This article is written by Somadatta Bandyopadhyay, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Intercompany loan refers to the amount or price advanced or granted by and between related companies. It is imperative that the transaction happens within the same group of companies or companies under a common control or ownership. The amount advanced may be for numerous purposes including but not limited to funding the day-to-day functions of the borrowing enterprise, helping the borrowing enterprise with the inflow of cash or even to fund certain fixed assets of the enterprise. However, like with any loan transaction, an intercompany loan also brings up interest obligations where the lender enterprise has interest income and the borrower enterprise has interest expense.
An intercompany loan can also be effectively used as a management technique for cash flow by the cash department of the group company or the holding company. If one company has been recurrently incurring losses and another one has had a significant inflow of cash with very less expenses, then the management of the company undergoing a cash crunch can undertake a decision to take loan from the company with the surplus funding. The rate of interest is to be decided by the parties to the agreement. The agreement should also carefully and explicitly stipulate how the payment is to be done, how frequently it has to be done, the tenor amongst other things. This aids in the management of short term finance for the companies.
How do Intercompany Loans work?
There are compliances to be done by both the lender and the borrower enterprise before the loan is initiated. Compliances have to be both corporate and tax compliances. Document approvals are to be done before the actual cash flow commences between the enterprises. Also, the agreement has to be made, which, if created in the lender company, a mirror transaction will be created in the lender company. The agreement usually specifies the tenor of the loan. However, it is normally made for short term finances i.e., to fund the company which has a cash crunch.
One of the very first steps that has to be taken is to analyze the cash position of the borrower enterprise and take a decision whether they would be able to recover to a spot to be able to repay the loan amount along with the interest. Once the decision is taken, an agreement has to be made between both the borrower as well as the lender enterprise on the loan. Once the agreement is enforced into a contract, the terms and conditions can be set in writing by the lender company. The mirrored loan contract by the borrower company has to be reviewed. This is a continuous process where regular follow up has to be done with respect to investment management and standard debts.
Novel ideas like treasury centers have also come up where companies with excess unrequired funds can deposit said funds in the treasury centers thereby facilitating the withdrawal of the amount by the companies who are in a cash crunch and require the funds.
Reasons for Intercompany Loans
The main reason to go give a green signal to an intercompany loan would be to support an enterprise, which is a part of a group of entities, in its operations when its cash resources are low and also is not in a position to raise capital through a bank or any financial institution.
Intercompany loans also help in the diversification of the business of the group of entities by way of an investment mechanism.
One major advantage is that when the loans are between companies or entities it saves a lot of effort and time with respect to the documentation, frequent follow ups that come along with acquiring funds from financial institutions.
Of course it goes without saying that intercompany loans improve the financial status of the borrowing enterprise and also encourages borrowing within the group of entities thus saving a lot of money on foreign exchange.
Some not-so-common yet relevant reasons for intercompany loans maybe for reasons like purchase of machinery or other fixed assets or management of working capital or even re-organization of the entire entity.
Challenges of Intercompany Loans
One severe implication of intercompany loans is dealing with taxation issues. The loans would be required to be regulated by the tax authorities as per the interest rates of the market; the transactions should be at arm’s length price. In case such pricing comes under the radar, both the lender and the borrower may find themselves in trouble with respect to interests, penalties or any other cost. It is more convenient for two entities to rather exchange the loan amount in the blink of an eye. But tax incompetency cannot be evaded so easily. The authorities have to be satisfied with respect to profit shifting and base erosion.
Another challenge that companies might face with respect to intercompany loans is the lack of requisite documentation capturing the loan. If there is no documentation that exists, then the loan falls under the purview of an investment which entails severe tax obligations.
When are Intercompany loans advantageous?
The distinctive advantage in which intercompany loans are deemed useful are that entities do not have to substantiate their credit score rating to the other related entities in the group. Of course, this kind of loan also allows a smoother and easier flow of cash as compared to traditional financial institutions. These loans are also very easily accessible and also the terms of repayment are flexible.
- These loans are available at the click of mouse pointers subject to the documentation hurdle to be suffered.
- The flexibility of the repayment terms & other terms can be agreed over between the entities & tax authorities normally have no issue with the tenor of the loans.
Scenario in India
Intercompany loans in India are governed by the Companies Act, 2013. Since India is undergoing massive industrialization, funds are required and therefore comes the need for intercompany loans.
Limit on Intercompany loan
Companies Act, 2013, sets some limits on intercompany loans.
Loans, securities or guarantees can be given by a company in excess of up to 60% of the paid up share capital.
Also, if the loan amount aggregate is not more than the stipulated limit, then the loan is processed only by passing a board resolution. The board resolution is passed only with the consent of the directors who are present at the specified board meeting. If there arises a case where the entire loan is above the stipulated limit, then a prior special resolution is prerequisite.
Restriction on Intercompany loan
If a company is unable to repay the interest amount, then said company is debarred from making any intercompany loan as per the Companies Act, 2013 and such debarring remains effective until the default in repayment is addressed. The loans are also not allowed to be given at a rate less than the prevalent lending rate of banks.
But in case, the loan is advanced for research and development purposes for the industry in which the paid up capital is 26% or more and held by the government, then the above mentioned rate of interest is not applicable.
Disclosure of particulars of the loan in Financial Statement
According to Section 186(4) of Companies Act, 2013, when a company provides loans then certain disclosures are to be made in the financial statement to the members which include: the loan amount, the guarantee given or the investment made, the reason for providing the loan, the source of the fund and the details of the enterprise making the loan.
Procedure for providing Intercompany loans
There has to be a particular procedure to be followed when it comes to providing intercompany loans. The loan can be given to up to 60% of the paid up capital through a resolution of thr Board. A meeting has to be done by the Board of Directors to this effect after giving a proper notice. The investment is to be done only after the resolution is passed. In case there’s an existing outstanding loan from any financial institution, the approval of said institution is required. A copy of the resolution is to be filed mandatorily in form Number MGT-14 along with the payment of prescribed fees as mentioned in Companies Rules, 2014 and this has to be done within a time period of 30 days of the passing of the resolution. The interest rate of the loan has to be kept in mind such that it does not get lower than the prevalent government security rate. And lastly, the entire particulars of the loan has to be disclosed by the company in the financial statement.
The most coveted resource to run any kind of business is money of course. The money for these businesses can come to companies from loans or shares or something similar, with loans being a major source. Therefore, intercompany loans are a great funding option. These loans tick off the check-list of satisfying the necessary capital source of the enterprise. The loan is processed only after the Board consents and approves of it. And just like other kindskind of loans, the borrowing entities are also required to repay the amount at the end of the tenor. Default in such payments can have adverse tax implications on the borrowing company. Therefore, these intercompany loans are best suited for short term finance and therefore it makes it easier for the entity to settle the amount in the stipulated time frame.
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