Assume Parent A advances a €200k unsecured loan to Subsidiary B on 1 January 2018. The loan is interest-free and is repayable in 5 years. At the same time, Bank X advances a €800k secured loan to Subsidiary B. The loan carries market rate of interest of 5% and is repayable in 5 years.
At initial recognition Parent A concluded that the loan to Subsidiary B met the criteria to be classified at amortised cost and applied the expected credit losses (ECL) model accordingly.
Rental yields for the first 2 years were locked in at €80k and this allowed Subsidiary B to service the external debt (i.e. 5% x €800k = €40k per annum) leaving residual cash of €40k each year. However, in 2020, yields have reduced to €40k, leaving no residual cash flow for the remainder of the loan maturity. In addition, the market valuation of the property has declined to €500k which has, in turn, breached a loan to value (LTV) covenant in the bank loan agreement resulting in an event of default. At this point, Bank X could seek recourse to any remaining liquid assets held by Subsidiary B and enforce security over the property.
However, following a negotiation, Parent A agrees to acquire the outstanding loan amount of €800k from Bank X through a newly set up intermediate subsidiary, Subsidiary C for an amount equal to the market valuation of the property i.e. €500k. Bank X accepts this offer because it avoids a potentially lengthy sales process during which time it could be exposed to further declines in property prices. Bank X considers that this would be inconsistent with the nature of its business as a lender. In contrast, given the nature of Parent A’s real estate business, it is willing to accept this level of property risk for the benefit of the wider group and wait for the market to recover over time. The following steps are taken:
- Parent A lends €500k to Subsidiary C – the loan is repayable on demand and interest-free;
- Subsidiary C uses the €500k to purchase the outstanding bank loan i.e. remaining 2-year maturity, 5% rate of interest and a notional of €800k.
Assume for the purpose of illustration that Parent A’s original loan to Subsidiary B for €200k has been fully impaired.
Classification Refinancing of bank debt Refinancing of bank debt
(i) Loan from Subsidiary C to Subsidiary B (novated interest-bearing bank term loan)
The loan from Subsidiary C is non-recourse in nature due to the fact that Subsidiary B only holds one asset being the investment property. Subsidiary C must therefore look through to the underlying asset (being the investment property) and determine whether this feature results in the Solely Payments of Principal and Interest test (the (SPPI test) being failed.
In considering the SPPI test, Subsidiary C notes that if the loan was considered a basic lending arrangement which met the SPPI test, it would also meet the definition of a ‘Purchased or Originated Credit Impaired’ loan because the discount of €300k would represent incurred credit losses. This means that a credit adjusted effective interest rate (EIR) taking into account those incurred losses would be calculated. At initial recognition, therefore:
- Fair value = €500k; Refinancing of bank debt Refinancing of bank debt
- Credit adjusted EIR = 8% (i.e. the interest rate which discounts future cash flows of €40k in 2021 and €540k 2022 back to the initial carrying amount of €500k).
Under this method of accounting, any subsequent changes (gains or losses) in lifetime ECL of €300k would be taken as an impairment gain or loss in future periods and would be entirely dependent upon the value of the property. This is not consistent with a basic lending arrangement and implies that the loan is more in the nature of an indirect investment in the underlying property than the provision of finance.
Based on the above analysis, Subsidiary C concludes that the loan fails the SPPI test and would be classified at fair value through profit or loss (FVPL). On an ongoing basis, the loan would be measured at fair value in accordance with IFRS 13 Fair Value Measurement with all movements in fair value going through profit or loss.
(ii) Loan from Parent A to Subsidiary C (interest-free demand loan) Refinancing of bank debt
The loan from Parent A is also non-recourse in nature due to the fact that Subsidiary C only holds one asset being the non-recourse loan to Subsidiary B. Parent A must therefore look through to that underlying asset and determine whether this feature results in the SPPI test being failed.
In contrast to the novated interest bearing bank term loan which has a contractual par amount of €800k, the demand loan has been advanced on an interest free basis with a contractual par amount of €500k. This means that unlike Subsidiary C, Parent A will never be entitled to an amount in excess of €500k as a result of an increase in the property valuation.
Determining whether the loan from Parent A meets the SPPI test will require judgment and will depend upon a detailed consideration of the individual facts and circumstances, including Parent A’s views on the property market. In this particular example, the fact that Parent A does not expect the property to decline in value below €500k means that it should receive back the full amount of €500k which may seem to suggest that the non-recourse feature will not result in the SPPI test being failed. However, consideration should also be given to the fact that even a slight decline in property prices could result in Parent A not recovering the amount advanced because the rental income and property valuation is only just sufficient to cover the principal and interest on the novated bank loan. This may imply that the nature of the loan is more akin to an investment in the underlying property than the provision of financing which would result in similar accounting to that of the loan from Subsidiary C set out in part (i) above.