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Financial instruments that are characterized as equity for tax purposes will not typically result in any current or future tax effects throughout the instrument’s life or upon settlement. However, financial instruments that are treated as equity for tax purposes may, in certain cases, be classified as a liability for financial reporting purposes. In circumstances in which, under the applicable tax law, the reversal of a book liability either through exercise, expiration, or cash payment will not result in a current or future tax consequence, no deferred taxes would be recognized. That is, the presence of any basis difference would not meet the definition of a temporary difference in accordance with ASC 740-10-25-30.

9.5.1 Tax accounting—preferred stock accounted for as a liability

A baseline example of differing classification for book and tax purposes is an issuance of mandatorily redeemable preferred stock. Pursuant to ASC 480, such stock may be required to be accounted for as a liability. As a result, the difference between its fair value at issuance and the redemption value will be accrued during its term as interest expense. This treatment generally departs from the tax treatment, whereby the security would typically be considered equity with no tax benefit to be realized either during its term or upon redemption. Accordingly, there would be no deferred taxes provided in relation to the liability, no tax benefit for interest accrued in periods leading up to redemption, nor any tax benefit associated with issuance costs. This type of financing generally results in an increased effective tax rate throughout its term.
Additionally, ASC 470-20 applies to certain convertible preferred stock that is mandatorily redeemable and classified as a liability for financial reporting purposes. For tax purposes, however, the instrument may be considered equity. In that case, the instrument may not result in a future tax liability in the event it is redeemed for the book carrying amount, nor would it provide tax deductions for accrued interest (which may constitute dividends for tax purposes). Consequently, deferred taxes would not be recognized because the liability’s carrying amount (or book basis) is expected to reverse without a tax consequence.

9.5.2 Tax accounting—equity-linked warrants accounted for as a liability

A freestanding (i.e., non-embedded) warrant contract to purchase shares of stock typically allows the holder (investor) the option to acquire shares of stock of the reporting entity that sold the option contract. The holder pays a premium to the issuer for the right (option) to exercise the warrant contract based on terms stipulated at issuance. For financial reporting purposes, such equity-linked contracts can be classified as equity or as a liability. Refer to FG 7 for additional information related to assessing whether a warrant should be classified as equity or a liability for financial reporting purposes.
For tax purposes, warrants that are indexed to and settled in an issuer’s own stock are generally characterized as a transaction in their own stock which are not subject to tax for the issuer. Accordingly, such equity-linked contracts generally result in no tax consequences throughout its life or upon settlement.
When an equity-linked warrant contract is classified as a liability for financial reporting purposes, any change in fair value that is recognized in earnings will impact pre-tax income with no corresponding tax effect.
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