The Added Value of Centralised Cash Management under BEPS

What would be the correct price (i.e., the arm’s length transaction) of a cash transaction under BEPS (Base Erosion Profit Shifting) Actions 8-10? That’s a key question which every treasurer of an international group needs to address. The right answer is far from easy to apply, but the guide currently being finalised for issue by the OECD helps to provide a clearer view and specifies what needs to be done.

The ‘right price’ for a cash transfer

Under the latest BEPS guidelines, an appropriate and fair transfer price also applies to all cash transfer operations. In practice, however, working out this ‘fair price’ is not always straightforward, and there  is still a risk of seeing the operation reclassified. Some treasurers have not changed their modus operandi one iota and believe there is no problem with their as-yet unchallenged approach. It would seem apposite, however, to ask the question for every funding operation, especially as a guide is currently being finalised by the OECD in order to help treasurers determine the right margin to apply and the criteria to be factored into the equation. 

It’s frequently forgotten, but the first major principle is to align the transfer price (TP) with the amount of value creation. Sections C, D & E of the guide specifically address cash pooling, intra-group funding, hedging, guarantees and reinsurance captives. When abstractions are made from the legal or fiscal rules, the capital debt ratio of an entity of a multinational company (MNC) should be the result of purely commercial considerations and left to the discretion of the group itself. The question is whether an independent entity operating in the same circumstances would benefit from the same borrowing conditions. The idea is to verify that the rate applied is well and truly ‘at arm’s length’ or whether it should in fact be regarded as a sort of payment or capital contribution. Each country can apply its own capital structure before considering the question of the acceptability of the level of the transfer, so this guide should be taken for what it is, an indication only. However, it’s fair to assume that the tax authorities will draw inspiration from it and alignment with them can only be a good thing. But each operation still needs to be analysed separately on its own merits rather than as a whole with others, and this involves more documentation and individual analysis. 

An individual and sectoral approach

The OECD has acknowledged the difference between activities and the need to take the sectoral aspect into account. A group’s overall approach to TP should be guided by an overall funding strategy that is the starting point for all consultation. Each transaction should be the subject of a preliminary identification of its economic characteristics and the commercial and financial relations between the parties, including the circumstances of these relations such as the contractual terms and conditions, the market and the economic situation (e.g., indicators such as the right to impose repayment, financial covenants, guarantees, option for the borrower to obtain bank loans, fixed repayment dates, term extension clauses, etc.). The risk is therefore twofold: if the margin is too high compared to a transaction between independent parties, it would then be revised downwards, or if the operation could not be justified, it would then be reclassified as an injection of capital. The issue is therefore considerable and merits cautious handling, all the more so as the difficulty stems from the lack of any frame of reference for the treasurer. 

The OECD appears to take a stringent approach in terms of the comparables to be considered for fixing the margin and size of a loan. The obvious advice for treasurers would be to compile the information and the comparables, along with any other element which helps demonstrate that the tested operation is ‘acceptable’ and ‘defendable’ in comparison with a theoretically similar transaction with a third party. So we shouldn’t baulk at retaining as much data as possible, including the banks’ ratings on bond issues and syndicated loans. However, this individual test is easier to prescribe than to perform. For instance, less common or non-standard currencies offer fewer comparables, while the entire analysis can be falsified by particularities of the sector or zone. 

Documentation is essential

The second key tip is to document such operations with detailed contracts and framework contracts. Here too, the absence of a minimum level of documentation or the mere confirmation of a loan will be fatal to the entire operation. Many MNCs don’t have the required minimum documentation or any description of their funding and TP strategy as a whole, and yet the operations’ characteristics and the functional analyses are important: who bears the ultimate risk? How is the loan monitored and possibly reviewed? And how often? Has the other party’s credit status changed and is it regularly reviewed in order to adjust the margin? What is the lender’s rank? These are all essential questions which the treasurer needs to address in order to achieve fiscal compliance. Each operation should have its characteristics and attributes clearly defined in advance, in order to facilitate assessment of the suitability of the price proposed (e.g., level of seniority and subordination, collateral provided or not, amount and currency, location of the borrower, sector, purpose of the loan, repayment schedule, timing of the operation, etc.). 

It’s essential  to adjust to economic circumstances which are fluctuating today more rapidly than ever before. The test can’t simply be done once at the start, as it’s vital to be able to demonstrate that it remains adjusted and tailored to the market. A good example is the phenomenon of ‘flooring’ imposed on any loan (e.g., floor at 0%, 0.5% or 1%).  If you want to do things by the book, this is an element that must be considered to adjust your loans. It should also be noted that negative interest rates on certain currencies including the euro have only complicated the situation, particularly with cash-pooling.  

Establishing the ‘arm’s length’ interest rate

The definition of the interest rate to be applied requires consideration of whether the lender possesses the necessary analytical capacity, as well as the decision-making functionality on the loan opportunity and on control of the risks linked to the funding operation. In the absence of such prerogatives, they should restrict themselves to the interest-free risk rate or the notional rate which could be obtained on an investment free from any risk of loss. It must be emphasised that the reference rate should always be compared to the rate applicable at the moment of the operation’s instigation and be based on the same duration. This risk-free rate is the basis to which a margin must then be added in order to define the risk-adjusted rate of return that the lender will demand from the borrower in order to compensate for the risk incurred. The spread should be assigned to the entity which has the capacity to manage the risk taken. This concept of effective control is vital for justifying  a profit transfer, but it’s also vital to define the financial risk taken by the lender and potentially the operational risk taken by the borrower. In such a case, the profit margin will not be fully assignable to the lender. 

The treasurer’s role

The approach to be adopted will depend on numerous factors such as the group’s strategy, the complexity of the operations, the sector concerned, its industrial cycle and the currency. The centralisation or decentralisation (autonomy of members) of cash management is a key factor for consideration. When a treasurer helps to decide the right capital structure for each subsidiary and manages the connected financial risks, they play a role which has a certain price. To do this, the treasurer needs to have effective control of the capital’s structure management. It’s not possible to cite the sole fact of having the power or the right without the actual effectiveness of the role. The definition of the funding strategy, of the capital structure and of the appetite for risk will determine the overall approach of the cash management activity and how it will be structured in practice (e.g., aims of the group’s policy: level of profitability of investments, reduction of the cost of capital and of volatility of cash-flow, level of financial ratios and so on). Just mentioning ‘cash management activities’ is not in itself enough to justify a margin; it all needs to be supported and documented. This is a support service designed to guarantee the value added by the operational side and possibly also to provide it via hedging a risk, reducing a funding cost or obtaining a loan.

Intra-group funding

The agreement must define the risks borne by the lender. It’s essential to determine, on a case-by-case basis, the risk according to i) the borrower’s country, ii) the activity sector or industry, iii) the member’s financial data, and finally iv) whether or not any support is provided by the parent company. It should be noted that the fourth point is not easy to assess and that sometimes, even if no guarantee exists, the subsidiary may be considered ‘too big to fail’, making the guarantee implicit. Each loan must be ‘repayable’ by the lender, as no bank will grant a guarantee-based loan unless it believes, based on the data at its disposal, that the lender will be capable of repaying it. If the interest and the principal per tranche cannot be repaid, the loan should not exist. A loan that is seen in advance to be impossible to repay would be null and void and would necessitate the (partial) recapitalisation of the borrower. 

Clearly, a parent company is not going to demand guarantees on assets which it already possesses, but the price should be deemed not guaranteed by assets even if this does not reflect the economic reality. It’s up to the lender to make provision for all scenarios in the same way as a bank does, such as a rise in interest rates, for example. The borrower, meanwhile, needs to ensure the best possible optimisation of its WACC (Weighted Average Cost of Capital) and be able to select the least costly method of obtaining funding, even if it involves providing collateral or a guarantee. The borrower should also consider the possibility of renegotiating the loan when necessary and possibly improving the loan’s terms if conditions change significantly. 

The use of credit rating when price-setting

The use of ratings enables the definition of the credit risk (probability of default) and subsequently the margin relating to it, by comparing the operation to similar operations with identical risks. Ratings can be obtained via tools such as those of Moody’s, S&P, Bloomberg etc., but you can also develop your own internal system using a variety of available methods. The advantage of the existing solutions is their robustness and methodology, while the main disadvantage is the price charged by the ratings agencies for their services. This rating is determined using quantitative criteria as well as (normally) qualitative ones, which explains the difficulty of comparing one entity with another: the higher the risk of default, the greater the margin would need to be in order to compensate for the risk taken. 

It’s vital therefore to carefully document and explain the rating awarded, as it could be derived from criteria which are not solely financial. Algorithms and models have their limits, as they very often generate similar results (apart from withholding companies, which are always complicated to assess due to their particularities and the absence of any operational side – they require a specific adjustment). The most accurate method would be only to use  ratings agencies for the real rating, as they include the full range of parameters. Unfortunately though, it’s scarcely practical to apply such a comprehensive approach to each and every subsidiary. Consequently, it’s necessary to adopt an intermediate model and remain within acceptable limits that won’t attract any dispute from the tax authorities. So we’re back once again to the group funding strategy that governs the financial covenants and capital applicable to the subsidiaries. The important thing remains coherence in the application of the principles. We should always bear in mind that this is one of the keys to BEPS. And finally, we also need to remember that the tax authorities themselves subscribe to external services.  

Implicit support from a parent company

In the absence of a real guarantee from a parent company, interpretation is essential. When the subsidiary is key to the group’s activity, implicit support can be presumed (e.g., strategic importance, use of the same brand, possible impact on reputation, statement of general intent, history of support for subsidiaries, percentage of control, etc.). The parent company’s support is a matter of judgement. Contrary to the OECD’s assertion, a subsidiary’s rating cannot be higher than that of the controlling parent company. The covenants help protect the lender, attesting to the risk taken and, for instance, the margin’s possible increase on the basis of price structures. It’s essential to demonstrate that these covenants are verified and monitored. If they are dead letters and there purely for cosmetic purposes, they will be disputed. A covenant automatically requires a degree of waiver or adjustment, or it is meaningless. It’s essential, however, always to ensure coherence, consistency and structure in your approach by avoiding unjustified exceptions, all while basing oneself on what a financial institution would agree to in a stand-alone situation. The OECD also envisages commitment fees, although this seems a trifle odd as the corporate sector is far from being subject to the Basel III requirements (BIS rules).

The guarantees may themselves be subject to the application of margin. If it’s a bank guarantee, an additional margin can simply be applied to that of the bank’s, based on criteria identical to the funding operation, although the margins will be less. However, if the guarantee comes from the parent company (i.e., a corporate guarantee), the guarantor cannot request the same margin as a bank guarantee. The price will be smaller than the margin of a credit operation, just as for a bank. A happy medium is called for and it is advisable to remain reasonable. 

Approaches and methods

Several well-known methods exist, including the CUP (Comparable Uncontrolled Price); ‘yield’ (i.e., a price with or without guarantee from the parent company) or the more complex CAPM  (Capital Asset Pricing Model). As already explained, the documentation needs to be as exhaustive as possible, since it is a matter of “comparing’. Comparison with an informal bank offer may be helpful but it is not sufficient (referred to as the bankability opinion) and is therefore only a starting point for the analysis. The real art lies in implementing adjustments in order to make the operation truly comparable. The idea is to align the cost of funding the subsidiaries (worked out separately for each one) with that of the parent company. The ALM (Asset Liability Management) structure of the parent company will determine the specific funding of the subsidiaries. One cannot be envisaged without the other, and neither can the varying  conditions of each local market be concealed. 

Cash pooling arrangements are tricky to plan as each participant needs to benefit from the pooling’s synergies. The participant needs to obtain a return on its own participation and on the funding of others which it is facilitating. However, the pooling already offers them the ease and automation of management through a low-cost overdraft, without having to worry about the size of the amount at stake. By agreeing on the deposit rate and the loan margin rate, they can improve on what they would obtain alone. Stable long-term positions could be contested, but if the position is structural, it’s advisable to distribute the dividend, to invest in the longer term or to borrow long-term. 

Cash-pooling is the trickiest structure for the tax authorities to grasp. If the ‘master pooler’ plays the role of agent, it may receive commission. The ultimate risk-bearer is also the key element to be addressed. The hedging of risks such as foreign exchange risk (FX) is possible and also involves a margin. Nothing specifies how to measure this, but common sense and reason should prevail, where the management is delegated and one is merely a broker or advisor. Prices vary according to  volume and FX lines with access to the trading floor are beyond the reach of small subsidiaries. The margin therefore remains justifiable but must always be documented. It’s also worth noting that a parent company guarantee is sometimes the sole means of obtaining the credit, so it has a significant price. And to be thorough, we should also mention that the parent company can invoice for its costs as an agent or consultant if it can provide evidence of them and demonstrate them by proving its expertise in cash management.