On 11 January 2010, the Norwegian Court of Appeal dismissed an appeal by two members of a major global integrated energy company. This resulted in an increase in their taxable income from an intra-group multi-currency cash pooling arrangement.
The income adjustment incurred by the two Norwegian members of the group was made on the basis that the interest income earned by depositing cash within the group cash pool was not considered to comply with the arm’s length principle.
What is Transfer Pricing and the Arm’s Length Principle?
When goods or services are sold between two independent parties, they are usually sold at a price that is determined by the market; that is to say on an ‘arm’s length basis’.
Within a multinational enterprise, different legal entities will be buying and selling goods and services across international borders. The goods or services will be sold between the related parties at the ‘transfer price’. The level of the transfer price will have implications for the underlying taxable profitability of the different legal entities. Tax authorities are concerned that some multinationals might manipulate transfer prices to obtain unjustified tax arbitrage between high- and low-tax countries.
To address this concern, tax authorities require companies to demonstrate that transactions between legal entities have been entered into on an arm’s length basis, that is, in a manner that is consistent with dealings between unrelated parties.
Transfer Pricing Implications of a Cash Pooling Arrangement
Cash pooling is a commonly used treasury technique to view cash on a regional and global basis while at the same time enabling liquidity to be centralised. A cash pool enables a multinational company to concentrate and even out the liquidity on a daily basis for all subsidiaries in each country and between countries. Cash pooling represents a form on internal financing between related parties and is therefore associated with transfer pricing implications.
The operation of a cash pooling arrangement will give rise to a number of inter-company transactions. Figure 1 presents a scenario where a group enters into zero balancing cash pooling across geographical borders (for tax and regulatory reasons) and notional cash pooling within countries.
Figure 1: Cash Pooling Arrangement
Source: Ernst & Young
The operations of a cash pooling arrangement give rise to a number of interesting transfer pricing issues, the three key issues being:
- What interest rate should be charged to affiliates who borrow via the cash pooling arrangement?
- What return should affiliates earn on placing deposits into the cash pooling arrangement?
- How should the netting benefit be split?
The key focus of this article is on a recent Norwegian court case regarding splitting the netting benefit, and this case is described in more detail below.
Briefly touching on issues one and two, it is vital from a transfer pricing perspective that the credit spread charged on short-term overdrafts, and the deposit spread earned on short-term deposits, are consistent with the arm’s length principle. That is, they should be consistent with the rate that an affiliate could obtain from a third-party bank.
Overview of the Netting Benefit
Within an inter-company cash pooling arrangement, a benefit arises due to the offsetting of positive and negative cash balances within the cash pooling arrangement. The level of interest income/expense is calculated on the overall balance of the cash pool. As such, a ‘netting benefit’ or ‘co-ordination benefit’ arises due to the difference between the interest income/expense on the overall balance of the cash pool and the amount of interest that would have been received or paid by each of the affiliates on their individual balances. It is the differential between the deposit rate and borrowing rate of the arrangement.
To further understand this, imagine a situation where one affiliate had a cash surplus of €1,000 and earned a return on deposits of 0.25%, and another affiliate paid 1% on an overdraft of €1,000. Overall the group would pay €7.5 in interest expense per year. However, by netting the two amounts, they would save €7.5.
The netting benefit, which was referred to as a co-ordination benefit in this case, was the focus of the recent Norwegian court case. In the case, the netting benefit was attributed to the UK company of the group that managed and co-ordinated the cash pooling arrangement. The court accepted the fact that the pool applied the same interest rate to borrowings and deposits, but ruled that the interest rate applied to deposits within the cash pool did not result in the net depositors receiving a sufficient share of this netting benefit.
Historically, many groups have retained the majority of the cash pooling netting benefit centrally. Such a policy may not be sustainable if a group has significant Norwegian deposits in its cash pooling arrangement.
Key Challenges in the Case
In the analysis of whether the two Norwegian companies were entitled to an element of the netting benefit, the case considered the following issues:
- The likelihood of the participants depositing cash at such interest rates on an independent basis. The case considered the liquidity requirements of the group companies and whether the cash would have been placed in a high-interest bearing account had it been invested on an independent basis.
- The treatment of transaction costs that would arise if each company entered into a similar independent scheme. While the company were of the opinion that a deduction should be made for transaction costs that independent parties would have occurred when comparing the interest income, the Court felt it was not appropriate to take account of transaction costs that had not arisen among the related participants in the cash pooling arrangement.
- The level of risk associated with the cash pool in comparison to a third party arrangement, and if depositing within an inter-company cash pool was more risky in nature than depositing cash with a third party bank.
- The characterisation of the cash deposits as short-term in nature in the context of the liquidity requirements of the group, and the comparison of the overnight cash pool rates with an external time deposit rate.
- The deposit rate on the header account (with a third-party bank) was applied on deposits made by affiliates into the cash pooling arrangement. It was argued by the group that the netting benefit should be retained by the cash pool leader for its role in organising the cash pool and the negotiating position it assumes with the bank. It was advocated that such a benefit would not arise in a third-party situation and the parent company should retain this benefit for its role performed over and above the roles performed by the individual participants. Therefore, the group claimed that the pricing of the cash pool was compliant with the arm’s length principle and the discretionary adjustments applied were not in accordance with economic theory.
Despite these arguments, the Norwegian Court of Appeal concluded that the economic benefits associated with the cash pool should be distributed proportionately between participants based on their contribution to the cash pool. The Court adopted the view that the credit and deposit spreads resulted in an asymmetrical distribution of the benefit from the cash pooling arrangement. Further, they argued that the level of risk assumed by depositors entering into the cash pooling arrangement with a strong liquidity position was greater than depositing excess cash with a third party bank.
Conclusion
Companies with cash pooling arrangements or similar inter-company schemes should consider the transfer pricing implications and potential risks associated with their current pricing policies.
Although the specific pricing will depend on the type of cash pooling arrangements being applied, we suggest the following action points:
A review of the interest rates applied to deposits and borrowings to ensure they are in accordance with the arm’s length standard.
Consideration of whether the benefit associated with the cash pool is fairly distributed among the relevant entities, and whether the benefit retained by the cash pool leader accurately reflects the functions it undertakes and the risks borne.
Assessment of the level of risk borne by participants of the cash pool, and the level of compensation received for assuming this risk.
The case continues a trend of increased focus on transfer pricing policies by the tax authority in Norway and the application of greater scrutiny to financial transactions (inter-company loans, guarantees, etc.) than has historically been the case. While there was no disagreement between either party to the case that independent parties do partake in such financial transactions, the area of dispute was around the treatment of the costs involved and the pricing mechanism that would be applied in a third party situation.