Jian Ming is an associate professor and Rony Lim is a lecturer at Nanyang Business School, Singapore

Picture a financial instrument that combines the benefits of two others: the protected returns of bonds and the growth potential of shares. The convertible bond offers a way of financing similar to traditional bonds as well as equity financing, converting into shares at a predetermined ratio. While interest rates remain high, convertible bonds can also help companies reduce borrowing costs.

Accounting impact

Under IAS 32 Financial Instruments: Presentation, an issuer of convertible bonds must perform split accounting to separate the liability and equity components on the issuer’s balance sheet. At initial recognition, the issuer is required to recognise the liability component at its fair value. The equity component will then be the difference between fair value of the convertible bond and the fair value of its liability component.

Issuers are often concerned about whether the distributions and issue costs are tax deductible

Tax legislation

In most jurisdictions, the discount attributed to the liability component may be taxable while the premium attributed to the liability component may be deductible. However, the equity component is not allowable as a deduction as there is no actual cash outlay and such components are capital in nature. Hence, a tax adjustment is required.

Issuers of hybrid instruments are often concerned about whether the distributions and issue costs are tax deductible. This will depend on the tax classification; in Singapore, for instance, the tax authority considers a variety of factors such as voting rights conferred by the instrument and obligation to repay the principal amount.

Here, two tax treatment scenarios are discussed. In scenario 1, the convertible bond is regarded as equity and no tax deduction is allowed. In scenario 2, it is treated as a liability and borrowing costs are tax deductible.

The entity may elect to exempt the accounting book’s liability component from deferred tax according to IAS 12: 15

In both scenarios, we make the following set of assumptions:

The fair value of the liability component of the convertible bond can then be computed as S$9.5m.

The journal entries are as follows:

* Similar journal entries at the end of years two and three will be recorded.

Tax treatment under scenario 1: the convertible bond is classified as an equity instrument by the tax authority

As the tax authority classifies the instrument as equity, distributions are regarded as dividends and are not tax deductible.

The convertible bond will be treated as entirely equity, so the tax base is nil. The entity may elect to exempt the accounting book’s liability component from deferred tax according to IAS 12: 15, which gives rise to a permanent difference, and no deferred tax liability (DTL) arises from the instrument.

In this scenario, the accounting profit before tax is S$50K. Interest expense amounted to S$950K. As interest expense is not tax deductible, it is combined with accounting profit before tax that results in a taxable profit of S$1m. Applying the tax rate of 20%, the income tax payable on the taxable profit is S$200K.

The journal entry to record the tax effect is:

Tax treatment under scenario 2: the convertible bond is classified entirely as a liability by the tax authority

Under this scenario, interest expense and borrowing cost recorded in the income statement will not be allowed as a deduction. Instead, the issuer is allowed tax deduction on interest payments based on a contractual interest rate. Where borrowing costs are in the form of a premium on redemption of convertible bonds, the deduction is allowed only when the bond comes due, and the deduction is given for the bond discount.

Since the tax authority considers the convertible bonds as a single debt instrument and does not recognise a separate equity component for the convertible feature, the tax base attributed to the bond (ie the amount shown on the tax balance sheet) is S$10m at inception.

A DTL arises because the accounting balance sheet recognises a separate equity option whereas the tax balance sheet recognises the instrument as a liability in its entirety. This is a day 1 DTL item as the difference in accounting rules and tax rules upon initial recognition gives rise to a taxable temporary difference, which requires the issuer to pay more tax when the liability matures. Since it arises from the initial recognition of equity options (and not the initial recognition of an asset or liability), it is not exempted from recognition under IAS 12: 15 or 24.

In this example, the S$10m tax base of the liability component on initial recognition is equal to the initial carrying amount of the sum of liability (S$9.5m) and equity (S$0.5m) (IAS 12: 23). The initial balance of DTL of S$100K (S$0.5m x 20%) is charged directly to the carrying amount of the equity component according to IAS 12:62A.

The journal entry to record the tax effect at 1 January 20×1 is:

On 31 Dec 20×1, the liability’s carrying amount is S$9,955K while its tax base remains at S$10,000K. As interest paid is less than interest expense, the entity obtains less tax deduction (and pays more tax) in 20×1 and will pay less tax subsequently. The deductible temporary difference, which is a future tax deduction, reduces future taxable temporary difference (future amount taxable) to S$45K. DTL decreases to S$9K (S$45K x 20%). The decrease in DTL of S$91K (S$100K-S$9K) will decrease tax expense.

The journal entry to record the tax effect on 31 December 20×1 is:

Note that scenario 2’s S$110K total tax payable (S$101K current tax payable and S$9K DTL) is lower than scenario 1’s S$200k total tax payable because, in scenario 2, the entity enjoys tax deduction on convertible bonds.

This article examines the important interaction between the tax treatment and deferred tax accounting of convertibles bonds, a popular financing option for Asia-Pacific companies. Whether the instrument is regarded as a liability or equity by the tax authority will significantly impact deferred tax for the issuing company.