What is an intercompany loan?
Intercompany loans are the basic balance management tool used by treasurers. When one entity needs to borrow and another entity has excess cash, it makes sense to replace bank loans with an intercompany loan to avoid bank spreads and fees. There may be a tax cost however.
With an intercompany loan, the borrowing entity and the lending entity are part of the same group. The lending entity pays the loan principal to the borrowing entity at the start of the loan, and then the borrowing entity repays the principal plus interest, and minus withholding tax if applicable, to the lending entity at the end or maturity of the loan.
How does it work?
The length of the loan (the tenor) can be anything the two entities agree, but in most corporate contexts the tenor is between 1 month and 1 year. Regulatory, compliance and tax complications sometimes make it cheaper and more efficient to do longer (i.e. multi-year) tenors. Shorter tenors bring more flexibility which helps to minimise idle cash.
Often intercompany loans are executed under longer tenor loan agreements to simplify documentation and if needed to reduce stamp tax. Suitable loan agreements help to satisfy tax authorities that the loans are at arm’s length and satisfy base erosion and profit shifting (BEPS) requirements. As an example, a five year $100 million loan agreement might be executed as 60 one month drawdowns with principals varying between $0 and $100 million priced at some fixed spread over one month LIBOR or FedFund rates.
Many corporates centralise intercompany lending to treasury centres for efficiency and control reasons. When using treasury centres for intercompany loans, operating entities deposit excess cash with the treasury centre and borrow from the treasury centre to cover deficits. In this way, the treasury centre can offset its excess and deficit positions across the whole group.
The economics of intercompany loans are simple. Corporates avoid bank spreads by lending between related entities. It is conceptually similar to peer-to-peer lending within a group. It is simplified because most corporates consider their own entities to have zero credit risk (because the corporate owns the entities, it can manage and control their repayments). The bank spread typically includes the market spread (LIBOR – LIBID), the cost of balance sheet (regulatory cost of capital and shareholders cost of capital), and the bank profit margin.
Generally, the saving from avoiding bank spreads exceeds any administration and execution costs the corporate might suffer in executing intercompany loans. The most common exception relates to tax – mainly the possibility that the cost of unrecoverable withholding tax exceeds the cost of bank spreads. Rarely, the regulatory and compliance costs of executing an intercompany loan exceeds the cost of bank spreads.
Intercompany loans compared
An intercompany loan is a balance management tool. An intercompany loan results in an intercompany balance rather than a bank balance.
Comparing intercompany loans to ZBA and IHB, one can say that ZBA is outsourcing intercompany loans to a bank, and IHB is automating intercompany loans with a corporate ERP or TMS. Because they are automated, ZBA and IHB normally operate daily whereas intercompany loans are typically monthly. Most TMS can automate daily cash sweeping like banks do with ZBA, but most corporates find it easier to outsource this to banks.
Most countries allow intercompany loans, but many impose withholding tax on interest (see tax below) on cross-border loans.
Many developing countries do not allow or severely restrict intercompany loans, though some offer work-arounds. Some examples include, China does not allow intercompany loans but allows “entrustment loans” mediated off balance sheet by banks for a small fee (normally less than 0.125%); India limits intercompany loans, called inter-corporate deposits in the companies act, between related parties with common directors; and Vietnam does not allow intercompany loans at all.
These countries have exchange control rules that make cross-border intercompany loans difficult or impossible. Where possible there are often tenor limits – some countries require longer tenors (more than one year) to limit so called hot money flows, other require shorter tenors (less than one year) to limit indebtedness. Some developing countries require that intercompany loans in foreign currency be fully hedged; since developing country foreign exchange markets are typically illiquid if not restricted, this can reduce the efficiency of intercompany loans.
Where registration is required, the proper approvals must be in place before transferring funds to ensure that the loan can be repaid at maturity. Cross-border intercompany loans that are not properly registered may be deemed capital, which makes repayment extremely difficult. China sometimes treats unregistered intercompany loans as income which makes them subject to 25% corporate income tax, generating not only losses but also further funding problems.
The primary tax consideration for intercompany loans is withholding tax on interest. This applies mostly to cross-border intercompany loans. Some countries levy withholding tax on domestic interest payments. China used to levy a business tax on interest and has now made domestic interest liable to value added tax (VAT); China also has withholding tax on cross-border interest (and dividends).
Withholding tax is often waived or lowered for bank loans, or non-existent for on shore loans, which can make them more cost effective than intercompany loans if the withholding tax is not recoverable.
The interest rate on intercompany loans must be set at arm’s length rates, and the pricing documented to avoid transfer pricing problems from tax authorities. New rules on base erosion and profit shifting (BEPS) have increased the importance of setting tax acceptable pricing and documenting this accordingly.
Thin capitalisation rules can limit the deductibility of interest for tax purposes. In many countries, interest deductibility is limited to specified debt to equity ratios.
Some countries charge a stamp tax on the principal of loans including intercompany loans – in the Philippines this is called documentary stamp tax (DST) and applies to both bank and intercompany loans.
Intercompany loans into the USA are often problematic because of Subpart F rules that limit repatriation of off shore income. If so affected, intercompany loans may be deemed dividends for tax purposes.
The first step in implementing intercompany loans is to determine the borrower’s needs based on a reliable cash flow forecast. If the lending entity is not a treasury centre, the lender’s availability of cash to lend must also be checked.
The second and third steps are to determine the regulatory compliance of the intercompany loan, normally with legal or other advisors, and its tax efficiency, normally with tax advisors.
The fourth step is to draw up intercompany loan documentation, with a view to regulatory compliance and tax efficiency. The most common format for intercompany loan documentation is a longer term loan agreement allowing for shorter tenor drawdowns, but this depends on circumstances as explained above.
Finally, it is good practice to review the cash flow forecast before each drawdown for efficiency from a cash management perspective.
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