Intercompany Loans: Smart Cash Management\n\nSometimes liquidity management is a challenging\nproblem for many companies. Particularly in case of companies that have many\nsubsidiaries located in different parts of the world. Companies that upscale\nvia the mergers and acquisitions route face this problem more. This is because\nthey generally have many subsidiaries, the business of which is not perfectly integrated\nwith one another.\n\nOver the years, companies realized\nthat it is very costly affair for individual companies to borrow from the\nexternal market. Also, it is not a worthy decision for one subsidiary company\nto borrow money from the market at a higher interest rate while another\nsubsidiary of the same company is having cash overflows and depositing money at\na lower rate of interest. Hence, there is a need of system wherein one\nsubsidiary of the company can give loan to the other and both companies are in\nwin-win situation. Such loans are called intercompany loans.\n\nIntercompany loans are loans from one subsidiary\nto another, within the parent company. These Loans are operated in the same manner\nas any other traditional loans. The borrower is under a legal obligation to repay\nthe money with interest to the lender. Interest is deducted during loan tenure\neach time from each recorded loan payment. Intercompany transactions generally have\na fixed interest based on the existing market rate with a loan term agreement\nfrom one year to five years. Intercompany lending has many benefits, such as\nquickly shifting cash between subsidiaries or avoiding bank fees and charges.\nThe loan should have an appropriate business purpose and be of interest for\nboth parties to the transaction.\n\nWhy Intercompany Loans?\n\nIntercompany loans are loans made from\none entity of a company to another, usually for one of the following reasons:\n\n\u00d8 \nTo shift cash to a business entity that would\notherwise experience a cash shortage\n\n\u00d8 \nTo shift cash into a business entity (usually\ncorporate) where the funds are pooled for investment purposes\n\n\u00d8 \nTo shift cash within business entities that\nuse a common currency, rather than transferring in funds from a foreign\nlocation that will be subject to exchange rate fluctuations\n\n\u00d8 \nIntercompany loans can help the company to reduce\nthe cost of financing to a great extent. Since the funds are accrued from\ndifferent subsidiaries within the same company, loan processing, loan\norigination and other loan charges do not have to be paid. \n\n\u00d8 \nCompanies use this type of funding as a ready\ncash flow problem solver. For example, a subsidiary can fix financial issues or\nlaunch a new product without burdening costs by borrowing from a parent\ncompany. \n\n\u00d8 \nA parent company can also release this stress\nby investing in the form of loan. The income earned is invested towards the\nloan, and the creditor takes their share from owning the subsidiary as net\nincome grows. \n\n\u00d8 \nBoth entities also reduce enormous paperwork\nassociated with bank loans. \u200d\n\n \n\nTypes of Intercompany Loans\n\nIntercompany loans can be of two major\ntypes based upon the cash flow arrangement between the companies. These two\ntypes are explained below:\n\nThe first type of intercompany loans\nis hub spoke model, all subsidiary entities (spokes) companies transfer their\nexcess money to a central organization (hub). This central organization then\ntransfers money to other subsidiaries which are in need of funds. This means\nthat the intercompany loans are not directly made, but indirectly. Every\nsubsidiary deals with the hub (parent company) in this arrangement. Most companies\nlike this type of intercompany loans since it removes the counterparty risk for\nthe subsidiaries involved.\n\nIn the second type of intercompany\nloans arrangement, the centralized approach is not followed. Each company has\nits own excess funds which they want to lend out. Many times, the parent\ncompany encourages lenders and borrowers to place a bid in a virtual\nmarketplace to ensure that funds are being utilized in the most optimal manner.\n\n \n\nProblems Faced While Making\nIntercompany Loans\n\nIntercompany loans are to be made within\na very short span of time. Many companies do not have correct data about the\namount of cash that they have on hand. The accounting for intercompany loans\ncan be quite complex at times. \n\n \n\nRole of Commercial Banks in Automated\nIntercompany Loans?\n\nThe fact is that commercial banks have\ncome to realization that companies do not always want to borrow from them. Most\nof the times, they want to make more efficient use of their own excess funds.\nCommercial banks are helping such companies to do so and have started earning\nrevenue in the form of transaction fees during the process.\n\nCommercial banks have realized this\nproblem and have come up with different solutions to make the intercompany loan\nprocess more . Some of the steps that commercial banks take are as follows:\n\nCommercial banks have created tools\nand software that enable automatic disbursement of intercompany loans up to a\ncertain threshold amount. Banks scrutinize the financials of each subsidiary\nand set a credit limit up to which funds can be easily disbursed at the click\nof a button. Hence, subsidiaries get access to funds in time which makes\nintercompany lending more viable.\n\nCommercial banks have also created web\ninterfaces where a wide variety of loans such as perpetual loans, long-term\nloans, working capital loans, etc. can be automatically made within a very\nshort span of time by click of a few buttons. Commercial banks have built-in\nspecialized software which assists in automatic tracking as well as the\nreconciliation of intercompany loans. \n\n \n\nAdvantages of Intercompany Loans\n\nIntercompany loans are highly useful,\nbecause no credit application is needed, the cash can be made available on\nshort notice, and repayment terms may be much longer than would be required by\na commercial bank. No need to fill out long irritating loan applications with\nmultiple banks or assent to high-interest rates. Intercompany Loans process is\ntypically done through third-party software. Investment capital raised by the\nparent company can be transferred directly to the subsidiary. Banks or\noutsourced companies take a share of the loan. Companies make full utilization\nof cash flows.\n\n \n\nDisadvantages\n\nIntercompany reconciliation and settlements: Though\nboth the parties are related but one party may question the interest\nrecordings, a payment could be logged as missing, or for different accounting\nperiods can cause problems with proper reconciliation.\n\nInability to pay: If the\nsubsidiary or borrower takes a brutal financial setback, the cash flow problem\ncan percolate to the issuer. This can negatively impact the financial worthiness\nof both companies and affect overall credit ratings, which can make bank\nborrowing harder in the future.\n\nComplex Tax issues: Intercompany\naccounting is a complex, multi-dimensional process that involves a number of\nstakeholders, including Accounting, Tax, and Treasury. For companies, getting\nstarted may seem very much overwhelming. The interest rate, payments and\ntransfers must be recorded, and each is subjected to individual tax\nregulations. Tax issues are very complex for both the entities. It is possible\nthat the use of intercompany loans may cause tax problems or other issues if\nnot handled properly. The subsidiary receiving the loan will have interest\nexpenses, while the creditor entity will have interest earnings. This is\nsubject to tax rules and regulations. The main challenge here is that the\ninterest rates should be market driven in accordance with an at arm\u2019s length\nprice. Intercompany loans are guided by specific principles to derive the at\narm\u2019s length price, which are laid down in the OECD Guidelines. A very important\naspect of the new guidelines is the inclusion of more methods to determine the\nat arm\u2019s length interest rate of intercompany loans, such as credit default\nswaps and economic modelling.\n\n \n\nTips for Intercompany Loans\n\nPerfectly defined roles: All\nperson\/legal entity involved in transferring and receiving intercompany funds\nshould have a clear and well-defined job with specific responsibilities to\navoid wire-crossing. \n\nProper tools and software: Implement\ntime-saving tools and software that seamlessly integrates funds with an\naccurate reflection of different metrics. This is very important when\naccounting periods do not line up between companies. \n\nCash management: This loan\nis most likely for a specific business purpose. Ensure that the parent company\nor the subsidiary know where the money is going.\n\n \n\nConclusion\n\nIntercompany loans have many\nadvantages and that\u2019s why many companies are engaged in these loans to make\noptimal utilization of cash flows. The use of intercompany loans can also cause\ntax problems, since the issuing business unit should record interest income on\nthe loan, while the receiving unit should record interest expense - both of\nwhich are subject to tax rules and guidelines. When an intercompany loan is made,\nit should be well documented, including the amount of the interest rate to be\ncharged and principal repayment terms. Otherwise, the loan might be considered\nan investment by the issuing business unit in the receiving unit, which can\ncreate other tax problems. Intercompany loans are recorded in the financial\nstatements of individual business entities, but they are eliminated from the\nconsolidated financial statements of a group of companies of which the business\nunits are a subsidiary, using intercompany elimination transactions. With a\nbunch of both pro and cons of intercompany loans, it is more sensible decision\nfor a parent company to make a balance between intercompany loans and external\nbank borrowings.\n\nAuthor: Vineet Bhardwaj\n\nVineet Bhardwaj is Chief Manager\n(Faculty) at Union Learning Academy for Strategy and Finance at Gurugram. He\ncan be reached at email@example.com\n\nDisclaimer: The views expressed by the\nauthor\/s in the article is\/are their own. Bank promotion Study\n(bankpromotionstudy.com) assumes no responsibility or liability for any errors\nor omissions in the content of the article. The information contained in the\narticle is provided on an "as is" basis.