Cash pooling: liquidity bundling within a company

Everything in one place – this is one way of de­scrib­ing cash pooling. In this special form of group financial man­age­ment, one group company’s credit balance is used to offset the negative balance of another. This offers a number of economic ad­vant­ages, but it is also as­so­ci­ated with potential taxes and company law risks. You should be aware of these if you want to set up and operate a cash pooling system.

Cash pooling, also known as liquidity bundling, is a special form of liquidity man­age­ment. It is mainly used in groups in which several companies are organised under the man­age­ment of a con­trolling company. Although the in­di­vidu­al companies are legally in­de­pend­ent, since the group as a whole acts as a strategic unit, mutual financial support and dis­tri­bu­tion of liquidity among the in­di­vidu­al companies is in the interests of all parties involved.

As the companies in a group are organised in­de­pend­ently of each other, their financial situation may well differ. This also has an impact on their liquidity or liquidity re­quire­ments (i.e. cash and cash equi­val­ents). While one company finances itself with loans at market interest rates, another may have financial in­vest­ments that are less prof­it­able. To remedy this imbalance, a cash pooling system can be set up. This is usually run by a central financial man­age­ment team organised by the parent company.

The parent company acts as a “cash pool leader” – or it assigns this task to one of its group companies. This cash pool leader then withdraws excess liquidity from the par­ti­cip­at­ing companies and collects it (for example, for in­vest­ments) on a “master account.” The money is then used to cover the financial re­quire­ments of group companies with low-interest loans in order to prevent higher borrowing rates, or, in extreme cases, in­solv­en­cies. Re­ceiv­ables and payables are ex­clus­ively settled in­tern­ally: The companies paying in the money have a repayment claim (without notice in an emergency) against the master account, while the borrower has a repayment ob­lig­a­tion.

The main advantage of cash pooling is that the capital available through­out the group is better used and the need for borrowed capital is reduced. External funds are only used if the group’s internal liquidity balance is in­suf­fi­cient to cover capital re­quire­ments. In addition, costs can also be saved in the pro­cure­ment of capital (loans, bonds, etc.). As a rule, a top man­age­ment group can negotiate better con­di­tions than an in­di­vidu­al group company. In addition, pro­cure­ment costs are reduced if just one unit has to deal with them. Central cash man­age­ment also has the advantage for group man­age­ment that it provides a direct insight into the liquidity of the in­di­vidu­al group companies. This makes it easier to predict financial crises and plan ap­pro­pri­ate counter measures.

However, this is also the biggest dis­ad­vant­age of cash pooling: Since the cash pool leader handles liquidity man­age­ment centrally, the group companies lose economic in­de­pend­ence. This is par­tic­u­larly det­ri­ment­al to the more solvent pool par­ti­cipants. On the other hand, fin­an­cially weak companies may rely too much on the cash pooling system and neglect their own liquidity planning.

Liability risk is another dis­ad­vant­age of cash pooling: If a group company en­coun­ters problems and runs into financial dif­fi­culties, this has a direct impact on the group as a whole via the cash pool. It is therefore very important to maintain an effective man­age­ment and early warning system linked to the cash pooling system.

In practice, cash pools can actually (“phys­ic­ally”) or only virtually be set up and operated. In the first case, the cash pool leader really has a master account to which one group company pays in excess funds and from which the other draws liquidity. On the other hand, it is also possible to leave the funds where they are and only allow them to flow virtually between the companies and the master account (known as notional pooling). In this case, the debit and credit interest of the in­di­vidu­al companies is still cal­cu­lated on the master account. This works because the banks are prepared, after con­sulta­tion, to grant their loans to the in­di­vidu­al companies at con­di­tions that they would grant to the central cash pool leader.

However, this model is more com­plic­ated from a billing point of view than real cash pooling. The fake variant offers a par­tic­u­lar advantage in this respect: Since there is no real cash flow, there are no real re­ceiv­ables or li­ab­il­it­ies that could be legally ques­tion­able under certain cir­cum­stances (see below). In­ter­na­tion­ally active companies in the eurozone sometimes also use hybrid cash pooling. With a mixture of the two models, the real variant is used within the eurozone and the fake cash pooling is used in exchanges with companies in other currency areas. On the one hand, this avoids the expense of the otherwise necessary currency con­ver­sions, like hedging trans­ac­tions. On the other hand, there are sometimes con­sid­er­able legal hurdles to overcome for genuine cash pooling across national borders.

For a long time, central liquidity man­age­ment in cor­por­a­tions did not have a good repu­ta­tion when it came to the law – es­pe­cially for reasons con­cern­ing capital main­ten­ance in cor­por­a­tions. Under certain cir­cum­stances, even cor­por­a­tion share­hold­ers could be held liable in an emergency. Another problem can arise if companies in a group borrow money from each other, this can be in­ter­preted as a hidden dis­tri­bu­tion of profits under ex­cess­ively fa­vour­able con­di­tions, with cor­res­pond­ing tax con­sequences. These fa­vour­able con­di­tions could be an unusually low interest rate or a credit security waiver.

More problems could arise with regards to company law: Under certain cir­cum­stances, a capital con­tri­bu­tion by the cash pool leader as share­hold­er of a group company can be in­ter­preted as a hidden con­tri­bu­tion in kind. This applies if a company loan is repaid to the cash pool. This means that if this group company were to go bankrupt, the cash pool leader as a share­hold­er would have to pay the con­tri­bu­tion again.

If, on the other hand, the group company’s balance on the master account is balanced or positive, this can be a so-called back and forth payment, if a con­tri­bu­tion paid in by the cash pool leader as share­hold­er of a group company sub­sequently lands on the master account as liquidity con­tri­bu­tion. Even then, the con­tri­bu­tion is deemed not to have been made because the group company does not have the money itself, but only a claim against the cash pool.

The situation can be ag­grav­ated by these problems if a company doesn’t document its cash pooling activ­it­ies suf­fi­ciently or not at all. The competent au­thor­it­ies or courts may conclude from this that tax and/or company law rules were de­lib­er­ately cir­cum­ven­ted.

The legal situation when it comes to cross-border cash pooling (also known as multi-currency pooling) is even more complex, i.e. when companies domiciled abroad par­ti­cip­ate with their re­spect­ive national cur­ren­cies. As there are no worldwide legal com­pli­ance standards, the cash-pooling laws of in­di­vidu­al states involved must be taken into account when setting up a system like this. Cash pooling is also pro­hib­ited in many countries with re­strict­ive financial systems, such as India. So, funds from a local company cannot simply flow into a master account (this is referred to as “trapped cash”).

In order to avoid tax issues or legal con­sequences, experts recommend observing some basic rules and civil law lim­it­a­tions. It is important to adhere to the arm’s length principal when designing a cash pool. There are no pre­scribed transfer prices for re­ceiv­ables and payables in internal liquidity balancing. However, the reg­u­la­tions adopted by the group must stand up to an arm’s length com­par­is­on. This means that financial in­vest­ments and loans must be offered within the framework of normal market con­di­tions – as would be the case for in­de­pend­ent companies. In case of doubt, the bank interest rate agreed for the master account should be used as a guideline.

Com­pli­ance with the arm’s length principle is important when designing the cash pool. Although there are no pre­scribed transfer prices for re­ceiv­ables and payables in the internal liquidity equal­isa­tion system, there is no such thing as an arm’s length principle in the design of the cash pool. However, the reg­u­la­tions adopted by the group must stand up to arm’s length com­par­is­on. This means that financial in­vest­ments and loans must be offered within the framework of normal market con­di­tions – as would be the case for in­de­pend­ent companies. In case of doubt, the bank interest rates agreed for the master account should be used as a guideline.

A cash pooling system should also be trans­par­ent. This includes regular reports from top man­age­ment and the right for all group companies to be able to see who is lending and receiving money at any time. In order to meet these re­quire­ments, ap­pro­pri­ate in­form­a­tion and exit mech­an­isms should be es­tab­lished. This is the only way for par­ti­cipants to be able to react to changes in the group’s liquidity situation, and, if necessary, cancel a loan that has been granted. In addition, it must be ensured that the cash pooling system benefits the group units or at least does not represent any dis­ad­vant­ages for them (through the permanent with­draw­al of liquidity or default risks out­sourced to them).

Last but not least, the group has a strict doc­u­ment­a­tion ob­lig­a­tion towards the tax au­thor­it­ies. This means that it must be able to demon­strate and justify the ap­pro­pri­ate­ness of its transfer prices at all times. If this is not done, there may be a threat of legal con­sequences.

Setting up a cash pooling system may require some effort, depending on how many companies are involved and whether foreign companies are included. A thorough pre­par­a­tion phase is re­com­men­ded, the first step of which is an analysis of the group: What are its struc­tures, which companies are suitable as par­ti­cipants, and what are their legal framework con­di­tions (es­pe­cially for foreign companies)? Prior to im­ple­ment­a­tion, the group units can be informed in workshops about the structure and func­tion­ing of the planned cash pooling system. Of par­tic­u­lar interest are the leading and trailing edges for those involved as well as liability issues. Security is provided by a written contract, which should cover the following contents, among others:

• Con­di­tions and credit limits
• Mutual loan granting
• Rights and ob­lig­a­tions of use
• Ar­range­ments for loan repayment
• In­form­a­tion rights
• Notice
• Admission of new par­ti­cipants
• Special rights of the cash pool leader

A char­ac­ter­ist­ic feature of a balanced contract ne­go­ti­ation is that no party is over­burdened, as otherwise the liability lim­it­a­tion is threatened.

You should then gain an overview of the sub­si­di­ar­ies account struc­tures. A bank that offers cash pooling is re­spons­ible for the actual pro­cessing of payments. The costs incurred play a central role in this, as the solution should be cheaper than the con­ven­tion­al banking trans­ac­tions of the in­di­vidu­al companies. Technical questions concern the file format for trans­ac­tions (e.g. XML) and the times when the bank does not process payments.

It is now necessary to choose a suitable trans­ac­tion model. With zero balancing, the as­so­ci­ated accounts are set to zero at the af­fil­i­ated companies on workdays or in some other regular manner and the balances are trans­ferred to the master account. In contrast, target balancing only balances liquidity up to a pre­vi­ously agreed base amount.

Liquidity bundling offers obvious business ad­vant­ages. All liquid capital is collected in one place, is centrally managed, and can be optimally dis­trib­uted through­out the group so that it is less dependent on borrowed capital overall. However, you should always be aware of one thing when setting up this kind of system: Cash pooling is often a reason why the tax au­thor­it­ies may take a closer look. If you follow certain prin­ciples, however, you can minimise the risks and take advantage of the economic benefits of central liquidity man­age­ment.

Please note the legal dis­claim­er relating to this article.