CMS Expert Guide to cash pooling in Hong Kong

On 1 July 1997, Hong Kong became the Hong Kong Special Administrative Region of the People’s Republic of China.  The foundation of Hong Kong’s legal system is English common law, which was is largely preserved beyond 1 July 1997. Article 8 of Hong Kong’s Basic Law provides that the laws previously in force in Hong Kong shall be maintained, except for any that contravene the Basic Law, subject to any amendment by Hong Kong’s legislature. 

In general, Hong Kong law does not prohibit the creation or implementation of cash pooling arrangements. 

The article below aims to set out (i) a brief overview of the cash pooling arrangements in Hong Kong, (ii) its liability risks, (iii) the legal structure to reduce liability risks, (iv) tax issues and (v) other issues concerning the cash pooling arrangements in Hong Kong. 

Cash pooling arrangements are becoming prevalent for companies in Hong Kong as they are used to fund expansion which requires both structural and working capital at a reduced procurement cost and provides a direct insight into the liquidity of the individual group companies. There are two types of cash pooling arrangements commonly available in Hong Kong, i.e. physical cash pooling arrangement and notional cash pooling arrangement.

a) Physical cash pooling arrangement 

Physical cash pooling, which is also known as cash sweeping, is an arrangement where the money is physically transferred between the bank accounts of group companies participating in a cash pool.  It is common that the transfers between the pool amounts are made on a day-to-day basis.  The ownership of the cash changes as the relationship moves from a deposit with a third party. 

Under the arrangement of physical cash pooling, the physical concentration to the designated header account effectively zero balances the sub-accounts and it can be used across multiple legal entities, located in the same or different countries, but on a currency-by-currency basis.  

b) Notional cash pooling arrangement 

Notional cash pooling allows the group to net off the balances of different accounts across jurisdictions, which does not involve the physical transfer of monies between accounts held by members within the pool.  It achieves a similar result as physical cash pooling, however, it is accomplished by creating a shadow or notional position resulting from an aggregate of all the accounts, which can be held in multiple currencies.  Interest is paid or charged on the consolidated position and there is no actual movement of funds. 

As mentioned above, there is no physical transfer of funds between entities is involved in notional cash pooling and it could reduce the transaction costs and management costs.  Furthermore, the time gap is saved from doing foreign exchange conversions and this would be beneficial for the group to reduce further time and costs.  Conversions can also be executed at a preferable rate at a later date after the payment obligation is fulfilled.  

A bespoke account structure has allowed funds from entities in overseas or Mainland markets to be concentrated in the cash pool structure in Hong Kong.  Funds collection and payment operations of the foreign entities can then be centralised.   Under the notional pool arrangement, funds in multiple currencies can be utilised across multiple entitles without physical movement.

It is quite common for the bank administering the pool to require cross-guarantees between the pool members and to offset credit and debit balances across the accounts of members within the pool.   This protects the bank’s interests in the case of a pool participant defaults in relation to the repayment of its borrowings.

c) Benefits of cash pooling 

Cash pooling is a best-practice technique to centralise and optimise liquidity through balancing excess and deficit cash across the corporations. With the combination of positive and negative positions from various subaccounts into one master account, the company’s treasurer can save considerable amounts of money by optimizing interest income, bank charges and tax costs. Furthermore, the costs of short-term funding can be reduced significantly.  

This also allows intercompany transactions which benefit the group as a whole or a key member of the group, and the entry into the transactions may benefit the parent company to maintain its solvency and to ensure continued and sufficient funding for the group and the ground’s activities.

For a Hong Kong company to enter into a cash pooling arrangement, we set out below the salient points that directors and shareholders should be cautious of concerning their respective liabilities.  

a) Liability of directors

A director of a company entering into a cash pooling arrangement should be aware of the director’s duties owed by him to the company.  In general, director’s duties in Hong Kong can be classified into two broad categories, (i) the duty of care, skill, and diligence; (ii) fiduciary duties. 

The Companies Ordinance (Cap. 622) codifies a director’s duty to exercise reasonable care, skill and diligence.  In determining whether a director has breached such duty owed by him to the company, his conduct is compared to the standard that would be exercised by a reasonably diligent person having (i) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the functions carried out by the director in relation to the company (an objective test); and (ii) the general knowledge, skill and experience that the director has (a subjective test).  A director of a company also owes common law fiduciary duties to the company which are uncodified and are subject to case law. 

A director who fails to comply with the above directors’ duties when entering into a cash pooling arrangement may, depending on the type of breach, be liable to civil or criminal proceedings and may be disqualified from acting as a director. 

The directors should also be mindful that the cash pooling arrangements entered into by the company does not constitute unlawful financial assistance in connection with the acquisition of shares of a Hong Kong company or involve an unlawful return of capital.  A director of a company which fails to comply with the relevant laws in this regard may be held criminally liable.

In general, there should not be any liability on the part of the directors of the company in the context of a company entering into a cash pooling arrangement provided that (i) a director properly exercises his duty of care and fiduciary duty to the company in relation to the cash pooling arrangement; (ii) the company complies with the relevant laws which may be applicable to the cash pooling arrangement; and (iii) the relevant acts in relation to the cash pooling arrangement are (a) duly authorised by the directors and, where applicable. The shareholders of the company, and (b) not inconsistent with the constitution of the company. 

b) Liability of shareholders 

In general, there are limited risks associated with becoming a shareholder of a limited company in Hong Kong.  A shareholder of a limited company in Hong Kong is normally only liable for the unpaid amount of his shares in the company.   Additional liability, however, may be taken on by a shareholder if expressly provided for in the company’s constitution or a shareholder agreement.  A shareholder may also assume additional liability in situations such as acting as a director of the company or where there is a tort claim against the company.  

c) Insolvency considerations

Cash pooling are akin to transactions involving the giving of guarantees. Such transactions may, in certain circumstances (especially where a company is unable to pay its debts as they fall due or otherwise insolvent), be susceptible to challenge if the guarantor subsequently enters insolvency.  

For example, if a company was insolvent at the time of any cash pooling transaction, and the cash pooling transaction is considered to be an unfair preference in favour of a creditor (e.g. the bank or another group entity) against other creditors, the court might set aside the cash pooling transaction entered into by a company up to 2 years prior (in the case of affiliated parties) or 6 months prior (in the case of non-affiliated parties) to its winding up (section 266 of Companies (Winding Up and Miscellaneous Provisions) Ordinance (CWUMPO) (Cap.32) “Cap 32”). 

If any cash pooling transaction is deemed to constitute “transactions at an undervalue” and takes place within 5 years of the company’s winding up, such transaction may also be set aside. “Transaction at undervalue” may occur if a company makes a gift to, or enters into a transaction with, a person on terms that provide for the company to receive no consideration; or enters into a transaction with a person for a consideration (to be assessed in terms of money or money’s worth) the value of which is significantly less than the value of the consideration provided by the company (section 265D and 265E of Cap 32). 

The above insolvency claw-back risks may be mitigated if the company can demonstrate that it entered into the cash pooling transaction in good faith for the purpose of carrying on its business and there are reasonable grounds for believing that the transaction would benefit the company (section 265D of Cap 32). 

For the cash pooling arrangements to be made possible, it would involve the preparation of legal documents, including but not limited to cash pooling agreements, guarantees, etc.  Furthermore, as addressed above, it is important to be mindful of the memorandum of articles and constitution of the company when drafting the legal documents in effecting the cash pooling arrangements as well as ensuring the company has the power and authority to enter into the transactions contemplated under the cash pooling arrangements, including but not limited to the granting and taking of intercompany loans, and the issuance of any required guarantees.

a) Cash pooling agreements and guarantees

The cash pooling agreements are in essence contractual agreements. The constituent legal elements of a valid contact include offer, acceptance, consideration and an intention to create legal relations. The right to set-off may be included by the banks. 
Pool members are commonly required to provide guarantee the liabilities of every other participant in a cash pool to the account bank.  These guarantee arrangements are typically required so that, if any group company becomes insolvency, the bank may set of the liability of another guarantor group company against the sums due from the insolvent entity. 

For physical cash pooling, movements between accounts are categorised as intercompany loans to and from the header entity and the participating subsidiaries.  Specific loan documentation related to the pool structure is prepared in advance.  The holding entity should be designated as an agent for the group which allows the interest paid and earned to be treated as bank interest and is not subject to withholding tax. 

The sweeping entries are documented daily though the bank transactions and arm’s length interest is paid or charged either monthly or quarterly.  The documentation and bank transaction detail leaves a sufficient audit trail that is appeared by corporate tax and would satisfy even a conservative interpretation in a tax audit. 

The bank (or system) managing the notional pool provides an interest statement reflecting the net offset that is similar to what would have been achieved with physical pooling.  As there is no physical movement of money, intercompany loans are not required to account for the offset.  

When preparing the legal documentation for notional cash pooling across multiple currencies usually requires that these currencies be brought to a common basis (usually EUR or USD) before the pooling and interest offset can take place.  
The multicurrency appeal of notional cash pooling is somewhat negated due to the complexity arising from the cross-jurisdictional nature of the arrangements and the need to accommodate multiple regulatory regimes.  If accounts are maintained across several banks in different countrites, there are complications with cut-off times to say nothing of extra transaction costs and bank fees.  Due to the opaque nature of the arrangement, it can trigger tax scrutiny. 

b) Corporate governance 

As a matter of good governance, the board of directors should consider the cash pooling arrangement and its related legal documentation and pass a resolution to confirm that the arrangement and related transactions should be approved with the benefits expected and financial condition of the company and other pool members being considered.  It is also usual that a shareholders’ resolutions is obtained where a company is proposing to guarantee its liabilities of its parent or sister companies. 

Hong Kong has been globally recognised as a “low, simple and competitive tax system” and the Government of Hong Kong has adopted the territorial source principle of taxation over the years.  We have highlighted the following tax issues that are relevant to the cash pooling arrangements. 

a) Thin capitalisation rules 

Hong Kong does not have thin capitalisation rules.

b) Interest deductibility

For intra-group cash pooling arrangements not involving a non-Hong Kong associated corporation, if a corporation obtains a loan from a non-financial institution in the ordinary course of its intra-group financing business, the interest expense is deductible, provided that the corresponding interest income of that non-financial institution is chargeable to Hong Kong profits tax. (see Departmental Interpretation and Practice Notes No.52)

For intra-group cash pooling arrangements involving a non-Hong Kong associated corporation, a corporate borrower carrying on in Hong Kong an intra-group financing business is allowed deduction of interest payable on money borrowed from a non-Hong Kong associated corporation under specified conditions. 

Such conditions being:

1. The deduction claimed must be in respect of interest payable by a corporation on money borrowed from a non-Hong Kong associated corporation in the ordinary course of an intra-group financing business;
2. The lender must, in respect of the interest, be subject to a similar tax in a territory outside Hong Kong at a rate not lower than the reference rate; and 
3. The lender’s right to use and enjoy that interest is not constrained by a contractual or legal obligation to pass that interest to any other person (unless as a result of a transaction between the lender and such other person dealing at arm’s length).

c) Transfer pricing 

The Hong Kong transfer pricing rules generally follow the OECD transfer pricing guidelines and require transactions with related parties to be on arm’s length terms.   The rules allow the Inland Revenue Department to impose transfer pricing adjustments on either income or expense arising from non-arm’s length transactions between related parties that create a potential Hong Kong tax advantage. 

d) Withholding tax 

Hong Kong does not impose withholding tax on dividends and interests.  Withholding tax is imposed on payments received by non-residents for the use of, or right to use, certain intellectual property in Hong Kong or outside Hong Kong where the payments are deductible for the taxpayer. 

e) Corporation tax 

The corporation tax rate applicable to corporations is 8.25% for corporations on the first HK$2 million of assessable profits and 16.5% for corporations on the remainder of assessable profits.

The tax rate on qualifying profits (those derived from (i) lending money in the ordinary course of a corporation’s intra-group financing business to a non-Hong Kong associated corporation; (ii) providing corporate treasury services to a non-Hong Kong associated corporation; or (iii) entering into corporate treasury transactions that are related to the business of a non-Hong Kong associated corporation) of a standalone corporate entity with 75% or above of its profits and assets related to qualifying corporate treasury activities (which includes services such as cash pooling) is 50% of the prevailing profits tax rate of 16.5% for corporations. 

f) VAT rules

Hong Kong does not have value added tax.

Hong Kong is an important gateway to Chinese markets, which attracts numerous foreign and PRC enterprises to operate in Hong Kong.  Cross-border cash pooling arrangements has become an integral part of Hong Kong’s cash and liquidity management as Hong Kong has no foreign exchange restrictions and is in close proximity to Mainland China.  A number of leading banks offer cross-border notional cash pooling and are equipped with expertise to advise corporate clients in establishing cross-border cash pooling arrangements between Hong Kong and Mainland China under the latest circular issued by the State Administration of Foreign Exchange (SAFE). 

It is also worth to take note that the account opening process will normally involve know-your-customer and anti-money laundering issues and Hong Kong has implemented anti-money laundering and counter-terrorist financing legislation, including but not limited to the following:

1. Drug Trafficking (Recovery of Proceeds) Ordinance (Cap.405);
2. Organized and Serious Crime Ordinance (Cap. 455);
3. United Nations (Anti-Terrorism Measures) Ordinance (Cap. 575); and
4. Anti-Money Laundering and Counter-Terrorist Financing (Financial Institutions) Ordinance (Cap.615)

The Hong Kong Monetary Authority has also issued a series of Guidelines on the prevention of money laundering.  A Financial Action Task Force (FATF) member observes most of the FATF-49 standards.  Hong Kong is also a member of the Asia / Pacific Group on Money Laundering (APG) and the Group of International Finance Centre Supervisors (GIFCS).  Financial institutions must apply customer due diligence measures when establishing a business relationship and the beneficial owners must also be identified.   Ongoing monitoring of accounts and transactions is required taking a risk-based approach and financial institutions in the broadest sense must record and report suspicious transactions to the Joint Financial Intelligence Unit.  Financial institutions must also maintain records for five years following termination of the business relations.