INTM503130 - Cash pooling: setting interest rates for participants on an arm's length basis
Application of the arm’s length principle
Following on from Example 1 provided in INTM503110, the allocation of the benefit of the cash pool (the £800k saving in Example 1) must be in accordance with the arm’s length principle. As stated in Section 147 TIOPA 2010, the arm’s length principle is “that which would have been made as between independent enterprises” and the UK legislation, at Section 164 TIOPA 2010 et seq., goes on to say that this should be interpreted in accordance with the OECD Transfer Pricing Guidelines.
Interest rates are typically used to allocate the benefit (£800k per Example 1, see INTM503110) among the depositors, borrowers and cash pool header. The spread between deposit rates and borrowing rates will often result in a “residual” amount, which is the remuneration of the cash pool header for their involvement. The cash pool header may alternatively be remunerated on a cost plus basis for the services provided, with the residual benefit flowing to the depositors and borrowers dependent on the cash pool header’s functions, assets and risks.
One of the difficulties with applying the arm’s length principle to cash pooling arrangements is that these arrangements are not entered into by independent enterprises, so there is no comparable uncontrolled price that you can use to assess how interest rates would have been set among independent third parties for the cash pooling arrangement as a whole.
Example 2 – how the interest rates affect where the benefit is allocated
To emphasise the importance of choosing the correct internal interest rates to be applied, the figures from Example 1 in INTM503110 have been used to show how the benefit flows to different participants, depending on the interest rates chosen. How the financial benefit of the cash pooling is split between the different participants should flow from the analysis of functions, assets and risks of each participant, which may vary considerably depending on the specific facts and circumstances of the cash pool. Therefore, it is difficult to provide a prescriptive approach which fits all circumstances.
- All the benefit flows to the borrowers
| External interest rates (without the cash pool) | Internal interest rates (with the cash pool) | |
|---|---|---|
| Deposit rate (instant access) | 0.5% | 0.5% |
| Borrowing rate (repayable on demand) | 2.5% | 0.5% |
| Company | Jurisdiction | Funding required -) £000’s | Excess funds held (+) £000’s | NO CASH POOLING Interest payable (-) /receivable (+) £000’s | WITH CASH POOLING Interest payable (-) /receivable (+) £000’s | SAVING/(-COST) TO COMPANY FROM CASH POOLING £000’s |
|---|---|---|---|---|---|---|
| A Ltd | UK | -10,000 | 0 | -250 | -50 | 200 |
| B GmbH | Germany | -30,000 | -750 | -150 | 600 | |
| C Sarl | Luxembourg | 40,000 | 200 | 200 | 0 | |
| D NV | Netherlands | 0 | 0 | 0 | 0 | |
| Total | -40,000 | 40,000 | -800 | 800 |
- All the benefit flows to the depositors
| External interest rates (without the cash pool) | Internal interest rates (with the cash pool) | |
|---|---|---|
| Deposit rate (instant access) | 0.5% | 2.5% |
| Borrowing rate (repayable on demand) | 2.5% | 2.5% |
| Company | Jurisdiction | Funding required (-) £000’s | Excess funds held (+) £000’s | NO CASH POOLING Interest payable (-) /receivable (+) £000’s | WITH CASH POOLING Interest payable (-) /receivable (+) £000’s | SAVING/(-COST) TO COMPANY FROM CASH POOLING £000’s |
|---|---|---|---|---|---|---|
| A Ltd | UK | -10,000 | 0 | -250 | -250 | 0 |
| B GmbH | Germany | -30,000 | -750 | -750 | 0 | |
| C Sarl | Luxembourg | 40,000 | 200 | 1,000 | 800 | |
| D NV | Netherlands | 0 | 0 | 0 | 0 | |
| Total | -40,000 | 40,000 | -800 | 800 |
- All the benefit flows to the cash pool header
| External interest rates (without the cash pool) | Internal interest rates (with the cash pool) | |
|---|---|---|
| Deposit rate (instant access) | 0.5% | 0.5% |
| Borrowing rate (repayable on demand) | 2.5% | 2.5% |
| Company | Jurisdiction | Funding required (-) £000’s | Excess funds held (+) £000’s | NO CASH POOLING Interest payable (-) /receivable (+) £000’s | WITH CASH POOLING Interest payable (-) /receivable (+) £000’s | SAVING/(-COST) TO COMPANY FROM CASH POOLING £000’s |
|---|---|---|---|---|---|---|
| A Ltd | UK | -10,000 | 0 | -250 | -250 | 0 |
| B GmbH | Germany | -30,000 | -750 | -750 | 0 | |
| C Sarl | Luxembourg | 40,000 | 200 | 200 | 0 | |
| D NV | Netherlands | 0 | 0 | 0 | 800 | 800* |
| Total | -40,000 | 40,000 | -800 | 800 |
*In this case, as a result of using external interest rates as a comparable uncontrolled price (“CUP”), all the benefit of the arrangement must automatically remain with the cash pool header. One should consider whether the functions, assets and risks of the cash pool header in relation to the arrangement justify the benefit remaining with this company.
- All the participants are made better off through the use of more favourable interest rates, and the spread between the deposit rate and borrower rate is the remuneration of the cash pool header company
| External interest rates (without the cash pool) | Internal interest rates (with the cash pool) | |
|---|---|---|
| Deposit rate (instant access) | 0.5% | 1% |
| Borrowing rate (repayable on demand) | 2.5% | 1.5% |
| Company | Jurisdiction | Funding required (-) £000’s | Excess funds held (+) £000’s | NO CASH POOLING Interest payable (-) /receivable (+) £000’s | WITH CASH POOLING Interest payable (-) /receivable (+) £000’s | SAVING/(-COST) TO COMPANY FROM CASH POOLING £000’s |
|---|---|---|---|---|---|---|
| A Ltd | UK | -10,000 | 0 | -250 | -150 | 100 |
| B GmbH | Germany | -30,000 | -750 | -450 | 300 | |
| C Sarl | Luxembourg | 40,000 | 200 | 400 | 200 | |
| D NV | Netherlands | 0 | 0 | 0 | 200 | 200 |
| Total | -40,000 | 40,000 | -800 | 800 |
Typically, the group will set the interest rates such that each of the participants is slightly better off than they would have been without the arrangement, when compared to depositing and borrowing from a local third party bank. Depending on the facts and circumstances of individual depositors and borrowers, there may be instances where at arm’s length, a participant may accept a less favourable interest rate because they are compensated by other benefits from the arrangement (e.g. a depositor who valued having access to cheap finance on a borrowing facility if required). However we would not expect this to be the norm.
Recent revisions to the OECD Transfer Pricing Guidelines emphasise the need to ensure that the UK company, in whichever role, is getting the appropriate return, and not retaining benefits (or for that matter, disproportionately suffering disadvantages) which it should be sharing with other group members. The material at D.8. (Para 1.157-1.173 of the revised Guidelines), currently contained in the OECD Final Report on Aligning Transfer Pricing Outcomes with Value Creation (published October 2015), discusses sharing the benefits and burdens resulting from “deliberate concerted group actions”. The main example discussed is that of procurement companies, but the principle is that group synergies should be shared among the companies whose concerted action gives rise to the benefits. Once the party performing the centralised function has been appropriately rewarded, remaining benefits should be shared among the group members. This exercise will be based on assessing the functional capabilities and degree of risk attributable to the cash pool header, as well as the relative contributions of the various participants. To be able to bear the risk, the cash pool header will have to be adequately capitalised, and the degree of expertise, independence and authority which it holds must be assessed.
For a cash pool, part of the consideration will be to maintain liquidity in the pool, so it would be counter-productive to price in a way that undermined that liquidity, but equally, it may be advisable to allow for a review of the pool header’s reward, a year or two after any in-depth review, to ensure that any inaccuracy in the original pricing or a change in circumstances has not led to an unmerited accumulation of profits or losses.
When considering the guidance on group synergies in the context of a cash pool arrangement, we should recognise that there is the possibility of the cash pool overall making a loss as well as a profit. If, for example, interest rates move unexpectedly and there aren’t enough deposit balances to match borrowings, the pool header may have to take on debt which is more expensive than the interest rate which it is lending out at to group borrowers. Therefore, unless the participants would be happy taking a share of this loss (which is unlikely given they are normally trading companies), we would not expect the full amount of benefits to flow to the participants in the way that perhaps they would in a procurement company example, where there is practically no downside risk.
The above examples illustrate how relatively straightforward it is to move profits from one jurisdiction to another through the use of the interest rates being applied. If the cash pool header is located outside the UK, HMRC would normally not have visibility of how the benefit of the arrangement is being allocated among the participants, and instead would previously have considered whether the particular UK borrower/depositor is acting as an independent enterprise in respect of the cost of its borrowing or the return it is receiving on its cash deposits. However, the new BEPS guidance requires us to look at the arrangement and the benefit it brings as a whole, moving away from the one sided approach.