Last reviewed October 7, 2026 · By the NYBACS advisory team
Short answer
Usually with a mix of equity and documented intercompany arrangements. Equity is simplest: no interest, no withholding and a stronger balance sheet for banks. Intercompany loans let the parent recover cash as repayments and interest, but need arm's-length terms, may trigger US withholding on interest and face interest deduction limits. Where the subsidiary serves the parent, a cost-plus service fee can fund it while it earns a modest taxable margin.
Key takeaways
- A capital contribution or share subscription from the parent is not taxable income to the US subsidiary, but it must be recorded as equity, not revenue.
- Interest paid by a US subsidiary to its foreign parent is generally subject to 30% US withholding unless an income tax treaty reduces the rate.
- The portfolio interest exemption is not available for interest paid to a lender that owns 10% or more of the borrower.
- Business interest deductions are generally limited to 30% of adjusted taxable income under Section 163(j), with excess carried forward.
- A US corporation that is at least 25% foreign-owned reports each related-party transaction category on Form 5472 with its Form 1120.
The three funding routes compared
| Factor | Equity (share subscription or contribution) | Intercompany loan | Service fee (cost-plus) |
|---|---|---|---|
| How cash goes back to the parent | Dividends, share buyback or liquidation | Repayment of principal plus interest | Not needed: the parent pays for services received |
| US tax on the subsidiary | None on receipt | Interest deductible, subject to limits | Fee is taxable income; the margin is taxed |
| US withholding on payments to parent | Dividends: 30% unless treaty reduces | Interest: 30% unless treaty reduces | None on the parent's payments into the US |
| Documentation | Board resolutions, share issuance, stock ledger | Written loan agreement, interest computation, repayment schedule | Intercompany services agreement, cost base, markup analysis |
| Effect on bank and auditor view | Stronger balance sheet | Higher liabilities; may raise solvency questions | Revenue shows the subsidiary as a functioning business |
| Transfer pricing focus | Low | Interest rate and debt capacity | Markup and scope of services |
Many groups start with equity to cover setup and early losses, then add a services agreement once the subsidiary is clearly performing work for the parent.
Equity: simplest, but harder to get back
Equity is the default for a new subsidiary. The parent subscribes for shares or makes an additional capital contribution, the board records it by resolution, and the stock ledger is updated. Banks and landlords like the resulting balance sheet, and there is no interest to compute or withhold.
The trade-off is exit. Returning equity requires distributable profits for a dividend or a formal capital reduction, and dividends to a foreign parent carry US withholding unless a treaty lowers the rate, typically after the parent provides a Form W-8BEN-E. Some home countries also impose their own approval or reporting for outbound equity: Indian parents, for example, make overseas direct investment through their authorised dealer bank.
Intercompany loans: what makes them hold up
A loan from the parent is attractive because repayments are tax-free returns of cash and interest may be deductible in the US. To be respected as debt, it should look like a loan between unrelated parties:
- A signed agreement with principal, currency, interest rate, repayment dates and default terms.
- An arm's-length interest rate supported under Section 482 transfer pricing rules, considering the subsidiary's credit profile.
- Actual interest accruals and payments, not a balance that silently grows for years.
- Reasonable debt capacity: a thinly capitalised startup funded almost entirely by parent loans invites recharacterisation of the debt as equity.
Interest paid to the foreign parent is reported on Form 1042-S and the annual Form 1042, with US withholding at 30% unless a treaty applies. The 10% shareholder rule means the portfolio interest exemption will not help. Deductibility is capped by Section 163(j), so the expected tax benefit is often smaller than founders assume.
Cost-plus service fees for support subsidiaries
When the US subsidiary exists mainly to support the parent, for example a sales, marketing or customer-success team selling the parent's product, the parent can pay it a fee equal to its costs plus a markup. The subsidiary then has revenue, a modest taxable profit and no need for repeated capital injections.
This model needs an intercompany services agreement, a defined cost base, a markup supported by benchmarking, and invoices issued on a regular schedule. It also needs care around who signs customer contracts: if the US team concludes sales in the parent's name, the parent itself may be treated as doing business in the US.
Reporting every flow on Form 5472
Whatever the mix, a US C-Corp that is 25% or more foreign-owned files Form 5472 for each foreign related party, reporting amounts such as loans received, interest paid, service fees received and other consideration. A missing or incomplete Form 5472 carries a $25,000 penalty per form.
Practical steps that make the filing straightforward:
- Use separate ledger accounts for equity contributions, loan principal, accrued interest and service revenue from the parent.
- Ask the parent to reference the resolution or agreement on each wire.
- Reconcile the intercompany balance with the parent's books every quarter, not only at year-end.
- Keep the agreements, resolutions and benchmarking studies with the tax file.
Common mistakes to avoid
- Booking parent funding as revenue, which overstates taxable income and confuses banks and auditors.
- Advancing money as a 'loan' with no agreement, no interest and no repayment plan, then trying to deduct interest later.
- Paying interest or dividends to the parent without withholding or collecting a Form W-8BEN-E to support a treaty rate.
- Funding a startup subsidiary almost entirely with debt, making the loan vulnerable to recharacterisation as equity.
- Letting the parent pay US vendors directly and forgetting these payments are related-party transactions for Form 5472.
- Leaving the intercompany balance unreconciled so the parent's and subsidiary's books disagree at year-end.
NYBACS 360° support
How NYBACS helps
- Models equity, loan and service-fee funding mixes for your US subsidiary with your tax advisers before money moves.
- Prepares board resolutions, share issuance records and stock ledger entries for each capital injection.
- Sets up intercompany ledger accounts and quarterly reconciliations with the parent's finance team.
- Prepares Form 1120 with Form 5472 and coordinates Form 1042 and 1042-S reporting where interest or dividends are paid abroad.
Frequently Asked Questions
Is money sent by the parent taxable income for the US subsidiary?
Not if it is a genuine capital contribution or loan. It becomes income only if it is payment for something the subsidiary provides, such as services under an intercompany agreement. The documentation decides the classification, so set it before the wire, not afterwards.
Can an existing loan be converted into equity?
Yes. The board can approve converting loan principal, and sometimes accrued interest, into shares. Conversion has tax consequences for both sides, including possible withholding on accrued interest, so it should be reviewed first.
Which interest rate should an intercompany loan carry?
One that an unrelated lender would charge a borrower with the subsidiary's credit profile, for a loan of that size, currency and term. Groups typically support the rate with a short benchmarking analysis and review it when terms change.
Does the parent's country also care how the subsidiary is funded?
Usually yes. The parent may need to report the investment, charge interest under its own transfer pricing rules and tax the interest or service fees it receives. Both countries' rules should point the same way before funding starts.
