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When Financial and Tax Accounting Diverge

Under GAAP, issuers of convertible bonds can account for inducements to convert them into stock as an expense. But the IRS calls them a nondeductible dividend.
Robert Willens, CFO.com | US
March 21, 2011

Issuers of convertible debt that has fallen "out of the money" (the conversion price is more than the applicable stock price) sometimes want to encourage conversion of the debt into its equity securities anyhow. To do that, they can provide an incentive, lasting for a brief period, for holders of the debt to exercise their conversion privilege.

Frequently, this inducement will take the form of a temporary lessening of the conversion price (and consequent increase in the "conversion ratio," which determines how many shares can be converted from each bond). Less often, the issuer may transfer cash or other property to those holders who can be persuaded to exercise the conversion privilege.

The financial-accounting and federal income-tax consequences of these arrangements differ quite significantly. Statement of Financial Ac counting Standards No. 84, Induced Conversions of Convertible Debt, addresses the financial-accounting ramifications of such arrangements.

The statement applies only to conversions that comply with two conditions. They must conform to changed conversion privileges that are exercisable for only a limited period. Further, they must include the issuance of all stock that can be issued in accordance with conversion privileges included in the terms of the debt at issuance.

The standard notes that the changed terms may be in the form of one of three kinds of inducements. The issuer can reduce the original conversion price, thus resulting in the issuance of added shares of stock. The company in other cases may issue warrants or other securities not provided for in the original conversion terms. Another possibility is that the issuer may pay cash or other considerations to those holders who convert during the specified time period.

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When convertible debt is converted to the debtor's stock as part of the inducement offer, the debtor must recognize as an expense the difference between the fair value of the shares transferred as part of the new arrangement and that of the shares issued under the original conversion terms, according to the standard. The expense must not be reported as an extraordinary item, the standard admonishes.

In contrast, the Internal Revenue Service treats conversion inducements as a dividend for tax purposes, rather than the expense that financial accounting considers them. The result? The debtor doesn't get a tax deduction for it.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.




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