Question

CCS Inc. paid $5,000 in interest on a loan it used to purchase municipal bonds. What is the nature of the book–tax difference relating to this expense?

Answer 1

Definitions to understand

Permanent differences are differences between the tax and book income/expense which will not be reversed in the future while temporary differences are temporary in nature and occurs when there is difference between tax base and carrying amount of amounts on balance sheet.

Favorable book-tax differences are subtracted from book income when the difference is reconciled to taxable income. In contrast, unfavorable book-tax differences are additions to book income when the difference is reconciled to taxable income. In other words, relative to book income, favorable book-tax differences reduce taxable income and so they are favorable and unfavorable book-tax differences increase taxable income and hence they are unfavorable.

In the given example,

Interest expense on loans to acquire investments that produce tax-exempt income is non-deductive. Hence it is a permanent unfavorable book-tax difference. Permanent because it will not be reversed in future and unfavorable since it will increase the taxable income.