We recently considered the Guidance issued by the City of London Law Society (CLLS) relating to guarantees, interest-free loans and distributions, highlighting a difference in the approach taken by the CLLS when compared with guidance on the same topic from ICAEW.
Hive-ups and intra-group loans
Intra-group loans often arise on group reorganisations involving a transfer of business and assets from a subsidiary to its parent – known as a ‘hive up’. On this type of transaction, the consideration due from the parent is often based on the book value of the relevant assets but, rather than cash actually being paid, the consideration is left outstanding on intra-group loan account due from the parent to the subsidiary. So the subsidiary has effectively made a loan of that amount to the parent and can demand (re)payment of that loan at any time.
What is a distribution?
Leaving the consideration outstanding as an intra-group loan brings the transaction into the scope of the CLLS Guidance. Amongst other things, that Guidance was concerned with whether an interest-free loan would be classed as a distribution by the subsidiary (the lender). A “distribution” for this purpose includes every description of distribution of a company’s assets to its members. The most common type of distribution is a cash dividend paid to shareholders but the definition is very wide and catches many other transactions.
There are strict statutory rules about distributions including a requirement that they can only be made out of distributable profits. So if the interest-free loan was classed as a distribution, but the subsidiary did not have sufficient distributable profits to make that distribution, the transaction would be unlawful.
“Normal” intra-group loans are not distributions
The good news is that the CLLS Guidance says that a “normal on demand intra group loan” is not a distribution. To be classed as a “normal” loan the subsidiary-lender’s directors must have considered the parent-borrower’s financial position when the loan was made (ie when the hive-up completed) and, based on those considerations, the directors must have decided in good faith and on reasonable grounds that the parent was likely to be able to repay the loan when demanded.
When might an intra-group loan be a distribution?
If on an objective view of the parent-borrower’s circumstances it is likely that the parent-borrower will not be able to repay the loan when demanded, and the subsidiary does not receive appropriate value for assuming that risk (such as an increased interest rate on the loan), then the loan may be classed as a distribution.
In addition if, at the time the intra-group loan is made, there is no intention that the parent-borrower will ever be required to repay the loan, then the transaction is also likely to be classed as a distribution.
What should directors do?
Considering the financial condition of the parent-borrower is a requirement for the directors of the subsidiary-lender in order to comply with their fiduciary duties, particularly the duty to exercise their powers in the best interests of the subsidiary alone, rather than the interests of the wider group of which it is a part. If there are no concerns about the parent’s ability to repay the loan when demanded, an interest-free loan is unlikely to be classed as a distribution (although the directors should still consider what the wider benefit is to the subsidiary in making the loan in order to satisfy their fiduciary duties). If there are concerns about the parent’s ability to repay an interest-free loan on demand, or if there is no intention to ever require repayment, the loan is likely to amount to a distribution and the subsidiary will need to have distributable profits equal to the amount of the loan in order for it not to be an unlawful distribution.
There are also wider considerations for the directors in these circumstances including breach of their duties and insolvency related matters such as transactions at an undervalue, preferences and even wrongful trading but these are beyond the scope of this insight.