Cash Management in the Baltic States
Cash management is one of the driving businesses in banking and is becoming more important in the Baltic market. Several years ago, cash management did not exist in its current form within the Baltic states. Banks are developing new solutions to facilitate local cash management as well as cross-border transactions and cash concentration methods. This region was a cash-based society for several years, and the evolution is a gradual one.
The modern banking climate is a young and developing one. A prime advantage of this area is its close proximity to other European markets, which allows increased development in many areas of banking. Banks in the Baltic market are learning from the experience of banks in western European countries.
When the three Baltic countries, Latvia, Lithuania and Estonia, joined the European Union (EU) in 2004, this increased momentum in the development of cash management services. The three Baltic states were perceived by many as one homogenous group of countries. This perception naturally required solutions from banks to present these countries as one market for investors, and cash management was the right tool to do this. Several years ago, banks started to think of the Nordic market as the Nordic-Baltic market, particularly in terms of the banks’ cash management services.
The rapidly growing banking industry (up 30 per cent yearly since 1999 in terms of assets) has influenced the growth of all corporate banking areas. Private and corporate lending, investments and cash management have been leaders in growth. This growth has been stimulated by private business expansion and rising personal wealth. Private businesses are now turning to modern e-banking with complex functions for financing, liquidity management and regional account management. The expansion of local businesses in the Baltics to other EU countries was closely followed by banking solutions for cross-border cash management and transactions.
The economic and political climate in the region has helped this expansion of business (both domestic and cross-border) and has benefited from favourable tax systems, European standards and labour markets.
After the EU accession wave of 2004, multinational companies realised that the financial operations of their subsidiaries in the Baltic states should be integrated into the company’s central business management system and the legal environment, aligned with European standards, supported this. Banks accordingly offered e-banking tools that covered the whole region, making group payments fast and cost efficient, and liquidity management tools that can cover domestic businesses as well as international business. Banks have also begun a partnership process that will ensure expanding geographical coverage for their services.
Having a treasury centre that can aggregate data from subsidiary treasuries across a region, but also maintain good regional coverage, is important for highly developed treasuries. The Baltic countries can be accessed, managed and controlled via high quality cash management e-banking tools as well as Swift. Banks in the region can offer different account set-ups so that, depending on the business structure, they can offer collection accounts in some countries with possible sweeping to the home country. In order to avoid cross-border lending or borrowing, banks also offer accounts to non-residents in their home country in order to connect them into a cash pool there. In this case we avoid transactions between separate legal entities and provide subsidiaries with financial capacity in the home country. Banks in the Baltic region also offer regional currency placement. The Nordic-Baltic region has seven different currencies, and sometimes also US dollar flow, so it is wise to have a cash management tool for the concentration of cash in the home country’s currency, for example Swedish krona in Sweden and euro in Finland. This allows the Baltics to be part of a complex cash management structure.
The most commonly used liquidity management techniques in the Baltic countries are:
Notional cash pool
A notional cash pool has been developed by many banks in the region using the framework of the European cash pool, which is based on the notional consolidation of group account balances in single or multi currencies. The conversion from local currency to the euro is done without a large expenditure because each of the local currencies in the Baltic states – the Estonian kroon, Latvian lats and the Lithuanian litas – are pegged to the euro. E-banking tools provide the possibility of applying limits to group account balances and the easy distribution of funds, which ensures that money is moved quickly to the place where it is most needed. Of course, no actual transactions are involved in this process. Funding provided within the Baltic States is substituted to a certain extent with bank credit facilities. This means that the ratio of borrowed funds to surplus funds is optimised within the company.
Interest compensation pooling
Banks are now also offering interest compensation pooling (ICP) as an alternative to notional cash pooling because it is less complicated. The bank takes all of a company’s same-currency accounts and joins them together in a collective pool. Features of an ICP are:
ICP products can be based on a combined interest set up. Minimum (fixed) and floating interest rates can be applied simultaneously when using ICP. Minimum interest rates ensure a stable income from interest on your account balance even in the case of a market recession. Floating interest rates allow the company to gain interest depending on the market situation. The interest payable by the bank would be the difference between the two.
Zero balancing
Zero balancing products are becoming more popular and are more widely used within companies with a high number of subsidiaries and a complex account structure. Cross-border zero balancing is also being used to align liquidity management processes in the Baltic countries. The sweeping of surplus funds at the end of the day into the target account and/or covering any deficits in any of the participating accounts involves real money transfers. If the target account is held by another legal entity, this is treated as inter-company lending and the consequences of this process need to be taken into account. If the minimal interest, established by law, is not paid by the target account holder, the provider of the zero balancing service is at risk of getting involved in the dispute among its clients and tax authorities. Also, if the holder of the target account is not a single shareholder of its subsidiary, the inter-company lending at the interest rate below the market price may be treated as the violation of minority shareholders’ rights. In addition, the company’s lending is limited by the company’s equity in Baltic countries (for example, in Lithuania the equity capital of the company may not fall to less than half of the amount of the statutory capital), and the requirements may be breached due to provision of zero balancing.
Cross-border zero balancing is also offered by banks. However, due to the requirements of reporting to the central bank and withholding tax, the economic background of this solution should be considered.
Estonia
In Estonia, taxation of interest payments depends on the residency and legal status of the recipient. Interest payments to the resident legal entity are tax exempted. Although, the obligation to use market prices is not clearly stated in the law, it is advisable to make the transaction at arm’s length. Interest paid to non-residents is generally tax exempted. However, if the interest rate is substantially higher than the usual rate on similar debt claims on the same market conditions, 24 per cent withholding income tax is levied on the difference. Due to the fact that generally interest paid to non-residents is tax exempted, the double taxation treaty application will become irrelevant. However, the exploitation of double taxation treaties is possible only in case the interest is substantially higher than the usual rate on similar debt and the transaction is not made between related parties. Furthermore, Estonia has implemented the EU Interest and Royalties Directive. The result of this is that interest is exempted from withholding tax and this exemption is not dependant on the status of the recipient of interest. Such exemption is effective from 1 May 2006 and amounts of withholding tax are deductible for tax purposes.
Latvia
Latvia imposes a withholding tax of 10 per cent on interest payments between related parties. Latvia has been granted a transitional period before it must implement the Interest and Royalties Directive. The rate will remain at 10 per cent until the end of 2008 and will be 5 per cent thereafter, decreasing to 0 per cent at the beginning of 2013. The withholding tax is a charge on the recipient of the interest and so is deducted from the interest payment. If the withholding tax is not accounted for, the whole payment is deemed as a non-deductible expense for corporate tax purposes. To minimize the disallowance, if the lender insists on the interest being received gross, it is possible to pay the interest less the withholding tax and account for the withholding tax to the tax authorities. The interest payment then becomes fully deductible (subject to thin capitalisation rules). Compensation for the withholding tax can be paid to the lender, thus ensuring full payment of the interest, but this compensation element becomes non-deductible since it has no business purpose. The rate of withholding tax stated in Latvia’s tax treaties is 10 per cent so there is no relief to be gained.
Lithuania
In general, interest paid by a Lithuanian entity to a foreign entity is subject to a general 10 per cent withholding tax. The domestic withholding tax rate can be lowered under double tax treaties to which Lithuania is a party. What concerns the provisions of EU Interest and Royalties directive is that Lithuania applied for a six-year transitional period during which a rate of 10 per cent will apply for the first four years and a 5 per cent rate for the remaining two years. Consequently, interest paid by the subsidiary to the mother company shall be subject to withholding tax of 10 per cent. Withholding tax reports must be filed by the subsidiary within 15 days following the end of a month when the taxable payment was made to a foreign entity. In case the above tax is not withheld but paid on top from the subsidiary’s own account, the arising withholding tax cost shall be non-deductible for profit (corporate income) tax purposes. Therefore, it would be reasonable that the tax is withheld and potentially used by foreign entities as tax credits in their countries.
As mentioned before, banks in the Baltic region have learned best practices, often from parent banks and this has allowed them to introduce a new consultancy approach to cash management. The region is considered fairly small in the eyes of global treasuries and one of the challenges facing banks in the Baltics is to adapt the processes of existing cash management structures in global companies to encompass the Baltics.
As preparation for joining the EU, the Baltic countries worked hard to ensure that their legal, tax and regulatory rules were in line with EU legislation. These countries had clearing, payments, e-banking and other banking services implemented and ready for many years before accession. A company that starts banking in the Baltic states will come across most of the banking system features found in western Europe.
The central banks in the Baltics have taken an observer’s role, mainly concentrating on bank risk assessment and driving the banking industry towards EU standards. In terms of cash management, the central banks require cross-border inter-company lending reporting, which is mainly for statistical purposes. Most reporting requested by the central banks is management by commercial banks.
According to the Estonian Money Laundering and Terrorist Financing Prevention Act, which is applicable both to national and cross-border transfers, entities that make or act as intermediaries for transactions of more than 200,000 kroons for non-cash transactions, or more than 100,000 kroons for cash transactions, are required to identify the beneficiary of the transaction, who acts as an intermediary for it, or the payor. To identify a legal person an extract from the commercial register or a copy of its certificate of registration is required
In Latvia, all transaction to or from non-residents over LVL1,000 should be reported to the central bank. Cross-border transfer of funds (loans) from a Lithuanian entity is subject to reporting to the central bank of Lithuania. Reporting is for statistical purposes only. A Lithuanian entity shall also notify the central bank about funds (loans) received from a foreign entity. The Lithuanian entity shall notify the tax authorities about all types of accounts opened/closed in a foreign credit institution outside the country.
The most discussed financial issue in the Baltic States today is the adoption of the euro. So far, Latvia has been less involved in the preparation process for the switch to the euro, which has been postponed most likely until 2009. Estonia is currently deciding on a process that will prepare itself for euro adoption in 2008. Lithuania can still expect to adopt the euro in 2007, and has already started preparations for this.
It is worth noting that again, these countries are in a strong position to benefit from the experience of their western colleagues. Companies in the region have already started reviewing contracts and adjusting ledgers accordingly. Banks are in the process of investigating required system adjustments. If the euro is adopted smoothly in Lithuania next year, it can be expected that the banking market will develop even further towards cross-border integrated solutions.
The future looks promising for this region. If adoption of the euro is successful for all the countries, the Single Euro Payments Area (SEPA) will also apply to the Baltics by 2010. Banks and clients alike will then be able to experience the full benefits of being part of a single European market.