Deductible temporary tax differences

Deductible temporary tax differences are temporary differences that will result in amounts that are deductible in determining taxable profit (tax loss) of future periods when the carrying amount of the asset or liability is recovered or settled. Deductible temporary tax differences

A case

Each component of the compound financial instrument needs to be assessed separately. The host debt component will be classified as a financial liability in its entirety. This is because there is an obligation to pay cash that the issuer cannot avoid (see above) and, for this component on a stand-alone basis, there is no feature that is similar to equity.

The conversion feature is then assessed, again on a stand-alone basis. Starting with the box at the top left hand side of the diagram:

• There is no contractual obligation to pay cash that the issuer cannot avoid. The equity conversion feature can only be settled through the issue of equity shares, otherwise it will simply expire unexercised
• There is no obligation to issue a variable number of shares. If exercised, the option will result in the issue of 10,000 shares
• There is no foreign currency element, as the issuer’s functional currency and the currency of the convertible instrument are the same.

Consequently, the conversion feature is classified as an equity component. Deductible temporary tax differences

This means that the note contains the following liability and equity components: Deductible temporary tax differences

On initial recognition, the contractual cash flows are discounted at the interest rate that would apply to a note without a conversion feature (12%). This is in order to calculate the fair value of the liability component of the compound financial instrument.

1. Calculation for the fair value of the liability component with a liability and an equity component Deductible temporary tax differences

 Year Cash flow Amount Discounting at 12% NPV 1 Coupon CU 100 1 / 1.12 = 0.89285 CU 100 x 0.89285 = CU 89 2 Coupon CU 100 1 / 1.12^2 = 0.79719 CU 100 x 0.79719 = CU 80 3 Coupon and principal CU 1,100 1 / 1.12^3 = 0.71178 CU 1,100 x 0.71178 = CU 783 Fair value of the liability component CU 952
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2. The fair value of the convertible debt option reserve Deductible temporary tax differences

The fair value of the liability component is then deducted from the fair value of the compound financial instrument as a whole, with the balance being taken directly to equity. The residual equity component is the transaction price of CU 1,000 (fair value) less the fair value of the liability component (see calculation) CU 952, i.e. CU 48.

3. Allocation of transaction costs

For compound financial instruments, IAS 32.38 requires these costs to be allocated to the liability and the equity components.

Entity A adjusts the carrying amount of the components for the CU 110 incurred in transaction costs as follows:

 Convertible debt option reserve A Fair value before transaction costs % B Transaction costs allocation A – B = Carrying amount Liability CU 952 95%1 CU 105 CU 847 Convertible debt option reserve CU 48 5%3 CU 5 CU 43 Convertible debt option reserve 100%

4. Recalculation effective interest rate

The effective interest rate is recalculated after adjusting the carrying amount of the host liability for the transaction costs. This results in the transaction costs being amortised over the term of the convertible note through an adjustment to the effective interest rate, which increases the rate to 17.00%.

Entity A will therefore record interest expense at the effective interest rate (17.00%). The difference between the total interest expense (16.41%) and the cash coupon actually paid (10%) increases the carrying amount of the liability so that, on maturity, the carrying amount is equal to the capital cash repayment that might be required to be made.

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The following table shows the balance of the liability component over the life of the loan.

 Year Opening Interest Cash coupon Closing 1 CU 847 CU 144 CU (100) CU 891 2 CU 891 CU 151 CU (100) CU 942 3 CU 942 CU 158 CU (100) CU 1,000

Assume that, at the end of Year 3, the holder elects to receive shares. Entity A would derecognise the liability (CU 1,000) and recognises an increase in equity of the same amount; no gain or loss would be recorded on conversion. Conversely, if the holder elects to receive cash, Entity A would simply derecognise the liability CU 1,000 and recognises a corresponding decrease in cash of CU 1,000.

Convertible debt option reserve

The conversion feature of CU 43 is classified in equity – as the convertible debt option reserve, it is not remeasured. Even if the conversion option is not exercised, the amount recorded in equity is not reclassified (or ‘recycled’), through profit or loss, It will be transferred from one equity reserve to another at the end of the option period (whether exercised or not). The only item that affects profit or loss is the recognition of interest expense at the effective interest rate for the liability component.

Deferred taxes

In most jurisdictions, only the coupon cash payment (10% in this example) and transaction costs would be tax deductible and it is unlikely that a tax deduction will be received for the interest expense (16.41% in this example) recorded under additional the effective interest method. Therefore, a deferred tax arises from the temporary difference between the carrying value of the liability component and the tax base of the liability for tax purposes. Deductible temporary tax differences

If the Entity A is subject to a 30% tax rate and assuming that transaction costs are also deductible over the life of the loan (that is, the element of the interest expense in profit or loss that represents transaction costs is tax deductible rather than the transaction costs being deductible in full when they are incurred), then a deferred tax liability of CU 13 ((CU 900 – CU 857) x 30%) should be recognised on initial recognition with a corresponding entry to equity. Deductible temporary tax differences

The effect of deferred tax is recognised in equity because IAS 12 Income Taxes requires that the recognition of deferred tax must follow the underlying transaction it relates to, and the temporary difference relates to the amount attributed to the equity conversion option. Deductible temporary tax differences

The carrying amounts of the liability component, and the associated tax effects over the life of the note, are summarised below:

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 Deductible temporary tax differences Initial recognition Year 1 Year 2 Year 3 Carrying value of the liability CU 847 CU 891 CU 942 CU 1,000 Tax base of the liability CU 900 CU 932 CU 965 CU 1,000 Temporary difference CU 47 CU 41 CU 23 Deferred tax liability (at 30% (effective) tax rate) CU 14 CU 12 CU 7 Deferred tax expense (income) CU (2) CU (5) CU (7) Temporary part of the current tax expense (income)1 CU 2 CU 5 CU 7 Net effect in Profit or loss Nil Nil Nil

The above perfectly illustrates the purpose of a deferred tax asset or liability.  The change in the deferred tax liability that is charged or credited to profit or loss always has an opposing effect included in the current tax expense or charge as recorded in the income tax return, the net effect is always Nil. Deductible temporary tax differences

Deductible temporary tax differences

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