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Situation: A plc issued 6% convertible loan stock amounting $10 million and the effective interest rate is 10%. The liability and equity component of this loan stock $9 million and $1 million respectively. The plc had recognized the interest expense for the of $900,000 when the interest to be paid was $600,000. The IRB will only recognize the interest amount paid during the year as deductible expenditure.
Answer
Accounting treatment:
The interest expenses of $900,000 will be included as interest payable of $600,000 where the excess will be amortized into convertible loan stock liability as premium. The carrying value is $9.3 million.
Tax Treatment:
Interest is deducted when paid. Since only $600,000 paid the excess is not deductible. Thus current and future tax charges will continue to be higher as the differences will not be deducted until the liability settled at $10 million. However the tax charges will be used to reduce the equity component. Tax base is $10 million.
CV – Tax Base = Temporary Difference
$9.30 – $10 = $0.7 Taxable Temporary Difference
My question is:
1) Does the nature of convertible loan stock affect the income tax / deferred calculation?
2) How to determine the carrying value of the convertible loan in company book at year end?
3) How come the tax base is $10 million whereas the situation stated that $0.30 ($0.9 – $0.6) was paid ?
Hi, thank you for even reading question. I appreciate all the help and view. I’ve posted the same question in P2 general forum as I did not know thar “ask the tutor” existed. I only found out about it after reading some of the topics. I’m sorry for cluttering the forum space.
Hi, welcome to “Ask the tutor” and don’t worry about cluttering the forum space 🙂
1) Not sure what you mean by “Does the nature of convertible loan stock affect the income tax …..” do you mean “Will the tax effect be different if it were 8% loan stock, or different if it were just redeemable and not convertible?”
Generally speaking, interest payable on loans is tax deductible on a cash basis ie when the interest is paid. In an exam question, the coupon rate and the effective rate will be different so a timing difference arises. Taxman will give allowances on the amount actually paid but CFO is including interest at the effective rate with the difference being added to the carrying value of the loan obligation.
If the loan is borrowed at a coupon rate that is the same as the effective rate, no timing differences arise so no worries about deferred tax.
2) Calculation of loan obligation carrying amount for the year end financial statements – value at date of borrowing (having identified the loan element separately from the equity element as we always do in the situation of a compound financial instrument) plus the difference between effective interest (effective rate applied to loan element of the compound instrument brought forward) and interest actually paid (coupon rate applied to face value of the loan note)
In the example you give, the loan element is given as $9m. The effective interest rate is 10% so effective interest is $900,000 but actual interest paid is coupon rate of 6% applied to the face value of $10m = $600,000
The double entry for the interest is Cr Cash 600,000, Dr Profit or Loss Finance Charges $900,000 and ……..?
The missing $300,000 is added to the obligation in Long Term Liabilities to give a carrying value for the loan of $9m + $300,000
Next year, effective interest in the Profit or Loss account will be 10% of $9,300,000
3) Nothing has been paid off the obligation. It started at $10,000,000 and there has been no payment made to reduce that figure. The only payments made with reference to this loan are the interest payments.
When you borrow money on to finance an investment and you agree with the bank / mortgage lender that it shall be an interest only loan, the amount borrowed will not change from one year to the next. That’s the same situation as you have outlined in your question
Ok?
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