9.7 Long-Term Intra-Entity Loans to Foreign Subsidiaries

In accordance with ASC 830-20-35-4, intra-entity loans to foreign subsidiaries that are of a long-term-investment nature and whose repayment is not foreseeable are treated as part of the overall net investment in the foreign subsidiary. If either the parent or the subsidiary has a different functional currency than the currency in which the loan is denominated, it will have foreign currency exposure for financial reporting purposes related to fluctuations in the exchange rate. In a manner consistent with the loan’s “part of the net investment” characterization, ASC 830-20-35-3(b) requires that any loan-related pretax foreign exchange gain or loss that would have been classified as a foreign currency transaction gain or loss in the income statement be recognized in the CTA account within OCI.

If the loan is denominated in the subsidiary’s functional currency, any gain or loss related to fluctuations in the exchange rate will reside with the parent. If the loan is denominated in the parent’s functional currency, any gain or loss related to fluctuations in the exchange rate will reside with the foreign subsidiary. In either case, as noted above, the gain or loss is recognized as part of the CTA account within OCI rather than as a foreign exchange gain or loss in the period in which the gain or loss arises.

Because the loan is characterized as part of the overall net investment, questions can arise regarding the recognition of deferred taxes. The next sections discuss in further detail the income tax accounting for a loan that is of a long-term investment nature.

9.7.1 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-Investment Nature Are Denominated in the Subsidiary’s Functional Currency

When a loan that is of a long-term-investment nature is denominated in the subsidiary’s functional currency and the parent will have an exchange-related gain or loss, the parent should not automatically apply the exception to the recognition of a DTL under ASC 740-30-25-18 (related to a taxable basis difference in a foreign subsidiary whose reversal is not foreseeable) or the exception to the recognition of a DTA under ASC 740-30-25-9 (related to a deductible temporary difference in any subsidiary that is not expected to reverse in the foreseeable future). Rather, an entity must consider applicable tax law and, if the taxable or deductible temporary difference related to the loan is expected to reverse in the foreseeable future, the entity should generally recognize deferred taxes (i.e., either a DTL or a DTA), setting aside “unit of account” considerations (see additional discussion in the next section).

For example, when the loan has a fixed term but it is asserted that repayment is not foreseeable, a representation is being made that the loan either will be extended when it would otherwise mature or will be contributed to the equity of the subsidiary. If either of those actions will result in the recognition of an unrealized foreign-exchange-related gain or loss for tax purposes, an entity should generally recognize a DTL or DTA (setting aside “unit of account” considerations). In other words, since both the loan’s maturity date and the date on which the related temporary difference will reverse are known, it appears that the related temporary difference (whether taxable or deductible) will reverse in the foreseeable future. Since the temporary difference is certain to reverse on a known date, the exceptions that might apply when the reversal of the temporary difference is not foreseeable should not be applied.

9.7.1.1 Unit of Account

The fact that the loan is considered under ASC 830 as part of the overall net investment in the foreign subsidiary raises an interesting question about the identification of the appropriate “unit of account.” For example, if the U.S. parent has a foreign-exchange-related gain or loss (the loan is denominated in the functional currency of the subsidiary) and there is a taxable temporary difference related to the loan but a deductible temporary difference related to the parent’s investment in the subsidiary’s shares (as a result of losses in the subsidiary), the overall basis difference (viewed as a single unit of account) might net to a deductible temporary difference (i.e., the subsidiary’s losses exceed the loan-related exchange gain). The reverse can also occur, in which case a taxable temporary difference related to the shares and a deductible temporary difference related to the loan would net to an overall taxable temporary difference for the single unit of account.

We believe that, in such instances, an entity should establish an accounting policy to address the “opposite direction” circumstances described above. One acceptable alternative would be for the entity to consider the loan and share temporary differences as distinct units of account, allowing a deferred tax to be recognized for the loan-related temporary difference irrespective of the overall temporary difference. According to this alternative, two distinct assets are recognized as existing under the tax law (the loan and the shares), each with its own separate and distinct basis difference. The other acceptable alternative would be to consider the overall temporary difference as a single unit of account for which deferred tax would be recognized for the loan-related temporary difference only if it is (1) in the same direction as the overall temporary difference and (2) limited to the greater of the overall temporary difference or the loan-related temporary difference. According to this alternative, the loan is considered part of the net investment in the subsidiary under ASC 830 (i.e., there is only one investment balance for book purposes).6

Note that the “unit of account” question primarily arises when the temporary difference related to the loan is in the opposite direction of the overall temporary difference (including the loan). This question can also arise when the loan-related temporary difference exceeds the overall temporary difference (including the loan). When the temporary difference related to the loan and the overall temporary difference are in the same direction and the overall temporary difference exceeds the loan-related amount, the DTL or DTA would be recognized under either accounting policy.

In accordance with the intraperiod allocation rules, specifically ASC 740-20-45-11(b), deferred income tax expense or benefit related to an unrealized exchange gain or loss with respect to the loan would generally be allocated to the CTA account within OCI.

9.7.2 Deferred Tax Considerations When Intra-Entity Loans That Are of a Long-Term-Investment Nature Are Denominated in the Parent’s Functional Currency

When a loan is denominated in the parent’s currency, the treatment of the loan as part of the overall net investment might raise the question of whether the loan should be treated as equity. Also, a question might arise regarding whether the subsidiary should consider any of the exceptions that might apply to a parent’s investment in a foreign subsidiary (generally, ASC 740-30-25-17 prohibits the recognition of deferred taxes when it is not foreseeable that the related taxable or deductible temporary difference will reverse).

When an intra-entity loan that is of a long-term-investment nature is denominated in the parent’s functional currency, the foreign subsidiary should generally record deferred taxes related to the pretax foreign exchange gain or loss unless the foreign subsidiary’s jurisdiction will not tax the foreign exchange gain or loss at any point in time. In such cases, the foreign subsidiary should neither analogize to ASC 740-30-25-17 or ASC 740-30-25-9 nor consider the loan a component of its equity that is therefore not subject to evaluation as a temporary difference.

It would not be appropriate for the foreign subsidiary to apply the exceptions in ASC 740-30-25-17 and ASC 740-30-25-9 because those exceptions apply to a parent’s outside basis difference in an investment in a foreign subsidiary (i.e., the exceptions apply to the parent as the “investor” in a foreign subsidiary and are not relevant to the foreign subsidiary “investee”).

In addition, although an intra-entity loan that is of a long-term-investment nature is treated as part of the parent’s net investment in the foreign subsidiary in the accounting for foreign currency fluctuations, it is still a loan, albeit one that has an indefinite duration. While an intra-entity loan that is of a long-term-investment nature might ultimately be contributed to the equity of the foreign subsidiary, in the intervening periods, an intra-entity loan that is of a long-term-investment nature is reflected in the books of the parent and subsidiary as an intra-entity receivable and payable (subject to the assessment of any uncertain tax positions). Therefore, the foreign subsidiary should not treat the liability as a component of its equity.

Accordingly, the temporary difference related to the foreign subsidiary’s liability will need to be determined as of each reporting date by comparing the tax basis, which is generally equal to the original amount borrowed (in terms of the local currency that is used to measure taxable income), with the book basis in the liability, which is equal to the amount required to repay the loan (again, determined in terms of the local currency and the exchange rate as of the reporting date). The difference, which represents a transaction gain or loss for tax purposes, will generally be included in the local tax return on either a realized basis or an unrealized basis as discussed in Section 9.2.3.

Because the actual mechanics may vary by jurisdiction (i.e., some jurisdictions might limit the deductibility of losses but require that all gains be taxed), an entity must consider the actual local tax law related to whether the foreign currency transaction gain or loss is taxable or deductible as well as the timing of recognition of any gain or loss.

Since it is not foreseeable that the loan will be repaid, it is expected that the loan would be extended upon its scheduled maturity or contributed to equity. If those events are not considered taxable transactions in the foreign subsidiary’s jurisdiction, it would be appropriate to apply the exception in ASC 740-10-25-30, which states that basis differences that do “not result in taxable or deductible amounts in future years when the related asset or liability for financial reporting is recovered or settled . . . may not be temporary differences for which a deferred tax liability or asset is recognized” (e.g., corporate-owned life insurance that can be recovered tax free upon the death of the insured in accordance with the intent of the policy owner).

While the preceding discussion focuses on a foreign subsidiary (i.e., a foreign corporation that is controlled and consolidated by the parent), the same potential for tax consequences would apply to loans made to a disregarded entity (i.e., an entity that is treated as a branch of the parent) or to loans between brother-sister entities. However, in the case of a loan made to a disregarded entity, the parent should also consider the FTC consequences of any current or deferred tax recognized by the foreign subsidiary.

A U.S. parent should also be aware that any gain or loss recognized by a foreign subsidiary might be treated as Subpart F income under the IRC.

Footnotes

Companies that have elected a policy to view the note and shares as one unit of account may still be able to disaggregate the outside basis difference into the underlying components. See Section 3.4.12A for further discussion of disaggregation.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.