Intercompany Loans

An intercompany loan is an 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 cash flow 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.

What is an Intercompany Loan?

Explanation
How Does it Work?
Example of Intercompany Loans
Reasons for Intercompany Loans
Challenges
When are they Useful?
Intercompany Loans vs. Capital Contribution
Conclusion
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Explanation

Intercompany-Loan

A loan is treated as an intercompany loan only when the borrower & lender belongs to the same group of companies. Here, both entities are called related entities or related parties.
It is used as a cash flow management technique by the head of the cash department of the holding company or group company.
Say one entity is running into losses & another company has huge cash inflows with lower cash expenses. The management of the cash-crunch company can decide to take a loan from the surplus-funded company.
Agreements between the parties drive the interest rates. The tenor, payment method, frequency of payment, and all other stuff are agreed upon as per agreement only.
It helps to avoid the spreads earned by banks & to manage short term finance for the related companies.

How Does it Work?

Before initiating the loan, corporate law compliances are made by both entities (i.e., lender and borrower companies). Basic documents of approval are made & then the actual cash flow things are shared.
The agreement usually specifies the tenor of the loan. However, it is normally made for short-term finances, i.e., to fund a company that 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. 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.

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 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

It supports the entity's operations in a group that has lower cash resources or cannot raise finance through a bank or another institution
To diversify the business of the group entities through an investment mechanism.
To save time & effort (i.e., documentation, follow-ups, payment schedule, etc.) on the funding from the financial institutions
To save on the spreads earned by banks.
To improve the face of financials of the borrowing entity.
To discourage external commercial borrowings & to encourage domestic borrowings within the group itself. It saves on the foreign exchange gains or losses.
To help the borrowing entity focus on the main business rather than the finances part.
Other reasons may include the purchasing of fixed assets or high-end machinery or re-organization of the whole entity or working capital management.

Challenges

One of the biggest challenges is dealing 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 and the 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 a second, but managing the tax front is not that easy in the case of intercompany loans. Satisfying 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 more 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 bank spreads. To evaluate the outcome of the arrangement, we are concerned with 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.
It ensures an easier flow of funds than institutional loans from banking companies.
These loans are available at the click of a mouse pointer, subject to the documentation hurdle.
The flexibility of the repayment terms & other terms can be agreed upon between the entities & tax authorities normally have no issue with the tenor of the loans.

Intercompany Loans vs. Capital Contribution

Intercompany Loans	Capital 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 equity ratio.
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 must be eliminated at the time of group consolidation of accounts. Like other loans, the borrowing company must repay the principal amount at the end of loan tenor. Companies cannot deny such payments since such denial may have serious tax and regulatory implications on both entities. To conclude, they are primarily provided for short-term finance, and thus, settlements in the same time frame make the job easy.