Strategy

Addressing Legal Issues In Cross-Border Cash Pooling


by FEI Daily Staff

Cross-border cash pooling has become an important cash optimization tool for multinationals.

A cash pooling program enables a corporate group to concentrate and utilize cash on a [daily] basis among the corporate group members. Better enterprise cash utilization means a reduced cost of capital and higher returns on otherwise idle cash. Cash pooling has been practiced for many years on a single country basis, without coordination across borders. Globalization means that single country cash management may not be the most efficient way to put cash to its best use. Multinationals increasingly desire to coordinate cash management globally or by region. This article discusses some of the legal issues typically associated with cross border cash pooling.

While the decision to pool cash across borders may well offer large benefits, it also presents several challenges. The first is whether cash pooling will attract a tax that might not otherwise exist had cash simply been left in the country. Among these are withholding taxes that may arise when money is paid across a border. Transfer pricing issues may also apply to intercompany loans used to accomplish pooling. The second challenge is exchange rates and the effect that cash pooling may have on the corporate currency hedging program. Pooled cash may be converted to a base currency, which may not occur if cash is simply left in country. This conversion means base currency results may change -- for better or worse -- and presents a currency management issue. The third challenge to cross border cash pooling are local laws that apply to each participant in the cash pool. These laws may limit the ability to pool cash and may require special solutions. This article will concentrate primarily on this third challenge. Before doing this, some background may be helpful.

Types of Cash Pooling

There are two types of cash pooling: physical and notional. In physical cash pooling, companies within the corporate group (“cash pool participants”) agree to move their excess cash on a periodic basis to an identified entity in the corporate group (“cash pool leader”) which concentrates cash on a periodic basis. To the extent a cash pool participant has excess cash, that excess cash earns an agreed rate of interest as an intercompany loan to the cash pool leader. Conversely, if a cash pool participant needs cash, it borrows from the cash pool leader and pays interest on those borrowings. A bank having operations in the region where the cash pool participants operate (“cash pooling bank”) will be appointed to maintain accounts and function as agent in the operation of the cash pooling program. To the extent the cash pooling bank does not have a presence in the jurisdiction, other banks will be involved and cash pool participants will agree to repetitively transfer excess cash to the cash pooling bank, usually by SWIFT messaging. A jurisdiction for location of physical cash pool must be selected and should be one with accommodating tax and regulatory rules. The Netherlands is frequently the country of choice.

By contrast, notional cash pooling does not involve the physical movement of funds. Instead, cash pool participants hire the cash pooling bank to maintain and monitor a consolidated, cross border, enterprise cash position. When a cash pool participant has excess cash to invest, it is credited with an agreed rate of interest by the cash pooling bank. On the other hand, the cash pool participant in need of cash is deemed to have received a loan on which it must pay interest. In this manner, the cash pool participant in a borrowed position can pay its bills without the physical movement to it of money. The cash pooling bank will make this happen but will require credit protection in the event a cash pool participant defaults on its loans. The extensions of credit it makes are on the balance sheet of the cash pooling bank. To protect itself, the cash pooling bank receives guaranties of its exposure from all cash pool participants. These include the right to set off any credit balances existing at cash pool participants having excess cash. The cash pooling bank will typically not allow the aggregate borrowed positions of cash pool participants to exceed available excess cash. In this manner, the cash pooling bank's exposure is continually covered by its offset rights in excess balances.

There is no single right approach as to whether to elect notional and physical cash pooling and these often exist side-by-side with the same cash pooling bank. The decision of which to use will turn on tax, accounting, cost and regulatory factors. Notional cash pooling can accommodate multiple currencies with much more ease. To do this, the cash pooling bank will simply compute and convert all currencies to a base currency on which intercompany extensions of credit are based. By contrast, physical cash pooling would typically require separate accounts for each currency, making it more difficult to truly integrate the cash pooling function. Note, however, that the conversion to base currency that otherwise might not occur could result in unintended currency exposures and imbalances that treasury management may need to address. Under notional cash pooling, the requirement that each cash pool participant guaranty the exposure of other cash pool participants could affect the ability to obtain credit. In the case of most investment grade multinationals, this is not a large issue. However, outstanding cash pooling liabilities are payable anytime on demand and there is no ability for these obligations to term out to enable the enterprise time to raise funds to cover any shortfalls. This might present some issues for group members in the event of a cash crunch. The workings of the system are in any case predicated on either expected net generation of excess cash within the cluster of cash pool participants or the existence of available sources of external capital.

Frequent Local Law Issues in Cash Pooling

What follows will discuss some of the frequent legal issues in cross border cash pooling and identify some solutions.

Financial Assistance Financial assistance laws may restrict the ability to use funds to acquire a cash pool participant’s own shares or the shares of its parent or affiliates. This should not be a commonplace occurrence, but needs to be noted and monitored and could arise unwittingly in the course of a corporate restructuring. While the risk would not be commonplace, financial assistance liability can be quite draconian, including both voiding of the relevant transaction and criminal penalties for responsible directors and management. Common advice would be to bar financial assistance transactions under the cash pooling documentation, although this is typically met with resistance by the cash pooling bank due to concerns about how to make these determinations and their ultimate effect.

Some jurisdictions impose a different and more encompassing concept of financial assistance that applies from the mere extension of credit to other entities in the corporate group, whether done physically or notionally. These are typically grounded in corporate law and call into question the authority of the entity to extend such credit. To address these issues, one must normally locate a legal exemption. Some jurisdictions will confer an exemption for transactions among entities which are subject to principles of consolidation and others merely do this so long as the entities are part of a group structure and meet certain conditions.

Arm's Length Standards and Corporate Benefit Other jurisdictions will apply concepts of adequate consideration. Under certain corporate law concepts a loan from a subsidiary to a parent set at other than arm's length terms may be considered an unlawful return of capital. In these jurisdictions, ascertaining market-based intercompany loan terms will be important not just for transfer tax considerations but also under the corporate law principles. This may also be expressed in terms of corporate benefit: if the loan is set at arm's length a benefit can usually be demonstrated. Unfortunately, there is no safe harbor for what would constitute arm's length terms, and determinants vary by jurisdiction. Additionally, such determinations are quite frequently based on specific facts and circumstances. This further means that these intercompany loan terms should be evaluated and reviewed by experts before embarking on a cash pooling program in a particular jurisdiction and after that on a periodic basis.

While these restrictions present a recurrent pattern, some jurisdictions present greater challenges than others. For example, German law requires that German cash pool participants have the right to refuse advances if these do not appear to be fully realizable or if the advance would deprive the cash pool participant of essential liquidity. There are various legal tests and regimens that apply to these determinations.   Sweden would deem loans not capable of repayment or loans on unfavorable terms to the Swedish participant to lack corporate benefit. The effect of this treatment would be to limit the amount of these loans to available distributable reserves. Generally, a well-recognized concept is that when a transaction occurs that reduces assets, it must not occur in an amount in excess of available distributable reserves. Similarly, Switzerland now deems intercompany advances to be dividends for corporate law purposes if the terms of such advances are not at arm's length. Treatment as a dividend means that such advances would be limited by company share capital (retained earnings plus paid in surplus), potentially curtailing the ability of the Swiss cash pool participant to successfully function in a cash pool. In Switzerland, there are various standards, mainly accounting driven, that would enable a cash pool participant to demonstrate that advances were made at arm's length. In practice, this may present issues with the cash pool participant's auditors who should examine the terms of the intercompany advances at inception.

Solvency and Prospects for Repayment In some jurisdictions there may also be an underlying presumption (which should be verified by managers) that the cash pool participants receiving extensions of credit have the ability to repay them. The law may provide that in the case of insufficient or deteriorating credit, collateral or credit enhancements must be furnished. This is normally not a practical solution, however. A corollary to this legal test may also be the legal requirement for managers to make a determination that participating in cash pooling does not jeopardize the existence of the cash pool participant or risk its insolvency.

Reporting While this article does not discuss jurisdictions that impose currency and exchange controls (because they are typically not viable for cash pooling) even jurisdictions that accommodate cash pooling may impose central bank monitoring or public registration and reporting requirements. A Czech entity may be subject to reporting to the Czech National Bank for transactions exceeding a cumulative monetary threshold in a given year and also based on amounts outstanding at year end. The Netherlands may require reporting to the central bank for purposes of government data collection and Slovakia also requires reporting of foreign assets and liabilities above a certain level. Typically, such reporting requirements do not provide exceptions for intercompany transactions.

Consequences When Things Go Wrong   For a solvent, creditworthy multinational, the good news is that many of the above concerns can be addressed with appropriate steps. When an enterprise experiences financial difficulty many of the limiting concepts discussed above come into play. While laws vary across jurisdictions, director and management team liability, both criminal and civil, is a real possibility if appropriate steps are not taken. Importantly, to the extent any action results in an illegality, there could be consequences for publicly traded companies that may include a need to disclose, which itself creates reputational and possibly credit risk. This would be especially true with regulated industries. Any solution requires close consultation with counsel in each jurisdiction and with the cash pooling bank.

A correctly-implemented and monitored cross border cash pooling program offers substantial financial benefits to multinationals. Any successful program requires close consultation among treasury, accounting, tax and legal professionals. Attention to local country compliance of the sort described above is one important aspect of a successful cross border cash pooling program.

Creighton R. Meland, Jr. is a partner at Baker & McKenzie LLP, Chicago ([email protected]). The author gratefully acknowledges the helpful comments to this article furnished by Stan Sirot, Associate, Baker & McKenzie LLP, Chicago.