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When a reporting entity issues convertible debt, it will generally be accounted for as a liability upon issuance under US GAAP and for income tax purposes. Basis differences can arise upon or after issuance for a number of reasons, including differences in the existence and/or amount of OID, debt issuance costs, marking the debt to fair value if the fair value option is elected for the convertible debt, and embedded conversion options (i.e., a derivative liability). Refer to TX 9.3 for tax accounting considerations associated with these items.
New guidance
In August 2020, the FASB issued ASU 2020-06, Debt – Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging – Contracts in Entity’s Own Equity (Subtopic 815-40). The new ASU eliminates the beneficial conversion and cash conversion accounting models for convertible instruments and supersedes the respective guidance within ASC 470-20 and ASC 740-10-55-51. With the elimination of the cash conversion and beneficial conversion feature models, more instruments will be accounted for as a single instrument rather than having their proceeds allocated between liability and equity accounting units.
The amendments in the ASU are effective for public business entities that meet the definition of an SEC filer, excluding entities eligible to be smaller reporting companies as defined by the SEC, for fiscal years beginning after December 15, 2021, including interim periods within those fiscal years. For all other entities, the amendments are effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years. Early adoption is permitted at the beginning of an entity’s annual fiscal year, but no earlier than fiscal years beginning after December 15, 2020.

9.4.1 Debt instruments with temporary differences (after adoption of ASU 2020-06)

In most situations, convertible debt will not be bifurcated on the balance sheet, unless there is an embedded derivative or a substantial premium paid. Refer to TX 9.4.3 and TX 9.4.4, respectively, for tax accounting considerations in these situations.
When a reporting entity 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 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.

9.4.2 Tax accounting—contingent payment convertible debt (after 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 an 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). However, 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. Thus, the excess deductions of interest for tax purposes give rise to a taxable temporary difference.
A deferred tax liability should be recorded for the tax effects of redeeming the debt at its carrying amount. If the debt is settled for cash, the temporary difference, which encompasses the excess interest recapture, is also settled. 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).

9.4.3 Tax accounting—conversion option bifurcated as a derivative liability (after 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 6.4 for additional information on evaluating whether the conversion option embedded in convertible debt requires separate accounting under ASC 815, and FG 6.5 for information on the accounting for convertible debt with a separated conversion option.
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 a temporary difference 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.
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.

9.4.4 Tax accounting—convertible debt issued at a substantial premium (after adoption of ASU 2020-06)

When a reporting entity concludes that a conversion option should not be separated from its host debt instrument under ASC 815, it should further evaluate whether the convertible debt was issued with a substantial premium. If a reporting entity concludes the convertible debt instrument was issued at a substantial premium, there is a presumption that the premium represents paid-in capital. In these cases, the convertible debt is reported by recording a liability at its principal or par amount, and the excess proceeds are reported as additional paid-in capital. Refer to FG 6.6 for more information on accounting for convertible debt with a substantial premium.
The tax treatment depends on why the premium was paid for the convertible debt. For example, if the premium is a result of a higher coupon rate, the premium is amortized for income tax purposes and treated as a reduction in the interest expense of the issuer, as discussed in TX 9.3.1. In this case, deferred taxes may need to be established through APIC for the different treatment between financial reporting purposes and income tax. Alternatively, if the premium arises because the conversion feature (e.g., the right to receive shares of the reporting entity) is “in the money” (e.g., the exercise price is less than the current fair market value of the shares), an analysis is required to determine the appropriate tax treatment and whether or not the instrument still qualifies as debt. Convertible debt issued at a substantial premium could result in the instrument being treated entirely as an equity instrument for tax purposes, with no tax consequences during its term or upon redemption. In situations where there is no future tax effect associated with the settlement of the convertible debt, we would not expect deferred taxes to be recognized.

9.4.5 Tax accounting–conversion of convertible debt (after adoption of ASU 2020-06)

If a convertible debt instrument (where the conversion option was not bifurcated) is converted into a reporting entity’s common or preferred stock pursuant to a conversion option in the instrument, it is not an extinguishment; the convertible debt is settled in exchange for equity and no gain or loss is recognized upon conversion. Refer to FG 6.8 for more information on accounting for debt conversions.
Any related tax effects upon conversion are 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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