Last week, we were asked by the European management team of a substantial multinational group to advise on a very common scenario in the current environment – a request by made by the overseas parent company to ‘repatriate’ cash, by way of loan. The key issue was whether the directors of the European subsidiaries involved could properly approve the request and grant a loan of ‘surplus cash’ to the parent entity, and what ‘surplus cash’ actually meant in this context.
One of the European subsidiaries had already received a government-backed coronavirus business interruption loan. Other subsidiaries were in the process of applying for such loans under their respective national government schemes. All the relevant entities had furloughed staff and were receiving government grants in their respective countries in order to allow them to pay a proportion of salaries. In addition, a number of the European subsidiaries had previously made loans to the overseas parent which remained outstanding. Those loan receivables currently appeared on the subsidiaries’ balance sheets at face value.
This scenario is a perfect example of the critical role of governance and legal analysis in group structures, and illustrates why transfer pricing policies which are adopted without robust legal implementation are dangerous.
Key legal considerations regarding loans by subsidiaries to parent or sister undertakings
Although clearly the precise legal position depends on the relevant applicable laws, a number of key legal considerations tend to be universal in this kind of scenario. The most important overriding principle is that the position of each subsidiary (prospective lender) needs to be looked at from a legal entity perspective, notwithstanding that those entities are members of a corporate group.
In general terms, the following legal considerations are likely to be relevant:
1. Contractual restrictions on application of funds received from third parties
The directors of the relevant European entities should consider the following in relation to each entity:
- The contractual terms on which each entity has received loans from third parties. This may include the specified purpose of the loans (e.g. whether the funds provided are to be used for the purposes of the operations of the specific borrower and/or in a specific), any contractual restrictions (such as on-lending, the payment of dividends, transactions on non-arms’ length terms or outside the ordinary course of business) and other relevant covenants;
- Legal terms which may apply to the receipt of other third party funds, such as government grants for paying salaries of furloughed staff; and
- Representations made in the course of applying for or concluding arrangements for third party funding (whether in the form of loans or grants).
2. Solvency issues
In general terms, directors have personal legal duties to safeguard the interests of each entity of which they are a director, including each entity’s creditors and employees. Those duties tend to become more acute if the entity is insolvent (on a balance sheet or a cashflow basis), or may become insolvent as a result of the proposed transaction.
Relevant considerations in relation to each entity requested to make a loan therefore include:
- The present balance sheet position of the entity (taking into account the realistic true value of loan receivables);
- The balance sheet position after making the proposed intra-group loan (again, taking into account the likely ability of the borrower to repay the loan); and
- The entity’s ability to continue to pay its debts as they fall due (including by reference to solvency, default provisions and covenants given on the government-backed loan terms). Clearly, this requires making certain assumptions as to future trading prospects, how long it may take for trading to ‘normalise’, and what a ‘new normal’, in terms of trade and financial performance, may look like.
3. Personal liabilities of directors
Applicable laws can expose directors to risks of personal liability. For example, if a UK company goes into insolvent liquidation, its directors may be held personally liable to contribute to the company’s assets in certain circumstances. Examples include a failure to take ‘every step’ which a reasonably diligent person would take to minimise potential loss to the company’s creditors, starting from the point when the directors knew or ought to have known there was no reasonable prospect of avoiding insolvent liquidation.
Please note that misrepresentations made in the course of applying for government funding (e.g. furlough grants) may be treated as a fraud on the relevant government treasury, and may entail strict criminal liability.
Practical next steps and recommendations
If, after consideration of the relevant issues, the directors consider that a particular entity may be able to lend funds to a related entity, then it is critical for any decision to be properly documented. This is so that if ongoing trading is not as expected at the time of making the proposed intra-group loan, and the entity goes into insolvent liquidation or a similar insolvency process, the directors are in the best position to defend and justify the decision they previously made.
The appropriate documentation should include:
- A record of the relevant funding arrangements with third parties which were considered, and why the view was taken that applicable restrictions and covenants were complied with;
- Pro forma balance sheets showing the realistic net asset position before and after the proposed intra-group loan;
- Cash flow forecasts; and
- Specific professional advice taken, whether from lawyers, insolvency practitioners or accountants (including in respect of terms applicable to the government backed loans in the relevant countries).
As part of this process, all relevant government backed loans and other third party loan agreements should be checked for restrictions on further lending, including any obligation to inform the relevant lenders of the intention to make additional intra-group lending following the date of the relevant government backed loans (or other third party lending in place).
This kind of review is not just required at the time at which a new loan is granted. It also needs to be carried out on a regular basis, in the context of ongoing financing arrangements, such as cash pooling mechanisms.
Implications for legal implementation of transfer pricing and intra-group arrangements generally
Although a scenario such as the one outlined above brings a heightened awareness of personal liability risks for directors, the legal principles involved apply to every intra-group transaction. Legal considerations and legal agreements are not ‘window dressing’ for giving transfer pricing policies the appearance of reality. They are fundamental for creating arrangements with true substance.
If you are a tax or transfer pricing adviser reading this, and you want the TP policies you create for your clients to have genuine substance, then you cannot leave legal implementation to chance. A good place to start is the LCN Legal Online Course in Intercompany Agreements for Transfer Pricing Compliance, which has been specifically designed for TP professionals. The course is listed by the UK’s Chartered Institute of Tax (CIOT) as relevant to its Advanced Diploma in International Taxation. You can find further details of the course here.