Intercompany Transactions

Intercompany Transactions (also known as 'Intra-group Transactions') are the secret handshakes of the corporate world. They are business deals—like sales of goods, provision of services, or loans—that occur between a parent company and one of its subsidiaries, or between two subsidiaries controlled by the same parent. Imagine a large family where the parent gives one child a loan to start a business, while another child, a baker, sells flour to their sibling, a pastry chef. In the corporate universe, these transactions are a routine part of life for large, complex organizations. On the group's consolidated financial statements, these internal transactions are eliminated to prevent the company from booking revenue simply by selling to itself. However, for a value investor, digging into the details of these transactions is crucial, as they can be a legitimate tool for efficiency or a clever disguise for financial manipulation.

While they can be a red flag, these transactions often have perfectly sensible business justifications. Companies aren't always trying to pull a fast one; most of the time, they're just trying to run a tight ship.

It's often cheaper and easier to “keep it in the family.” A parent company can provide centralized services like IT support, human resources, or legal counsel to all its subsidiaries, charging them a management fee. This avoids the cost and hassle of each subsidiary hiring its own external firm. Similarly, a subsidiary that manufactures car engines can sell them directly to a sibling subsidiary that assembles the final vehicle. This creates a streamlined and reliable supply chain.

Growing a business requires money, and sometimes the cheapest and fastest lender is your own parent company. A parent can provide a direct loan or a capital injection to a subsidiary for expansion or to cover a temporary shortfall. This internal financing avoids the lengthy process and scrutiny of applying for a bank loan or issuing new debt on the public market.

This is where things can get murky. Multinational corporations operate in many different countries with varying tax rates. By strategically pricing goods and services sold between subsidiaries in different jurisdictions, a company can legally minimize its overall tax bill. This is done by shifting profits from high-tax countries to low-tax ones. While legal, the methods used can sometimes be aggressive and warrant a closer look.

As a value investor, your job is to be a healthy skeptic. Intercompany transactions are a prime area for skepticism because they offer a tempting opportunity to bend the rules and paint a prettier financial picture than reality warrants.

This is the golden rule for judging intercompany dealings. An arm's length transaction is one where the buyers and sellers act independently and in their own self-interest. The price and terms should be the same as if the transaction were happening with a totally unrelated company.

• Good Practice: Subsidiary A sells a product to an external company for $100. It sells the same product to its sibling, Subsidiary B, for $100.
• Red Flag: Subsidiary A sells that same product to Subsidiary B for $10 or $2,000. Any price that deviates significantly from the fair market rate should make you ask, “Why?” This practice of setting prices for internal transactions is known as transfer pricing.

When the arm's length principle is ignored, companies can start to perform financial magic tricks.

• Hiding Weakness: Imagine a struggling subsidiary is sitting on a factory that's losing value. To avoid booking a loss, it could sell the factory to a healthy sister subsidiary at an inflated price. This creates a “gain” on the selling subsidiary's books, making it look profitable and stable, while the healthy subsidiary now holds an overvalued asset.
• Dodging Taxes: A company might have its subsidiary in a high-tax country (e.g., Germany) sell goods to a subsidiary in a low-tax haven (e.g., Cayman Islands) at an artificially low price. This ensures very little profit is recorded in Germany, while the Cayman subsidiary can then sell the goods to the final customer at a high price, booking the majority of the profit in the low-tax jurisdiction.

An especially deceptive tactic is creating “phantom revenue.” This can happen when two subsidiaries sell goods or services back and forth to each other, often with little real economic substance. This is sometimes called “round-tripping.” Each sale gets booked as revenue, making it appear as if both divisions are growing rapidly, when in reality, no new money is coming into the overall company.

Luckily, companies can't completely hide these dealings. You, the diligent investor, just need to know where to look. Your primary tool is the company's annual report, specifically the 10-K for U.S. companies.

1. The Notes to the Financial Statements: Buried deep within the annual report is a section often titled 'Related Party Transactions'. This is your treasure map.
2. What to Look For: Companies are required by accounting standards to disclose the nature, volume, and monetary value of their intercompany transactions. Read these notes carefully. Do the transactions seem logical? Are the amounts significant relative to the company's total revenue or assets? If a company generates 20% of its revenue by selling to itself, you need to understand the commercial logic and be confident that the pricing is fair. If the explanations are vague or the logic is fuzzy, it’s a bright red flag.