Inter-company loan accounting and tax treatment

Why related-party loans need extra rigor.

When a sole owner runs three companies, money moves between them constantly. Company A has surplus cash, Company B needs working capital, the owner transfers $5 million. From a family-business perspective this is just internal cash management. From your tax authority's perspective, it is a related-party transaction that triggers Section 108 (documentation requirements), Section 109 (transfer pricing), and potential treatment as deemed dividend or income under specific clauses. Without proper paperwork, the deduction for interest paid is denied, and the recipient may be taxed on the full receipt.

regulators care because related-party loans are the easiest way to shift profit between entities, abuse tax rates, or extract owner profit without paying tax. A clean inter-company loan with formal documentation, market interest rate, and proper books treatment is acceptable. A casual transfer is not.

The documentation your tax authority expects.

Five documents per inter-company loan. First, a written loan agreement specifying parties, amount, interest rate, repayment schedule, security if any, and default provisions. Second, board resolutions on both sides authorizing the loan. Third, IBO (Inter-Bank Operations) compliance if the entities are related under State Bank rules. Fourth, banking proof of the disbursement and any repayments. Fifth, the inclusion of the transaction in Section 108 statement filed annually with the income tax return.

The interest rate matters. Use a rate that is at arm's length, meaning what an unrelated lender would charge. KIBOR plus 1-3% is a defensible range for most short-term inter-company loans. Below KIBOR, your tax authority can argue the borrower received undue benefit and impute interest. Above commercial rates, your tax authority can argue the lender shifted profit to a low-tax jurisdiction (or just to a relative). Document the rate basis with reference to KIBOR on the loan date.

Journal entries on both sides.

Lender (Company A) disbursing $5,000,000 to Borrower (Company B): DR Inter-Company Receivable - Company B 5,000,000 / CR Bank 5,000,000. Borrower receiving the same: DR Bank 5,000,000 / CR Inter-Company Payable - Company A 5,000,000. Note: not Owner Equity, not Other Income, not Sundry. A specific Inter-Company account on each side, balancing.

Monthly interest accrual at, say, KIBOR plus 2% (assume 16% annual = 1.33% monthly). Lender: DR Interest Receivable / CR Interest Income on Inter-Company Loan, both $66,667. Borrower: DR Interest Expense on Inter-Company Loan / CR Interest Payable, both $66,667. When interest is paid, the receivable/payable clears and bank moves. Repayment of principal: DR Inter-Company Payable / CR Bank on the borrower side; DR Bank / CR Inter-Company Receivable on the lender side.

Withholding tax on inter-company interest.

Interest paid by a company to another company is subject to withholding tax at 15% under the relevant statute if the recipient is not a banking company. The borrower deducts withholding tax from each interest payment, deposits it via tax-payment receipt, and issues a certificate. The lender claims the withholding tax credit in his annual return. Failing to deduct creates personal liability for the directors of the borrower.

Worked example: $66,667 monthly interest accrual, paid quarterly = $200,000 per quarter. withholding tax at 15% = $30,000 deducted, net $170,000 paid to lender. Borrower entry: DR Interest Payable 200,000 / CR withholding tax Payable 30,000 / CR Bank 170,000. Lender entry: DR Bank 170,000 / DR withholding tax Receivable 30,000 / CR Interest Receivable 200,000. withholding tax receivable becomes a tax credit when the lender files annual return.

Transfer pricing under the relevant statute.

Section 109 of the your country’s tax code gives the Commissioner power to adjust the tax computation if a transaction between associates is not at arm's length. For loans, this means the interest rate must be defensible. If you charged 5% when KIBOR was 14%, the Commissioner can impute 14% interest, tax the lender on the difference, and deny the borrower's deduction at the higher rate.

Companies above $250 million turnover or with cross-border related-party transactions must file Form-3CD-style transfer pricing documentation. Smaller SMBs must still maintain enough documentation to justify the rate. Best practice: for every inter-company loan, attach a one-page memo citing the KIBOR rate on the disbursement date and the rationale for any margin. Two minutes of documentation; saves hours during an audit.

Common treatments that fail an audit.

Pattern one: classifying the inter-company loan as Owner Equity Contribution. The owner moved money between two of his companies; the receiving company books it as fresh equity from the owner. This skips the loan documentation. your tax authority can disallow because the lender is the company, not the owner directly. Re-characterize as a loan with imputed interest.

Pattern two: no interest charged. "It is family money, why charge interest?" Because Section 109 says you must. The Commissioner imputes interest, the lender pays tax on imputed interest, the borrower gets no deduction. Net effect: tax on phantom income.

Pattern three: written off informally. Company A "forgives" the loan to Company B. Without proper accounting, this is a deemed dividend to the owner under the relevant statute, fully taxable. Done correctly, with board resolutions and tax planning, it can sometimes qualify as something else, but the default treatment is harsh.

• No written agreement.
• No interest charged or below-market rate.
• No withholding tax deducted on interest payments.
• Not disclosed in Section 108 statement.
• Forgiven without proper restructuring.

IBO and State Bank compliance.

For larger inter-company transactions and any cross-border movement, State Bank IBO regulations and Foreign Exchange Manual rules apply. For purely domestic inter-company loans between non-financial growing SMBs, IBO is generally not triggered. But for any inter-company loan involving foreign exchange, an authorized dealer must process the transaction and report it, and SBP approval may be required for amounts above thresholds.

Even purely domestic loans benefit from formal banking treatment. Use a bank transfer with a clear narration ("Inter-Company Loan, Co A to Co B, Agreement dated DD/MM/YY"). Avoid cash transfers for inter-company loans; your tax authority treats those as undocumented and they are difficult to defend even with paperwork. Bank trail plus signed agreement is the bulletproof combination.

Restructuring or settling the loan.

When the borrowing company can repay, the principal moves back via bank transfer with both sides booking the closing entries. When the borrowing company cannot repay and the loan must be restructured, options include extending the term (with a written amendment), converting to equity (issue shares to lender, complex but legitimate), or partial waiver (with tax implications under the relevant statute). Each path has paperwork and tax consequences; do not pick one in a casual conversation between owners.

For a loan converted to equity: Borrower entry: DR Inter-Company Payable / CR Share Capital and Share Premium. Lender entry: DR Investments in Subsidiary / CR Inter-Company Receivable. Plus formal share issuance, SECP filings, transfer pricing documentation. With Nonari's related-party transaction module, the documentation workflow steps you through each requirement before the entries post.