Many large, single-parent captive owners borrow significant amounts of cash from their captives each year. These are commonly known as "loan-backs," and they are popular because they provide parent companies with the opportunity to invest the cash in their business in lieu of the captive investing the funds in relatively low-yield securities.
Captives, like all insurance companies, must maintain a relatively high level of liquidity, meaning that their investments must be readily convertible into cash. The problem is that short-term, fairly liquid investments have quite meager returns. This problem has been exacerbated over the past few years as the Federal Reserve has kept interest rates at historic lows in an attempt to counter the effects of the Great Recession.
For captives that do not purport to be bona fide insurers per the Internal Revenue Service's (IRS) guidelines, meaning that they do not use insurance accounting, a loan-back is quite benign. However, captives that do use insurance accounting in accordance with IRS safe harbor guidelines and/or applicable case law should be circumspect when using loan-backs to transfer cash back to the parent company.
One of the fundamental precepts guiding single-parent captives that employ insurance accounting is that they must maintain "arm's-length" relationships with their parent companies. Put another way, the "mind and management" of the captive and its parent must be kept as separate as possible. Loaning money back to the parent, some observers have argued, compromises the spirit, if not the letter, of the mind and management separation mandate.
The rules for loan-backs are few but very important. First, the captive must charge a market rate of interest for the loan. If the parent pays nothing (or next to nothing) for the funds, most believe that that would constitute a "sweetheart deal" and would materially affect the parent-captive relationship. Second, the loan must be relatively short term, 1 to 3 years in duration. Third, the captive must be able to call the loan at any time, for any reason. There can be no covenants restricting the captive's ability to call the loan.
While the IRS has not prohibited the practice, it has questioned the degree to which loan-backs might degrade the arm's-length relationship between the captive and the parent. Small loans tend not to be a problem, but loans that comprise a significant amount of a captive's assets can attract unwanted attention from the U.S. tax authorities.
There is an interesting alternative to loan-backs—receivables factoring. The purpose of factoring is to convert a nonliquid asset (receivables) into cash. Factoring is similar to a financial guaranty (FG). FG transactions commonly transfer credit risk, which can take a wide variety of forms.
Factoring transactions involve three parties: (1) the company selling the receivables (the captive's parent), (2) the debtor, and (3) the factor (the company purchasing the receivables, in this case, the captive).
Commercial factors make money by discounting the sales price of the seller's receivables, assuming that it will receive a higher amount from the debtors. The price includes a provision for uncollectable debt. The factor also collects a fee based on a portion of the receivables' sales price, known as the reserves.
By monetizing a portion of its parent's receivables, a captive replaces cash with receivables. The transaction is not a loan wherein the receivables are used as collateral—factoring is a sale of assets (receivables) for a fair and reasonable price. To maintain the necessary liquidity, captives should only purchase their parents' high-grade receivables. A high-grade receivable is one provided to a long-term customer with a history of on-time payments. The longer the relationship with the customer is, the better for the captive, as customers are loath to jeopardize prized relationships with certain suppliers.
Factors not only monetize receivables; they also assume full responsibility for collecting the outstanding debt. As the majority of single-parent captives have no employees (all of the professional services are outsourced), collecting their parent's debt is not an option. The solution is for the captive to outsource (also called "back-source") this function to the parent company. Likewise, most single-parent captives cannot perform credit analysis on their parents' receivables, so this is also outsourced to the parents.
Similar to loan-backs, captives factoring their parents' receivables must conform to the rules and conventions utilized by commercial factors. And, as with all nonstandard captive uses, the domicile regulator must review and approve the business plan.
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