Key Issues Associated with Cash Pooling for European Treasury Tax
Over the last 10-15 years, and especially since the introduction of the euro, many multinational company groups have implemented cash pooling arrangements in one form or another. In order to understand the tax issues associated with cash pooling, however, we must first understand the precise legal nature of the arrangements.
Cash pooling is used as a term for short-term intra-group financing arrangements that are aimed at reducing the overall interest costs for a group. While there are many variations, in essence there are two main forms of cash pooling: notional pooling or zero balancing. From a tax (and legal) point of view, there are distinct differences.
In the case of notional pooling, the debit and credit balances kept by the various members of the pool are added up and interest is calculated on basis of the net result. The balances themselves are, however, not transferred to one separate central entity, but remain with the individual member companies of the pool.
What this means in practice is that notional pooling is only possible if the various members of the pool hold accounts with the same banking organisation. A key aspect of a notional cash pool is that the bank will require a right of off-set. It will also insist that the members of the pool guarantee the debit balances of all participants. So if, for example, the pool consists of companies in Belgium, France, Germany and the Netherlands, and the Belgium and German companies are overdrawn, the French and the Dutch companies would need to guarantee the obligations resulting from the debit positions of the former two companies.
In the case of zero balancing (also known as sweeping) the balances of the pool members are physically transferred (i.e. swept) to one central entity (the pool leader).
At the time of the sweep (normally at the end of the day), positive balances will be transferred to the pool leader. The pool leader will also provide the necessary cash to those entities that are in an overdraft position resulting in the individual companies having a zero balance at the end of the day. (It is, however, possible that the credit positions will not be zero-balanced entirely, but that a certain amount (collar) is kept in the account of pool members).
While economically the same, these two forms of cash pooling have substantially different tax and legal aspects.
First, some countries do not allow the legal right of off-set as required by the bank. Second, there are countries that do allow such a legal right of off-set within the same country but which do not allow off-setting across borders. Such legal aspects of notional pooling also raise a substantial number of documentary issues, in particular regarding the enforceability of the right of off-set.
In the case of zero balancing, however, the balances are actually transferred to one separate entity and there is no need for the legal right of off-set. Actual one-on-one (overnight) loan and deposit relations are created. Zero balancing, therefore, also allows the credit-worthiness of each of the individual pool members to be taken into account to a much larger extent.
One of the other important differences between notional pooling and zero balancing is the nature of any payments that the companies pay or receive under each of the schemes.
In the case of zero balancing, it is clear that any payment received from the pool leader on positive balances will be interest, while any payments due by an overdraft member of the pool will be an interest charge.
The nature of the settlements in case of notional pooling, however, is less evident. Certainly part of any payment will be interest and, part, maybe considered a guarantee fee where some members are in a debit position. Arguably, part of such payments can also be characterised as a form of standby fee.
Economically guarantee fees, standby fees and similar payments certainly would be seen as payments akin to interest. Conceivably, however, these fees may be governed by different rules for tax purposes. Similarly, they may be subject to different tax treatment with the recipient, which could, for example, influence thin capitalisation issues (see below).
The tax rules of some countries have specific definitions of interest. In certain countries, the law clearly assimilates guarantee fees with interest for the purpose of withholding taxes. Other countries, however, have less broad definitions, and as a consequence an argument could be made that no withholding taxes are due on the amount of guarantee fees or standby fees. Furthermore, analysing whether and at which percentage withholding tax is due will become highly complicated in case of notional pooling. Basically, any interest (component) in the settlement payments made by a debtor in the pool has to be divided over all the pool members that hold a credit balance in the pool. In zero balancing, there is only one other party involved – the pool leader.
Another aspect related to withholding taxes is the timing of any tax filing. In cases where withholding tax must be declared and paid on a cash basis as and when interest is settled, a notional pooling arrangement will raise substantial questions as to when such withholding tax becomes due. In case of zero balancing, the pool leader will generally provide periodical details and issue ‘invoices’ for the interest due on overdraft positions.
Most countries that have rules limiting the amount of interest deductibility seem to refer to the net balance of (inter-company) interest costs, i.e. in determining whether or not any interest charge (paid to group companies) is deductible, interest received and interest paid is balanced and only the net result is taken into consideration. Situations can, however, be envisaged where the above referred to fees are not treated as interest and are therefore left out of the equation.
Both forms of pooling constitute intra-group transactions. The payments under a notional pooling arrangement are payments made by or to a bank and interest received is legally bank interest. However, by the nature of the multiparty agreement, the administrator of the pool must allocate the payments in the same way as intra-group payments to avoid transfer pricing issues and should, in doing so, apply the arms’ length principle. The somewhat ambivalent nature of these allocations can have tax consequences in, for example, the field of withholding taxes, but also in some countries with respect to stamp duties and similar levies, which are not due on payments made to or from financial institutions.
An aspect of greater importance in the intra-group relationship, as compared to independent financing with a third party (bank), is the impact of thin capitalisation rules. In most countries, thin capitalisation rules will only apply in respect to interest payments made between companies that are members of the same group. Whether or not companies are considered members of the same group will depend on each country’s legislation.
What this means in practice is that, when contemplating the introduction of a cash pooling arrangement, multinational groups can suddenly be confronted with a limitation of deductible interest. Payments made on overdrafts under a cash pooling arrangement become akin to payments to group companies; whereas without cash pooling they would (in general) remain payments to third parties and thus outside the scope of thin capitalisation legislation.
In the case of zero balancing, benchmarking the arms’ length rate interest income received from the pool leader suggests that this should not be less than the interest that would have been received from a third party. Similarly, the interest charged should not be higher than a third party rate.
In the case of notional pooling, the issue is more complicated since the number of counterparties is much larger. Since the deposits in the notional pool will benefit both stronger and weaker parties, the remuneration on such deposits should in fact reflect these differences.
Cash pooling schemes exist in many forms and in this article we have focused on:
While notional pooling appears straightforward, a number of countries do not allow a legal right of off-set – especially in cross-border situations – and accordingly a question of enforcement arises. Zero balancing, on the other hand, is at least much clearer and in many cases is easier to implement. In terms of the tax issues, while there are more considerations with zero balancing, those associated with notional pooling are not insignificant.
What this means in practice is that while notional pooling is regularly applied within a single country, zero balancing has the advantage when it comes to cross-border, and therefore European, cash pooling.
In our next article, we will take a detailed look at the debt financing rules in a number of key European jurisdictions and will compare and contrast some of the key aspects, such as interest deductibility and withholding taxes. You can read the previous article here: Interesting Times for European Treasury Tax: the Treasurer’s Perspective.