SimplifiTax - Tax, Accounting & Financial Advisory

Shivam Tara – [2024] 164 taxmann.com 245 (Article)

Compound financial instrument, like the term suggests, is a combination of financial liability and equity instrument like a bond or debenture convertible by the holder into a fixed number of ordinary shares of the entity. In general, these are issued to attract investors by providing an avenue to earn regular interest income while also participating in the potential appreciation of the company’s equity. Additionally, the issuing entity will be able to save on interest bills and taxes while delaying the dilution of its shares. The accounting treatment of these instruments can be somewhat challenging and varies on the terms of their issuance. There can be scenarios where it may be difficult to determine the inherent nature of the instruments as equity or liability at the outset. On top of that, elements like embedded derivatives, call and put options engraved in the contacts can further complicate the situation.

Deferred tax arises when the tax and accounting treatment of a transaction differs and creates a temporary difference until the ultimate settlement of such transaction happens. Simply put, a deferred tax liability represents an obligation to pay taxes in the future and a deferred tax asset represents a future tax recoverability.

Before going further, it is imperative to recall and gather few key definitions and concepts at one place for easy reference. In this discussion, reference is made only to the plain vanilla CFI contracts where the split is easily identifiable as the discussion is largely around the deferred tax implication on CFI rather than other complexities surrounded by it. Although effort has been made to keep the discussion simpler and provide necessary explanations wherever necessary, it is presumed that the audience of this article is familiar with these concepts, as well as a few related ones not directly addressed but are mentioned in the forthcoming discussion.

1. Compound financial instruments

A compound financial instrument as defined in the standard is one which:

creates a financial liability (a contractual arrangement to deliver cash or another financial asset) and
grants an equity instrument (a call option granting the holder the right, for a specified period of time, to convert it into a fixed number of ordinary shares of the entity)

Hence the economic effect of issuing such an instrument is substantially the same as issuing simultaneously a debt instrument with an early settlement provision along with warrants to purchase ordinary shares. Accordingly, the entity needs to identify and present the liability and equity components separately in its balance sheet.

2. Deferred tax, tax base and temporary differences

Deferred tax – Deferred tax is the amount of income tax payable (recoverable) in future periods as a result of past transactions or events. It represents the tax impact on the recovery or settlement of carrying amount of the asset or liability that can make the future tax payments larger or smaller.
Tax Base – Effectively represents the amount at which the asset or liability would be recorded in a notional tax balance sheet.
Tax Base of an Asset is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the carrying amount of the asset.
Tax Base of Liability is its carrying amount, less any amount that will be deductible for tax purposes in respect of that liability in future periods.
The general definition of tax base of an asset and liability is given above however it is to be noted that these are only for cases where the tax base is immediately apparent. For cases where the tax base is not immediately apparent (as in the case of a CFI transactions), it is helpful to consider the fundamental principle of the standard which states to provide for the tax that would be payable or receivable if the assets and liabilities were to be recovered or settled at book value. Another way to derive the correct tax base is to construct a notional statement of financial position prepared for the tax authorities according to tax laws.
Temporary differences are differences between the carrying amount of an asset or liability in the balance sheet and its tax base or simply put book base (bb) v. tax base (tb). Temporary differences are of two types:

1. Taxable temporary differences lead to the creation of deferred tax liability (DTL). These result in taxable amounts in future periods when the carrying amount of the asset or liability is recovered or settled.
  DTL are the amounts of income taxes payable in future periods in respect of these taxable temporary differences. DTL will arise if carrying amount of an asset is higher than its tax base (bb>tb) or the carrying amount of liability is lower than its tax base(bb<tb).
2. Deductible temporary differences lead to creation of deferred tax asset (DTA). These result in deductions or tax savings when the carrying amount of the asset or liability is recovered or settled.
  DTA are the amounts of income taxes recoverable in future periods in respect of these deductible temporary differences and the carry forward of unused tax losses and tax credits.DTA will arise if carrying amount of an asset is lower than its tax base (bb<tb) or the carrying amount of liability is higher than its tax base (bb>tb).