Hello All, First of all, my apologies for asking such an open ended question. What would be the tax treatment for different types – discount, on-par, zero-coupon, and premium bonds – be? (Will these create DTA vs DTLs?) I looked through the CFA1 material, but I couldn’t find any leads. Taxes are covered before bonds. Leases do have a good amount of write-up on taxes, but bonds don’t. I would appreciate your thoughts. Here’s what I think (I have taken a stab at this one – just based on my limited understanding of the material):
#1 - Discount bonds — because the interest expense is greater than coupon payments, the taxable income will be lower and thus tax payments will be lower.
#1a - Are these discount bonds similar to OID (Original issue discount) ?
#2 - Premium bonds — because the interest expense is lower than coupon payments, the taxable income will be higher and thus tax payments will be higher.
#3 - On-par — because the interest expense = coupon payments, taxes will be what the firm is supposed to pay.
#4- Zero-coupon bonds - I think this will be like #1 because the PV of these will be lower than the face value.
#5- Lastly, I am not sure whether we should think about DTA or DTLs for bonds. We think about DTAs and DTLs when dealing with depreciation of assets.
I could be wrong because it’s been only a month since I read accounting.
I don’t know whether the amortization of premia and discounts that we use on financial statements is allowed on tax returns. If not, then they’ll create DTAs and DTLs.
Thank you for your response. I have a follow-up question on this.
Assuming that IRS doesn’t allow amortization of premia and discounts are not allowed on tax returns, can you please explain why DTAs and DTLs will be created?
I thought about taxes on bonds in terms of DTAs and DTLs, but I didn’t have the datapoints to think about it. I am clueless, to be honest.
Suppose that you issue a bond at a discount: its YTM is higher than its coupon. You amortize the discount over the life of the bond, showing higher interest expense than coupon payments, reducing your earnings before taxes. If the amortization isn’t allowed for taxes, then you have to wait until the bonds mature before you show a taxable loss: you pay higher taxes today (compared to what you would pay if you could amortize the discount), but lower taxes in the future. It’s a temporary difference, giving rise to a DTA.
Similarly with a bond issued at a premium: if the amortization isn’t allowed for taxes, it will create a DTL.
For what it’s worth, none of this will appear on the exam. You might not want to dwell on it further.
Thank you for your response. I understand that this is probably going out of the syllabus, but I am curious. I could understand your entire response, but I have a quick doubt. I hope it would be okay to discuss this.
I think what this means is that we won’t show the total interest expense (as per Amortization schedule), and but only the coupon portion of the bond. Hence, lower expenses mean higher income, which in turn means higher taxes, leading to DTAs. I am a beginner, and I am not sure whether I know these concepts in and out, and hence I thought of confirming them.
Thank you so much, sir! Thanks to your guidance and helpful tips, I now like CFA, or Finance in general. Otherwise, I would have lost interest in this field long time ago.
Note - this is a “real-life” answer, not a “CFA” answer.
In real life, bonds are just like stocks. You pay taxes on the cash flows you receive, and you pay capital gains taxes on the sale of the bonds. You also get to deduct your losses.
For stripped or zero-coupon bonds, you will get a 1099-OID that shows your portion of the “interest” that you received that year. Even though you don’t actually receive any cash flows, the IRS treats the amortization of the bond as interest paid to you, and you have to pay taxes on it.
