Approaches to Funding Subsidiaries

Commentary

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This call came out of a series of discussions with treasurers: we spend a lot of time worrying about intercompany loans, external funding locally, etc. But a lot of these issues arise as a result of a series of key decisions, which are strategic and often historical: how do we structure our subsidiaries?

This is a complex decision. A non-exhaustive list of considerations includes:

• Company policy: the more equity in a foreign entity, the bigger the perceived risk
• Flexibility: loans can be quickly repatriated (at least, in theory): equity cannot
• Duration and refinancing risk
• Involvement of the in-house bank
• Exchange controls
• The need for internal loan agreements
• Tax. This is very complex, and can become circular:
  
  • Local thin capitalisation and equity requirements
  • Arm’s length pricing for intercompany loans – the end of LIBOR complicates this
  • Profitability of the local business
  • Charging for credit risk – this is circular, as we control the credit quality
  • Country risk
  • Implicit guarantees
• Business performance issues: equity does not result in a charge in the local books. This can disguise the true cost of funding working capital or capital expenditure
• Difference between local accounting rules and those of the parent
• Workload: the analysis is usually manual, which can be a problem if there are many subsidiaries

Most of these topics came up in the call. As always, there are a variety of approaches, with no one right (or wrong!) answer. But some shifts seem to be under way:

• People seem to be considering equity more than in the past
  
  • Transfer pricing is becoming more of an issue, so Tax is having a bigger say
• Specific problem with negative interest rates, especially for the euro
• In-house banks initially just provided short term funding. Some are moving to do all funding

Bottom line: it can be worth taking some time to stand back to look at the overall structure, and ask “What would I do if I started from a clean piece of paper?” We never start from a clean piece of paper, but it is good to have a view of what the preferred structure would be, and work towards it.