Magazine du trésorier, May 2018

Luxembourg: cash pooling and transfer pricing requirements

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The transfer pricing framework (i.e. prices charged between associated enterprises) governing the practice of cash pooling is currently evolving. In July 2017, the Organization for Economic Co-operation and Development (OECD) published recommendations and new principles on financial transactions that are expected to be adopted by the OECD in the course of 2018.
The Luxembourg legislator has implemented rules which transcribe into Luxembourg law the arm's length principle and documentation conditions. These rules are in line with the new OECD BEPS (Base Erosion and Profit Shifting) requirements.

Under Luxembourg law, the deductibility of interest expenses at the level of the cash pooling central entity (cash pool leader) is thus subject to the arm's length principle. This principle is therefore of major importance for the many groups that have their treasury operations in Luxembourg.

Basic principles

Cash pooling allows cash flow centralisation and optimisation within groups. As a result, it has become an essential tool in cash management.

Two types of cash pooling are usually implemented: (i) physical cash pooling (zero- balancing cash pooling) with a physical transfer of participants’ cash to the cash pool leader at the end of the day or (ii) notional cash pooling with no physical cash transfer. Both types of structures are nevertheless subject to the same transfer pricing principles.

The main advantage of cash pooling is an improvement in borrowing and deposit conditions on the market. Thanks to synergy effects, cash pooling stakeholders can benefit from conditions that would not have been available in the absence of such a structure.

Based on the OECD recommendations published in July 2017, when corporate synergies arising from deliberate, concerted group actions provide material advantages that are not typical of comparable independent companies, three elements are to be analysed: (i) the nature of the advantage, (ii) the amount of the benefit provided and (iii) how that benefit should be divided among members of the group1. Given that cash pooling generates such an advantage through synergies, it needs to be analysed under each of these aspects.

OECD recommendations

Nature of the advantage

The improvement of borrowing and deposit conditions for cash pooling stakeholders is essentially linked to the following two elements:

  • Benefits are realized through cash flow netting at the level of the cash pool leader. The cash pool leader generally has a better credit rating as it profits from both a diversified risk profile (it diversifies its risk by lending to many entities of the group) and implicit (or explicit) credit support from the group. Within cash pooling, only the cash pool leader borrows on the market. This reduces counterparty risk for third-party banks and ultimately interest rates on borrowings.
  • Benefits are realized due to the larger cash flow volumes obtained by pooling the cash flows of the different participants. These larger volumes provide better market conditions, such as reduced bank costs or higher interest rates on deposits.

Amount of the advantage

The amount of the benefit conferred by the cash pooling is to be estimated by analysing the conditions obtained by the cash pool leader on the market and those that the participants would otherwise obtain. Recent or estimated future cash pooling balances are also to be analysed in order to estimate this benefit.

Distribution of the advantage

The OECD recommendations published in July 2017 advocate allocating synergies by members of the group in proportion to their contribution to the creation of the synergies2.
The contribution of each of the stakeholders to the cash pooling must therefore be estimated on the basis of the functions performed, the risks incurred and the assets held. One could also refer to the economic theory that recommends allocating netting benefits to the cash pool leader and volume benefits to the participants. Different scenarios can therefore arise:

  • The cash pool leader only performs coordination/intermediary functions between the participants and third-party banks. Cash pool participants incur the vast majority of risks. In this case, remuneration corresponding to administrative functions should suffice to remunerate the cash pool leader. The residual profit should be distributed among the different participants by using an appropriate allocation key.
  • The cash pool leader has a functional profile similar to that of a third-party bank. It has the know-how, bears significant risks and has the capacity to bear these risks. In this case, the cash pool leader should generally earn an arm’s length handling fee (covering administrative functions) and a return for its equity at risk (covering risks related to the granting of funds within the cash pooling). The residual profit is again to be allocated to the participants through the use of an appropriate allocation key.
  • A simplified approach involves allocating netting benefits to the cash pool leader and volume benefits to the participants. The distribution of profits is then to be made on the basis of recent or estimated future cash pooling balances. The implementation of such an approach will depend on the materiality of the transactions and the approach of the involved tax authorities.

The distribution of the benefit conferred by cash pooling between the parties will allow an estimation of the interest rates to be applied within the cash pooling.


Conclusion


The OECD principles may have a material impact on cash pooling transactions and their application may be quite complex. In the context of bringing Luxembourg law in line with international requirements, these principles and their evolution must be carefully considered and appropriately used in a transfer pricing study.


 

1. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017, paragraph 1.161

2. OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017, paragraph 1.162