Cash pooling and transfer pricing

Cash pool structures are common treasury tools or solutions to optimize the use of and access to liquidity within an MNE. Liquidity and cash management is becoming increasingly important as we witnessed a few years ago at the start of the Covid crisis and, more recently, once more following the Russia / Ukraine crisis and subsequent impact on capital and commodity markets.

Cash pooling is an instrument that can help to achieve more effective liquidity management by centralizing credit and debit positions of various accounts into one account (either notionally or physically). As such, following the netting of credit and debit balances, the need for external borrowing can be reduced, effectively optimizing the use of liquidity available in the Group and resulting in lower interest costs for the company on external financing.

Cash pooling is a popular financial instrument for MNE Groups, but does not occur – due to its nature – between independent parties. This makes it inherently difficult to demonstrate that cash pooling arrangements are at arm’s length. Next to that, cash pool structures are commonly not set up for tax purposes but have been exclusively in the domain of the treasury department. However, with tax authorities increasing their understanding of cash pool structures and how to interpret them for tax and transfer pricing purposes, this has been followed by an increased level of scrutiny.

In this respect, the final OECD guidance on the transfer pricing aspects of financial transactions including cash pooling, now included as a new chapter X in the 2022 OECD transfer pricing guidelines, formalizes what we have been advising and witnessing (in audits) for years on the relevant transfer pricing elements to consider in ensuring the cash pool transactions are priced at arm’s length. In practice we observe that these elements are increasingly considered in transfer pricing policies for cash pool structures, yet there are a few common pitfalls to be mindful of.

OECD transfer pricing guidance

In conducting a TP analysis for a cash pool structure a couple of elements are to be considered:

• Accurate delineation of the cash pool and transactions;
• Accurate delineation of the cash pool leader and its remuneration;
• Arm’s length interest rates (borrowing and deposits); and
• Cash pool synergies shared appropriately among cash pool participants.

The cash pooling transactions should first be accurately delineated by looking at the functional and risk profile of the parties involved, particularly the cash pool leader. This is especially important for cash pooling transactions since independent enterprises seldom undertake transactions of this type. As such, there is little or no direct evidence of what conditions would have been established by and between independent enterprises. This step basically entails developing a thorough understanding of the nature of the cash pool and its relevant economic characteristics, e.g. is it a physical pool, currencies involved, involvement of the cash pool leader, the overall cash position of the pool, etc.
Another important aspect of a transfer pricing analysis relating to cash pooling is the concept of ‘options realistically available’. No member of the pooling arrangement would participate in the transaction if it made them any worse off than their next best option. In this step one thus needs to ensure that cash pool participants benefit from being a member of the cash pool. The OECD refers to the cash pool (and any benefits derived therefrom) being the result of a concerted group action. In doing so, it links it to the guidance on synergies in Chapter I of the OECD Guidelines, which states that any benefit derived therefrom should be passed back to the entities that contributed thereto.
Any cash pool policy applied should thus ensure and demonstrate that the synergies achieved are appropriately identified and shared with the members of the pool, including the cash pool leader, where appropriate. Such is not always apparent from cash pool policies or agreements.

A cash pool leader should be rewarded in accordance with its functional and risk profile. In this respect, the OECD’s starting position is that, in most cases, a cash pool leader performs no more than a co-ordination or agency function and, hence, it would be entitled to a service like remuneration. Only when the cash pool leader performs additional functions, controls and bears the financial risks contractually allocated to it, particularly credit, liquidity and FX risk, and has the financial capacity to bear those risks, a risk related return would be appropriate

Finally, the remuneration of the cash pool participants should be calculated through the determination of the arm’s length borrowing and deposit rates within the cash pool, which should ideally allocate the synergy benefits arising from the cash pool arrangement amongst the pool members.

Potential Pitfalls

As mentioned before, cash pooling can be a great instrument to achieve more effective liquidity management. Nevertheless, it is important to be aware of the existing pitfalls. The most common pitfalls we encounter include:

• Long Term Positions: Long term requalification could occur when liquidity arrangements that are treated and priced as being short-term (i.e. cash pool) remain outstanding (or appear to be so) for a longer term. Such might occur unintentionally, and might even be caused by transfer pricing applied on other intercompany transactions, for instance when a cash generating (profitable) entity gradually increases its excess cash on deposit in the cash pool that over time might have been outstanding for a longer term, while remunerated at a short term rate. This might be challenged and potentially such position might be requalified to a long term financial instrument, e.g. a long term loan, and priced accordingly. Before such conclusion is reached, however, details are needed on how these positions have evolved as well as the business rationale for holding cash or liquidity over a number of years. In general, we observe that 12 months is considered as the cut-off moment between short and long term.
• Re-evaluation:
  • Regular (annual) updates of the interest rates: The borrowing and deposit rates applied within the cash pool should be subject to a regular (e.g. quarterly and at the very minimum annual) update to take into account market prices. In practice, the use of floating rate notes might capture market developments, albeit that interest spreads applied do need to be periodically re-set.
  • Functional and risk profile of the parties involved: Any changes in the facts and circumstances of the cash pooling arrangement require a re-evaluation of the cash pooling intra-group arrangement as a whole.
• Options realistically available: It is unlikely that entities would opt to participate in a cash pooling arrangement if it would make them any worse off than any other option realistically available. The analysis of the entities’ decision should be made taking into account those options realistically available and evidence is to be provided that they are indeed better off, and how synergies are reallocated to the cash pool members. Such is not always immediately apparent from the cash pool policy or agreements.
• Delineation: The role of the cash pool leader can range from a service provider (starting premise) to an inhouse bank. Accurate delineation of the cash pool leader’s role is crucial in determining the arm’s length return it is entitled to (which might range from a service like return to the interest spread achieved). If a risk related return is considered, this requires a detailed functional and risk analysis to support said higher remuneration. Also, the necessary substance should be in place to perform the more extensive functions and assume / control the related risks (e.g. liquidity risk and credit risk).
  

Key takeaways

The OECD transfer pricing guidance on financial transactions provides tax payers and authorities with a (theoretical) roadmap for establishing / examining transfer pricing policies with respect to cash pooling. In practice, however, the management of and documentation supporting the arm’s length nature of a cash pool is not always sufficient, which might only become apparent upon an audit. Proper documentation, updates and management / implementation of a transfer pricing policy for cash pool structures is thus advisable (and be mindful of the pitfalls).

Contact us:

Julie Costermans
Senior Manager Transfer Pricing
Deloitte Belgium
Phone: + 32 2 600 68 62
jcostermans@deloitte.com