The cash management function is demanding more accurate and continuous information on its cash position to provide responsive forecasting data and handling, so that availability of liquidity at the right time and price can be ensured.
As a result, cash managers are turning to the banks for more sophisticated cash and liquidity management solutions to improve their liquidity management. To meet this demand, banks need to develop new or more advanced liquidity management solutions. And to develop a successful solution as a bank, it is imperative that any liquidity solution understands the current and future demand of the client, and is compliant to the existing and future regulatory environment.
But what are the demands and regulations a bank needs assess to improve its liquidity management solution? To address this question, we first need to look at which solutions are already available within the market.
Liquidity Management Solutions in the Market
The two core liquidity management techniques are netting and cash pooling. Netting aims to reduce the transfer of funds between subsidiaries or separate companies by settling the funds to a net amount. Netting can be achieved by internal processes or a third party that enables the matching of transfers.
Cash pooling allows enterprises to combine positive and negative positions from various bank account into one account. Pooling is a common treasury technique that can improve the balance sheet through efficient use of internally generated funds. This aims to reduce the short-term borrowing costs and maximise returns on short-term cash. Pooling can be accomplished through by two ways, namely physical or notional.
Physical pooling, or cash concentration, is an automatic transfer of funds from clearly defined sub-accounts to a master account on a value date basis. Cash concentration can occur domestically or cross-border depending on the corporate structure and capabilities of the bank partner. There can be several individual specifications for the subaccounts, for example minimum balance held on the account, minimum amount for transfer or fixed time or days for transfer of funds. Cash concentration can be done either in single currency or multi-currency. Cash concentration multi-currency functionality involves currency conversions. Both involve complex bank account structures.
Notional pooling is the offsetting of consolidated cash surplus and deficits in separate bank accounts. It has the same objective as cash concentration, except that there is no physical transfer of funds between accounts. All participating accounts are combined virtually for the purpose of interest calculation, whereby balances are automatically offset, which results in a reduction of the difference between debit interest on debit and credit interest on credit balances. The interest is paid on the net balance position and the results are compensated.
The interest paid can either be posted to one of the involved bank accounts or to a separate account. Also, there is the possibility to allocate the interest back to each of the sub-accounts of the involved participants in proportion to its contribution of the offset interest.
Implementation of International Cash Pooling
During the implementation or optimisation of a cash pooling structure, enterprises have to consider internal and external aspects:
- Internal: treasurers have to take into account the company strategy (e.g. expansion-orientated), the organisation structure (domestic and international), internal policies in respect to cash, dividend, risk and inter-company loans.
- External: these aspects include legal and tax requirements, bank services and structure, costs, foreign exchange (FX) risks, international and national cash pooling specifications/requirement, regulatory reporting, and national capital controls.
These aspects have to be considered by the corporate treasurer, but also by the service providing bank, before the bank can offer an appropriate solution. To understand which part of the solution offering could be automated, it is important to take into account the external aspects described below.
The implementation of efficient cash pooling structures differs from region to region. Single currency pooling structures can be much easier to implement than a multi-currency pooling. Also, some countries have put up boundaries due to their central bank regulations. Others have put up boundaries for only their own domestic currency e.g. if their domestic currency is not fully convertible.
- Asia/Far East: implementing corporate cash pooling structures remains a challenge for organisations in Asia and the Far East. Distinct tax and legal requirements, as well as prevailing capital controls and inherent FX rate risks, often prevent enterprises from executing cash pooling. In Asia, China, India, Indonesia, Malaysia, Pakistan and Vietnam do not allow notional pooling participation, while Korea, the Philippines and Taiwan allow participation. In the Middle East, an increasing number of countries are willing to allow cash pooling. Examples include Israel, Saudi Arabia, UAE, Kuwait, Bahrain and Tunisia.
- North America: countries such as Puerto Rico and Mexico allow their currencies to participate in a notional pool, but US only allows cash concentration. Canada permits notional pooling, provided the financial institution has the ability to unconditionally set-off pooled deposits and overdrafts.
- Europe: due to the harmonisation of tax and legal requirements of the EU, pan-European cash pooling structures can be implemented, in most cases, very effectively. In Europe, cash pooling structures are common practice, with exceptions of Belarus and Malta. In Croatia and Ukraine, domestic cash pooling structures are available, but there is no practice of cross-border pooling structures due to a lack of FX controls.
- Africa: Africa is still a troubled continent regarding cash pooling. In South Africa, cash pooling is allowed, but in other countries, regulations regarding cash pooling are non-existing, but also non-existence of exchange controls and local market circumstances of several countries contribute to non-existence of cash pooling services. But some African countries are changing rapidly and it will be a matter of time before these services will be available.
The regulatory reporting and approval required in many countries is extremely cumbersome and the administration cost of pool definition is considerable higher because of the regulatory issues.
Standby fees, economic guarantee fees and similar payments can be seen in some countries as payments of interest. These fees, therefore, are structured by different rules for tax purposes by different countries and can be subject to different tax treatment with the recipient. Due to the complexity, enterprises are discouraged from entering into an international pooling arrangement.
Any enterprise with operations in more than one country will need to make and receive intergroup, cross-border payments. For the most part, these payments consist of interest payments on inter-company loans and dividend payments from subsidiaries to headquarters. Both these payments are subject to tax, known as withholding tax.
These taxes are mostly applied on cross-border payments between companies, but also some countries demand that the tax is applied to domestic payments, e.g. intergroup payments between central treasury and a local subsidiary.
But legislation around withholding tax is not the same in all countries. Some countries use specific definitions of interest in their tax rules. Other countries clearly state that guarantee fees are similar to interest for the purpose of withholding taxes. And other countries have less broad definitions.
Also, analysing whether and at which percentage withholding tax is due becomes highly complicated in case of notional pooling. Basically, any interest in the settlement payments made by a debtor in the pool has to be divided between all the pool members that hold a credit balance in the pool. This is easier in cash concentration, where there is only one party involved, namely the pool leader who holds the master account. Also, enterprises can reduce the withholding tax liability by locating the central treasury in a country with a good double taxation treaty network.
This allows an enterprise to eliminate or reduce the liability to have to withhold tax and may also offset a withholding tax liability in one country against the liability in the country, where the central treasury is located.
Another aspect is the timing of any tax filing. Where withholding taxes must be declared and paid on a cash basis and when interest is settled, a notional pooling arrangement will raise questions, such as when the withholding tax is due.
These questions don’t have to be asked in a zero balancing arrangement, since the pool leader will mostly provide periodical details and invoices for the interest due on debit balances.
Thin capitalisation rules determine the maximum extent to which an enterprise may cover its capital requirement with external capital, such as a parent company to its subsidiaries. It aims to limit the amount of debt financing provided by foreign shareholders or parent companies to its subsidiaries, ensuring the subsidiary has an adequate debt-to-equity ratio.
Regulations regarding thin capitalisation are not unified from region to region, which complicates cash pool structures. This lack of clarity results in tax issues, as interest paid to the parent company can be subjected to dividend tax, which is not eligible for business expense deduction. In some countries, enterprises can deduct interest payments on foreign shareholder loans or other cross-border, inter-company loans from their tax obligations. Furthermore, in most countries, thin capitalisation rules will only apply in respect to interest payments made between companies that are members of the same group.
Membership of the same group will depend on each country’s own legislation. Therefore, thin capitalisation rules can affect cash pooling. With the introduction of a cash pooling arrangement, multinational groups can be confronted with limitations to funding its subsidiaries due to the country’s debt-to-equity ratio. In addition to this, payments made on overdrafts under a cash pooling arrangement are like payments to group companies, whereas without cash pooling, these payments could remain payments to third parties and thus outside of the scope of the thin capitalisation regulation. This could affect the deductibility of taxes.
With cash concentration, the ‘arms’ length’ principle suggests that the interest income received from the master or pool leader should not be less than what would have been received from a third party. And vice versa, the interest charged should not be higher than a third party rate, which could be difficult to achieve, depending on the structure of the pool.
When applying notional pooling techniques, the owner of the pool must allocate the payments in the same way as intra-group payments to avoid transfer pricing issues. They should, therefore, use the arms’ length principle. Non-compliance with these rules could put an company in a difficult situation. As deposits in the notional pool will benefit both stronger and weaker parties, the issue with thin capitalisation is more complicated, because the allocation of interest should reflect the balance differences.
Most developing countries have very strict regulations regarding FX. In most of these countries, local currencies have restrictions and are not as freely convertible or as widely traded as hard currencies. These restrictions include market intervention and capital controls and/or limited international tradability. These restrictions add challenges to organisations that want to do international cash pooling.
Technology and Infrastructure
To reap the benefits of liquidity management solutions, adequate business processes and technologies need to be in place at the enterprise side and at the bank of choice. For the enterprise, this means having an integrated finance organisation, globally managed standards, consolidation of various cash management and payment transaction applications and centralisation of all cash management activities. Many enterprises are still struggling to reach the desired level of centralisation and optimisation.
But the service-offering bank also needs to have optimised processes and products that add value to the client’s desired level of optimisation and centralisation. Currently, most banks don’t offer multi-currency, multi-country end-of-day notional pooling and/or end-of-day cash concentration. To offer these services, banks have to optimise their systems and make use of centralised applications. In addition to this, banks have to take into consideration new regulations (such as Basel III), time zones, region preferences, local regulations and credit risk. But banks don’t just need to offer the correct service, this service also has to have the ability to meet the information demand of its clients.
So what will the future of international cash pooling bring, when there are so many aspects to be taken into account?
In the future, international cash pooling will have new dimension due to the introduction of multi-currency, multi-country notional pooling and cash concentration without the use of an FX transaction. This is possible by first consolidating accounts in the same currency pool using notional or physical pooling of account balances in multiple locations, and perhaps even multiple banks, to calculate the net balance in the base currency chosen by the enterprise and by adding these account to a multi-currency notional pool or cash pool.
The interest applied to these cash balances will increase interest income as well as adding value to other liquidity management requirements, such as visibility and control of global cash without FX transactions or risk.
How to develop a multi-currency international cash pool
By using the services of a local bank where possible, each local entity/ subsidiary can centralise its local balances to its own local master account. This centralisation can be done automatically or manually during the day or end-of-day. When using end-of-day, time zones, opening hours and the location of the top master account will have a greater impact. The local debits will be funded from the local notional pool/physical pool with optimised credit facilities.
After centralising individual countries, organisations will be able to centralise these individual countries to a global structure, varying cash surplus and deficit positions of the worldwide group companies. When using notional pooling, the credit and debit balances will be offset on a multiple currency basis without moving or converting the currencies. This offsetting process will result in a total consolidated cash position. This consolidated position will need to apply proper interest conditions to all of the cash pool accounts. The cash pool bank needs to reallocate the pool interest margins, effectively an intra-company margin, to its clients on compensated balances in the cash pool.
To meet the requirements of visibility and information, internet reporting of all account positions needs to be available real time, or near real time. By using multi-currency, multi-country end-of-day cash concentration, companies have to consider consequences such as a delay of funds received on the master account or a delay of funds received on debit balances on sub-accounts.
Due to timelines and the opening hours of the bank’s back office system, there could be delays when funds are received or send. For example, consider that a master account is located in Hong Kong, while a sub-account is based in the UK. While the value date of Hong Kong will be closed, the sub-account in the UK will be open. After closure, the surplus of the UK will be transferred to Hong Kong with a value date of yesterday and will be accessible when Hong Kong reopens. This means there is a time span where the funds are in the system.
Due to value dating and back value transaction methodology, the enterprise can make use of true end-of-day cash concentration. The master account can be a multi-currency account, which decreases the FX risk exposure.
Benefits of new services to corporates
By using these new types of services, organisations will be able to integrate and automate their international transactions, exposure management strategies, FX payments and receipts as well as highly sensitive tax transactions and accounting requirements such as inter-company loans administration.
In most cases, structures including domestic and international services, notional pooling and cash concentration will be in place for companies to receive the most benefit from these services, in a format most suitable for their tax and regulatory requirements.
With these new services, companies will be able to integrate and automate their international transaction exposure, while the services will be able to mitigate the cost of fluctuating account balances and capture interest spread. But next to these services, excellent information sharing and visibility is required to meet the growing needs of the corporate treasurer and cash manager.
The bank that can meet the growing needs of corporate treasurers and cash managers for these new service offerings and understands the issues that are faced in international cash pooling, will win the day.
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