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Intercompany Loans: Smart Cash Management Sometimes liquidity management is a challenging problem for many companies. Particularly in case of companies that have many subsidiaries located in different parts of the world. Companies that upscale via the mergers and acquisitions route face this problem more. This is because they generally have many subsidiaries, the business of which is not perfectly integrated with one another. Over the years, companies realized that it is very costly affair for individual companies to borrow from the external market. Also, it is not a worthy decision for one subsidiary company to borrow money from the market at a higher interest rate while another subsidiary of the same company is having cash overflows and depositing money at a lower rate of interest. Hence, there is a need of system wherein one subsidiary of the company can give loan to the other and both companies are in win-win situation. Such loans are called intercompany loans. Intercompany loans are loans from one subsidiary to another, within the parent company. These Loans are operated in the same manner as any other traditional loans. The borrower is under a legal obligation to repay the money with interest to the lender. Interest is deducted during loan tenure each time from each recorded loan payment. Intercompany transactions generally have a fixed interest based on the existing market rate with a loan term agreement from one year to five years. Intercompany lending has many benefits, such as quickly shifting cash between subsidiaries or avoiding bank fees and charges. The loan should have an appropriate business purpose and be of interest for both parties to the transaction. Why Intercompany Loans? Intercompany loans are loans made from one entity of a company to another, usually for one of the following reasons: Ø To shift cash to a business entity that would otherwise experience a cash shortage Ø To shift cash into a business entity (usually corporate) where the funds are pooled for investment purposes Ø To shift cash within business entities that use a common currency, rather than transferring in funds from a foreign location that will be subject to exchange rate fluctuations Ø Intercompany loans can help the company to reduce the cost of financing to a great extent. Since the funds are accrued from different subsidiaries within the same company, loan processing, loan origination and other loan charges do not have to be paid. Ø Companies use this type of funding as a ready cash flow problem solver. For example, a subsidiary can fix financial issues or launch a new product without burdening costs by borrowing from a parent company. Ø A parent company can also release this stress by investing in the form of loan. The income earned is invested towards the loan, and the creditor takes their share from owning the subsidiary as net income grows. Ø Both entities also reduce enormous paperwork associated with bank loans. Types of Intercompany Loans Intercompany loans can be of two major types based upon the cash flow arrangement between the companies. These two types are explained below: The first type of intercompany loans is hub spoke model, all subsidiary entities (spokes) companies transfer their excess money to a central organization (hub). This central organization then transfers money to other subsidiaries which are in need of funds. This means that the intercompany loans are not directly made, but indirectly. Every subsidiary deals with the hub (parent company) in this arrangement. Most companies like this type of intercompany loans since it removes the counterparty risk for the subsidiaries involved. In the second type of intercompany loans arrangement, the centralized approach is not followed. Each company has its own excess funds which they want to lend out. Many times, the parent company encourages lenders and borrowers to place a bid in a virtual marketplace to ensure that funds are being utilized in the most optimal manner. Problems Faced While Making Intercompany Loans Intercompany loans are to be made within a very short span of time. Many companies do not have correct data about the amount of cash that they have on hand. The accounting for intercompany loans can be quite complex at times. Role of Commercial Banks in Automated Intercompany Loans? The fact is that commercial banks have come to realization that companies do not always want to borrow from them. Most of the times, they want to make more efficient use of their own excess funds. Commercial banks are helping such companies to do so and have started earning revenue in the form of transaction fees during the process. Commercial banks have realized this problem and have come up with different solutions to make the intercompany loan process more . Some of the steps that commercial banks take are as follows: Commercial banks have created tools and software that enable automatic disbursement of intercompany loans up to a certain threshold amount. Banks scrutinize the financials of each subsidiary and set a credit limit up to which funds can be easily disbursed at the click of a button. Hence, subsidiaries get access to funds in time which makes intercompany lending more viable. Commercial banks have also created web interfaces where a wide variety of loans such as perpetual loans, long-term loans, working capital loans, etc. can be automatically made within a very short span of time by click of a few buttons. Commercial banks have built-in specialized software which assists in automatic tracking as well as the reconciliation of intercompany loans. Advantages of Intercompany Loans Intercompany loans are highly useful, because no credit application is needed, the cash can be made available on short notice, and repayment terms may be much longer than would be required by a commercial bank. No need to fill out long irritating loan applications with multiple banks or assent to high-interest rates. Intercompany Loans process is typically done through third-party software. Investment capital raised by the parent company can be transferred directly to the subsidiary. Banks or outsourced companies take a share of the loan. Companies make full utilization of cash flows. Disadvantages Intercompany reconciliation and settlements: Though both the parties are related but one party may question the interest recordings, a payment could be logged as missing, or for different accounting periods can cause problems with proper reconciliation. Inability to pay: If the subsidiary or borrower takes a brutal financial setback, the cash flow problem can percolate to the issuer. This can negatively impact the financial worthiness of both companies and affect overall credit ratings, which can make bank borrowing harder in the future. Complex Tax issues: Intercompany accounting is a complex, multi-dimensional process that involves a number of stakeholders, including Accounting, Tax, and Treasury. For companies, getting started may seem very much overwhelming. The interest rate, payments and transfers must be recorded, and each is subjected to individual tax regulations. Tax issues are very complex for both the entities. It is possible that the use of intercompany loans may cause tax problems or other issues if not handled properly. The subsidiary receiving the loan will have interest expenses, while the creditor entity will have interest earnings. This is subject to tax rules and regulations. The main challenge here is that the interest rates should be market driven in accordance with an at arm’s length price. Intercompany loans are guided by specific principles to derive the at arm’s length price, which are laid down in the OECD Guidelines. A very important aspect of the new guidelines is the inclusion of more methods to determine the at arm’s length interest rate of intercompany loans, such as credit default swaps and economic modelling. Tips for Intercompany Loans Perfectly defined roles: All person/legal entity involved in transferring and receiving intercompany funds should have a clear and well-defined job with specific responsibilities to avoid wire-crossing. Proper tools and software: Implement time-saving tools and software that seamlessly integrates funds with an accurate reflection of different metrics. This is very important when accounting periods do not line up between companies. Cash management: This loan is most likely for a specific business purpose. Ensure that the parent company or the subsidiary know where the money is going. Conclusion Intercompany loans have many advantages and that’s why many companies are engaged in these loans to make optimal utilization of cash flows. The use of intercompany loans can also cause tax problems, since the issuing business unit should record interest income on the loan, while the receiving unit should record interest expense - both of which are subject to tax rules and guidelines. When an intercompany loan is made, it should be well documented, including the amount of the interest rate to be charged and principal repayment terms. Otherwise, the loan might be considered an investment by the issuing business unit in the receiving unit, which can create other tax problems. Intercompany loans are recorded in the financial statements of individual business entities, but they are eliminated from the consolidated financial statements of a group of companies of which the business units are a subsidiary, using intercompany elimination transactions. With a bunch of both pro and cons of intercompany loans, it is more sensible decision for a parent company to make a balance between intercompany loans and external bank borrowings. Author: Vineet Bhardwaj Vineet Bhardwaj is Chief Manager (Faculty) at Union Learning Academy for Strategy and Finance at Gurugram. He can be reached at vineet.710@rediffmail.com Disclaimer: The views expressed by the author/s in the article is/are their own. Bank promotion Study (bankpromotionstudy.com) assumes no responsibility or liability for any errors or omissions in the content of the article. The information contained in the article is provided on an "as is" basis.

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Intercompany Loans: Smart Cash Management

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