698(Vol.14,no.17) In Practice The Profit Split Method in Cash Pooling Transactions BY JORG H Cash Pooling strument that gs by achiev- compared to a situa- tiona have im tems. The creased which has border cas This a spective how cas into arm's-length method applied t tion. nk In today's prac tion schemes bank a applicatio simple calculation rates Dr. Jorg Hulshorst is economist with the team of Deloitte Touche GmbH in Dus seldorf, Germany 12-21-05 Copyright 2005 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069
IN PRACTICE (Vol.14,No.17 699 OECD Guidance the pool. K only covers indirect items that are not di ectly attributable to individual pool members. Direct The Organization for Economic Cooperation and costs such as transaction costs in connection with the velopment transfer pricing guidelines acknowledge members bank accounts(for instance, fees for money that interrelated transactions may not be evaluated on a transfers, foreign exchange)will be charged directly to separate basis. Under those circumstances, indepen the members and will not be included in the pool inter dent enterprises might agree to a form of profit split est ra Profits should be split on an economically valid basis Based on above definitions, the cash pool profit, Il, at Contributions should be evaluated in respect of the in.a given point in time can be expressed as tangible property employed. A division of profits also may be derived from economies of scale or other joint (1)Ⅱ= Min(C,d)×(r-r)-K. efficiencies. Based on the principles set forth in the In Equation (1) Min(C, D) denotes the minimum of OECD guidelines, the profit split method can be reason- the total credit or debit balance; in other words, it rep- ably applied to cash pooling transactions because esents the pool's matching balance On th e matchin a cash pooling transactions are highly interrelated in balance a spread between market debit and credit inter he sense that interest advantages can be realized only est(r-r*)is earned. This term represents the joint in when there are both debtors and creditors to the pool; terest savings of the pool compared to a situation with a efficiency gains are generated jointly by all pool separate bank accounts. The pool profit actually is a re sidual profit after reducing the pool administrators a the allocation of efficiency gains can usually not be arm's-length remuneration for performing routine type determined by reference to independent transactions of administrative functions. The arms-length compen and sation for such routine activities will be included in K a pool members' contributions are purely monetary Now let ri be the transfer price of the pool in re- and can be easily observed and measured as they are spect to the balance of creditor i,(that is, the pool's linked to pool accounts' cash balances credit interest granted to creditor i) and let ri: denote Cash pooling systems are rather homogeneous in the debit interest of the pool charged to debtor j. Then, hat they are all subject to the same value creation prin he benefit of a typical creditor i is ciple(that is, the generation of interest advantages (2)x=c1×(r-r+), through matching of balances). Therefore, a common model framework for applying the profit split method wherer indicates the interest advantage a member receives when participating in the pool can be established Analogously, the benefit of a typical debtor i can be calculated as follows Basic Model framework A cash pool consists of a given number of members The interest advantages of creditors and debtors in which are either debtors or creditors to the poow ao gf can achieve when lending money to the pool, ci, or bor- Equations(2)and (3) are derived from the spreads they be the number of creditors to the pool at a given poi in time and let m stand for the number of debtors. with rowing from the pool, d, instead of keeping their sepa- out loss of generality, it will be assumed that n and m rate bank accounts or going to the money market.Be may vary from time to time. Further, let C denote the credit balance of creditor ii=l.,, n, and let spreads are solely determined by choice of pool interest rates. Hence, r and r; are the relevant transfer prices through which the allocation of pool profits among in- dividual members is established Due to the pools overall budget restriction, the ben- e the sum of pool creditors'balances. Analogously, efits received by creditors and debtors must equal the d, represents the debit balance of debtor j, j pool profit (4) 129+12=∏ D=∑d Application of Profit Split is the sum of pool debtors balances. Assume that r and r are the market (bank) interest rates on the pools Having set up the basic model framework, the next master account for positive and negative pool balances, steps will be to Hbpectively. The costs of the cash pool is denoted as K, a calculate individual contributions to the pool ch represents all administrative expenses (including a for each individual pool member, set contributions an appropriate mark up to the pool administrator equal to benefits; and based on the cost-plus method) that are not directly at a derive arm' s-length interest rates such that pool ial guarantee costs to cover credit risk associated with their individual contributions. ool members according to OECD, Transfer Pricing guideline In the following, assume that all pool members are similar terprises and To istrations, July 1995(4 Transfer Pric- in terms of credit risk. If credit risk were distributed uneven! ingi Para 3.5 of the OECD guideli Report207,8295) among the members, individualized spreads reflecting default risk would have to be added to the debit interest rates. Al Para 3.7 of the OECD guidelines other implications of the analysis remain unchanged TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 12-21-05
700 (Vo.14,No.17) IN PRACTICE A member's contribution generally can be inter- Employing Proposition 1, a rule for the split of the to- preted as the value of the matching potential it brings tal cash pool profit between creditors and debtors (e termined assume a situation in which creditors' total the second type of allocation rules), can be derived balance, C. is 100 and debtors'total bala D. is 80. In amounts to 80. Only a fraction of Min(C, D)/C, or 80/100, of an individual creditors balance, Ci, effectively con Equation ( 9) shows that net benefits are allocated fooL. In other words, if a creditor's balance amounts to properly between both groups, if interest rate spreads butes to the interest savings generated through the only a portion of eight is valuable to the pool in that equal the inverse proportion of creditors'and debtors' it can be used to finance debtors' cash demand. The re total balances. Considering the pools total budget con- straint, the following Proposition 2 results: 8 mainder of two is subject to market interest Now. assume an individual debtor's balance, di, is 5 Proposition 2. When applying the profit split method This makes up d /Min(C, D), or 580, of the pool's match in a cash pooling transaction, spreads between pool ing balance. Consequently, creditor i's contribution and market interest rates should equal the inverse ith respect to debtor j equals 10 times 80/100 times proportion of creditors' to debtors'total balances In 5/80 times j's individual interest savings. Formally, such a situation the cash pool residual profit is creditor i's total contribution to all other pool members shared equally between the group of creditors and can be expressed as the group of debtors Arms-Length Interest Rates ∑=4 Now that rules for a proper allocation of the pool where pi denotes creditor i's contribution. profits among creditors and debtors have been devel oped, arm's-length transfer prices can be determined Analogously, a debtor's contribution, p;, reads as 6x4=n∑a1cx(r-r2) I When applying profit split method, the pool's ef- (11) ficiency gains must be allocated contribution-wise, that is, pool benefits are properly allocated when each pool members benefit equals its contribution Equations (10) and (11) describe the arms-length pool interest rates for creditors and debtors. Each credi tor is granted an interest rate that equals the market in (7)-=p half of the cash pool profit in the absence of a pool, plus fit per unit of total credit bal ance. Analogously, a debtor is charged the market debit interest rate minus half of the pool profit per unit of to- Before dealing with the implications of (7)and(8) Proposition 3 summarizes the above pricing rules detail, please note that we need to derive two types of d profit allocation rules. The first type is to determine Proposition 3. When applying the profit split metho in cash pooling transactions, pool profits are allo be allocated to each individual creditor, and which part cated properly among all creditors and debtors, if of all debtors,' share should be allocated to each indi- market interest rates are adjusted according to pool vidual debtor. The second type divides the pool's total members' s-length benefits. Pool members rofit between the group of all creditors on the one arm's-length benefits equal half of the pool profit per hand and the group of all debtors on the other. Both unit of total credit or debit balance, respectively, As types of allocation rules jointly ensure that each credi- suming a positive pool residual profit, the arm's or and each debtor are allocated their proper th credit interest rate of a pool should always be contribution-based shares within the range of the market credit interest rate (ower bound) and the midpoint of the spread be Lets proceed with the first type of allocation rules ween debit and the market credit interest rate(up Using the above system of equations, the following in- utive Proposition I results per bound). Accordingly, the arm's-length debit in- terest rate of the pool should always be within the Proposition 1. When applying the profit split method range of the midpoint of the spread between debit in a cash pooling transaction, all creditors should face identical pool credit interest rates and all debt. 7 To arrive at(10), just insert(2) and to(7 and con rs should face identical pool debit interest rates sider identical spreads to market interest 8 The last sentence of Proposition 2 can easily be verified by Note that, Min(C, D) has been cancelled down in nomina tor and denominator to arrive at(5) ineng()and(3)in the budget constraint (4), and then apply- 6 For the credit side, use(7) together with(2)and(5); for Use Proposition I and Proposition 2 in the budget con the debit side, use(8) together with (3)and(6) straint (4)and solve for r and rd, respectively 22105 oyrighte 2005 TAX MANAGEMENT INC, a subsidiary of The Bureau of National Affairs, inc. TMTR ISSN 1063-2069
IN PRACTICE (vol.14,No,17)701 and credit market interest(lower bound) and the the profit split method Given the monthly credit/debit market debit interest rate (upper bound) balances, cash pool costs as well as(monthly) market The analytical results described above should apply interest rates, the monthly cash pool profit is computed to all cash pooling situations when a pool residual profit by using equation( 1). The monthly cash pool profit is is to be distributed among the pool members. The ex- then allocated to members via pool credit and debit in- ample will serve to illustrate how the profit split method can simply be applied, and to show how arms-length terest rates that satisfy equations (10) and (11) interest rates are affected by fluctuating pool balances Monthly interest times 12 gives the annualized monthly interest Example Table 1 shows how arm's-length interest rates are calculated on a monthly and annual basis according to 656665656565|651 201001100 3008200810082008 7307 0170190.240.22021 023 0120140150161681 a2a224|2624272020420420202172321 1741.814018018517015915414916184190168 Table 1: Calculation of cash pool Interest- Example The example refers to a cash pool with stable debit and 1.68 percent for the creditors, Because balances alances, D, while credit balances, C, fluctuate heavily match in total over the year, profits are allocated sym over the year. On an annual basis, however, pool bal- me ances match perfectly. For the sake of simplicity, mar spreads of 0.68 percent compared to market interest ket interest rates and pool costs will be constant rates(debtors: 3.00 percent minus 2.32 percent; credi hroughout the year. In that scenario, the pool gener tors: 1.68 percent minus 1.00 percent) The fluctuation of annualized monthly arms-length length pool interest rates of 2 32 percent for the debtors I pool interest rates is illustrated in Figure below 3.00 220 1.20 Month (annualized) ri+(annualized) Figure 1: Development of cash pool interest -Example TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 12-21
702Vo.14.No.17) IN PRACTICE Figure 1 shows that arms length credit and debit in asymmetrical situation when total balances diverge, the terest rates differ significantly in situations in which lower of the credit or debit balance(that is, the scarcer matching balances are low(for example, Month 3)or, factor in the generation of the joint efficiencies) should in other words, the mismatch of balances is high. In receive the higher interest spread advantage from the those situations, spreads are distributed very asym-pool Limitations of the Analysis balance, the interest advantage of a debtor is almost The allocation mechanism for the profit split focuses zero(0. 12 percent annualized) whereas the interest ad on the pools residual profits that are not directly attrib vantage of a creditor is comparatively high (0.48 per- utable to individual members. In deriving joint interest cent annualized) show almost identical balances, which indicates that matching benefits are high and arms-length spreads in a situation in which some members are in a perma between pool and market interest are almost identical nent borrowing position to the pool, credit risk may be for debtors (0.84 percent annualized) and creditors come an issue, which should be reflected in higher debit (0.96 percent annualized) interest rates for those members(see Fn. 4) Conclusion quantified on an individual basis by using capital mar ket instruments (for instance, by looking at money mar This article developed arms-length pricing rules for ket or bond market spreads over risk-free assets). As cash pool transactions by using profit split methodol- credit risk is directly attributable to debtors, risk- ogy. It argued that profit split is a reasonable method to appropriate spreads should be added to the cash pool debit interest rate to arrive at individual arms-length a cash pool generates joint efficiencies. As contributions can be observed and measured easily a general alloca Economies of scale and risk diversification, which tion scheme was established are sometimes mentioned as economic reasons for As a central rule, spreads between pool and market building up a cash pool, have not been investigated ex- nterest rates should equal the inverse proportion of licitly The rationale behind those arguments is that a creditors'to debtors'total balances Given market inter pool would negotiate more favorable interest terms for est rates and pool administrative costs, arm's-length its members than members would do individually. If ad- pool interest rates should reflect the magnitude of ditional sources of joint efficiencies exist in a cash pool, credit and debit balances. Arms-length credit(debit) the associated portion of the residual profit would need interest generally should be high (ow)in a symmetrical to be allocated based on an allocation scheme similar to situation when credit and debit balances equalize. In an I the one derived here 1221-05 Copyright o 2005 TAX MANAGEMENT INC, a subsidiary of The Bureau of National Affa TMTR ISSN 1063-20
