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A convertible bond is a type of bond that comes with the right to convert the debt into equity instruments. Investors that invest in these bonds get the benefits of other debt instruments while also getting the option to receive equity investments. Convertible debts come with interest payments and face value like other debt instruments. However, they also have an equity instrument due to the conversion option involved.
Due to the complex nature of convertible bonds, accounting for convertible bonds is complicated. Similarly, the convertible bond tax treatment is also crucial to understand. The tax treatment of convertible bonds may differ according to the bond’s current stage. Given below are details of how this treatment works.
Purchase of Convertible Bond
When an investor purchases a convertible bond, there is no taxable event. It is because acquiring convertible bonds do not create any income or value for investors. Instead, it results in an increase of assets for the debtholder. There may be tax implications if the holder transfers a capital asset in exchange for the debt. However, the purchase itself is not taxable.
Holding Period of Convertible Bond
As mentioned, convertible bonds come with all debt instrument features. Therefore, investors holding convertible bonds will receive interest payments according to a predetermined coupon rate. This interest is subject to income taxes according to the interest rules that apply to other interest payments. Investors are also subject to tax implications if they purchase the bond at a discount or premium.
Sale of Convertible Bond
As with traditional bonds, investors have the option to sell a convertible bond before maturity. In this case, there are some tax implications for the investor. Usually, when investors dispose of a convertible bond, they will create a capital gain or loss for themselves. It represents the difference between the bond’s original price and the fair market value of the proceeds received.
The investor will also have to adjust the convertible bond’s price to reflect any accrued but unpaid interest at the disposal date. Once they do so, they will have to pay the tax on the capital gain according to the applicable capital gain taxation rules. Investors can also receive tax deductions in case of capital losses on the sale.
However, there are some rules that may classify the gain on disposal as normal income rather than capital gain. For instance, it may occur when there is an accrued market discount on the debt at the disposal date. In that case, normal income tax rules will apply instead of capital gain taxes.
Conversion of Convertible Bond
If an investor chooses to convert a convertible bond into equity instruments, they will not be subject to taxation. It is because the tax laws view the conversion as a transformation of ownership rather than a disposition. Therefore, the debtholder will not be subject to any taxes on conversion even if there is a difference between the bond and equity instrument’s value.
Investors will have to pay taxes for any stock they receive in exchange for any accrued interest on the bond. This case only applies if the investor hasn’t already paid taxes on the accrued interest. At conversion, the interest payments to the investor will also stop. Therefore, taxation on interest payments will also end.
Convertible bonds are instruments that include a debt and equity component. Convertible bond tax treatment differs according to the stage in which investors are. Usually, investors have to pay taxes on convertible bonds for the interest received. Similarly, they also have to pay taxes on the sale of the bond.
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