Intercompany Loans

What is Intercompany Loan?

Intercompany loan is the amount lent or advance given by one company (in a group of companies) to another company (in the same group of companies) for various purposes including to help the cashflow of the borrowing company or to fund the fixed assets or to fund the normal business operations of the borrowing company, which gives rise to interest income to lending company & interest expense to borrowing company.

Explanation

Intercompany-Loan

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For eg:
Source: Intercompany Loans (wallstreetmojo.com)

How Does it Work?

  • Before the initiation of the loan, corporate law compliances are made by both the entities (i.e., lender as well as borrower companies). Basic documents of approval are made & then the actual cash flow things are shared between each other.
  • The agreement usually specifies the tenor of the loan. However, it is normally made for short term finances i.e., to fund the company which has a cash crunch.
  • On the other hand, few companies can also enter into long term loan agreements as per the need.
  • In either of the cases, loan agreements are required for corporate compliances & tax compliances.
  • In many corporate entities these days, we have the concept of treasury centers wherein the cash-rich companies deposit their unrequired excess funds into the treasury center, and at the same time, the cash-poor companies withdraw the balance as per requirement. Such a treasury center is often made with the control objective in place.

Example of Intercompany Loans

Let’s take an example.

You can download this Intercompany Loans Excel Template here – Intercompany Loans Excel Template

Let’s have a look over the intercompany loan calculations:

Intercompany Loans Example

Explanation:

  • The borrowing company will present $9.2 million as interest expense & $150 million as a loan from a related party in its books of accounts. It will also provide disclosures in its notes to accounts regarding the said transaction.
  • The lender company will show $9.2 million as interest company with $150 million as advance given to the related parties. It will provide the relevant disclosures as mandated by the accounting standards.

Reasons for Intercompany Loans

Challenges

  • One of the biggest challenges is to deal with the tax impacts of the intercompany loan agreements. Taxing authorities require the loan to be managed as per the market-driven interest rates i.e., at arm’s length price. In case arm’s length price is questioned by the taxing authorities, the lender, as well as borrower, may fall into the trouble of tax penalties, interests, or any severe costs. Thus, it seems easy for two companies to exchange the amounts in a fraction of seconds, but managing the tax front is not that easy in case of intercompany loans. Satisfy the tax authorities regarding base erosion & profit shifting, requires expertise.
  • Lack of documentation can cause the loan to be treated as an investment by one entity into another. Now, this has serious tax implications than the mere lending part. Hence, documentation of the loan arrangement is also a tough task to deal with.
  • Normally, intercompany loan agreements are made to avoid the bank spreads. To evaluate the outcome of the arrangement, we are concerned with the two things. The first thing is savings due to avoidance of bank spreads, and the second thing is the administrative costs involved in the arrangement. If the former exceeds the latter, the agreement is profitable. However, if the latter exceeds the first, there is the possibility of uninvited troubles.

When are they Useful?

Intercompany loans may be seen as useful in the following scenarios:

  • Companies are not required to prove their credit standing to the related entity in the group.
  • This ensures an easier flow of funds as compared to institutional loans from banking companies.
  • These loans are available at the click of mouse pointers subject to the documentation hurdle to be suffered.
  • The flexibility of the repayment terms & other terms can be agreed over between the entities & tax authorities normally have no issue with the tenor of the loans.

Intercompany Loans vs. Capital Contribution

Intercompany LoansCapital Contribution
Loans are given by one related entity to another related entity of the same group.These are investments by one entity to another entity.
The lender earns interest income.The lender earns dividend income from the investee company.
The lending company acquired the position of “finance providers” & not owners.Investor acquires the position of owners in the investee company.
The return is assured by the agreement & has to be paid by the rule of finance.The return is not assured & it depends on the profits of the investee company.
Tax compliances are stricter.Regulatory compliances are stricter.
The lender does not take part in the business of the borrowing company.The lender has the right to take part in the business of the borrowing company.
It increases the debt-equity ratio of the borrowing company.It reduces the debt-equity ratioDebt-equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more.
The lender acquires no special rights from the borrowing company other than the commitment to pay the interest due on time.The investor may acquire special rights such as preferential payment of dividends.

Conclusion

Even if the intercompany loans are treated as assets and liabilities in the respective entities, these balances are required to be eliminated at the time of group consolidation of accounts. Like other loans, the borrowing company is required to repay back the principal amount at the end of loanPrincipal Amount At The End Of LoanLoan Principal Amount refers to the amount of money loaned by the lender to the borrower. Furthermore, it is the amount on which the lender charges the borrower interest for fund utilization.read more tenor. Companies cannot deny such payments, since such denial may have serious tax as well as regulatory implications on both the entities. So as to conclude, they are primarily provided for short term finance, and thus, settlements in the same time frame make the job easy.

Recommended Articles

This has been a guide to what is Intercompany Loans and its definition. Here we discuss challenges, examples, and how do intercompany loans work along with reasons and uses. You may learn more about financing from the following articles –