Interest-free demand or term loan or Senior bank term debt
Parent A advances a €200k unsecured loan to Subsidiary B on 1 January 2018 with the following terms:
- 0% interest and repayable on demand; or IFRS 9 Interest-free demand or term loan
- 0% interest and repayable in 5 years (assume 5-year market rate of interest = 7%).
At or around the same time, Bank X advances an €800k senior secured loan to Subsidiary B with the following terms:
- Market rate of interest of 5% i.e. €40k per annum; IFRS 9 Interest-free demand or term loan
- Repayable at par in 5 years and at any time at par plus accrued interest.
This means that the loan to value (LTV) for the combined funding is 100% (i.e. €1m / €1m). However, from the perspective of Bank X the LTV is 80% because it is secured over a property worth €1m (i.e. €800k / €1m). The loan from Bank X must be repaid in full before the loan from Parent A1.
Funding involving senior ranking interest bearing bank debt – Additional considerations IFRS 9 Interest-free demand or term loan
Determining how the loan from Parent A should be classified and how the impairment model should be applied requires a similar approach to that outlined in ‘Interest-free demand loan – No bank debt‘.
However, the introduction of a senior ranking interest bearing bank term loan does give rise to additional considerations, including for example:
- Estimation of expected cash flows – Subsidiary B is expected to earn €80k annual rental income but will be required to pay annual interest of €40k (i.e. 5% x €800k) to Bank X which reduces cash flows available to meet the principal and interest payments on the loan from Parent A;
- Refinancing Risk – As the loan from Bank X has a 5 year term, this gives rise to refinancing risk at the end of year 5 which needs to be considered irrespective of whether the loan from Parent A is repayable on demand or repayable in 5 years;
- Significant Increases in Credit Risk (SICR) – A breach of covenant or late payment under the bank loan may be indicators of a SICR on the loan from Parent A;
- Default – Events of default under the bank loan may trigger a default under the loan from Parent A;
- Recovery Strategies – Parent A will need to take into account not only its own position but that of Bank X. For example, Bank X could wish to enforce security in accordance with the terms of the loan agreement at a point that maximised its own recoveries but not those of Parent A. This could in turn lead to Parent A being forced to refinance the bank loan itself (see ‘Refinancing of bank debt‘).
Classification IFRS 9 Interest-free demand or term loan
The loans are in a hold to collect business model and therefore the key classification issue is the Solely Payments of Principal and Interest test (the SPPI test). In this example, the contractual terms of both the demand loan and term loan only specify payments of principal and interest and are not linked to changes in the property value but Parent A is required to consider whether the non-recourse nature of the loan results in the SPPI test not being met.
Parent A’s intention is to provide financing to its subsidiaries for the purposes of their ongoing business activities which will in turn generate rental income for the group. In addition, Subsidiary B is expected to earn sufficient rental income to service the bank debt and will have accumulated an additional €200k (i.e. net rental income of €40k x 5 years) by the time that the bank loan is due to be repaid. At this point, assuming (i) the property value remains stable at €1m and (ii) the additional €200k can be used to part repay the bank debt, a number of scenarios could arise, including:
- Subsidiary B could refinance both the bank loan and the loan from Parent A with a new third party loan for €800k i.e. at an LTV of 80%;
- Parent A may wish to continue funding Subsidiary B, meaning that only €600k of new debt at an LTV of 60% would be required2;
- Subsidiary B could choose to sell the property in order to fund the repayment of both loans in full.
In all of the above scenarios, Parent A is likely to conclude that both the demand loan and the term loan are basic lending arrangements that meet the SPPI test and would therefore be classified at amortised cost because they are in a hold to collect business model.
Impairment IFRS 9 Interest-free demand or term loan
Once it has been determined that the loan is classified at amortised cost, it is within the scope of the expected credit losses (ECL) model and subject to the general approach. Applying the ECL model follows a similar approach to that to that outlined in ‘Interest-free demand loan – No bank debt‘ but as with the classification decision, a number of additional considerations arise.
1. Staging Assessment and estimating the risk of a default occurring IFRS 9 Interest-free demand or term loan
In the case of a demand loan, on the basis that Subsidiary B would not have sufficient funds to repay the loan on demand, the risk of default is likely to be close to 100%. As explained in ‘Interest-free demand loan – No bank debt‘, this means that the loan will be in Stage 3 and Lifetime ECL will be recognised. IFRS 9 Interest-free demand or term loan
The staging assessment for a term loan follows a similar approach to that set out in Example 1.2. with some additional considerations for Parent A including:
- Monitoring actual or expected breaches of covenant and/or late payments on the bank loan as indicators of an increased risk of default/Significant Increases in Credit Risk (SICR) on Parent A’s loan to Subsidiary B;
- Incorporating interest payable to Bank X which reduces available cash flows of Subsidiary B which is in turn likely to increase the risk of a default occurring.
2. Measuring ECL IFRS 9 Interest-free demand or term loan
A similar approach to that outlined in ‘Interest-free demand loan – No bank debt‘ should be followed. However, the expected cash flow scenarios that would arise upon a default and related credit losses will need to take into account the cash flows required to service and repay the bank debt in full, prior to repaying the loan from Parent A.
In addition, Parent A will need to factor in the possible recovery strategies of Bank X that may influence its own actions. For example, Bank X could wish to enforce security in accordance with the terms of the loan agreement at a point that maximised its own recoveries but not those of Parent A. In this case, Parent A might consider refinancing the bank loan itself as illustrated in ‘Refinancing of bank debt‘.