Pay Now or Pay Later?
by Carol Stuckley
Avoiding the Pitfalls of Intercompany Funding
Nascent private US companies are often lured into overseas expansions, before they fully comprehend the consequences of the capital structure and operating decisions associated with each of the foreign legal entities they establish during the expansion process. The initial temptation may be to finance foreign subsidiaries via a series of short-term intercompany loans or cash advances. If the private US company does not prepare consolidated US financial statements, any losses by the foreign subsidiaries will not be reflected in the stand alone US financial statements, at least not in the short term.
There are many considerations when evaluating alternatives for “funding” foreign subsidiaries. Expense reimbursement alternatives will affect the P&Ls of both the Parent Company and Subsidiary immediately. In contrast, loan and investment alternatives will predominantly inversely affect the balance sheets of both companies, normally without an immediate or substantial P&L affect. The following discussion will focus on a Subsidiary obtaining funding from its US Parent which does not prepare consolidated financial statements.
Intercompany Funding: Alternatives & Implications | Permanent Cash Transfer? | Permanent Profit Transfer? | Permanent Capital Change? | Immediate and Direct P&L Impact? |
| Expense Reimbursements | Yes | Yes | No | Full, FX |
| Loans (1) | No | No | No | Interest, FX |
| Cash Advances (1) | No | No | No | FX |
| Investments (2) | Yes | No | Yes | No |
Notes:
(1) Assumes repayment of loans & advances remains feasible.
(2) Assumes investment is not “other than temporarily impaired” & written-off.
FX = Foreign Currency related gains & losses due to transaction exposures.
- Expense Reimbursements – Where the Parent books revenues and essentially sub-contracts its Subsidiary to perform services on its behalf, the Parent should normally reimburse the Subsidiary for the expenses incurred in performing those services plus an appropriate profit margin or “mark-up,” in accordance with tax guidelines. The expense reimbursement is a permanent cash and profit transfer that reduces the cash and profits earned by the Parent and increases the cash and profits (or reduces the losses) of the Subsidiary by the amount of the cash transfer. In some foreign jurisdictions, Value Added Tax (VAT) or other indirect taxes may apply to expense reimbursement or sub-contracting transactions.
- Loans – A Subsidiary’s short to medium term funding needs may be more efficiently addressed with an intercompany loan than with a local bank loan for a variety of reasons. When an intercompany loan is extended, the Parent records an asset in its books (Loans Receivable) and the Subsidiary records an offsetting liability in its books (Loans Payable). In cases where repayment remains probable, the current P&L impact would be limited to the offsetting interest income/interest expense recorded by the Parent/Subsidiary as well as any unhedged currency related gains/losses which arise when the Parent and Subsidiary have differential functional currencies. Interest rates should be established based on “arms length” principles, in accordance with the term and currency of the loan, and tax guidelines. In some foreign jurisdictions, withholding taxes or other indirect taxes may apply to interest payments. If loan repayment becomes unlikely/improbable, a write-off may be required with the Parent absorbing the full adverse P&L effect.
- Cash Advances – Intercompany Cash Advances are normally short term in tenure and bear no interest income/expense. Some countries may not allow intercompany cash advances, and in those cases, an interest bearing loan may be the only interim intercompany funding alternative. The current P&L impact associated with a cash advance would exclude interest, but may include currency related gains/losses if the Parent and Subsidiary have different functional currencies. If a repayment risk arises in the future, the Parent may need to absorb the full adverse P&L effect of a write-off.
- Investment – When a Parent increases its investment in its Subsidiary to provide adequate working capital, capital asset or operating expense funding, it records a long term asset on its books and the permanent equity of the subsidiary is increased by the same amount. The P&Ls of the Parent and Subsidiary are not immediately affected by this investment. Depending on the country, equity increases may be recorded as “capital stock”, “paid-in capital”, “capital surplus” or “loss compensation”.
Care must be taken in the selection of the permanent capital investment account as many countries charge stamp taxes or other duties/fees when capital stock is increased and many require that certain actions be taken when capital stock is eroded by operating losses beyond a specific percentage. Investments via the “Paid-In Capital” or “Capital Surplus” accounts (vs. the Capital Stock Account) are normally more flexible and normally do not attract stamp taxes and other duties. In accordance with Fair Value concepts, a P&L charge could become necessary if the Parent’s investment in Subsidiary became “other than temporarily impaired” as evidenced by eroded local equity (i.e. fair value less than value on the Parent’s books) and projected ongoing operating losses.
A few guiding principles regarding Statutory Accounts:
- Symmetry – With few exceptions, Parent and Subsidiary transactions must be recorded as proper mirror images in the statutory accounts; a Parent’s loan receivable must be offset by the Subsidiary’s loan payable, a Parent’s investment in Subsidiary must be offset by an increase in the Subsidiary’s equity account, etc.
- “Arm’s Length” principals in accordance with tax guidelines must apply to the establishment of “markups” or profits on expense reimbursements and interest rates on loans. The arm’s length interest rate will be influenced by both the currency in which the loan is denominated and the term of the loan.
- P&L – Immediate full P&L affects associated with fund transfers are largely avoided with loans, cash advances and equity investment alternatives, provided that the loan and advance repayments remain viable and the investments do not become “other than temporarily impaired”. If cash advance or loan repayments become unlikely and/or investments become “other than temporarily impaired”, the Parent’s P&L will be adversely affected by the amount of the required “write-off” or “write-down”.
- Currency – Where the Parent and Subsidiary have different functional currencies, foreign exchange (currency) related P&L impacts associated with expense reimbursements and loans/advances may occur without offset, unless the currency exposures are hedged. The transaction currency will dictate which party bears the currency risk.
- Indirect Taxes & Income Taxes – Indirect taxes such as VAT, withholding taxes, stamp duties, etc., together with income taxes, should be taken into consideration when assessing the total cost and efficiency of various funding alternatives for the Subsidiary.
- Consolidated Accounts – In accordance with US GAAP rules, the financial statements of majority owned and controlled subsidiaries (with few exceptions) must be consolidated with the Parent Company financial statements. Intercompany transactions that are reflected on the statutory books of both the Parent and Subsidiary are “eliminated” in the “consolidation” process. The profits and losses of Majority owned or controlled Subsidiaries are reflected in the Parent’s consolidated accounts.
In summary, a non-consolidating US private company may be able to maximize US profits in the short term by funding foreign subsidiaries via loans, cash advances and/or investments in its Subs, without the immediate reduction in US earnings that would result from the direct reimbursement of the Subsidiary’s expenses. If over the medium to longer term, however, the Subsidiary continues to incur chronic losses so that cash advances/loans cannot be repaid, and/or the investment in Subsidiary becomes “other than temporarily impaired”, the non-consolidating US Parent company will at that time need to recognize an appropriate P&L charge on its statutory books. The P&L charge will reflect the “write-off” of the loan or cash advance and/or the “write-down” of the impaired investment in a Subsidiary.??
The adage “Pay Now or Pay Later” therefore applies when the foreign Subsidiaries of a non-consolidating US Parent Company are not able to earn profits and maintain positive net equity in the medium to longer term. The previously deferred P&L charges on the US Parent company books will eventually appear as a “write-off” of the loan or cash advance and/or a “write-down” of the impaired investment in Sub. In contrast, the consolidating US Parent company has no “Pay Now or Pay Later” flexibility, beyond its statutory accounts.
