Intercompany loans without charging interest expense

Daniel Magliari's Profile

Intercompany Loans

I am working for a privately held company that has recently acquired a couple of subsidiaries internationally. 

We currently need to provide an intercompany loans to two of the subs (located in Germany and Taiwan).  The subs are wholly owned by the parent.

In loaning the funds intercompany ("parent-to-sub" or "sub-to-parent"), is it absolutely necessary to charge interest on the loans - or for simplicity, can we loan funds back-and-forth without charging interest? (while still documenting and recording the intercompany loans in the financials).

We would like to forego the requirement for charging interest expense in order to minimize the internal accounting effort since it is all internal to the corporation. 

Can we loan funds without charging interest on the loan?

Answers

Member's Profile

I think GAAP doesn't care (except for treatment of exchange gains or losses - see FASB 52 for difference in treatment of revaluation between LT and ST intercompany balances.) All inter-company so eliminated for consolidation.

Your issue is going to be tax driven. US tax could say you should be imputing income. Foreign tax could say unless you have documentation, you can't deduct interest expense. You could end up with income taxed, but deduction disallowed. Also could have the loan re-characterized as a capital contribution by tax authorities, with implications when you try to pull funds back out - repayment of capital could be subject to backup withholding, etc.

Best to discuss with your international tax advisors, they are the ones most likely to be concerned that these loans are properly documented.

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FIN 48 and the uncertainty of your tax position.
Agree with the other comments.

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Yes, this is primarily tax driven. Intercompany loans (rather than trade intercompany or very short term advances) from US parent to non-US subsidiary requires an interest rate. Note the interest rate must be an arm's length rate. Also, note that the interest may require tax withholding (reduced treaty rates may apply) which will require a US tax computation for foreign tax credit purposes.
If there is a loan from the sub to the parent make sure to check whether there is a deemed repatriation of funds under Section 956.

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We have wholly owned subsidiaries both in the states and oversees and we do not charge interest on the loans. Our auditors have never questioned it.

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Mark,
I find it hard to believe that both audit and tax issues haven't been raised for you.
1) Auditors always question whether or not interest should be imputed on any and all loans, unless the activity is so transient (i.e., short-term Due To / Due From offsets) vs real loans, which always require repayment Ts & Cs. (Maybe yours waive their issues due to immateriality or otherwise,

2) Tax advisors you use don't indicate a requirement to formalize the loans, establish standard arms-length Ts & Cs, which would require interest as Allan and Zach have already commented.

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when I took a 3 Mn long term ( 3 to 5 years) loan from an US company (parent co) for the 100% Indian subsidiary , I took the Indian government's (Reserve Bank of India) permission as an External Commercial borrowing with an interest of around 3% + LIBOR rate. So the bottom line is that for long term loans interest should be charged notwithstanding the accounting involved.

If you are looking at a short term of 30 to 90 days , some kind of trade advance should not be a problem without any interest. This will be ultimately set of against the running transactions. This is my personal opinion based on past experience.

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I agree with Allan Kaplan, above. The issue is tax-driven.

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GAAP is not the driver. It is US and Foreign Tax issue. Doing things to make accounting easy should be the first clue that it may not be correct.

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US tax law requires interest be charged to your foreign subs. This position does not depend upon whether it is an actual loan or a long term balance in an intercompany account. When you are audited, the US tax you would have paid if you charged interest will be levied by the IRS. There is no doubt. The difference at that point will be that it may no longer be deductible in the foreign sub. Most companies do seek to minimize the interest rate and this has survived audits.

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I concur with most comments. With my previous employer which operate globally, interco loans are commonly used to optimize use of funds within the organization. When we loaned money to parent or a sister sub, we charged interests based on Applicable Federal Rate (AFR) issued by the IRS monthly http://www.irs.gov/app/picklist/list/federalRates.html. The imputed interest income is taxable. On the other end, when we loaned money from foreign parent or sister subs, we were charged Libor plus an agreed upon mark up rate. It is part of APA program with the IRS. I think it is advisable to consult with an international tax attorney or the tax partner of your accounting firm before signing into an interco loan agreement.

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Hi Daniel,
You will have to refer to your country's Transfer Pricing Regulations. Usually an interest free loan transaction between parent and foreign subsidiary (Associate Enterprise) will be subjected to an adjustment for notional interest for the purpose of tax computation of the lending entity.
The tax officer may take a position that such interest free loan transactions is designed to evade local income tax and resulting into shifting of profits of your corporate group from the USA to a country outside US.
It is, therefore, advisable to charge fair interest rest on such loan transaction.

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I concur with Pawan. Transfer Pricing rules are important in this situation. When you treat your subsidiary differently than you do a third party entity, you can run afoul of the tax authorities. Check the box entity or not, may also have bearing on this situation.

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Tax law is the key driver here and you must charge interest for US tax purposes. Additionally at some point in the future when you want to repatriate the money it will be easier to do if it is a true loan and not equity.

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First, need to remember that from any foreign location it is easier to put money in than taking money out.
Second, think about using intercompany receivables and payables terms to move money out of a location without triggering other issues. Do not change terms very often and document the business reason for the change.
Third, also consider alternatives such as a letter of awareness, minimum capital guarantees, even intercompany volume guarantees, etc.
Fourth, the principle for intercompany loans has to be to do it at "arms-length terms". In other words, charge each other the some amount that a third part would charge. Otherwise someone is getting an intercompany subsidy.(read next point)
Fifth, may need to overlay the tax consequences. One answer might be to minimize or maximize interest charged to the other party in which case your MIS should capture this and adjust it. If your business is not borrowing and lending money the interest charged intercompany might have some flexibility in terms of nominal rates.
Sixth, be aware of local regulations as in some case the adverse tax consequences of not doing so can be very large. For instance a loan might be assessed by some tax authority as a "deemed" dividend.
Seventh, need to identify, measure and monitor the cross-border risk you start running with the transaction (cross-border risk defined as the risk of nationalization, expropiation, convertibility and transferability). There are books written in each of those.
Eighth, need to establish a process that reviews the situation on a regular basis as many will try to game the system for business unit profits.

Lastly, take a holistic view and make sure it makes sense from a business and corporate perspective.

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Jorge, I enjoyed your comments. Can you expand a bit on your seventh point on cross border risk. I'd appreciate to get info of books discussing risk of nationalization, expropiation, convertibility and transferability. Thank you. Sophia

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Each institution has a slightly different definition on X-Border risk. The most useful thing would be to read the following paper from the Fed: http://www.newyorkfed.org/prc/report.pdf

Although the paper has a securities bias on it, if you look at the logic behind the risks mentioned then you can develop a framework to look at any business situation a define the risks that would apply to it.

Regards,

jorge

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Interest charges are likely required under U.S. tax laws for tax purposes, and are often required by tax laws of other countries. GAAP/IFRS will care if separate financial statements of the subsidiaries are issued, but not if only consolidated financial statements are published.

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We had a tax audit last year and the only adjustment made was to impute interest income on our inter company balances that were over 90 days old. The IRS is definitely looking at it if you get audited.

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Proformative Advisor
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For tax purposes you will have to charge interest or this would have to be classified as an investment and appropriate equity entries recorded. I would also make sure this agreement is "papered" and make sure you are charging the appropriate market interest rate. This can be your cost of capital. Some considerations for doing this include allowing you to move money out of the country without taxation.

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Topic Expert
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One thing that I did not see in this thread is that you may have entered (and so should properly document) the very happy structure of the Equity Loan. I believe that in the stated jurisdictions this is permissible, and doesn't trigger any IRS issues.

An equity loan is essentially APIC of a special flavor. It can be repatriated without a dividend-trigger (so no repat taxes). It does not need to bear interest. It is simply an increase in APIC that can be drawn back at any time. It acts like debt, but with the effect of increasing the Equity, not a Liability, so if the company goes under, you're at the bottom of the pile and can't recall the funds in the manner you could call in a debt.

Do check with your tax accountant about this, but it may be an easy out for you.

Otherwise, as above, yes. Short term (<90) AP and AR between companies is fine as long as it clears. If it is clearly long term, then either you need to have nominal interest, which should be a deductible expense, or you could fall into one of the many traps mentioned. Basically, you can't just send money back and forth willy-nilly. They are separate companies so you need to have some clear structure.

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An intercompany loan agreement is relatively straight forward to set up and I believe it is to help you avoid tax issues in the future. Do something basic such as 3% unless Libor + x is more than 3%. More paperwork and the accounting isn't too complicated.

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