Cash pooling is a solution many treasury professionals use as a means for optimizing cash management. It is often the responsibility of a treasury department rather than tax specialists to coordinate with a third-party bank to set up a cash pool, and as a result, certain embedded tax risks and planning opportunities can be overlooked.

By their nature, cash pools (both notional and physical) result in intercompany account balances. While the interest rates paid or received by cash pool participants on these intercompany balances may not impact what is paid to the third-party bank or directly impact the multinational’s overall pre-tax cost of funds, there are tax consequences from these rates. Tax authorities will be concerned that non-arm’s-length interest rates could potentially reduce the taxes owed in their jurisdiction. Given this, companies need to determine arm’s-length rates that conform with the tax rules in the jurisdictions of all parties involved to minimize tax risk (i.e., potential income adjustments, penalties, double taxation).

While the relevant tax regulations vary by country, the Organization for Economic Cooperation and Development publishes global standards for all types of intercompany transactions. Many jurisdictions follow the spirit of this guidance, and some simply adopt it as law. Recently, the OECD published a discussion draft, which included proposed frameworks for how companies and tax authorities should analyze cash pools. The United Nations also recently released a new proposed chapter on intra-group financial transactions. The attention of these bodies on this topic is indicative of the growing tax scrutiny on intercompany financing structures.

BENCHMARKING INTERCOMPANY INTEREST RATES

Intercompany balances between cash pool participants can be viewed as separate intercompany loans, all of which feed into the company’s cash pool arrangement with the bank.

While third-party banks typically offer systems that manage cash balances and corresponding fees across the cash pool, when it comes to setting fees, the banking partner is usually only focused on setting its borrowing/lending rates and administrative fees. It is therefore left to the company to set and provide the appropriate intercompany rates.

Under the arm’s-length standard, the intercompany interest rates for balances with the cash pool should be no higher or lower than the interest rate participants would potentially pay/receive for short-term borrowings/deposits in the open market under similar circumstances. Setting intercompany interest rates in the context of a cash pool is facts and circumstances dependent, but a common approach is to base the interest rates on the credit risk profile of each respective cash pool participant.

Similarly, the cash pool header’s credit risk profile is often used in setting the appropriate interest rate it owes to cash pool participants for their sweeps into the cash pool. Short-term yield data can then provide a reliable benchmark for market interest rates across the spectrum of potential credit ratings. Many cash pools operate using spreads over floating rates so the yield curve information (often provided as fixed rates) may need to be converted to the proper underlying base rates using swaps. For multicurrency cash pools, the swap can simultaneously convert the fixed rate to a floating rate across the functional currencies.

Barring any material changes to the OECD’s discussion draft and the UN’s proposed chapter upon their finalization or the introduction of other regulatory guidance, we expect this general approach to continue to be the best practice for setting intercompany interest rates for cash pools.

ALLOCATING THE POOLING BENEFIT

Separate from and in addition to calculating the interest rates, the bank will also calculate the “pooling benefit.” In general, the pooling benefit is the savings achieved by the cash pool from reducing its external cost of funds. This savings is typically calculated as the difference between the net interest theoretically earned if each entity were to make deposits into their respective separately managed account, versus the interest earned when cash balances across entities are pooled and deposited (notionally or physically) by the cash pool header.

The pooling benefit can either be allocated to the cash pool header or dispersed among the cash pool participants. If the cash pool header operates as an in-house bank—bearing credit risk, liquidity risk, and/or currency risk (and deciding when and how to hedge risk)—it arguably should earn the upside from the cash pool and thus receive all or most of the pooling benefit. If on the other hand the cash pool header is more of an administrative agent, the pooling benefit may be more appropriately allocated across the cash pool’s depositor entities or all participants. The administrative fees charged by the bank should likewise be allocated, such that the costs of running the pool generally follow the pooling benefit.  

SHORTCUTS TO AVOID

When setting up cash pools, many companies use a single borrowing interest rate for all cash pool participants, along with a separate rate for interest owed by the cash pool header for deposits. This can cause problems if the participants in fact have varying credit quality when viewed individually. Further, this single borrowing rate across participants is usually set lower than prevailing market rates to provide low-cost working capital to the participants. While understandable from a business perspective, using an artificially low rate creates tax risk for the cash pool header because its interest income, which is usually taxable, will be too low. Companies may try to correct for this by using an even lower rate for the cash pool header’s interest owed on sweeps into the cash pool. However, this correction only shifts the burden of below market interest rate returns to the cash pool’s depositor entities, creating tax risk in those jurisdictions.

We also see many companies leverage the rate set by the bank to establish intercompany rates. Depending on the structure of the cash pool, the rate charged by the bank may be akin to an overdraft line, provided as a safeguard in the event of a cash shortfall within the pool. In these circumstances, the interest rate is typically quite high because it is intended to serve as an extraordinary source of funds. Most companies aim to limit the use of this safety net for this reason and instead have a separate line of credit available, either with an external bank or a related party such as the parent company, in case of a longer-term cash shortfall. External arrangements for short-term cash needs (e.g., lines of credit) that are separate from the cash pool may be closer in spirit to an appropriate intercompany rate for credit balances in the cash pool, but even these should be carefully analyzed for comparability to cash pool arrangements, with any suitable adjustments made.

Stefanie Perrella is Managing Director, Transfer Pricing, in Duff & Phelps’ New York Transfer Pricing Practice. Beau Sheil is Director, Transfer Pricing, in Duff & Phelps’ New York Transfer Pricing Practice.

For more insights on cash management and risk mitigation, check out the host of sessions in the Treasury Management and Risk Management tracks at AFP 2019.