Intercompany Loan: What Happens If The Borrowing Company Becomes Insolvent?
You may well know what an intercompany loan is… But do you know what can happen if the borrowing company becomes insolvent, or enters liquidation?
An intercompany loan can provide a quicker and less expensive way for a business to borrow funds.
But there are risks involved for the lending company in particular which could be overlooked and we’ll explore a key one in this guide.
We explain what happens if one company lends to another and then the latter ultimately becomes insolvent or goes into liquidation.
What is an intercompany loan?
As the term implies, an intercompany loan involves a lending arrangement between two related businesses.
This is typically one company – often the parent one – lending money to a subsidiary. In other words, both companies involved in the transaction are part of the same corporate group.
Interest rates on intercompany loans are usually at a rate that reflects the market price for similar borrowing arrangements between unrelated parties.
Intercompany loans can have varied terms – including the amount borrowed, repayment schedule, collateral requirements, and so on.
The lending company may insist on securing the loan using fixed or floating charges. Read our article on the differences between fixed and floating charges.
It’s common for the lending and borrowing company to use a dedicated loan account – a more informal arrangement can have tax implications and present risks. Accurate and up-to-date documentation is very important to maintain.
For wider reading, the government has different guidance for intragroup short and long-term loan relationships:
- Revolving loan accounts between group companies
- Long-term aggregated loan relationships
- Finance arrangements with a long-term funding purpose and examples
- Examples of arrangements without a long-term funding purpose
- Schemes or arrangements that exploit the short-term debt rules
There are some potential advantages associated with an intercompany loan in comparison with traditional lending arrangements.
Within a group of companies, intercompany loans can be an efficient way for businesses to manage cash flow, fund operations, and avoid the costs associated with external financing.
However, there are several disadvantages too which we’ll explain shortly.
What happens if the borrowing company becomes insolvent?
Let’s say that Business A has lent money to Business B within the Group. One of the biggest risks of intercompany loans is – what happens if Business B becomes insolvent?
Taking a step back, there are three simple methods to detect insolvency – covered in more detail in our guide, When Is A Company Insolvent?:
- The cash flow test: Can the company pay its debts when they fall due?
- The balance sheet test: Does the company owe more than it owns?
- The legal action test: Has the company received a County Court Judgement (CCJ), a winding-up petition, statutory demand or other form of legal enforcement action?
If the company is insolvent it should seek advice immediately from an expert insolvency practitioner. What happens next depends on the company’s prospects.
For instance, the insolvency practitioner may recommend a Company Voluntary Arrangement (CVA) if the business is able to keep trading while paying back its debts. CVAs typically last up to five years but can bring a company out of debt.
However, if the company’s struggles necessitate it, sometimes the best choice is liquidation. In which case, a Creditors’ Voluntary Liquidation (CVL) is preferable to a compulsory one.
Once passed, the liquidator distributes company assets to creditors, fulfilling debts wherever possible. There is a set hierarchy dictating which creditor category receives repayment first, as per the Insolvency Act 1986.
If there is little to no money available to repay specific creditors, the only option may be to write off a loan.
In terms of an intercompany loan, that means Business A may not receive repayment for its loan to Business B. There is also the risk of a knock-on effect, with Business A’s cash flow worsening due to the absence of loan repayments from Business B.
Final thoughts – Intercompany Loan: What Happens If The Borrowing Company Becomes Insolvent?
In summary, when two businesses are involved in an intercompany loan, the lender risks not receiving repayment if the lendee becomes insolvent and ultimately enters liquidation.
While financial institutions and banks factor such risk into their business model… A regular firm that lends within an intercompany loan arrangement may struggle to cope with such a financial setback.
As mentioned, if your business is at risk of failing one of the three checks for insolvency, we recommend seeking advice from experienced insolvency practitioners without delay.
With over 20 years of experience in business rescue and resolving financial difficulties, that’s where Hudson Weir can help. Whether the circumstances involve an intercompany loan or not, we help businesses make the right choice for the scenario in front of them.
For more information about our services or to make a general enquiry, please don’t hesitate to contact us.
