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CHAPTER IX

CAPITALISED BASIS OF BRANCH ACCOUNTING.

134. If branch establishments are to be treated as separate business units for accounting and tax purposes, it is logical, though not absolutely necessary, that an adequate capital be formally assigned to each. This is sometimes done by the general management of business concerns as a means of placing upon branch managers a definite responsibility for earning enough profit to meet interest, dividend, and income-tax requirements on the capital invested at the different branches. If a definite capital is to be assigned to each branch, it should be fixed by an appropriate resolution of the board of directors. The branch capital structure, in other words, should be built up as carefully as that of a truly autonomous subsidiary company. The only essential difference between the two would be that the branch remains unincorporated. This method presupposes that the branch is treated as an independent entity separate from the enterprise, and therefore advances to it from the enterprise are considered as borrowed capital and not capital of the branch of the enterprise itself. The interest payable on such an advance would therefore constitute a deductible expense under the law of the country of the branch and would not be subject to the generally observed rule that a taxpayer may not deduct interest on its own capital. Because of this fiction it would be immaterial whether the funds advanced to the branch were entirely out of the capital of the enterprise or partly out of borrowed funds, and the interest charged to the branch on advances would be considered as income to the enterprise.

TREATMENT OF BRANCH AS SEPARATE ENTITY.

135. There is no formula by which the proper amount of branch capital can be exactly determined, but there are several tests which may be applied. A comparison with the figures of independent dealers in the same business should indicate roughly the amount of capital required, and a detailed analysis of branch operating data will show whether the branch needs more or less capital than the average independent. If branch income and expense are carefully budgeted, it may be possible to compute directly the amount of capital required. A simpler method, however, is to assign to each branch as permanent capital an amount which bears the same ratio to total branch assets as the total capital of the company bears to its total assets. This computation is possible only if the branch regularly carries cash balances sufficient for its needs and otherwise has the full complement of assets which an independent concern would need. Even so, the method is not strictly valid for branches engaged in different lines of activity. In the absence of data which indicate the specific capital requirements of a particular branch, however, it does give a reasonable approximation. When the amount of permanent branch capital has been determined, it should be set up on both branch and home office books. At the branch this may be done by debiting the home office current account and crediting a branch capital account. At the home office the corresponding entry would be to debit a branch capital account and credit the branch current account.

136. After branch capital has been removed from the home office current account, any remaining credit balance is in the nature of an advance from the home office. A debit balance would ordinarily indicate a deficiency of branch capital, though it could indicate an advance to the home office. Advances to branches from the home office are of three types. Some advances consist simply of amounts currently due for merchandise or supplies. No interest should be charged by the home office on such items, if they are regularly settled by branch remittances within the thirty, sixty, or ninety day term for which commercial credit is usually extended. Or the advances to a branch may be temporary advances of current funds to take the place of bank loans. On these, interest may properly be charged at the rates currently applicable to bank loans. Finally, there may be permanent advances which are equivalent to the funded debt of independent concerns, Since trading concerns are seldom financed to any great extent by means of long-term borrowing, advances of this kind in the case of sales branches should be strictly limited. Interest on permanent advances of this character, where justified, should be figured at approximately the rate which applies to the funded debt of the company. Some companies which have a substantial amount of funded debt find it advantageous to apportion it among the branches in order that each branch manager may realise clearly his responsibility for earning the interest charges on the amount of debt which properly relates to his branch. This amount may be entered on the books of a branch by debiting the home office current account and crediting an account which may be called home office borrowed funds. A contra account should, of course, be opened on the home office books.

137. If this procedure of placing branches on a capitalised basis is fully carried out, the usual home office current account will be divided into at least two sections — namely, branch capital account and a true home office current account. Interest may be charged on that part of the current account which represents a real temporary advance which takes the place of a bank loan. A third section for borrowed funds or permanent advances may be introduced if the branch financial structure is of a type that would justify long-term financing in an independent concern. Such financing would not ordinarily be proper unless the branch investment in fixed assets is relatively heavy. The interest on advances from the home office will be debited to interest expense by the branch and credited to the home office current account, or remitted in cash. The home office will debit the branch current account or cash and credit interest charged to branches, or perhaps interest earned. The treatment of these intra-company interest charges for tax purposes will be discussed in the latter part of this chapter.

APPORTIONMENT OF INTEREST ON GENERAL INDEBTEDNESS.

138. If branches are not placed on a capitalised basis, interest paid on the general indebtedness of a concern may be apportioned among them. This represents a departure from the concept of a branch as a separate business unit, but it may, nevertheless, be used with satisfactory results. There are several different methods of apportionment, but only one will be presented here—namely, apportionment on the basis of net assets or net worth. Other methods, such as apportionment according to total assets or in proportion to funds used, are less definite and less satisfactory. The exact methods to be followed can be more clearly explained by the use of illustrative figures.

Trial Balances of Company X and Branches A and B.

                             
Branch A  Branch B  Home office  Consolidated 
Assets: 
Current assets  1,500,000  500,000  2,000,000  4,000,000 
Investments  —  —  1,000,000(a)  1,000,000 
Fixed assets  500,000(b)  1,500,000  3,000,000  5,000,000 
Branch A current  —  —  1,700,000  — 
Branch B current      800,000   
2,000,000  2,000,000  8,500,000  10,000,000 
Liabilities and Capital: 
Current liabilities  300,000  200,000  500,000  1,000,000 
Funded debt  —  1,000,000(c)  3,000,000(d)  4,000,000 
Home office current  1,700,000  800,000  —  — 
Net worth      5,000,000  5,000,000 
2,000,000  2,000,000  8,500,000  10,000,000 
Interest actually paid  5,000  50,000  130,000  185,000 

(a) The investments consist of the stocks and bonds of subsidiary and associated companies.

(b) Most of the real estate used by Branch A is rented on a long-term lease. The fixed assets shown consist largely of furniture, fixtures and equipment of various kinds.

(c) The million dollars of funded debt listed at Branch B consists of a 5 per cent first mortgage on the fixed assets of the branch.

(d) The three million dollars of funded debt carried at the home office consists of 4 per cent debenture bonds.

139. In order to make a satisfactory allocation of interest in accordance with net assets or net worth, it is necessary to adopt the following procedure:

140. In the X company illustration, $5,000 of interest can be definitely allocated to branch A; $50,000 to branch B; and $38,000 to the home office. The $38,000 of interest expense specifically allocated to the home office is made up of $10,000 of interest on current indebtedness pertaining to the operations of this office, and $28,000 of interest on the $700,000 which was assumed to have been borrowed for the purpose of carrying the investments in subsidiary and associated companies. After making these specific allocations of interest to the different branches, $92,000 of interest expense remains to be apportioned. The method of making this apportionment and the results are shown in the table which follows:

           
Net assets  Per cent  Interest apportioned  Interest directly allocated  Total interest 
Branch A  1,700,000  23  21,160  5,000  26,160 
Branch B  800,000  11  10,120  50,000  60,120 
Home office  4,800,000  66  60,720  38,000  98,720 
7,300,000  100  92,000  93,000  185,000 

141. In the first column the net assets of each branch are shown. The total assets of branch A. as given in the balance-sheet of paragraph 138, amount to $2,000,000. From this the $300,000 of current liabilities are deducted, leaving $1,700,000 as the net worth or net assets of branch A. The total assets of branch B are likewise $2,000,000, but from this amount it is necessary to deduct not only the $200,000 of current liabilities, but also $1,000,000 of funded debt, leaving net assets of only $800,000. The computation of the amount of net assets which belong to the home office is a little more difficult. In the first place, the amounts of $1,700,000 and $800,000 which represent the net investment in branches A and B respectively must be excluded. The $6,000,000 remaining represents the value of assets pertaining to the operations of the home office. Before the net assets of the home office can be ascertained, the amount of indebtedness pertaining to its operation must be determined. It may be assumed that all of the current liabilities, amounting to $500,000, are incurred by the home office for its benefit. As has already been stated, it is assumed that $700,000 of the funded debt represents an amount borrowed to carry the investment in subsidiary and associate companies. This amount should be assigned to the home office, bringing the total amount of home office liabilities up to $1,200,000. Subtracting this amount from the $6,000,000 worth of assets leaves $4,800,000 as the value of the net assets of the home office.

142. As shown in the table, the net assets of the three branches combined before deducting general indebtedness amount to $7,300,000. The second column in the table shows the percentage which the net assets of each branch bear to the total net assets. These percentages, when applied to the $92,000 of interest to be apportioned, give the amounts assignable to the different branches as shown in the third column. When these amounts are added to the interest directly allocated, as shown in the fourth column, we find the total amount of interest chargeable to each branch.

143. The entries required for placing the apportioned charge for interest on the books of the different branches are given below:

                         
Branch A’s books: 
Interest expense  21,160 
Home office current  21,160 
(Apportioned charge for interest on company indebtedness.) 
Branch B’s books: 
Interest expense  10,120 
Home office current  10,120 
(Apportioned charge for interest on company indebtedness.) 
On the home office books: 
Branch A current  21,160 
Branch B current  10,120 
Interest expense (or interest charged to branches)  31,280 
(Interest apportioned to branches.) 

144. The advantage of this method is that it reduces to a minimum the amount of interest which has to be apportioned, and obviously no general apportionment of interest among branches of an international enterprise can hope to be particularly accurate. In applying the proposed method, however, some difficulties may be met in making the direct allocation of liabilities and corresponding interest charges to branches. In general, the obligations assigned to branches should be limited to local branch indebtedness and to mortgages on branch property. The fact that all or part of the proceeds of a bond issue were used to finance a branch does not necessarily indicate that the bond issue and the interest thereon relate specifically to the branch in question. The exact manner in which the funds are used may be largely accidental. A bond issue, for instance, may serve simply to replace current funds which have been temporarily diverted to the construction of additional plant facilities.

TAX ASPECTS OF INTRA-COMPANY INTEREST.

145. It has been shown that intra-company interest charges may arise in either of two ways, though not properly by both:

146. The treatment of intra-company charges of either type will depend upon the general rule adopted for the taxation of interest. Interest may be taxed either in the country of origin or at the domicile of the recipient, and the significance of intra-company interest charges under the two methods is quite different. It will be assumed first that interest is to be taxed in the country of origin.

147. Interest paid by a branch on advances from another branch, usually the home office, clearly originates in the country in which the branch making payment is located. The making of such a charge indicates that the branch is to be treated as a separate business unit, and under similar conditions there would be no doubt as to the place of origin of interest paid by an independent concern to a foreign creditor. The country of origin may tax such interest either by refusing to allow it as a deductible expense in computing the net taxable income of the branch, or it may levy a tax on the home office (or other branch) as the recipient of the income. The former method would be simpler and entirely proper unless interest income and business profits are taxed by different methods or at different rates.

148. Interest of the second class — i.e., interest expense apportioned to a branch — also has its origin in the country of location of the branch against which the charge is made. The only justification for making an apportioned charge of this kind is the assumption that the branch in question is using the borrowed funds to which the interest relates. If the funds are actually used by the branch, it is clear that the interest originates there. Apportioned interest should therefore be treated exactly like interest on advances. It should, in other words, either be disallowed as a deductible expense on the branch return, or taxed as income of the home office originating in the country in which the branch is located. In view of these facts, it is apparent that, under a system of origin taxation, there is little need for making an apportionment of interest to branches. Such an apportionment would ordinarily have little, if any, effect on the amount of tax payable at the branch. A different situation exists, however, if interest is taxable at the domicile of the recipient.

149. If profit is to be taxed in the country of origin and interest at the domicile of the recipient, it is obvious that the two forms of income must be kept separate. The problem as it usually arises is to prevent the diversion of profits from the country of origin to some other country in the guise of interest. If no limitations were placed on intra-company interest charges, it might be possible for a company to escape all income taxation in the countries in which it had branches by the simple expedient of making excessive charges for interest. The country of domicile, on the other hand, might properly object if the home office made no interest charges whatever against its foreign branches.

150. Under the rule of taxing interest at the domicile of the recipient one further question arises with respect to intra-company interest. Methods have been suggested by which the amount of intra-company interest may be computed, but must these charges be made? In particular, must interest be apportioned to a branch or charged on branch advances even though the branch suffers a loss or fails to earn the full amount of interest? If branches are regarded as independents, the logical answer is yes, but these are questions of fiscal policy which are not within the scope of this report.

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