When the accurate delineation of a cash pool balance shows that the same short-term lending or depositing position remains present year after year, the OECD Guidelines detail it may be appropriate to treat such a financing position as something else, such as a long-term loan. In line with this OECD guidance, multinational groups often undertake regular reviews of their cash pool balances, reclassifying certain short-term positions into longer term loans, as appropriate. In many cases best practice dictates that such reclassifications are based on structured and methodological manner. However, when the cash pool leader (short-term) is also the central financing entity (long-term), the mere methodological reclassification of a structural position (e.g. reclassification of a structural deposit position made by a cash-pool participant towards the cash-pool leader) can, in certain circumstances, lead to circular long-term loan transactions. Recently, tax authorities have intensified scrutiny on these practices, seemingly creating a tension field between the requirement to reclassify structural cash pool balances and the aversion of circular loan transactions.
Background
- Since the introduction in the OECD Guidelines of the (current) Chapter X on financial transactions, tax authorities have increasingly scrutinised the short-term qualification of structurally outstanding cash pool positions (Paragraph 10.122 et seq. OECD TPG). Whereas the OECD Guidelines only suggest assessing the correctness of the short-term delineation of structural cash-pool transactions, the Belgian Transfer Pricing Circular (2020/C/35) seems to adopt a tighter stance, stating that Cashpool positions outstanding for more than 12 months should be considered to apply an interest rate for to long-term loans (Paragraph 267).
- Commonly, material cash pool positions outstanding for more than 12 months (so-called “structural positions”) are therefore proactively reviewed and possibly requalified by taxpayers into long-term loans, ensuring the legal and (expected) tax classification of the transaction are fully aligned.
- However, when the cash pool leader, responsible for centralising the short-term excess cash of group affiliates, also operates as the central financing entity, responsible for long-term funding of the same affiliates, the rule-based reclassification of a short-term position into a long-term loan may in certain situations result in the creation of a circular financing transaction:
- Tax authorities increasingly scrutinise these circular loans, as they may appear unjustified: the Group treasury centre lends funds to a Group affiliate, whilst simultaneously ‘borrowing’ (through the cash-pool deposits) from the same affiliate, leading to an interest cost and income in both countries, with the same counterparty.
- This concern may be further aggravated to the extent that market conditions, and therefore the arm’s length interest rate, at the time of the initial loan (in order to finance the investment) and the second loan (reclassification of the structural deposit) have changed materially. More in particular this could lead to a yield differential on the upstream and downstream loan, effectively resulting in a profit/loss for one of the parties to the transaction.
- As such, the mere rule-based reclassification of structural short term cash pool balances into a long-term loan could lead to scrutiny from tax authorities who could challenge the presence of a loan payable and receivable with the same counterparty albeit at a different interest rate, effectively generating a profit or loss at one of the parties involved.
Transfer pricing considerations
It is clear from the above that mechanically reclassifying short-term cash pool balances into long-term loans – in an attempt to meet tax authorities’ expectations regarding the application of the arm’s length principle – might in itself be scrutinised by tax authorities and possibly challenged.
There are obviously various cases where the co-existence of a loan payable and receivable with the same counterparty will be fully justified. Assume for example an initial loan granted by the treasury centre to another group entity to finance a CAPEX investment. The CAPEX loan is fixed interest bearing, amortising in line with forecasted cash flows resulting from the investment and does not allow for early repayment. Furthermore, since interests have generally been increasing over the period since issuance, an early repayment would not be beneficial to the borrowing entity as it has access to relatively cheap funding through its CAPEX loan. When the borrowing entity now starts building up excess cash more rapidly than anticipated and in a structural manner, due to the success of its investment, a situation may arise where the borrowing entity may issue a longer-term loan back to the treasury centre, at a higher interest rate than its CAPEX loan. The treasury centre, also benefiting from the high-interest rate environment can however use these funds to issue a new loan, at an even higher interest rate to another group entity.
In cases where the facts and circumstances do not justify these two-way funding flows, the situation can luckily still be resolved through (partial) early repayments of existing long-term loan positions before requalifying the (excess) of the structural cash pool position into a new long-term loan. In doing so, a review will be conducted of the outstanding loans between the cash pool leader and the group entity. Whenever possible, the existing long-term loan will be (partly) early repaid to the amount of the structural cash pool position.
It is however important that also such an early repayment of any preexisting loan occurs in line with the arm’s length principle. Broadly speaking there are 2 main potential scenarios which may prevail:
1. The contract of the pre-existing loan foresees an early repayment option – The early repayment should be performed in line with the modalities of the contract and common market practices. In this case, it is important to verify whether the contractually agreed modalities are in line with the arm’s length principle; or
2. The contract of the pre-existing loan does not foresee an early repayment option – In this case, parties can mutually agree to still opt for early repayment, as long as they act in line with the arm’s length principle. Hereto, the parties must show that an early repayment is a viable option realistically available (“ORA”) for all parties involved. In most cases, this will require executing a financially “neutral” early repayment with the application of a repayment penalty which could e.g. be based on a funding loss-principle. Other more qualitative considerations such as the need for immediate cash etc. could also be considered depending on the facts and circumstances of the case. One should note also that the possibility for a lender to request the full amount of its funding loss may in some cases be limited by law.
Key takeaways
- A sustainable financing policy should embed a clear and comprehensive mechanism on how to deal with structural cash pool positions, the reclassification into long-term loans and the potential risk of creating circular loans.
- When granting intercompany loans, it may be relevant to foresee an early repayment option with appropriate modalities and tailored pricing. Particular attention may also need to be granted to stipulations in the governing law of the transaction.
- Unresolved circular loans should be properly documented.
For more information or advice, please reach out to David Ledure, Maxime Dessy, or your regular PwC contact.
