Cash pooling arrangements allowing companies to optimize their cash and better manage liquidity have been present as part of the financial product offered by banks to their clients for some time now.
While the notional cash pooling involving the consolidation of cash balances for the purpose of calculating interests is regularly used in practice, the physical cash pooling involving physical transfer of funds between bank accounts (providing optimization of liquidity management) is rarely used.
Even though there is no statutory framework regulating cash pooling arrangements, definitions of notional and physical cash pooling are imposed in the by-laws enacted by the Croatian National Bank for the purpose of collecting information on transactions between residents and non-residents.
In the CNB’s Instructions on Collection of Reports (CNB Instruction) envisaged under the Decision on Collection of Information for the Purpose of Drafting the Balance Sheet, Foreign Debt and International Investment Levels Delivered to the CNB in Electronic Form (CNB Decision), cash pooling is defined as a specific financial product that enables the consolidation (viewed as a net balance) or aggregation of positive and negative balances on bank accounts of different entities onto a single (master) account.
Depending on the type, cash pooling is classified under the CNB Instructions as either lending activity or deposit-taking activity.
The physical cash pooling models involving the actual transfer of funds from residents to non-residents and vice-versa are classified under the CNB Instruction as other lending activities and have to be reported as such to the CNB.
If there are no physical transfers of funds from residents and non-residents and the residents have full and unrestricted control over the funds in their accounts opened in a foreign financial institution participating in the notional cash pooling, such a transaction is considered deposit-taking activity as per the CNB Instructions.
Thus, according to the mentioned by-laws, physical cash pooling should be deemed as lending activity, at least for the purpose of appropriate reporting to the CNB.
In practice, the notional cash pooling arrangement is regularly practiced and offered by the banks as part of their services. The model is mostly established between the mother company and its subsidiaries having the bank accounts opened with the same bank which operates the cash pooling arrangement based on the cash pooling agreement entered into between a bank and each cash pooling participant.
Physical cash pooling is rarely, if at all, used in practice.
The question that arises is whether the physical transfer of funds would even be possible without it being legally grounded and what would that ground be.
Having in mind the by-laws regulating physical cash pooling for the purpose of CNB reporting, it is likely that such arrangements would need to be structured as intra-group loans – either by the subsidiary in favor of the mother company (to fulfill the target budgeting) or by the mother company to the subsidiary in order to allocate the funds collected at the treasury account, representing also the ground for banks to do the transfers.
Provided that would be the case, physical cash pooling could have certain tax and legal consequences.
Consequences Connected to Physical Cash Pooling
From the “borrower’s” perspective, the companies should observe the withholding tax aspects of the transaction as well as the interest deductibility rules which could be relevant to interest expenses they would be charged.
When in a “lender’s” position, the transfer pricing rules would determine the level of interest income relevant for the lender.
One of the legal consequence is that the physical cash pooling could be considered as hidden distribution of profits prohibited under the Croatian Companies Act provided the funds are not fully recoverable by the participating companies.
Furthermore, the cash pooling arrangement could be challenged by the company’s creditors or bankruptcy trustee in the event of insolvency provided such an arrangement impacts the company’s liquidity and jeopardizes the company’s ability to fully fulfill its payment obligations. The consequence of successful challenges would be the obligation of the company to reimburse the amount transferred under the cash pooling arrangement back to the “paying” company.
Final Remarks
While there is no legal obstacle to entering into cash pooling arrangements involving the physical transfer of funds, the underlying agreement would most probably be regarded as a loan agreement (intercompany loan agreement) having certain consequences (both legal and tax-wise) that need to be taken into consideration when structuring such a transaction as a mode of optimizing the cash management of the group companies.
By Martina Kalamiza Grozdek, Partner, Lovric Novokmet & Partners
This article was originally published in Issue 11.12 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.