Circular loans involve the lending of funds between two legally separate businesses that share a single owner, such as a parent company. While some circular loans serve a legal purpose, many circular loans violate the law.
Circular Loan Essentials
A legal circular loan follows a specific pattern: Biffcorp and Janecorp share a parent company, Dadcorp. Janecorp took in record profits last year and controls underused cash. Biffcorp took a loss last year but looks on track to stay steady this year, if it gets a short-term influx of cash. Dadcorp arranges for Janecorp to loan some of its excess cash to Biffcorp. Since Dadcorp owns both, the money never leaves Dadcorp’s control. Later, when Biffcorp repays Janecorp, the transaction amounts to Dadcorp paying itself. The transfer of money from one business owned by a single entity to another owned by the same entity and back again makes the loan circular. The single ownership of the money and a lack of substantive gain or loss arising from the loans also make them circular.
Circular loans often signal some form of fraud. A person who owns multiple businesses can use circular loans to avoid taxes on profits by transferring funds from a successful business to an unsuccessful one, although this does not always violate tax law. Circular loans can facilitate money laundering and artificially inflate the value of a business. In 2007, the Securities and Exchange Commission investigated the role of circular loans in a large-scale stock loan fraud at several major Wall Street stock brokerages.