Which of the following tax effects could not occur the purchase and sale of a corporate bond
The correct answer and explanation is:
The correct answer is: A tax deduction for interest paid by the bond purchaser.
Explanation:
When a corporate bond is bought and sold, several tax effects can occur, but a tax deduction for interest paid by the bond purchaser is not one of them. Here is why:
A corporate bond is a debt instrument issued by a corporation to raise capital. The bond issuer promises to pay interest periodically and to repay the principal at maturity. The interest payments made by the issuer are generally tax-deductible expenses for the corporation that issued the bond, because interest is considered a cost of borrowing.
However, the bond purchaser is the lender or investor buying the bond. From the purchaser’s perspective, interest received on the bond is considered taxable income. The purchaser does not pay interest; they receive interest payments from the issuer. Therefore, the purchaser cannot claim a tax deduction for interest paid because they are not paying interest—they are receiving it.
Tax effects related to the purchase and sale of corporate bonds for the purchaser typically include:
- Interest income: The interest received by the bondholder is taxable income and must be reported on their tax return.
- Capital gains or losses: If the bond is sold before maturity, any difference between the sale price and the purchaser’s cost basis can result in a capital gain or loss. Capital gains are taxable, while losses can be used to offset gains.
- Original issue discount (OID): If a bond is purchased at a discount to its face value, part of the discount may be treated as taxable income over time as OID.
- Accrued interest: When a bond is bought between interest payment dates, the purchaser pays the seller accrued interest. This accrued interest is treated as interest income by the seller and as an adjustment to the purchase price for the buyer, but it is not deductible as an interest expense by the purchaser.
In summary, the purchaser of a corporate bond cannot claim a tax deduction for interest paid because they do not pay interest—they receive it. Interest expense deductions apply only to the issuer, not the bondholder.