In the current economic environment, liquidity management is a key function for multinational corporations. Many multinationals operate some form of group treasury structure, such as centralized or regional treasury centers; in-house banks; foreign exchange (FX) centers; and payment factories, which are central units that execute payments on behalf of one or more subsidiaries. Through these various treasury structures, multinationals undertake activities like centralized lending, payment management, risk management, and FX hedging.
For short-term cash management, cash pooling is often the most effective way to optimize both excess and deficit cash positions within a group of companies. By allocating internal funds, rather than depending entirely on external sources, a large business can minimize its interest costs overall. Moreover, cash pooling can lead to significant savings when the group marshals its combined market power in dealing with external banks and through centralization of cash management, which may lead to economies of scale.
But when a cash pooling system straddles multiple countries and currencies, it gives rise to a range of tax issues. One of the more complicated issues is transfer pricing, which evaluates the intercompany payments and allocation of benefits that are inherent in a cash pooling structure. Tax authorities around the world are keenly interested in transfer pricing, as many are focusing increasing attention on protecting their tax base. Although cross-border cash pools have proliferated since the introduction of the euro, we are far from reaching consensus on the proper transfer pricing treatment of these arrangements. In some cases, different countries have taken inconsistent approaches to transfer pricing, increasing the challenges for multinational corporations’ treasury functions.
Complications of Cross-Border Cash Pooling
In a rudimentary cash pooling arrangement, also known as a “zero-balancing” cash pool, funds are transferred on a daily basis to or from a cash pool leader (CPL). The CPL is the group entity that manages the pool; it’s usually a centralized treasury operation or a separate function within the parent company. In contrast, with a “notional” cash pooling system, the debit and credit balances of all cash pooling participants are offset virtually and directly by a third-party bank, but the pooling involves no actual funds transfers.
Although they’re quite different in practice, zero-balancing and notional cash pooling structures have similar transfer pricing implications. For simplicity’s sake, we’ll focus this article primarily on the activities and ramifications of a zero-balancing cash pool.
Cross-border cash pooling systems have important transfer pricing implications in both the nation where the cash pool leader is located and the countries where the cash pool members are established. In all affected regimes, the revenues and costs related to the cash pool should be allocated in alignment with the “arm’s-length principle.” This means that the terms and conditions relating to the cash pooling arrangement—as for any intercompany financial transaction between related parties—should correspond to the terms and conditions that third parties would have agreed to.
Determining arm’s-length terms and conditions can be challenging, since we generally cannot observe cash pooling systems among unrelated parties. Nonetheless, that is the standard by which multinationals must evaluate their internal transactions. The primary issues around which a multinational needs to hold its transfer pricing at arm’s length are:
Interest rates paid to cash pooling participants for credit balances (i.e., deposits). A cash pooling participant that deposits excess cash will earn an interest return on that cash, either through the CPL or directly from a third-party bank. If the participant and the related CPL are in different tax jurisdictions, this interest rate becomes a transfer pricing issue. When a third-party bank is involved, the deposit rate offered by the bank usually reflects a premium because of the combined size of all of the multinational’s deposits—i.e., because of the size of the cash pool’s net credit position. This means any single participant earns a higher interest rate on its credit balances than it likely would have received on its own. Should excess earnings on individual deposits be paid to the CPL if the global network is responsible for the premium? In practice, the structure of the cash pool arrangement is decisive for the allocation of the excess earnings between the CPL and the other cash pool members.
Interest rates paid by participants for debit balances (loans). Similar issues apply to the interest rates paid by participants who borrow from the cash pool, whether the participant is borrowing internal funds (i.e., borrowing from the deposits of other participants in the company’s cash pool) or borrowing bank funds, which happens if the pool is in a net debit position. If the loan is financed entirely by internal, related-party deposits, does the borrower need to pay any interest? Alternatively, if the pool is in a net debit position, should the borrower pay the group rate charged by the bank? If the entity pays a lower rate than it would pay if it borrowed on its own, then the transaction would appear to not meet the arm’s-length criterion. The solution may lie in factoring in the role of the CPL or parent company in securing the group benefits of the cash pool.
Netting and volume benefits resulting from participation in the pool. Typically, a third-party bank earns the spread between credit and debit interest rates, but a cash pool can eliminate this spread within the group. This is the so-called "netting" benefit. "Volume" benefits result when a multinational group can negotiate better rates with banks than cash pooling participants could get on their own. Although these distinct benefits can theoretically be unraveled, it is not always possible to do so in practice since the two are highly interrelated. Therefore, netting and volume benefits are often considered in tandem and are allocated among all pool participants and the CPL based on the structure of the cash pool arrangement.
The impact of any guarantees on the overall pricing and capital structure of the cash pool. Participants that borrow from a multinational corporation’s cash pool generally benefit from a low interest rate, which is appropriate to the credit rating of the group overall. Thus, the CPL and/or parent company is guaranteeing, whether explicitly or implicitly, the ability of the borrowing entities to repay the loans. Consequently, from a transfer pricing perspective, the borrower owes a guarantee fee to the CPL. This fee could be calculated based on the difference in borrowing rates, on a stand-alone basis, between the CPL/parent company and the relevant cash pool participant.
Alternatively, the CPL may be covering the net shortfall in the pool with its own funds from other sources, which means that any related entity in a debit position is, in effect, borrowing from the CPL. In that case, transfer pricing rules would require that cash pooling participants pay an arm’s-length interest rate, which is to say a rate commensurate with the borrower’s credit quality on its own. In practice, such an interest rate may be roughly equivalent to the combination of a group rate paid to the external bank and a corresponding guarantee fee to the CPL.
Note that while guarantees usually come from the CPL or the parent company, there could also be a system of cross-guarantees throughout the group of participants in the cash pool. In such a situation, companies with stronger balance sheets support those with weaker ones, which leads to the proliferation of cross-border issues.
Compensation for administration of the cash pool. Aside from questions about interest rates and guarantee payments to the CPL, cash pooling participants might need to compensate the CPL for the administrative functions it performs in managing the cash pool. This is typically done by reimbursing the costs incurred, adding a profit markup.
How to Allocate Cash Pooling Benefits
In practice, netting and volume benefits are often considered in tandem as “total cash-pool profits.” For transfer pricing purposes, these benefits have to be allocated among all participants in the cash pool, including the CPL and/or parent company, in a way that reflects each entity’s contributions in terms of function, assets, and risks. If the CPL is responsible for the entire risk related to the cash pool, by way of an overall guarantee agreement, it is entitled to a larger part of the netting and volume benefits than it would be if it were operating only as an administrative service provider (as it may in the case of a notional cash pool, particularly if individual participants receive and pay close to market-level interest rates in their dealings).
The share of overall netting and volume benefits allocated to individual participants in the cash pool should depend on whether each entity is in an overdraft or deposit cash position; the size of its balances; and the differences between the deposit and lending rates offered by the third-party bank, compared with the corresponding rates credited or debited by the CPL. The closer CPL rates are to external rates, the larger the share of the cash pooling profits that should go to the participants—with each participant’s portion corresponding to the relative size of its deposit or loan.
One means of allocating cash pool profits is a “residual profit split” transfer pricing methodology that remunerates more routine functions first. For example, a company could remunerate the administrative function of the CPL with a fee that covers costs and includes a profit markup. A routine remuneration could also be provided for the capital that the CPL puts at risk under a guarantee agreement; this could be a risk-rated return. Then the remaining cash pool benefit could be allocated to all cash pool members on the basis of certain allocation keys, such as the size of different entities’ balances. Conversely, if the CPL is performing more than routine administrative functions—acting more like a bank, with all the pertinent functions and risks—then it may be part of the profit-split allocation and may be able to earn more-than-routine returns.
Cross-border cash pooling arrangements present unique transfer pricing exposures and opportunities. There is little agreement among tax authorities around the world as to how the related-party payments and interactions inherent in such arrangements should be analyzed or priced. For example, some tax authorities may not make a distinction between cash pooling systems and more traditional centralized treasury operations when evaluating transfer pricing issues.
To ensure that it’s complying with the appropriate transfer pricing tax rules, a company needs to understand how it’s allocating the total profits from its cash pool among the CPL and the cash pool members, and why it’s using that allocation methodology. Further, given the uncertainty about how global tax authorities will view the same issues, multinationals that operate internal cash pools would be well-advised to proactively consider and document their responses to all the transfer pricing issues we’ve discussed. Not only is a careful examination of allocation of cash pooling benefits likely to help a business optimize its savings (both tax and non-tax), but it will also provide cover should the company have to defend itself under audit by tax authorities in one of the jurisdictions in which it operates.
Sherif Assef is a managing director in the New York office of Duff & Phelps. He has extensive experience advising clients on all types of transfer pricing matters, specializing in the financial services industry. Sherif has assisted clients in analyzing a variety of related party transactions—including the global trading of financial instruments, asset management services, brokerage services, the sharing of banking fees, insurance and re-insurance transactions, loans, guarantees, management services, and administrative services.
Dick de Boer is a director in the Amsterdam office of Duff & Phelps. With a broad range of experience in international tax consulting, Dick has performed transfer pricing services such as IP (re)structuring, policy design and documentation (also for financial transactions), valuations, and dispute resolution. He has particular expertise working with tax authorities in relation to transfer pricing tax audits, APAs, and horizontal monitoring.