By Susan Hillman, Treasury Alliance Group LLC
More and more multinationals are opting for cash pooling to effectively manage global liquidity, simplify bank account structures and reduce overall bank transaction costs. Here’s what to know before starting a global cash pool.
[Editor’s Note: An updated 2016 report, including structures most used by members of The NeuGroup’s Global Cash and Banking Group, is available here]
Cash pooling has enjoyed renewed interest over the past few years as the financial crisis has raised many firms’ interest in maximizing the availability of internal sources of capital. This very useful cash management strategy, particularly when executed on a global scale, is a proven method of effectively making more cash available while simplifying bank account structures and reducing overall bank transaction costs.
Any multinational company looking to embark on an international cash pooling project should start with a basic understanding of a typical cash pooling arrangement and then consider organizational, tax, regulatory and banking issues critical to a successful implementation (a subject for part 2).
Pooling is usually accomplished through an arranged bank account structure that mimics corporate accounting treatment and offsets cash deficits with cash surpluses between different legal entities in a corporate group. There are generally two types of pooling arrangements, notional pooling and physical pooling.
Notional Pooling
Notional pooling refers to the offset of interest income and expense (credit and debit interest), resulting from the varying cash positions in separate bank accounts held at the same bank. Each company participating in the pool maintains its own accounts. The bank then creates a shadow or notional position from all of the participant accounts reflecting the consolidated cash position on which interest is paid or charged.
Notional pooling is not permitted in all countries, notably the US and Germany, where tax authorities consider it to be a co-mingling of funds.
Because there is no movement of funds involved, the pooling is referred to as notional and the legal and tax separation of the pool participants—who ultimately share a common parent—is maintained. There is no co-mingling of funds (although some local tax authorities may interpret this differently, see below).
Due to its simplicity and ease of operation, notional pooling is the technique of choice for single currency pools within a particular country where there are varying cash positions; that is, if notional pooling is allowed.
Notional pooling is not permitted in all countries, notably the US and Germany, where tax authorities consider it to be a co-mingling of funds.
Countries where notional pooling is most common such as the UK, Netherlands and Belgium, have minimal or no withholding tax on interest, but there may be country-specific interpretations that require a holding company to function as the pool manager – such as France, for example.
- Right of offset (are guarantees needed?) Where allowed, central Bank regulations will dictate how the pooling bank, as the service provider, accounts for this arrangement on its balance sheet. For example, in many of the countries where notional pooling is permitted, the relevant central bank requires that the bank performing the pooling have cross guarantees between participants in the pool. The logic behind this is that deficit balances from pooling participants appear as assets on the bank’s balance sheet. Since the bank does not earn interest on these assets because of the notional offset with participant surpluses, they could be considered non-performing loans unless the bank has a clear right of offset.
The guarantees enable the banks to prove the right of offset, or the right to use surplus funds to cover deficit positions. However, this cross guarantee requirement does not apply in the Netherlands, hence the popularity of the Netherlands as a location for notional pooling.
Notional pooling takes on more complexity when it expands from a single country to multiple-country arrangement. This is due to both the cross-currency and cross-regulatory nature of the pool.
- Currency conversion. When dealing with more than one currency, it is necessary to bring the currencies to a common base currency, usually the Euro or US dollar, before the pooling and interest offset can take place. This is done in one of two ways:
1) Short-dated swaps: one currency is swapped for another at a specified rate. This arrangement can easily be handled internally as the company can execute the swap transaction and thus have better control—or at least transparency—of both FX and interest rates. However, the internal management of this process becomes somewhat unwieldy from an administrative perspective if there are more than three or four currencies involved.
2) Notional conversion to a base currency with the risk covered through the adjustment of the interest rates paid or charged in each currency.
Either approach from a bank’s perspective may make the process more problematic and less cost effective as the bank’s desire to be compensated for its risk takes place at the expense of the corporate pooling its funds. Usually fees will be assessed to cover cost and provide profit incentive to the bank. In cases where cost or jurisdictional prohibitions limit notional pooling, multinationals turn to physical pooling.
Physical Pooling
Physical pooling is also referred to as zero balancing. It can be achieved on both a single-country and cross-border basis, but only for a single currency at a time. As with notional pooling, each company division or subsidiary maintains its own bank accounts, which are normally sub-accounts linked to a main or header account (see chart below). These accounts can be held in any location, assuming there is no regulatory restriction.
Each division or subsidiary conducts its commercial operations, paying and receiving money, ideally through these sub-accounts held with the pooling bank. At the close of each business day, the net funds positions in these accounts are physically transferred to the main account. Usually the main account is maintained in the name of another legal entity, such as the parent, a regional subsidiary, or a finance company: whatever is best from both a practical and tax perspective.
When dealing with more than one currency, it is necessary to bring them to a common base currency.
From there, the net position in the main account is either invested, if there is excess cash, or funded through a centralized credit facility. The movements of money to and from divisional or subsidiary accounts are generally treated as intercompany loans unless all movements take place within the same legal entity.
Whether the physical pooling takes place within a single country or cross-border, the issues of concern are the cutoff times for transactions, the actual cost of the transaction and the ability of the company to handle the intercompany loans associated with the pooling.
Since the physical pooling typically takes place within the same banking network, the transfers are then book transfers, so the transaction fees are typically lower than those levied on transfers through a clearing system.
The bank essentially substitutes its DDA system for costly and inconvenient local or cross-border transfers through national and cross-border clearing systems. Banks able to do this may waive the book transfer change and assess fees based on a monthly pooling charge or by the number of accounts included in the pooling arrangement.
- FX issues. Because there is a physical movement of funds, this type of pooling on a cross border basis is not possible where FX regulations prohibit the unrestricted cross-border movement of funds, as is the case in Brazil, China, India and Korea.
Even if the FX flows are allowed, they may not be cost effective. For example, in Mexico, there are significant withholding tax implications relating to parent/subsidiary intercompany loans that make cross border physical pooling impractical and costly.
Once the funds are in the central location, the company can choose to have interest paid on each currency pool or may elect for the bank to notionally pool the separate header accounts to achieve interest maximization.
More proactive treasuries will manage the excess cash positions themselves and determine whether to invest by currency or enter into short dated swaps in order to achieve the notional pool interest effect.
- Cash to intercompany loan balances. The impact on each pool sub-participant’s financials is as follows: what may have been excess cash is now characterized as a loan to the Holding Company. The funds will remain as an asset on the subsidiaries’ balance sheets, but restated as a note receivable.
If desired, a footnote can be made on the balance sheet regarding the arrangement. Pooling in this way does not impact capital structure or create any impression of thin capitalization.
The process works in reverse as well: if a shortfall position arises for a few days or weeks during normal business cycle fluctuations, the net deficit amount in the subsidiaries’ sub account will be funded by a sweep from the pool. This is also treated as an intercompany loan and the subsidiary will be charged interest by the Holding Company.
Susan Hillman is a Partner at Treasury Alliance Group LLC. She can be reached at: 847-295-6414, or [email protected]