CMS Expert Guide to cash pooling in England and Wales and Scotland

Neither English law nor Scots law hasexpress or implied prohibitions on the creation or implementation of cash pooling arrangements.  However, numerous legal principles can come into play in the context of any cash pooling arrangement and the most significant are set out below.

For a notional cash pooling arrangement to work, the bank needs to have a legal right of set-off against a company’s credit balances to clear the debit position of the other companies in the pool.  Essentially this means that each company in the pool must agree to guarantee the liabilities of the other companies to the bank (cross-guarantees).  Although a cross-guarantee structure is not normally essential in the case of physical cash pooling, in practice cross-guarantees are often taken.

Under a physical cash pooling arrangement, every time its account is swept, each company in the pool effectively swaps cash for a debt owed to it by the pool leader/treasury company.  

The directors of each company that proposes to enter into a cash pooling arrangement will need to satisfy themselves that, on balance, the actual or potential detriment to the company of the pooling arrangement is outweighed by its actual or potential benefit.  

In the case of notional cash pooling:

• the main risks are likely to be the bank exercising its rights to set off against the company’s credit balances, and/or calling on the cross-guarantees, to make up a negative cash position of another pool member; and 
• the main benefits are likely to be that the company may be able to obtain a higher rate of interest on its personal account than it could obtain without a pooling arrangement.

In the case of physical cash pooling:

• the main risks are likely to be the pool leader not repaying each debt to the company in full, either because of its own cash shortages or those of other pool members, and the weak cash position of the pool leader or other pool members reducing the ability of the company to draw on the master account; and
• the main benefits are likely to be that the company may be able to obtain a higher rate of interest on the pooled cash than it could obtain if the cash were held in its own separate account. 

It may also be possible to identify savings related to the centralisation of cash management – e.g. lower treasury and back office costs, lower overdraft fees or lower interest charges on debit balances and removal of the requirement for external financial resources by offsetting debit and credit within the group.  

Finally, where a benefit to the group as whole, or to a key member of the group, may indirectly benefit the company, this can be taken into consideration.  For example, the company may benefit where entry into a transaction is necessary to maintain the solvency of the parent company on which the company is reliant or to ensure continued funding for the group where the group’s activities are so closely inter-connected that the failure of one group entity would adversely affect all the others.  However, it is not sufficient that the arrangement only benefits the group as a whole.   

An English or a Scottish company can enter into a cash pooling arrangement provided that the transactions involved (e.g. lending to other group companies or the granting of cross-guarantees) are permitted by the company’s constitution.  If there is any doubt about whether the transactions are permitted, the company should first obtain a shareholder resolution to amend the constitution.  If, for some reason, a company enters into a cash pooling arrangement that is not permitted by its constitution, in most circumstances the bank and other group companies should nevertheless be able to enforce the arrangement against the company; but the directors will be liable to the company for exceeding their authority. 

In addition to constitutional matters, the company would need, of course, to comply with its existing contractual obligations (e.g. in financing agreements), which may restrict the making of loans, the granting of guarantees or the incurring of financial indebtedness.  Where restrictions apply, the company will need to obtain waivers or consents in order to enter into the pooling arrangements.

Cash pooling agreements are contractual arrangements and English and Scots law requires that, in order for there to be a valid contract, there must be offer, acceptance, consideration and an intention to create legal relations.  Banks may include rights of set-off (to bolster banker’s rights of set-off, a special right recognised as a matter of common law) and flawed asset clauses (clauses which provide that title to a particular right or asset is conditional in some way- for example, that a depositor has no right to its deposit back unless certain liabilities have been discharged).  

As a practical measure to give assurance that, overall, the arrangement benefits the company, the company’s board of directors should pass a resolution confirming that it has considered the matter and concluded that the arrangement and related transactions should be approved.  It may be helpful to identify in the board minutes the benefits expected (whether tangible or intangible) and to include the board’s assessment of the solvency of the company and other pool members.  

One or more directors should be tasked with monitoring the risks and benefits of the arrangement, and reporting back to the board, on a regular basis.  This will entail monitoring the financial position of the other pool members.  The pooling arrangement should be terminated if and when the board concludes that the level of risk to the company outweighs the benefit – e.g. because a serious deterioration in the financial position of another pool member makes it likely that the bank will call on the cross-guarantee or that a loan will not be repaid.

As set out above, cash pooling agreements will also usually include guarantees, and guarantees are required to be made in writing and signed by or on behalf of the guarantor.  The Companies Act also legislates for the manner in which contracts or under English law deeds (as the case may be) are executed.  Although not a statutory requirement, under English law guarantees are often entered into as deeds which will avoid any questions regarding presence or (from the perspective of legal formalities only) sufficiency of consideration. Under Scots law, guarantees are usually entered into in accordance with the Requirements of Writing (Scotland) Act 1995. In addition, where a company is proposing to guarantee the liabilities of its parent or sister companies, it is usual practice to obtain a shareholder resolution approving the guarantee.  Unless the arrangements give rise to the creation of security, however, there should be no public registry registration requirements.  Passing a shareholder’s resolution can also reduce or eliminate the risk of the company subsequently (perhaps at a time when it is under the control of a new owner) challenging the validity of the arrangement on the basis that it was not in the best interests of the company.  However, such a resolution will not be effective if the company is insolvent, or threatened by insolvency, at the time of the resolution.  Nor will it prevent the guarantee being challenged as a transaction at an undervalue or a preference under insolvency legislation (see paragraph 4 below) or as an unfair preference or a gratuitous alienations with regard to a guarantee granted by a Scottish company (see paragraph 5 below).

England and Wales

If an English company, which gives a cross-guarantee for the purposes of a notional cash pooling is subsequently found to have been insolvent at that time or becomes insolvent as a result, the cross-guarantee may be capable of being challenged as a “transaction at an undervalue” or a “preference” pursuant to section 238 or section 239 of the Insolvency Act 1986 (the “Insolvency Act”) respectively.  The guarantee could be at risk as a “transaction at an undervalue” if it is given within two years of the commencement of insolvency proceedings in respect of the company.  Under section 239 of the Insolvency Act, the guarantee could be at risk as a “preference” if it is given within six months of the commencement of those proceedings (or two years if it is given to a person connected to the company).  Any such guarantee, if capable of being challenged, is more likely to be challenged as a transaction at an undervalue and would depend on whether the value of the guarantee provided is significantly more than the value of any consideration received by the guarantor as part of the transaction.  Guarantees are not usually at risk of being preferences.

Similar considerations apply to a physical cash pooling arrangement but, in practice, intercompany payments made as part of that arrangement are unlikely to be attacked as a “transaction at an undervalue”, because: 

• the “value” in this context would be expected to consist of the loan that would arise by virtue of each relevant cash transfer (assuming the recipient is solvent so could be expected to be able to repay the loan); and
• the company transferring cash is likely (because of its persistent credit balances) to be in a relatively strong, rather than weak, financial position and accordingly the danger of it being insolvent at the time of or as a result of the payment should be remote.

Whether such payments could be challenged as preferences would depend on whether the recipient was also a creditor, surety or guarantor of the party making the payment.  However, even if that were the case, for it to be capable of being challenged as a preference, there would need to have been a desire on the part of the party making the payment to “prefer” the recipient as opposed to the better position the recipient would have been placed in merely being a consequence of the transaction. 

Any intercompany payments made under pooling arrangements may not be made following the commencement of a winding-up procedure.  Accordingly, if a winding-up resolution is passed by the company or a winding-up petition is presented to the court, the pooling arrangements could only be relied on in relation to intercompany payments made prior to such time or in relation to debts incurred in favour of the bank prior to that time.   

Scotland

In Scotland, the legal position on insolvency is different to England and Wales.Sections 242 and 243 of the Insolvency Act govern the two main antecedent transactions which exist in the Scottish legal system: “unfair preferences” and “gratuitous alienations”. 

Unfair preferences share many of the same traits as the English law equivalent “preferences” described above, including the same six-month hardening period whereby a transaction can be challenged as an “unfair preference” if it occurred not earlier than six months prior to the winding-up of the company (in Scotland this period applies whether or not the unfair preference is given to a person connected to the company). The main difference between the two, however, is that there is no requirement to show a desire to prefer in Scotland. As noted above, in England and Wales, for any payment to be challenged as a “preference” it must be demonstrated that the party making the payment held a desire to “prefer” the recipient as opposed to the better position recipient. This requirement does not exist in Scotland, and it is therefore potentially easier to challenge any inter-company payment or cross-guarantee made under a cash pooling arrangement in Scotland on the basis of “unfair preference” as there is one less condition to satisfy.  

“Gratuitous alienations” as set out under section 242 of the Insolvency Act provide that in the event a Scottish company disposes of property for no or inadequate consideration within two or five years of the commencement of its winding up (depending on who the transaction favoured), it can be challenged and, if successful, unwound by the court. Therefore, in the same way a cross-guarantee made for the purposes of a notional cash pooling could be challenged as a “transaction at undervalue” in England, it could be challenged as a “gratuitous alienation” in Scotland. The period for challenge in Scotland extends to five years if the transaction is deemed to be in favour of someone associated with the company, and the main defences available are (i) the alienation was made for adequate consideration, or (ii) the alienation was a conventional or charitable gift, or (iii) immediately, or at any other time, after the alienation, the company’s assets were greater than its liabilities.

Unless the pooling arrangements somehow constitute financial assistance in connection with the acquisition of the shares of an English or Scottish public company (e.g. where the public company is required by the buyer’s lending bank to enter into a cash pooling arrangement that will reduce the buyer’s liability to that bank) or involve an unlawful return of capital (see below) or misconduct on the part of the directors, there should be no corporate, civil or criminal liability issues for the English company or Scottish company or their respective directors or managers.  

Scottish and English law imposes maintenance of capital rules on UK companies.  An arrangement that involves a transfer of assets (e.g. a loan), or the assumption of a liability (e.g. a guarantee), that in either case is for the benefit of one or more shareholders, may amount to an unlawful reduction of capital if, as a result of the arrangement, there would be a reduction in the net assets recorded in the company’s books and that reduction exceeds the amount of the distributable reserves of the company.  An arrangement that constitutes an unlawful return of capital will be void and recipients may be liable to account to the company for assets received.  Parties to a cash pooling arrangement where moneys are passing between group companies will want to ensure that the status of these transmissions is clear so they are not construed as potentially unlawful distributions. 

To reduce the risk of a cash pooling arrangement being challenged on this basis, it will be helpful, where relevant, for board minutes to demonstrate that the directors have considered whether the arrangement will lead to a reduction in net assets and, if so, the amount of profits available for distribution.  This will involve an assessment of the likelihood of any loan not being repaid or any guarantee being called and, under some accounting standards, the market value of a loan made or a guarantee given.  If, on normal accounting principles, the loan or guarantee does not require an immediate accounting loss to be recognised, there should be no unlawful return of capital.  

The Companies Act 2006 (as amended from time to time) contains several statutory duties which are owed by the directors to the company.  In general, only the company can enforce these duties, although, in certain circumstances the shareholders may bring an action (known as a derivative action) against the directors who are in breach.  If a director acts in breach of any fiduciary duty to the company in entering into the pooling arrangement, he will be liable to indemnify the company for any loss it suffers as a result, and to account to the company for any profit he makes.   

In particular, where a director of one group company (company A) is also a director of another company within the pool (company B), he may, in approving the pooling arrangement, be in a position where his duties to company B conflict with his duties to company A – particularly if one of the companies stands to benefit from the arrangement to a much greater extent than the other.  In such circumstances, unless the constitution of each company permits the director to take part in the approval process despite the conflict, best practice is for the director to step out of the discussions on both boards.  Where this is not practicable, the prudent course is to obtain a shareholder resolution to authorise the director to participate despite his position of conflict.

Ultimately, if the cash pooling arrangement is for the commercial benefit of the company and the shareholders have approved it, then there should be no liability for the directors.

Account establishment processes typically raise know-your-customer and anti-money laundering issues.

Cash pooling arrangements will have regulatory implications for the deposit-taking bank.  CMS’s UK financial services regulatory team are very happy to advise further.

a) Interest deductibility

Interest on loans is deductible if the loan is a “loan relationship” (i.e. a money debt).  The interest will be deductible in accordance with relevant accounting treatment.  Any loan relationship entered into for unallowable purposes (which includes tax avoidance) will not be deductible.
There is a further limit on deductibility where interest is paid by a close company to a participator resident in a non-qualifying jurisdiction; and: 

• the full amount of the interest is not assessable on the lender under the loan relationship legislation (i.e. where the lender is outside the charge to corporation tax); and
• the interest is not paid within 12 months of the end of the accounting period in which it was accrued.

Payments of “interest” may be re-characterised as a dividend in the following circumstances:

• to the extent that any interest that exceeds a commercial rate of return under section 1000(1)E of the Corporation Tax Act 2010 (“CTA 2010”);
• where the interest is payable on a debt which is more like a share than a debt (by virtue of section 1000(1)(F) CTA 2010); and 
• where the interest is payable on securities which are convertible, directly or indirectly, into shares of the company, unless the securities of the company are quoted on a recognised stock exchange (by virtue of section 1000(1)(F) CTA 2010).

By virtue of section 54 of the Corporation Tax Act 2009, interest payable in respect to a contract debt (i.e. not a money debt) will not be deductible unless it is wholly and exclusively incurred for the purposes of the trade of the company in question.

b) Withholding tax

Notional cash pooling possibly reduces withholding tax issues, as interest is likely to be treated as interest from the bank rather than from another member of the group.  Under UK legislation, there is no withholding tax on payments to UK banks and to other UK corporates.

Under physical cash pooling arrangements, intra-group loans will arise on which interest will be payable by one group member to another.  One would need to look at the relevant tax treaties to see if tax needs to be withheld and whether this can be reduced by making a treaty clearance application.

c) Thin capitalisation rules

HM Revenue and Customs (“HMRC”) generally operate on the basis that they do not like companies being funded by debt from related third parties beyond the level a third party bank would be willing to contemplate.

Since 1 April 2004, the UK thin capitalisation legislation has been a subset of the UK transfer pricing rules.  As a result, much of the basic transfer pricing approach carries over to thin capitalisation cases and, like transfer pricing, the thin capitalisation provisions need to be interpreted in accordance with the Organisation for Economic Co-operation and Development guidelines.

The UK’s application of thin capitalisation relies upon the arm’s length principle – how much the borrower would have been able to borrow from an unconnected third party.  In applying this principle, it is necessary to consider the borrower in isolation from the rest of the group.

This does not, however, require actual assets or liabilities to be disregarded.  For example, shares in subsidiaries and intra-group loans should be taken into account in calculating borrowing capacity to the same extent that they would be taken into account by an unconnected lender.  In the case of shares, the practical effect of this rule is thought to be that all assets and liabilities in direct or indirect subsidiaries should be taken into account.  Equally, income or expenses arising from intra-group trading contracts should not be disregarded.

Under the transfer pricing rules, where a loan exceeds the amount that would have been provided by an unconnected lender, the interest on the excessive part of the loan is disallowed as a tax deduction for the borrower.  Nevertheless, the excessive interest can be paid without deduction of tax.  This is because the rules provide that the excessive interest is not treated as interest for tax purposes, and so the condition in section 874 of the Income Tax Act 2007 to deduct tax at source is not met.
Furthermore, under the distribution rules, where an interest payment (or part of it) is recharacterised as a dividend there is also no requirement to withhold tax in respect of it.

d) Cap on interest deductibility

Groups with net interest and financing costs of over £2million a year may be subject to the Corporate Interest Restriction, which limits the amount of tax relief available for interest and other financing costs.In addition, anti-avoidance rules may prevent a tax deduction for interest payments where a “hybrid mismatch” arises, for example double deductions for the same interest expense, or deductions for an interest expense without the corresponding receipt being fully taxed.

e) Value added tax

Under Council Directive 2006/112/EC (the “VAT Directive”), with effect from 1 January 2010, the general position with regard to transactions involving services supplied to business customers was reversed, such that they will be deemed to take place in the jurisdiction where the recipient belongs or has a fixed establishment.  This change has been implemented under UK law in section 7A of the Value Added Tax Act 1994 (“VATA”) and will not change the position in relation to services currently listed in schedule 5 VATA which, for business customers, were always deemed to be supplied where the recipient belonged and include banking and financial services, such as treasury services being performed by a parent.  

Where services supplied in the UK are received by a UK taxable person from a person established outside the UK, the reverse charge mechanism will apply so that the recipient may have to account for VAT on his receipt of the services.  The reverse charge mechanism should not, however, result in any VAT in this case because financial services are generally exempt in the UK.

There is no stamp duty or other indirect taxes that will be payable on the principal or on the return of the cash transactions.