Intercompany loans are loans made from one business unit of a company to another, usually for one of the following reasons:
- To shift cash to a business unit that would otherwise experience a cash shortfall
- To shift cash into a business unit (usually corporate) where the funds are aggregated for investment purposes
- To shift cash within business units that use a common currency, rather than sending in funds from a foreign location that will be subject to exchange rate fluctuations
The use of intercompany loans can 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. Also, the interest rate associated with such a loan should be one that would be derived in an arm's-length transaction with a third party.
When an intercompany loan is created, it should be fully documented, including the amount of the interest rate to be charged and principal repayment terms. Otherwise, the loan might instead be considered an investment by the issuing business unit in the receiving unit, which can create other tax problems.
Given the extent of these tax concerns, a company using intercompany loans should be prepared to undergo a tax audit that focuses on the underlying reasons for and documentation of these loans.
Intercompany loans are recorded in the financial statements of individual business units, but they are eliminated from the consolidated financial statements of a group of companies of which the business units are a part, using intercompany elimination transactions.
Despite the issues just noted, intercompany loans are extremely useful for the following reasons:
- No credit application is required
- The cash can be made available on short notice
- Repayment terms may be much longer than would be required by a commercial lender