There has been an abundance of guidance and legislation from the OECD and HMRC in recent months on corporate interest limitations, which have dominated the discussion around financial transactions. However, with little fanfare or market notice, HMRC has recently issued guidance on transfer pricing issues related to cash pooling - an issue closely aligned with inter-company debt. As companies evaluate their treasury arrangements, it is important to consider this new guidance and to assess whether the group's transfer pricing policies for cash pooling are aligned. This alert highlights some of the more important considerations, and suggests a number of actions that multinationals might take in order to implement the latest guidance.
Cash Pooling Transfer Pricing Issues
The guidance in the International Manual (INTM 503110 to INTM 503200), finalised in February 2017, provides a helpful outline of the commercial and transfer pricing issues for consideration. In a nutshell, cash pooling relates to arrangements that a multinational puts in place through its corporate treasury structure, usually involving third-party banks, to efficiently manage the cash balances, whether positive or negative, held by the group's operating companies.
In the diagram below, subsidiaries A and B in country 1, and C and D in country 2, may have a range of both positive and negative balances. If all four subsidiaries transacted with their local bank independently, there would be a net interest margin earned by the bank, even if the net sum of all the balances were zero, because the rates charged on negative balances will be higher than the rates paid on positive balances. The goal of the pool is to net these amounts, so that the third party transaction with the bank is limited to either depositing or borrowing the final net amount, hence eliminating the net interest margin on the offsetting balances.
In the diagram above, there are five group companies involved. Suppose the following:
- Entity A is a net short term depositor of £100 in the pool
- Entity B is a net short term borrower of £200 from the pool
- Entity C is a net long term depositor of £400 in the pool
- Entity D is a net long term borrower of £350 from the pool
- Entity E is a group treasury company that operates the master account
In aggregate, the four companies borrow £50 more than they deposit in the pool, which is funded through the terms of the master agreement between the bank and the header account holder. If the bank were to pay 1% on deposits and charge 2% on loans, without the cash pool, the group would pay 2% on £550, or £11, and earn 1% on £500, or £5 for a net cost of £6 (ignoring any fees the bank may also charge). With the cash pool, the group pays only a net interest cost of £1 (2% on the net balance of £50) hence the pooling strategy has generated a net group benefit of £5.
The transfer pricing question is to set the internal interest rates between the entities above, and to determine how this allocates the group benefit. To be more specific, this issue leads to a number of questions which are addressed by the new guidance:
- Should the group benefit be retained by the header company that has arranged and operates the program with the bank, or should the benefits be shared among the relevant group entities?
- Should the policy differentiate between entities with short term and long term balances?
- Should the transfer pricing arrangements reflect the credit risk presented by either the group treasury company or any of the entities that borrow from the pool?
Allocation of Group Benefits
On the first point, the guidance refers to the discussion of synergy benefits, or those resulting from deliberate concerted group actions, in the revised OECD Transfer Pricing Guidelines and concludes that such benefits should be shared among the group companies that contributed to the relevant synergies. In this case, the header company arranging the pool is providing a service in the first instance, for which a service fee may be appropriate as a starting point, and additional profit may also be suitable as compensation for bearing credit and liquidity risks, or committing capital to support the arrangement.
Once the treasury company has been compensated suitably, the residual benefit may be allocated to the group companies in the form of more favourable rates than those offered by the bank on the net group balances. In the above example, if the group benefit from the pooling arrangement is £5, and suppose that the arm's length compensation for the header company is £2, including any program fees it pays to the bank, then one would expect the remaining £3 to be allocated to the group companies, presumably through an improvement in the interest rates.
Short Term vs Long Term Balances
HMRC's guidance presents the clear view that they may challenge whether a long term or 'structural' deposit is an arm's length arrangement. It may in fact be a disguised long term loan which may require a higher rate consistent with its characterisation as a loan rather than a deposit, taking into account the longer term of the arrangements and potentially the credit risk of the borrower.
What should multinationals be thinking about in response to the recent HMRC guidance?
The starting point is the contribution of the header company to fully understand what services it provides, and whether it bears risks, provides assets or capital, or incurs costs to manage the overall program. It is also important to consider the pool participants - do they cross-guarantee each other explicitly or implicitly? Is their commercial participation really consistent with the operation of a cash pool?
How does one determine the arm's length interest rates to pay or charge? Are there useful CUPs to apply? It may be the case that the header rates paid or offered by the bank to the treasury company are a useful starting point. Spreads may be narrowed to reflect the sharing of the synergy benefits with the group members. Alternatively, additional margins may be added on funds borrowed from the pool to reflect the specific credit risk presented by the borrower.
Tax issues other than transfer pricing
HMRC notes that it is important to recognise that inter-company debts arising from a cash pool must also be analysed for compliance with the interest limitation rules and withholding requirements.
The final guidance on documentation issued by the OECD under BEPS Action 13 made it clear that greater focus on financial transactions is expected. In addition to the general OECD requirements, INTM 503200 sets out a number of detailed requirements to be addressed in the documentation, including:
- Details on the terms and commercial arrangements related to the deposits that impact the UK;
- The rates earned or paid and any changes during the year;
- Transfer pricing documentation specific to the cash pool policy, including a functional analysis which is to include the header company even if it is not in the UK;
- The legal arrangements with the third party bank; and
- Economic support for the transfer pricing.
HMRC has issued guidance on an issue that can be very complicated, given the intricacy of some of the complex cash pooling arrangements operated by multinationals. Through this action, HMRC is making it clear that it expects multinationals to come to terms with the challenges, and resolve them in a manner that is commercially sensible, and does not result in long term loans disguised as a cash pool deposit, for example. The economic analysis can also be complex as groups face the task of setting rates on the cash pool that result in a sensible allocation of the overall cash pool benefit. Last but not least, HMRC also expects to see specific documentation addressing the issue.