Effects Of COVID-19 On Intercompany Loans
Posted by Sanjeev Kumar on May 14, 2020
The COVID-19 crisis has significantly disrupted or is likely to disrupt the financial situations and cash positions of many businesses. Central banks in the U.S., Europe, and Asia have reduced bank lending rates to nearly zero in order to preempt a potential liquidity crisis. While some borrowers are expected to default on their debt payment obligations, they are simultaneously weighing the costs and benefits of refinancing their debts to take advantage of lower interest rates. As a result of falling profits and worsening cash flows, the credit ratings of many borrowers are expected to fall substantially. Other notable effects may include:
- Borrowers being unable to make interest and principal payments
- Companies taking on more debt to alleviate immediate cash flow predicaments (and potential debt to equity issues)
- Parent companies guaranteeing loans to third party lenders
- Companies facing potential transfer pricing issues with regard to establishing arm’s length interest rates for intercompany loans
These changes, among others, are likely to affect intercompany debt transactions significantly. This article addresses certain key issues from the perspective of an intercompany borrower, including the risk of violating loan covenants, the ability to make required loan payments, creating a need for increased debt, and benchmarking interest rates.
Debt Agreement Covenants
Written intercompany loan agreements typically stipulate the rights of the lender and the obligations of the borrower, consistent with the requirements of Internal Revenue Code (IRC) Section 385, which deals with intercompany indebtedness. Taxpayers are advised to carefully monitor financial covenants which might require penalty for late interest payments or trigger higher interest rates if leverage ratios fall below a specified threshold. Borrowers with debt agreements that include a prepayment option should evaluate the costs and benefits of refinancing their existing debts to reduce their interest rates, as tax authorities may expect of them. (Tweet this!)
Ability To Meet Repayment Schedules
As stated above, loan agreements generally require the borrower to make periodic principal and interest payments to avoid triggering penalty provisions. If profits fall more than the borrower could have reasonably anticipated at the time the debt instrument was executed, it may become difficult to honor payment obligations. This situation could cause interest rates to increase and late fees to be applied for failure to make timely payments.
Need For Higher Debt
As losses increase, a company may need to borrow cash to cover its expenses. Funds may be borrowed from other related party entities or from third-party lenders. The need for additional debt creates two issues (among others):
- Debt Capacity Issues—Debt capacity represents a borrower’s ability to take on, and therefore repay, a certain level of debt. It is often a function of the borrower’s cash flow (EBITDA), which may now be reduced as a result of COVID-19 crisis. Further, the debt-to-equity ratios of many borrowers may also be affected. This financial ratio is one of the several factors enumerated in IRC section 385. A cash infusion from one related party to another to assist with a shortage of cash may cause the borrower’s debt-to-equity ratio to fall to levels inconsistent with those of industry peers and even its own historical ratios. Borrowers can analyze these ratios in various ways, such as looking at multi-year averages, although it remains to be seen what time horizons tax authorities will accept.
- Parent Loan Guarantees—Loan applicants may require guarantees from their parent companies to raise debt capital in local lending markets. Due to expected operating losses and pressure on cash flows, these guarantees may be increasingly required. Parent guarantees may require not only an analysis of the guarantee fee payable to the parent company, but also the enhanced debt capacity of the borrower.
Benchmarking Intercompany Loan Interest Rates
The current crisis is expected to affect the interest rate benchmarking process in at least two ways.
First, in light of exceptionally low market interest rates, certain taxpayers who historically preferred to use the Applicable Federal Rate (AFR), a safe haven rate under Treasury Regulation section 1.482-2, may find the market interest rates even lower.
Second, reduced levels of third-party lending as a result of expected liquidity crises and lenders’ concerns regarding the ability of loan applicants to service debt payments will produce fewer market benchmarks available for analyzing intercompany loan agreements.
Any opinions expressed in this article are those of the authors, and not necessarily those of Valentiam Group.
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