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Barriers to Cash Pooling
Corporates looking to improve their liquidity have focused on cash pooling with renewed vigour since the credit crunch. In this article, we take a look at some of the problems treasurers face when putting these structures in place, focusing in particular on the challenge of getting subsidiaries on board with a new pooling structure.
In a bid to become more self-sufficient in terms of liquidity, treasuries have had more reason than ever to practice cash pooling since the credit crunch. While cash pooling enables corporates to maximise returns in a miserly interest rate environment and cut down on overdraft fees, treasurers continue to face a number of difficulties when introducing these structures.
Many of the problems corporates face when pooling their cash are well-known and encountered by most companies at some stage in the pool's implementation. Other problems are specific to individual countries or spheres of industry.
Getting subsidiaries on board
Notional pooling has become increasingly popular in some parts of the world - especially those in which the movement of physical funds is restricted or imposs ible. The practice is very popular in the Netherlands and has slowly caught on in other parts of the world. While it provides an ingenious means of working round the barriers to physical pooling, it is not without its own problems.
In order for a bank to operate a notional cash pool on oehalf of a company, the participating entities must allow heir bank accounts to be included in the notional header account. They do this by signing an agreement - a right of offset - that allows the bank to net the subsidiary's balance with the others in the pool.
Perhaps understandably, subsidiaries are sometimes reluctant and even unwilling to participate in a group cash, pool operated under these terms. It exposes them to the losses of their fellow pool members and can mean that should one or other subsidiaries go bankrupt, they could be liable for the shortfall.
In other cases, subsidiaries which have maintained strong relationships with their local banks and those that have strong cash positions are sometimes reluctant to give them up. Installing a cash pool structure often means that a regional or global bank takes the place of the local bank.
"The idea that cash is king means some subsidiaries are reluctant to participate in the pool. They are not really willing because they might lose their independence. Cash pooling is very democratic, but it's intrusive, too," says Enrico Rao, Group Treasurer of Alpitour .
Roche
This was part of the problem faced by Roche's treasury team when it decided to introduce a global cash pool. Martin Schlageter, Head of Treasury Operations at Roche, says if the subsidiaries had reservations at first, these were soon overcome : "We told them, you get better interest rates with us. Whatever you do with your cash, there is no way of getting better than from us," he explains.
For the most part, Roche's cash pool implementation passed without incident. The changeover did, however, face a unique set of problems in North America, where a legacy treasury centre which oversaw operations had to be shut down if the pool were to function on that side of the Atlantic.
"The introduction of cash pooling and in-house banking had of course an impact on our local or regional treasury organisations. To carefully manage their transition into the new structure was probably the most critical stage in the process ", he says.
Tenneco
These problems aren't rare when it comes to introducing a cash pool with global reach. Gary Silha, Assistant Treasurer at Tenneco Inc., tells a similar story. For him the resistance at the local level was minimal because he took the subsidiary's concerns in hand from the start. A notional pool, he realised, would allow the subsidiaries to retain their local banking relationships and therefore reduce friction at the grassroots level.
The cash never leaves the subsidiary legal entity. All they are doing is sending their cash up and earning a rate of interest that they wouldn't at the local level perhaps. Or if they need cash and are running an overdraft at the pool they're borrowing, vvhich they wouldn't be ab le to do locally," he says
For corporates who haven't been as successful as Schlageter and Silha in convincing the troops on the ground that a cash pool is the way forward, the lack of a right of offset can prove a real barrier when it comes to pooling cash noitionally.
It means that the balances appear on the corporate's and the bank's balance sheets gross - not net. For the banks, deficit balances on a bank's balance sheet appear as non-performing loans unless the right of off-set has been established. This can have an impact on the pricing the bank is able to offer corporates and can affect the corporate's cost/benefit analysis as a result.
The guarantees and right of offset allow the banks to use surplus funds to cover deficit positions at other subsidiaries. In the Netherlands, however, this does not apply, which perhaps serves to explain the popularity of the country as the location of many notional pool headers.
Other obstacles to cash pooling
When cash is pooled physically, interest payments between members of the pool may be liable to withholding tax when the cash is swept across national frontiers.
This tax is reduced or eliminated in countries which have signed double tax agreements (DTA), but in places where this isn't the case this tax can prove a real barrier to cash pooling.
It is not just withholding tax that can impede the successful operation of a physical cash pool. Certa in countries impose exchange controls on the movement of their currency and thereby limit the cash pooling that can be performed in the country.
Fewer tax issues are associated with notional pooling than with physical pooling, but the former can give rise to a number of corporate governance issues (see below) within an organisation. These can affect the internal dynamics of an organisaiton and inhibit the successful implementation of the pool.
Cash pooling: an overview
Physical cash pooling - or cash concentration, or zero balancing (ZBA) as it is also known - involves the physical sweeping of a subsidiary 's surplus cash from a number of bank accounts into a single header account. Funds may also be transferred from the header account to participant accounts to cover any debit balances. The accounts can be held in one or a number of countries.
In a notional pooling arrangement, as the name suggests, the cash doesn't move, but the bank that operates the pool applies an 'overlay structure' to the several accounts. This allows the bank to notionally off-set the individual balances in the pool and net the various surpluses and deficits. Interest is then applied to this aggregated balance by the bank.
Notional pooling allows cash to be pooled across national borders and currencies, relieving the treasury of the problems associated with FX exposure and withholding tax that comes with ZBA pooling
Co-mingling, hybrids and Eastern Europe
A company wishing to zero balance cross-border accounts needs to ensure that its bank or banks support the structure and are able to perform automated cash sweeps.
Corporates in some countries find obtaining the necessary go-ahead from the authorities difficult or sometimes impossible because of the laws that govern cash concentration and notional pooling. In the United States, for example, notional pooling is not permitted (IRS regulations don't allow it). The same goes for Italy.
The banks can provide workarounds for some of these problems and they usually involve the implementation of some kind of hybrid structure in which the subsidiaries in those countries able to notionally pool do so and those that can't have their funds transferred back and forth via inter company loans.
In some countries, cash pooling isn't permitted at all. This is especially true in parts of Central and Eastern Europe, where developments in cash concentration have inched forward over the past few years, but as yet lag far behind developments in the western half of the continent.
This is the case in countries like Belarus, Croatia, and the Ukraine, for example, where cash pooling of any type is seldom - if ever - practised in any real sense. It's a similar story in Russia and Poland, where tax and regulatory issues mean cash pooling is tricky, but not impracticable.
In the latter, each transfer of cash made via a cash pool incurs a 2% tax. This has prompted corporates to find workarounds to this problem and most have now opted for either Cinderella pooling - ie sending the cash up to the header overnight and back to the subsidiary in the morning - or offshoring their cash to zloty accounts held outside Poland.
The domestic appliances manufacturer lndesit has recently taken the second course of action. It sought and obtained the go-ahead from the country 's central bank to allow it to operate a hybrid pooling structure which would see it maintain a zloty account in Amsterdam and sweep funds back and forth across the border. This would allow the Polish-based entity to draw on the overseas zloty account as long as the euro account in the Netherlands was in credit.
"At first we got a mixed answer from the financial authorities," says Mustafa Kilic, the company's Regional Treasurer and Group Insurance Manager. "They were treating the solution as one of the traditional instruments. They thought it was a notional pool , but it's not - it's a hybrid pool."
"It wa s difficult to explain to them what it is and how it works because it 's a new instrument. On the banking side. they aren t offering any help to their clients, so companyes are alone. They have to get the approval alone. It was the biggest difficulty we faced," he adds.
A similar set of circumstances presents itself to corporates looking to pool their cash in Russia, says UniCredit's Markus Straussfeld, Head of Cash Management and sales:
"Cross border pooling is a challenge. Haveing it in place with one client doesn't necessarily mean you can do it with another client.''
Interest enhancement
It's not just in Eastern Europe where treasurers face difficulties. Certain regions and countries do not permit pooling at all. In China, where direct inter-company lending is not permitted, cash pooling arrangements can only be made via an entrustment loan, an instrument that allows funds to be lent from one party to another and which is operated by a third party, thus solving the prohibition of inte r-company lending.
In other parts of the world interest enhancement can help squeeze extra yield out of un-pooled cash which the bank aggregates in a way tha t shares some characteristics with notional pooling.
In countries where cash pooling is difficult or impossible, the banks have developed a number of novel workarounds for corporates wanting to make the most of their cash, but whose hands are tied by red tape, says Ian Blackburn, Senior Product Manager, Liquidity Solutions at- HSBC.
"Where there are restrictions and barriers on getting funds out of a country then techniques such as interest enhancement can be used - where the bank will apply relationship pricing to standalone accounts.
This means you can still get some benefit from funds in a country by the bank looking at the aggregate balance picture rather than on a country-by-country basis, which is of particular relevance in the emerging markets."
Transfer pricing, thin cap and arm's length pricing
Finally, legal constraints present a number of barriers to both physical and notional cash pooling structures.
Transferring funds between different entities constitutes an intra-group transaction and as such leaves the corporation open to charges of hidden profit distribution and transfer pricing manipulation if the transfers aren't made in accordance with thin capitalisation rules and the arm's length principle.
The so-called arm's length principle means that any intra -company loans or interest that is shifted from one part of the company to another must reflect the interest rate spreads they would receive from a third-party lender. Corporates who fail to stick to these principles expose themselves to tax on the interest on their debt repayments.
Thin capitalisation rules usually restrict the ratio of debt to equity - 'thin capitalisation' means that the level of debt and corresponding interest payments are too high in relation to a company's equity. Companies need to comply with thin capitalisation rules to avoid transfers being treated as either non-deduc tible or as dividends , and thus being taxed. While thin capitalisation rules have not been set with cash concentration in mind, any physical cash pooling arrangement will need to consider the rules of all locations participating in the cash pool.
The members of the cash pool must monitor these debt levels if the pool is to operate efficiently. Similarly, the members of the cash pool which loan the funds must ensure that the interest it receives is in keeping with arm's length pricing and transfer pricing rules.
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