Guidelines for Transfer Pricing related interests & spreads applied in Zero Balancing Cash Pools – Part 2
Executive summary A Zero Balancing structure mirrors the core activity of a bank. Therefore, managing a Zero Balance Account (ZBA) structure requires a corporate treasury to operate an In-House Bank. This In-House Bank must apply Arms-Length interest to balances in its In-House Bank accounts as well as to InterCompany Lending and Depositing/Investing, both debit and credit. To comply with OECD BEPS Transfer Pricing regulations, Arms-length must adhere to a logical spread similar to that used in core banking operations. This entails ensuring that the spread on current account interest (debit/credit) is further from the reference rate than the spread on InterCompany Lending/Depositing. This white paper discusses, in two parts, the background and guidelines of setting Transfer Pricing related interest spreads in Zero Balancing Cash Pools. Read the Part 1 of this White paper: Guidelines for Transfer Pricing related interests & spreads applied in Zero Balancing Cash Pools – Part 1 Are you an experienced treasurer or someone looking to enhance their knowledge of financial management? We extend a warm welcome to TreasuryMastermind.com. Join our vibrant community and become a valued member of a network that prioritizes collaboration, expertise, and the pursuit of excellence in corporate treasury. Let’s initiate discussions and together elevate the art and science of treasury management! PART 2 Current Account Interest versus Lending/Deposit Interest Now that we have explained the background why an In-House Bank with In-House Bank accounts is required for ZBA structures, and why we should apply interest to the In-House Bank accounts, let’s have a look at different types of interest. I will look at different types of interest for commercial banks and how that is linked to interest applied by an In-House Bank. In general, commercial banks calculate current account interest on the basis of risk and balance commitment. This means that a commercial bank will apply different interest rates; for credit interest, the commercial bank will look at the time that idle cash will sit in the bank account and what is the risk (or freedom) is the accountholder to withdraw the balance. For debit interest, the commercial bank will assess the time and amount that an overdrawn balance will exist, as well as the risk that the account owner will (or can) get the overdrawn bank account back to a positive balance. However, when both credit balances and debit balances will exist for a longer time, commercial banks will offer different solutions with more favorable interest rates. But the favorable rates will usually come with restrictions. In the case of a credit balance, banks may offer better interest rates if the account holder maintains a certain positive balance in the account for a certain period of time. Banks can also request account holders to transfer the positive balance to a separate account from the bank in order to apply the more favorable interest rate. In financial terms we call this “time deposits”. The interest rate of a time deposit will depend on the amount, tenor and the revocability of the transferred balance. The higher the amount, the longer the tenor, the lower the revocability, the higher the credit interest. Conversely, for a debit balance the banks may offer better interest rates when the account holder agrees on an amount that is needed to cover for the overdrawn balance. These agreements usually include conditions that stipulate how long the amount is needed, when will the amount is needed to be paid back and whether the amount can be reused again after paying back. In financial terms we call this “loans”. Obviously, banks can offer a range of similar interest-bearing products that can be tailored to the specific needs of a customer or of the bank. All is based on the core banking model as explained in the first chapter of the white paper. The bank business model is based on the difference between debit and credit interest. Time and risk, but also the level of balance will determine what interest rate a bank is willing to offer to account holders. Also, the balance sheet of a bank may set guidelines for the interest rate settings. A bank with too much risk on the balance sheet (or a certain mismatch between the assets and liabilities) may cause a bank to decide to offer higher credit interest rates than competitors. This is to attract additional cash. To further reduce the balance sheet risk, a bank can also increase debit interest to discourage accountholders to overdraw their accounts or to reduce (outstanding) loans. Vice versa, banks that are “overfunded” (meaning they have too much cash / liabilities on the balance sheet) may consider lowering the credit interest to discourage customers cash balances and lowering debit interest to encourage customers to take more loans. Calculation of Current Account Interest Commercial banks view current account balances as uncommitted cash and as such cash that can be withdrawn instantly by the account holder (high risk). To support that, commercial banks use a reference rate (usually based on overnight rates) and apply a relatively large discount spread on credit balances and a relatively large uplift spread on debit balances to calculate the applied interest on daily current balances. With this approach, commercial banks incentivize account holders to convert non-current larger balances to more committed cash balance (= time deposits). This means that banks will apply a relatively small discount spread on committed cash deposits. In the previous chapter I was referring to “time deposits”; the longer the tenor of committed cash deposits (1 month, 3 months, 6 months, 12 months), the smaller the discount spread on cash deposits (and thus a higher interest yield). Vice versa, banks apply a relatively small uplift spread on committed loans; various committed loan types with various tenors will get different smaller uplift spreads. In general, the following sample schedule shows the relationship between applied interests on various types of cash flows: Reference rate Inter Bank Offered Interest Rate – Overnight Lending/borrowing Applied spread (indicative sample) current account credit balance -/-200 Basis point current account debit balance +/+ 500 Basis…
Guidelines for Transfer Pricing related interests & spreads applied in Zero Balancing Cash Pools – Part 1
Executive summary A Zero Balancing structure mirrors the core activity of a bank. Therefore, managing a Zero Balance Account (ZBA) structure requires a corporate treasury to operate an In-House Bank. This In-House Bank must apply Arms-Length interest to balances in its In-House Bank accounts as well as to InterCompany Lending and Depositing/Investing, both debit and credit. To comply with OECD BEPS Transfer Pricing regulations, Arms-length must adhere to the logical spread similar to that used in core banking operations. This entails ensuring that the spread on current account interest (debit/credit) are further from the reference rate than the spread on InterCompany Lending/Depositing. This white paper discusses, in two parts, the background and guidelines of setting Transfer Pricing related interest spreads in Zero Balancing Cash Pools. Are you an experienced treasurer or someone looking to enhance their knowledge of financial management? We extend a warm welcome to TreasuryMastermind.com. Join our vibrant community and become a valued member of a network that prioritizes collaboration, expertise, and the pursuit of excellence in corporate treasury. Let’s initiate discussions and together elevate the art and science of treasury management! PART 1 Many companies are considering or have already adopted Zero Balancing Cash Pools structures to optimize working capital and operating cash. The beauty of Zero Balancing Cash Pools lies in the ability to prevent idle cash from sitting at the operating unit, and automatically funding operating units with cash needs. Consequently, the cash pool leader (often the central Treasury) can manage idle cash centrally while efficiently funding working capital needs. It is essential to emphasize that cash in a Zero Balancing structure is operating cash,representing short term working capital. In this white paper part 1, the importance of setting the right interest rates (both debit and credit) for Zero Balancing structures will be explained; Part 2 discusses the appropriate level of interest spreads to meet OECD BEPS Transfer Pricing guidelines. To come to this, it’s necessary to explain the basics of banking and how they relate to Zero Balancing structures. Core banking explained The primary function of a commercial bank is to attract money from those who have surplus cash and subsequently use those funds to finance those who need money. Banks offer unique bank account numbers where you can deposit money or borrow from (overdrawing a bank account). The bank compensates idle cash with credit interest, usually lower than the “fee” for borrowed money (debit interest). The difference between credit interest and debit interest forms the primary business model of commercial bank. Bank operate on the legal premise that every penny in a bank account is legally owned by the bank; thus, deposited money becomes the bank’s property; It is legally not your money anymore. Effectively you transfer ownership of your money to the bank. This allows banks to redistribute funds by lending them out, as the money in the bank account is legally considered a liability to the account holder. Consequently, every account holder with “surplus cash” in the bank account must regard this as a loan to the bank and an asset on their balance sheet. Obviously, you can freely tap on this asset when needed (e.g. for making payments, etc.). Vice versa, an overdrawn bank account is effectively money that the bank is lending to you and is therefore a liability on your balance sheet. I am using the words “lending to/from the bank” as this is an important subject for tax authorities. I will come back to that later in this white paper (see “Commercial bank interest versus In-House Bank interest”). Understanding the legal aspects of bank accounts explains why the core business model of banks can exist and why depositors may incur losses if a bank faces financial trouble, and eventually files for Chapter 11. Core banking mechanism versus In-House Bank mechanism The business model of a bank elucidates the legal aspects of Zero Balancing structures, as these structure mimics core banking mechanisms. In a ZBA structure, excess cash is legally transferred to the cash pool leader, and overdrawn bank accounts are funded by the cash pool leader. This ensures that all participating bank accounts start each day with a “fresh” Zero Balance, allowing the cash pool leader optimal access to the company’s operating cash. The ZBA structure, by mimicing the core banking mechanism, designates the Cash Pool leader as the “In-House Bank”. Below diagram shows the basics of a ZBA structure where Operating unit A has a cash balance of 500 and Operating unit B has an overdrawn balance of -100. At End-Of-Day, after the ZBA sweeps have been applied, the balances of all Operating Units are zero and the net cash balance of 400 sits with the cash pool leader. Zero-Balancing sweeps and the In-House Bank By default, a Cash Pool leader (referred to asthe In-House Bank) possesses the cash of the participating operating units. However, each sweep between the master account of the Cash Pool Leader and the accounts of Operating units will create either a Liability (credit sweep) or an Asset (debit sweep) for the In-House Bank. This is because the In-House Bank mimics the core banking mechanism. Consequently, the In-House Bank must record all these ZBA sweeps to track accumulated balances per Operating Unit over time. Each sweep must be registered at a unique identifier linked to the operating bank account so that both the In-House Bank as well as the owner of the operating bank account can determine the net transferred balance over time. This unique identifier is often referred to as the “In House Bank account”. Thus, a USD 500 balance in an operating account will be swept at the end of the day to the master account of the In-House Bank, simultaneously recorded as a USD 500 liability in the unique In-House Bank account. Therefore, the bank account of the operating unit must logically be linked to the unique In-House Bank account. It is akin to transferring the End-Of-Day operating balance to “Savings” account with the In-House Bank. In the…
Paul Buck