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9.4A Tax accounting—convertible debt (before adoption of ASU 2020-06)
Publication date: 30 Sep 2023
us Income taxes guide
The issuance of convertible debt may result in a temporary difference for which a deferred tax asset or liability would be required under ASC 740. Temporary differences often arise due to the differences between the financial reporting requirements and the applicable tax requirements for convertible debt.
The determination of whether a basis difference is a temporary difference will often depend on the manner in which a liability is expected to be settled and whether the settlement method is within the reporting entity’s control.
9.4A.1 Debt instruments with temporary differences (before adoption of ASU 2020-06)
When a company issues convertible debt at a discount, the discount is amortized (or the debt’s carrying amount is accreted) to face value for financial reporting purposes through a charge to interest expense over the life of the debt. For some convertible debt issuances, the conversion option is not bifurcated and no amount is attributed to equity assuming that the conversion feature is not considered a beneficial conversion feature as defined in the FASB’s Master Glossary. For financial reporting purposes, if the debt is converted to equity, it would be reclassified from debt to equity at its carrying amount on the conversion date. Refer to FG 6.9A for further details on the accounting for the conversion of convertible debt.
For tax purposes, unless the discount were to otherwise qualify as OID, amortization of the discount is generally not deductible on a periodic basis. In certain cases, the tax law allows deductions for the difference between the issuance proceeds and the ultimate repayment amount if the debt is extinguished by repurchase or repayment at maturity, but generally does not allow such deductions if the debt is converted into equity. Thus, any tax deduction may depend on the manner of settlement.
For cases in which the tax law provides for a deduction when the debt is settled, we believe that a temporary difference exists to the extent that debt has a different basis for book and tax purposes, irrespective of expectations that the holders are likely to convert. Analogizing to ASC 740-10-25-30 (basis differences that are not temporary differences) would not be appropriate in this situation. Although the example in that ASC paragraph refers to management’s expectation of the manner of settlement in the context of a company-owned life insurance policy, we believe an important distinction in that scenario is that management controls the manner of settlement. Because the holders of convertible debt (not management) control the outcome—settlement as debt or conversion as equity—it would not be appropriate to analogize this temporary difference to the cash surrender value of an officer’s life insurance.
Importantly, however, if the debt is ultimately converted to equity and no tax deduction arises, we believe the corresponding write-off of the deferred tax asset would be to shareholders’ equity in accordance with ASC 740-20-45-11(c).
9.4A.2 Tax accounting—contingent payment convertible debt differences (before adoption of ASU 2020-06)
Some forms of convertible debt provide for contingent payments, such as incremental interest payments once the issuer’s common stock reaches a target market price. When the arrangement is characterized as a “contingent payment debt instrument,” the tax law allows the company, in certain cases, to deduct interest equal to that of comparable nonconvertible fixed-rate debt in lieu of deducting the stated rate of interest actually paid. If properly characterized under these rules, total interest deductions for tax purposes will generally exceed total interest expense recognized for financial reporting purposes. This can happen, for example, when the interest expense recognized for financial reporting purposes is equal to the stated rate of interest (i.e., coupon rate). Interest deductions in excess of the stated rate will be recaptured for tax purposes, in whole or in part, if the debt is retired (either through early redemption or at maturity) or converted to stock with a fair value at the time of conversion that is less than the tax basis of the debt. Under the applicable tax regulations, the excess deductions of interest for tax purposes increase the tax carrying value (i.e., adjusted issue price) of the debt, giving rise to a taxable temporary difference since the tax carrying value of the debt will be higher than the book basis of the debt.
We believe that a deferred tax liability should be recorded for this taxable temporary difference. The recapture of the excess interest deduction is not within the reporting entity’s control because conversion is at the option of the investor and, even when converted, whether interest is recaptured depends on the market value of the reporting entity’s stock at that time. If the debt is settled for cash and the excess interest is subject to recapture, the temporary difference is also settled and reversed with a deferred tax benefit recognized in the income statement. If the debt is converted into equity and the additional interest deduction for tax purposes is ultimately not recaptured, the deferred tax liability should be reversed with a corresponding credit to additional paid-in capital in accordance with ASC 740-20-45-11(c).
9.4A.3 Tax accounting–convertible debt with cash conversion option (before adoption of ASU 2020-06)
ASC 470-20 requires a reporting entity that issues convertible debt with a cash conversion option to bifurcate the debt into its liability and equity components in a manner that reflects interest expense at the interest rate of similar nonconvertible debt. See FG 6.6A for information on the accounting for convertible debt with a cash conversion option for financial reporting purposes.
From a tax accounting perspective, the application of ASC 470-20 often results in a basis difference associated with the liability (debt) component.
Recognizing convertible debt instruments within the scope of the Cash Conversion Subsections as two separate components—a debt component and an equity component—may result in a basis difference associated with the liability component that represents a temporary difference for purposes of applying Subtopic 740-10. The initial recognition of deferred taxes for the tax effect of that temporary difference shall be recorded as an adjustment to additional paid-in capital.
The basis difference is measured as the difference between the carrying amount of the liability component for financial reporting purposes and the convertible debt instrument’s tax basis (which is generally its original issue price adjusted for any OID). Although the discount created in the debt instrument is amortized to interest expense for financial reporting purposes, it is not deductible for tax purposes. Consequently, the amortization of the debt discount creates a basis difference in the liability component that is a temporary difference.
At inception, a deferred tax liability should be recorded through additional paid-in capital pursuant to ASC 470-20-25-27. In subsequent periods, the deferred tax liability would be reduced and a deferred tax benefit would be recognized through the income statement as the debt discount is amortized to interest expense.
Example TX 9-3A illustrates accounting for the tax effects of issuing convertible debt with a cash conversion option.
EXAMPLE TX 9-3A
Accounting for the tax effects of issuing convertible debt with a cash conversion option
Accounting for the tax effects of issuing convertible debt with a cash conversion option
Company A issues a convertible bond that will be settled upon conversion by delivering (1) cash up to the principal amount of the bond and (2) net shares equal to any value due to the conversion option being in the money. Company A concludes that the bond must be bifurcated into its debt and equity components pursuant to the guidance in ASC 470-20.
Using a present value calculation, Company A determines the initial carrying amount of the debt to be $76 million. The embedded equity conversion option is $24 million, the difference between the $100 million proceeds and $76 million debt liability.
Assume Company A is subject to a 25% tax rate and interest expense is deductible currently for tax purposes.
Company A calculates deferred taxes associated with bifurcating the convertible debt into its liability and equity components as the temporary difference between the book basis of the debt ($76 million) and the tax basis of the debt ($100 million) multiplied by Company A's tax rate of 25%, resulting in a deferred tax liability of $6.0 million ($24 million × 25%).
The following table illustrates the amortization of the debt discount and the resulting change in the deferred tax liability over the expected life of the convertible debt.
(in millions) |
Issuance |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Carrying amount of debt |
$76.0 |
$80.1 |
$84.5 |
$89.3 |
$94.4 |
$100.0 |
Amortization of discount |
— |
4.1 |
4.4 |
4.8 |
5.2 |
5.6 |
Tax basis of debt |
100.0 |
100.0 |
100.0 |
100.0 |
100.0 |
100.0 |
Taxable temporary difference |
($24.0) |
($19.9) |
($15.5) |
($10.7) |
($5.6) |
$— |
Deferred tax liability |
($6.0) |
($5.0) |
($3.9) |
($2.7) |
($1.4) |
$— |
What journal entries should Company A record (1) upon issuance of its convertible debt and (2) during year 1?
Analysis
At issuance (amounts in millions):
Dr. Cash
|
$100.0
|
||||
Dr. Debt discount
|
24.0
|
||||
Cr. Convertible debt
|
$100.0
|
||||
Cr. Additional paid-in capital
|
24.0
|
||||
Dr. Additional paid-in capital
|
$6.0
|
||||
Cr. Deferred tax liability
|
$6.0
|
||||
To record the issuance of the convertible debt and deferred tax liability.
During year 1 (amounts in millions):
Dr. Interest expense
|
$6.1
|
||||
Cr. Cash
|
$2.0
|
||||
Cr. Debt discount
|
4.1
|
||||
To recognize (a) the payment of the 2% cash coupon ($100 million × 2%) and (b) the $4.1 million amortization of the debt discount using the effective interest method (as per the table above).
Dr. Current tax payable
|
$0.5
|
|||
Cr. Current tax benefit
|
$0.5
|
To recognize the current tax benefit from the cash interest deduction ($2 million x 25%).
Dr. Deferred tax liability
|
$1.0
|
|||
Cr. Deferred tax benefit
|
$1.0
|
To recognize the $1.0 million ($6.0 million - $5.0 million) reduction of the deferred tax liability from the Year 1 discount amortization recorded through the income statement ($4.1 million x 25%).
9.4A.3.1 Tax accounting—convertible debt with a cash conversion option—issue costs (before adoption of ASU 2020-06)
ASC 470-20-25-26 requires transaction costs incurred with third parties other than investors that directly relate to the issuance of convertible debt instruments within the cash conversion subsections to be allocated to the liability and equity components in proportion to the allocation of proceeds to those components. Allocated costs should be accounted for as debt issuance costs and equity issuance costs, respectively. See FG 1.2.2 for information on the accounting for debt issuance costs and FG 7.4.2 for information on the accounting for equity issuance costs.
Costs associated with the issuance of convertible debt with a cash conversion option are generally treated as debt issuance costs for tax purposes because the applicable tax treatment does not require bifurcation of the debt into liability and equity components (i.e., it is one unit of account for tax purposes). Therefore, all of the debt issuance costs attributed to the debt for tax purposes will generally be greater than the issuance costs allocated to the debt for financial reporting purposes. Thus, the future tax deductions associated with the issuance costs will exceed the amortization recognized for financial reporting purposes, resulting in a deferred tax asset. Based on the guidance in ASC 740-20-45-11(c), the deferred tax asset associated with the tax deductible costs related to the equity component should be initially recognized with a corresponding credit to shareholders’ equity.
9.4A.3.2 Tax accounting—derecognizing convertible debt with a cash conversion option (before adoption of ASU 2020-06)
ASC 470-20-40-20 provides that the accounting for derecognition of a convertible debt instrument with a cash conversion feature is the same whether the convertible debt is repurchased (extinguished) or converted into shares. In either case, the reporting entity should allocate the fair value of the consideration transferred (cash or shares) and any transaction costs incurred between (1) the debt component – to reflect the extinguishment of the debt and (2) the equity component – to reflect the reacquisition of the embedded conversion feature. An extinguishment gain or loss is recognized in earnings for the difference between the fair value of the debt and the carrying amount of the debt upon derecognition. See FG 6.6A for additional information on accounting for the extinguishment of convertible debt with a cash conversion option.
The related tax effects upon extinguishment should follow the basic intraperiod allocation model in ASC 740-20-45 for allocating income taxes between income from continuing operations and other financial statement components. This basic model (often referred to as the “with-and-without” calculation) is discussed in detail in TX 12. Example TX 9-4A further addresses some of the other complexities of intraperiod allocation that may exist.
EXAMPLE TX 9-4A
Accounting for the tax effects upon the repurchase of convertible debt with a cash conversion option resulting in a gain on extinguishment of debt
Accounting for the tax effects upon the repurchase of convertible debt with a cash conversion option resulting in a gain on extinguishment of debt
Company A issues a convertible bond that will be settled upon conversion by delivering (1) cash up to the principal amount of the bond and (2) net shares equal to any value due to the conversion option being in the money. Company A concludes that the bond must be bifurcated into its debt and equity components pursuant to the guidance in ASC 470-20. The principal amount of the debt was $100 million with a coupon rate of 2%.
Assume Company A is subject to a 25% tax rate and that the 2% interest payment was determined to be deductible currently for tax purposes.
The following table illustrates the amortization of the debt discount and the resulting change in the deferred tax liability over the expected life of the convertible debt.
(in millions) |
Issuance |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Carrying amount of debt |
$76.0 |
$80.1 |
$84.5 |
$89.3 |
$94.4 |
$100.0 |
Amortization of discount |
— |
4.1 |
4.4 |
4.8 |
5.2 |
5.6 |
Tax basis of debt |
100.0 |
100.0 |
100.0 |
100.0 |
100.0 |
100.0 |
Taxable temporary difference |
($24.0) |
($19.9) |
($15.5) |
($10.7) |
($5.6) |
$— |
Deferred tax liability |
($6.0) |
($5.0) |
($3.9) |
($2.7) |
($1.4) |
$— |
At the end of year 2, Company A repurchases the convertible debt for $90 million in cash. Company A’s deteriorating results prompted investors to accept the repurchase offer for an amount less than the stated par value.
The fair value of the debt immediately prior to extinguishment is determined to be $81.5 million (based on current market conditions and Company A’s deteriorating credit). Company A allocates the $90 million cash consideration as follows: (1) $81.5 million to extinguish the debt and (2) the remaining $8.5 million to the reacquisition/retirement of the embedded equity conversion option.
For financial reporting purposes, a gain on extinguishment of $3 million arises from the difference between (1) the fair value of the debt prior to conversion ($81.5 million) and (2) the carrying amount of the debt at the end of year 2 ($84.5 million).
For tax purposes, assume that cancellation of debt income is $10 million (the $100 million tax basis of the debt compared to the $90 million paid to extinguish it).
How would Company A record the extinguishment?
Analysis
Repurchase at the end of year 2:
Company A would derecognize the convertible debt instrument (net carrying value of $84.5 million, $100 million par value less unamortized discount of $15.5 million), recognize a cash payment of $90 million, recognize a $3 million gain on extinguishment ($81.5 million of proceeds allocated to the fair value of debt compared to the $84.5 million carrying amount of debt), and reduce additional paid-in capital by $8.5 million (representing the retirement of the equity conversion option). Company A would record the following entry (in millions):
Dr. Convertible debt
|
$100.0
|
||||
Dr. Additional paid-in capital
|
8.5
|
||||
Cr. Cash
|
$90.0
|
||||
Cr. Debt discount
|
15.5
|
||||
Cr. Gain on extinguishment
|
3.0
|
||||
In order to determine the amount of the tax benefit from the derecognition of the deferred tax liability that would be recognized in income and the portion that will be recognized in equity, Company A would follow the basic with-and-without model for allocating income taxes between financial statement components under ASC 740.
Company A would have a total tax benefit of $1.4 million, the net of the $3.9 million deferred tax benefit from the derecognition of the existing deferred tax liability, and a current tax expense of $2.5 million on the cancellation of indebtedness income.
Assuming no other activity for the period other than the debt extinguishment, the tax expense allocated to continuing operations would be $0.8 million (the pre-tax gain of $3 million × 25%).
In the final step, Company A would allocate the difference between the total tax (the “with” amount) and the amount allocated to continuing operations (the “without” amount), to the other components of income. Again, assuming no other components of income, the remaining net benefit of $2.2 million would be allocated (credited) to additional paid-in capital as follows (in millions):
Step 1
|
Total tax provision / (benefit)
|
(1.4)
|
Step 2
|
Tax provision / (benefit) attributable to continuing operations
|
- 0.8
|
Tax provision / (benefit) remaining to allocate to other components
|
(2.2)
|
|
Step 3
|
100% allocated to additional paid-in capital
|
(2.2)
|
9.4A.4 Tax accounting—convertible debt with beneficial conversion feature (before adoption of ASU 2020-06)
When a reporting entity issues convertible debt with a beneficial conversion feature (BCF), the BCF should be separated from the convertible debt and recognized in additional paid-in capital. See FG 6.7A for information on the identification of BCFs and the accounting for instruments that contain a BCF.
Separation of the BCF creates a discount in the convertible debt for financial reporting purposes. For tax purposes, the tax basis of the convertible debt is the entire proceeds received at issuance of the debt. Thus, the book and tax bases of the convertible debt are different. ASC 740-10-55-51 addresses whether a deferred tax liability should be recognized for that basis difference.
The issuance of convertible debt with a beneficial conversion feature results in a basis difference for purposes of applying this Topic. The recognition of a beneficial conversion feature effectively creates two separate instruments-a debt instrument and an equity instrument-for financial statement purposes while it is accounted for as a debt instrument, for example, under the U.S. Federal Income Tax Code. Consequently, the reported amount in the financial statements (book basis) of the debt instrument is different from the tax basis of the debt instrument. The basis difference that results from the issuance of convertible debt with a beneficial conversion feature is a temporary difference for purposes of applying this Topic because that difference will result in a taxable amount when the reported amount of the liability is recovered or settled. That is, the liability is presumed to be settled at its current carrying amount (reported amount). The recognition of deferred taxes for the temporary difference of the convertible debt with a beneficial conversion feature should be recorded as an adjustment to additional paid-in capital. Because the beneficial conversion feature (an allocation to additional paid-in capital) created the basis difference in the debt instrument, the provisions of paragraph 740-20-45-11(c) apply and therefore the establishment of the deferred tax liability for the basis difference should result in an adjustment to the related components of shareholders' equity.
As the discount created by the recognition of the BCF is amortized, the temporary difference reverses.
9.4A.5 Tax accounting—conversion option bifurcated as a derivative liability (before adoption of ASU 2020-06)
Convertible debt that contains a conversion option that meets the definition of a derivative and does not qualify for the ASC 815-10-15-74(a) scope exception for instruments indexed to a reporting entity’s own equity should be separated into a debt host and a derivative liability. The derivative liability is carried at fair value and remeasured to fair value at each reporting period with changes in fair value recognized in the income statement. The allocation of the proceeds between the debt component (host contract) and the derivative liability results in a debt discount that is amortized over the life of the debt instrument. See FG 6.4A for additional information on evaluating whether the conversion option embedded in convertible debt requires separate accounting under ASC 815, and FG 6.5A for information on the accounting for convertible debt with a separated conversion option.
From an income tax accounting perspective, ASC 740-10-55-51 provides guidance on accounting for the tax effects of convertible debt instruments that contain a beneficial conversion feature that is bifurcated and accounted for as equity. Furthermore, ASC 470-20-25-27 provides guidance for situations in which a convertible debt instrument with a cash conversion option requires the conversion feature to be bifurcated and accounted for as equity. However, when the conversion option is accounted for as a derivative liability, and there are two liabilities (the debt and the derivative), two temporary differences arise. There is no explicit tax law for situations in which the conversion feature is bifurcated and accounted for as a separate derivative liability. In such cases, there is typically a difference between the financial reporting basis and tax basis of both the debt component and the derivative liability. These basis differences result from the convertible debt being accounted for as two separate instruments for financial reporting purposes (i.e., a debt instrument and a derivative liability) but as a single debt instrument for tax purposes (i.e., one unit of account).
The differences between the financial reporting basis and the tax basis of both the debt component and the derivative liability should be accounted for as temporary differences in accordance with ASC 740. The tax basis of the debt will generally be in excess of the financial reporting basis due to the debt discount recognized for financial reporting purposes, which would typically give rise to a deferred tax liability. The financial reporting basis of the derivative liability will almost always exceed (it cannot be less than) its tax basis of $0, which would give rise to a deferred tax asset. The deferred tax liability recognized for the debt component and the deferred tax asset for the derivative liability will typically offset at issuance. However, changes in fair value of the derivative liability and amortization of the debt discount will result in the deferred taxes no longer offsetting in subsequent periods, so the two deferreds should be tracked separately.
In situations in which there will not be a future tax benefit for the settlement of the convertible debt (both the debt host and derivative liability are settled together) for an amount greater than the tax basis, we would not expect a net deferred tax asset to be recognized. That is, the deferred tax liability and the deferred tax asset recognized for the debt host and derivative liability should not result in the recognition of a net deferred tax asset. This may be the case when, under the applicable tax law, settlement of the convertible debt (debt host and derivative liability) at an amount greater than the tax basis would not result in a tax deductible transaction. This would be consistent with the guidance in ASC 740-10-25-30 and the definition of a temporary difference in ASC 740-10-20.
9.4A.6 Tax accounting – conversion of convertible debt (before adoption of ASU 2020-06)
When convertible debt that does not require separate accounting for all or a portion of its conversion option (either as a derivative or as a separate component of equity) is converted into equity in accordance with its original conversion terms, ASC 470-20-40-4 requires the carrying amount of the debt, including any unamortized premium or discount, to be credited to the capital accounts to reflect the stock issued; no conversion gain or loss is recognized.
Any related tax effects upon conversion are also accounted for in equity in accordance with ASC 740-20-45-11(c). From a tax perspective, if a borrower repurchases its own convertible debt (or the debt is converted by a holder) for an amount greater than the debt's adjusted issue price, the excess may not be deductible. An exception to the general rule exists if the reporting entity can demonstrate that the premium is attributable to the cost of borrowing and is not attributable to the conversion feature.
While uncommon, a taxable gain could arise if the fair value of the stock provided upon conversion is less than the tax basis of the convertible debt. For example, in the US, the excess tax basis over the fair value of the stock provided upon conversion is treated as CODI and includable in taxable income.
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