount and tax basis of the warrants, as the reversal of the warrant liability will not result in a current or future tax consequence.

The financial reporting basis of the debt is $600,000 ($1 million less $400,000 discount) and the tax basis of the debt would be $700,000 ($1 million less $300,000 value of the warrants for tax purposes). Therefore, Company A would recognize a $25,000 deferred tax liability [($600,000 - $700,000) × 25%] with the offsetting debit recognized in the income statement through its tax provision.

Note: If the warrants were instead classified as equity for financial reporting purposes, the tax effect would have been recorded as a charge to equity in accordance with ASC 740-20-45-11(c) instead of deferred tax expense.

In subsequent periods, the warrant liability will be remeasured to fair value with changes in fair value recognized in earnings. Because no temporary difference exists, no deferred tax benefit/expense will be recognized when changes in fair value of the warrant are recognized in net income.

At the end of year 1, assume the warrant liability has increased to $450,000. For simplicity purposes, assume the debt discount will accrete over the 5-year period on a straight-line basis for financial reporting purposes ($80,000 per year) and tax purposes ($60,000 per year, noting this is solely for illustrative purposes, as straight line is not an appropriate OID accrual method).

Company A would recognize $100,000 in interest expense: the cash coupon of 2% ($20,000) plus amortization of the debt discount ($80,000). The warrant liability will be remeasured through earnings ($50,000 expense) with no corresponding tax effect.

Company A would record the following journal entries for financial reporting purposes (amounts in thousands):

As of December 31, 20X1, the temporary difference on the debt will have decreased by the $20,000 difference in book and tax amortization of the discount. The corresponding reduction in the deferred tax liability of $5,000 ($20,000 x 25%) would be recognized as a tax benefit in the income statement.

A current tax benefit would be recognized for the cash coupon ($20,000 × 25%) and amortization for tax purposes of the current period OID deduction ($60,000 × 25%) for a total current tax benefit of $20,000, assuming there are no limitations to deducting interest under the respective tax law.

In total for this instrument, a pre-tax expense of $150,000 would be recognized with a total income tax benefit of $25,000.

In certain circumstances, a reporting entity may elect to account for its debt at fair value in accordance with the guidance in ASC 825, Financial Instruments. When a reporting entity elects to carry its debt at fair value, the change in the carrying amount of the debt for financial reporting purposes will have no corresponding effect on the tax basis.

If a reporting entity has elected to account for its debt at fair value and the fair value of the debt drops below its tax basis, it should record a deferred tax liability. If, however, as a matter of tax law, settlement of the debt at an amount other than its tax basis does not result in taxable or deductible amounts, no temporary difference exists and no deferred taxes should be recognized, consistent with the guidance in ASC 740-10-25-30. In those circumstances, the change in fair value of the debt would have no corresponding tax effect, resulting in an impact to the reporting entity’s effective tax rate (i.e., a permanent difference).

A debt extinguishment can occur when a reporting entity settles its debt for cash, other assets, or equity. In accordance with ASC 470-50-40-2, an extinguishment gain or loss equal to the difference between the re-acquisition price and the net carrying amount of the debt instrument should be recognized in the income statement. See FG 3.7 for information on the accounting for debt extinguishments for financial reporting purposes.

In order to determine the related tax effects of a debt extinguishment, the applicable tax law will need to be considered. The extinguishment of debt at a premium (i.e., paying more than the tax basis) may result in an additional interest deduction equal to the payment in excess of the tax basis. For instance, the applicable tax law may allow a reporting entity that repurchases its debt at a premium to deduct the premium paid, in whole or in part, as interest expense. However, in some cases the premium paid to re-acquire debt in excess of its tax basis may be disallowed, in whole or in part, as a tax deduction. For example, if the premium paid relates to the conversion feature in convertible debt, the repurchase premium may not be deductible for tax purposes. In these circumstances, some or all of the extinguishment gain or loss recognized for financial reporting purposes would have no corresponding tax effect.

In the US, the extinguishment of debt for an amount less than the tax basis typically gives rise to cancellation of debt income (CODI) and is includable in taxable income.

Debt extinguishment gains and losses are recognized in the income statement; therefore, any related tax effects (current tax effect or deferred taxes that are eliminated or reversed upon the extinguishment) should also be recognized in the income statement, through the income tax provision.

ASC 740 provides that certain current and deferred tax effects be recognized outside of the income statement. For example, ASC 740-20-45-11(g) relates to transactions among or with shareholders and may require the impacts for a change in tax bases be allocated to shareholders’ equity in certain circumstances.

Example TX 9-2 illustrates the income tax accounting effects in a reporting entity’s separate financial statements for the purchase of its outstanding debt at a discount by a related party.

EXAMPLE TX 9-2
Income tax accounting for the purchase of a reporting entity’s debt at a discount by a related party

OP Co is wholly-owned by PE Fund, a private equity fund. OP Co issues $100,000 of public debt at face value. Subsequently, when the debt is trading at 80% of face value, PE Fund purchases the debt at a discount, as follows:

For financial reporting purposes, no transaction has occurred at OP Co, as the public debt was purchased by PE Fund in the secondary market in a transaction that did not involve OP Co.

Under US tax law, a borrower may realize cancellation of indebtedness income if their debt is purchased at a discount to its adjusted issue price by a related party. Accordingly, for tax purposes, the debt is deemed to be purchased at a discount, resulting in an immediate taxable gain to OP Co of $20,000.

It is assumed for purposes of this example that the various exceptions provided in the tax law for exclusion of the taxable gain, such as insolvency or bankruptcy, are not applicable.

Under the relevant tax law, the debt is then considered to be re-issued by OP C0 to the purchaser of the debt (i.e., PE Fund) with an OID of $20,000. As a result, OP Co’s tax carrying value in the debt is reduced from $100,000 to $80,000.

Ordinarily, OP Co would be entitled to deduct the OID as interest in future periods. However, assume that the debt is considered an Applicable High Yield Discount Obligation and that $6,000 of the OID will be permanently disallowed under the tax law.

OP Co is subject to a 25% tax rate.

How should OP Co account for the income tax effects of this transaction in its separate financial statements?

OP Co should account for the income tax effects of this transaction in its separate financial statements in accordance with ASC 740-20-45-11(g) and record the income tax effects in equity. OP Co would record the following entries (amounts in thousands):