Jumping into the deep end of the (cash) pool

From a financial liquidity perspective, cash-pooling arrangements are a useful financing tool for multinationals seeking to ensure that funds are available to their entities. However, Canadian tax rules have generally rendered the use of cross-border “cash pools” prohibitive for Canadian entities within multinational groups, despite the commercial benefits of these types of arrangements.

Canada has enacted a multitude of complex income tax provisions targeting related-party upstream, downstream, and side-stream lending and borrowing arrangements, and these provisions have created an onerous compliance burden; in many cases, they have also resulted in a Canadian tax cost associated with cash-pooling arrangements. Further, given the CRA’s designation of certain back-to-back arrangements¹ as being notifiable under the mandatory disclosure rules (MDR), taxpayers may now be required to go to the CRA “hat-in-hand” to disclose their participation in certain types of cross-border cash-pooling arrangements. Given this tax complexity, should the treasury departments of multinationals give pause to the participation of Canadian entities in cross-border cash-pooling arrangements?

Cash pools 101

For context, what do we mean by a “cash-pooling arrangement,” and how does it benefit an organization? Financial institutions use various terms to refer to these types of arrangements, such as liquidity management solutions, cash concentration arrangements, and global cash management arrangements. For the sake of this discussion, let’s refer to these as cash-pooling arrangements, a term that broadly encompasses financial arrangements used to deploy cash resources within an organization in a timely manner. These arrangements have been in practice for decades and have increased in sophistication over time.

Generally, there are two types of cash pools: 1) physical cash pools, whereby participating entities have their bank account “swept” of its excess cash resources, which are then placed into the bank account of the cash pool manager (i.e., a financing entity within the group)—usually on a daily or continuous basis; and 2) notional cash pools, whereby there is no physical movement of cash, but the participating entity’s bank account balance will be “notionally” debited or credited with the cash-pool balances of other participants, thereby optimizing the financial costs associated with treasury activities. Regardless of the type of pool, however, there are no explicit Canadian tax rules that address cash-pooling arrangements, and Canadian tax jurisprudence generally treats these transactions as having the character of a loan or indebtedness.

There are many upsides to using cash pools within a multinational organization, and the benefits can be meaningful. For example, cash pools can be used to allow for:

• Increased flexibility and timeliness in supporting the cash needs of discrete entities within the group;
• More centralized control and oversight of cash resources;
• Better management of foreign exchange exposures;
• Lower costs compared to those incurred when sourcing the funds externally; and
• A greater ability to streamline external banking relationships to one entity.

While tax is one of the many considerations for any treasury department considering a cash-pooling arrangement, it seems to play a particularly weighty role for multinationals that are attempting to include Canadian entities—in effect, tax in this case is like the metaphorical “tail wagging the dog.” Moreover, given the CRA’s administrative views concerning these types of arrangements, the unwary who choose to use them may face significant tax costs, such as income inclusions and withholding taxes.

A sample scenario

Since 2012, Canada has significantly strengthened the protection of its tax base through the introduction of (and amendments to) upstream loan provisions; foreign affiliate dumping rules; thin capitalization provisions and the recharacterization of denied interest to dividends; back-to-back rules in numerous parts of the Act²; and shareholder loan provisions.

Take a scenario whereby a Foreign Corporation (ForCo) has a Canadian Subsidiary (CanSub), as well as multiple Foreign Subsidiaries (ForSubs), and it employs a cash-pooling arrangement. If, as the cash-pool manager, ForCo uses positive funds from its ForSubs to support the cash needs of CanSub, these amounts will be treated as inbound loans to Canada for Canadian tax purposes. The consequential Canadian tax implications might include:

• The limitation of interest deductibility under the thin capitalization rules³ (not to mention, the now effective EIFEL⁴ rules);
• The leakage of withholding tax on interest paid to the cash pool manager; and
• The potential application of the back-to-back withholding tax rules, meaning that the CRA will look to the ultimate funding entity and not just the pool header (ForCo) to determine the proper entitlement to withholding tax.

This requires treasury departments to methodically trace the use of the funds within cash-pooling arrangements and create a system that will enable them to prove such tracing to the authorities, if ever challenged. If the corporate structure is simple and there are few entities in the cash pool, it’s possible that the Canadian tax consequences could be manageable. However, when multiple entities are participating in a cash pool and potentially sweeping cash on a daily basis, the tracing of loan balances—which entities must do to comply with Canadian tax rules—is entirely impractical.

Slight modifications to the example above wherein CanSub either acts as a lender to the pool (i.e., CanSub has surplus cash that can be redeployed to other entities within the multinational group) or has its own foreign subsidiaries that are participants in the pool, render the Canadian tax consequences virtually impossible to manage, as both scenarios would require a constant and ever-updated analysis of the Canadian income tax provisions invoked. Some of the potentially-applicable provisions have exceptions,⁵ but often the criteria for these exceptions depend on the length of time the loan is outstanding (subject to the existence of a series of loans and repayments), the filing of certain elections, or the tracing of the loaned funds to the lender’s active business. All of this means that if the lending/borrower position is only reviewed once per year, there may not be enough time to act in a way that mitigates the Canadian income tax exposure created by the cash-pooling arrangement.

Furthermore, tax directors are also charged with keeping all transactions in line with transfer-pricing parameters and considering the impact of the Multilateral Instrument6 on withholding tax instances. Essentially, the ever-changing lending and borrowing position of a single Canadian entity participating in a cash pool increases the burden of tax analysis exponentially. And, ultimately, the attributes of a cash-pooling arrangement that are attractive from a treasury perspective (i.e., flexibility and the fluid movement of cash) are the very same attributes that complicate the Canadian tax analysis.

Adding to this complexity, Canada has now mandated that taxpayers (and their advisors) notify the CRA of the existence of certain “notifiable” transactions, and those who don’t face large penalties. Under the MDR, a transaction becomes notifiable if it is the same as or substantially similar to the transactions designated by the Minister of National Revenue. Notably, one of the transactions designated as notifiable involves back-to-back arrangements in a manner seemingly broad enough to capture certain cash-pooling arrangements.

Using the earlier example to illustrate this complexity, if the Canadian withholding tax rate applicable to interest paid on a loan granted by ForCo to CanSub is less than the rate that would otherwise be applicable to interest on a loan granted by one ForSub to CanSub, the taxpayer may face significant penalties if they don’t disclose the transaction on a timely basis. Additionally, an “advisor” involved in the transaction may also be liable for penalties if they themselves fail to disclose the transaction.

The upshot

So where does this leave Canadian tax and treasury teams seeking cash management solutions? Considering the factors discussed in this article, it’s arguable that cross-border cash-pooling arrangements involving Canadian entities are not feasible from a Canadian tax perspective except in the case of very specific and narrow fact patterns. Moreover, even with narrow “permissible” fact patterns, compliance with Canadian tax rules requires significant monitoring of the use of funds.

Realistically, for Canadian tax reasons, treasury departments may be wise to eschew the involvement of Canadian entities in cross-border cash-pooling arrangements and choose simpler alternatives such as equity investments and straightforward lending arrangements, which have well-understood Canadian tax consequences.

Author

Tessa Reah, CPA, CA, is a senior manager in KPMG’s international corporate tax practice in Vancouver. She advises on Canadian and international tax matters for clients in a wide range of industries and specializes in financing and structuring of inbound investment into Canada, outbound investments from Canada, corporate reorganizations, and the planning and compliance of foreign affiliate structures.

The article was originally published in the September/October 2024 issue of CPABC in Focus.

Footnotes