How to Settle Intercompany Balances Without Cash

Intercompany balances, which are receivables and payables between related entities under common control, arise from the normal course of business. These can stem from a parent company providing services to a subsidiary, a subsidiary selling goods to a sister company, or centralized payment processing. While these balances are often settled with cash, companies may settle them without a physical transfer of funds to manage liquidity, where a subsidiary with limited cash can clear a debt to its parent without straining its financial resources.

Another reason for cashless settlement is to improve the financial health of a subsidiary. By eliminating a large payable from a subsidiary’s balance sheet, the parent company can make the subsidiary appear more financially stable to external creditors, lenders, or potential investors. This can be useful when a subsidiary needs to secure its own third-party financing. Cashless settlements also offer administrative simplification by reducing the number of transactions that need to be processed and reconciled.

Required Information and Documentation

Before any cashless settlement of intercompany balances can occur, thorough preparation and documentation must be completed. This includes:

• A detailed schedule of all outstanding intercompany balances. This schedule must identify each transaction, the date it occurred, the amount owed, and which entity is the debtor and creditor. This listing is a foundational record for the settlement and financial audits.
• A clear understanding of the corporate structure, visualized through an entity relationship chart. This chart should map out the ownership connections between the parent, its subsidiaries, and any sister companies. A review of existing intercompany loan or service agreements is also needed to ensure the proposed settlement does not violate established terms.
• Formal authorization through a board of directors’ resolution or a written consent from the members or shareholders of the involved entities. The resolution should state the amount of the debt being settled, the names of the entities involved, and the settlement method. This formal approval protects directors and officers by demonstrating that the action was taken with proper authority.
• A documented solvency analysis. This involves the directors of each entity affirming that, after the proposed settlement, the company will still be able to pay its other debts as they come due. This step is important for corporate governance, as transactions that render a company insolvent can be challenged by other creditors as a fraudulent conveyance.

Methods for Cashless Intercompany Settlement

One of the most common methods for a parent company to settle a receivable from its subsidiary is through a capital contribution. The parent company forgives the debt owed by the subsidiary. Instead of the subsidiary paying cash, the parent treats the forgiven amount as an additional investment into the subsidiary. This is recorded on the subsidiary’s books as an increase in equity, often in an account titled “Additional Paid-In Capital” (APIC).

If a subsidiary has a receivable from its parent, it can declare a dividend to the parent. Instead of paying the dividend in cash, the subsidiary settles the dividend obligation by canceling the receivable it holds from the parent. The net effect is that the parent’s debt is paid off, and the subsidiary’s retained earnings are reduced by the amount of the dividend. This method is contingent on the subsidiary having sufficient retained earnings and profits to legally declare a dividend.

For companies that have mutual debts, intercompany netting is an efficient settlement process. This occurs when one entity owes money to a sister company, which in turn owes money back to the first entity. Through a formal netting agreement, the two companies can offset their respective payables and receivables. After the offset, only the net difference, if any, remains as an outstanding balance.

A debt-for-equity swap is where an intercompany debt is converted into an equity stake in the debtor company. For example, a sister company that is owed money by another subsidiary could agree to cancel the debt in exchange for receiving ownership shares in the debtor company. This transforms the creditor from a lender into a shareholder. This approach requires careful valuation of both the debt and the equity being issued to ensure the exchange is fair.

A debtor entity can transfer a non-cash asset, such as equipment or real estate, to the creditor entity to satisfy the intercompany debt. This method requires a precise valuation of the asset being transferred, based on its current fair market value. Using an asset’s book value is not appropriate unless it aligns with the fair market value. The asset transfer must be properly documented with a bill of sale or title transfer to formalize the change in ownership.

Accounting and Tax Implications

For a capital contribution where a parent forgives a subsidiary’s debt, the parent company would debit its “Investment in Subsidiary” account and credit its “Intercompany Receivable.” The subsidiary would make a corresponding entry by debiting its “Intercompany Payable” and crediting “Additional Paid-In Capital.” This transaction is tax-free for both entities under Internal Revenue Code (IRC) Section 118, as it is treated as a contribution to the capital of the subsidiary. The parent’s stock basis in the subsidiary increases by the amount of the forgiven debt.

When a subsidiary settles a receivable from its parent by declaring a dividend, the accounting entries are different. The subsidiary would debit “Retained Earnings” and credit “Dividends Payable,” followed by a debit to “Dividends Payable” and a credit to its “Intercompany Receivable.” The tax consequences depend on the subsidiary’s accumulated and current earnings and profits (E&P). If the distribution is made from E&P, it is treated as a taxable dividend to the parent. Corporate parents may be eligible for a dividends-received deduction, which can reduce or eliminate the tax liability.

The forgiveness of debt can sometimes create Cancellation of Debt Income (CODI) for the debtor entity, which is considered taxable income under IRC Section 61. If a creditor entity that is not a direct shareholder simply forgives a debt, the debtor may have to recognize income. However, IRC Section 108 provides several exceptions. For instance, if the debtor is insolvent both before and after the debt cancellation, the CODI may be excluded from taxable income.

Intercompany netting itself does not typically create significant tax issues, as it is merely a mechanism for settling existing obligations. The underlying transactions that created the payables and receivables are what have the tax impact. All intercompany transactions, including the sales of goods or provisions of services, must be conducted at an “arm’s length” price. This principle, outlined in IRC Section 482, requires that transactions between related parties are priced as if they were between unrelated parties. Failure to adhere to arm’s length pricing can result in the IRS reallocating income and deductions between the entities.

When an asset is transferred to settle a debt, the debtor entity is treated as if it sold the asset for its fair market value. If the fair market value of the asset exceeds its tax basis, the debtor must recognize a taxable gain. Conversely, a loss may be recognized if the value is lower than the basis, though losses on sales between related parties are often subject to limitations. The creditor entity receives the asset with a basis equal to its fair market value at the time of the transfer.