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Home > Cash Flow Management Best Practice > How Taxation Impacts on Liquidity Management

Cash Flow Management Best Practice

How Taxation Impacts on Liquidity Management

by Martin O’Donovan

Executive Summary

  • Efficient cash and liquidity management will involve centralizing cash within a single entity, on a country, regional, or even global basis.

  • The movement of cash between entities and between countries will create complex tax considerations, so that all loans and rates of interest applied must be at arm’s-length pricing.

  • The cash centralization is normally arranged with the group’s bankers who can offer a notional pooling or a physical movement of cash.

  • Interest payable on the balances arising from the cash centralization or from the overall funding structure of the group can be subject to withholding tax (WHT), which may be reduced to zero by tax treaties or may be reclaimable through a variety of mechanisms.

The Basis for Taxation

Taxation is highly dependent on the specifics of the companies concerned and the tax jurisdictions to which they are subject. Nonetheless, there are sufficient structural similarities between countries so that background generalizations can be made, although the specific rules and tax rates vary over time and will need to be verified with local tax experts.

Tax is initially assessed on the basis of each legal entity in isolation, but various allowances exist that enable operations to be examined from a group or subgroup perspective.

The legal grouping of companies, the managerial grouping, the accounting grouping and taxation group may each be on a different basis.

Taxable profit is not calculated in the same way as accounting profit. The latter may be generated using IFRS (International Financial Reporting Standards) or local GAAP (Generally Accepted Accounting Principles) using cash accounting or some taxation specific rules.

Efficient liquidity management for an international group involves making best use of the cash resources existing or being required or generated across the group.

In order to manage the daily flows of cash across the group there are normally efficiencies to be gained by centralizing cash flows within a central entity for each country or region, or, if practical, globally. The consequent movement of cash around the group, whether buying and selling goods between companies, or lending cash backward and forward, have significant tax consequences, made complicated by the interaction of different national and international rules.

Tax is therefore a major issue in the selection of a treasury center location. Areas set up specifically to attract treasury may be located in tax environments where local taxes are low and where there is special treatment of foreign earnings. They will be located in countries with extensive tax treaties, and there will be no WHT on interest earned or paid, or on income from dividends. These locations should also enable the repatriation of profits without tax deductions. Note, however, that in common with many business decisions, tax is not the only factor. Issues over staff availability and retention, proximity to management and major investors (for example, in London) are equally important factors.

Transacting with Connected Parties

Transfer Pricing

Most developed tax systems contain provisions that allow the tax authorities to increase the taxable profit, or reduce the allowable loss, of an entity which has entered into transactions with affiliates on non-arm’s-length terms. In some jurisdictions, including the United Kingdom, this now includes domestic transactions as well as cross-border items. The concern for tax authorities is that profits are artificially moved between countries and, in particular, from a high tax area to a lower tax area.

Transfer pricing rules concern the provision of services as well as goods, and so they affect not only intragroup funding and hedging arrangements but also the provision of centralized treasury services. From a practical perspective, this means that apart from keeping contemporaneous documentary evidence of group transactions:

  • all intercompany loans should carry a market rate of interest or other finance charge;

  • commercial foreign exchange rates should be used when transacting between group companies;

  • central treasury services should be recharged among those group members that benefit from them.

In-house re-invoicing and factoring centers usually receive particular scrutiny from the tax authorities of all the countries where participating group members are based.

Thin Capitalization

A company is said to be “thinly capitalized” where it is particularly highly geared. The tax authorities are concerned to ensure that companies do not receive debt funding from affiliates at levels that mean their profits are largely sheltered by interest expense. Many jurisdictions have now passed rules that set out what they consider to be an acceptable level of gearing for tax purposes. In some cases, for example in the United States, Germany, or Australia, the rules prescribe a maximum debt/equity ratio or required interest cover, and in others, such as the United Kingdom, the rules restrict finance charges by reference to the company’s capacity to borrow from a third party on a stand-alone basis. Where the acceptable level of debt is based on subjective tests, it is frequently possible to secure advance clearance from the fiscal authorities on the proposed level of gearing.

In the UK a new debt cap takes effect for accounting periods beginning on or after 1 January 2010, running in parallel with the arm's length principle. The debt cap applies to limit the tax deduction for finance expense payable by UK group companies by reference to the consolidated worldwide gross finance expense of that group. This is intended to counter the risk that groups with little or no external debt may nevertheless leverage their UK operations to reduce UK corporate taxes. There is a risk that interest deductions on intragroup loans could be denied in the UK, while the corresponding receipt remains taxable in a foreign country.

For companies, the downside is that if transfer pricing or thin cap rules are breached a tax deduction for interest expense may be denied, while at the other end of the transaction the lending company is still taxed on the interest income.

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