This reduces the tax liability in the country of the borrowing company while simultaneously retaining the funds (interest) within the group. September 21, Companies prefer to go the loan route (especially when it is an international organization) due to the fact a loan agreement allows for interest to be charged on the loan. At least this way, the tax on the interest payable and receivable nets off at the group level and cash that would otherwise be paid for interest stays within the company. However, for tax purposes, the interest charge must be deemed to be at arm's length and a notional interest charge / receivable has to be put through the tax computation of the relevant subsidiaries using an arms length interest rate. The inter-company loan agreement could state that the loan is not subject to interest charges and therefore no interest charge for this is posted to the profit and loss account. If a subsidiary has excess funds in the bank, it is pointless for another subsidiary to get funding externally and have to pay a high interest rate. Problems can easily arise if tax authorities reached the conclusion that the loan is being extended to a loss-making entity that would not receive funding externally.I work for a company with a number of subsidiaries, including Ireland and Scotland, and we have inter-company loans, rather than being funded externally. They should not be a quick substitute for proper due diligence. Internal loans should always be monitored. Traditionally rates can be fixed or floating with a premium. They need to determine what price they would pay externally to fund the loan and then apply a premium to the subsidiary. That means that when trying to determine the interest rate, full attention should be given to the funding costs of the main company. PricingĪs previously stated, an internal loan should replicate the general conditions of an external loan. If no matrix is available, then problems can occur. Whilst tax authorities may question the integrity of the credit modelling matrix, this can at least be negotiated if a dispute arises. Just with a normal external loan, attention should be paid to the ability to repay. Standard metrics can be used to ascertain an internal rating. Credit modellingĪs most subsidiaries are small and have no independent credit rating, an approach must be taken to attempt to define their creditworthiness. Included within the documentation should be a detailed explanation as to how the price and spread was determined, along with external data proof. Whilst the documentation does not have to be as large as that used by banks, it should always contain all relevant clauses, and both parties must adhere to the signed loan agreement. If a subsidiary is granted an embedded option (early repayment without a penalty) then this must be clearly noted. Standard covenants should be included together with a schedule showing repayment of principal and interest. Just as with external financing, legal documentation needs to be drawn up and signed that clearly shows the terms and conditions of the loan. The pricing of the loan must reflect the perceived credit risk of the entity that is seeking funding. A business can not adopt a more generous approach to funding its subsidiaries than could be obtained externally. Arm’s length principleĪll terms and conditions of the intercompany loan – with special consideration for the interest rate – must be consistent with independent external loan funding. Below we attempt to explain the relevant procedure. Whilst this can be a good procedure, consideration must be given to the fact that the loans must still be proper loans, compliant with normal market practices. During the financial crisis external funding became more difficult to obtain, and more businesses attempted to finance their operations internally. Many businesses (not just multinationals) finance the operations of their subsidiaries/affiliates via intercompany loans.
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