thecorporatetreasurer.com2 corporate treasurer June / July 2016 thecorporatetreasurer.com2 corporate treasurer June / July 2016

China liquidity management alchemyChina’s tax reforms may not reduce tax burdens on popular cash pools, and might even increase costs. The traditional zero-balance cash pool structure specifi cally suff ers. Ann Shi reports

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cash pooling

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F or treasurers managing corporate cash pools in China, the new nationwide value-added tax (VAT) rules, which took effect on May 1, offer little in the

way of perks. Under the new tax system, four sectors –

construction, real estate, fi nancial and the consumer services industry – have joined other sectors in China in adopting VAT for their tax fi lings. Previously, they were subject to business tax (BT), for which rates vary within the range of 3% to 20%.

Even when a company does not fall into those four sectors, as long as it provides an entrust loan (also called entrustment loan or entrusted loan) to its group companies or affi liates, and obtains interest or similar income from such loans, it is subject to 6% VAT on interest income received, according to Xiong Yi, a treasury consultant at iSpan and former China head of cash management and liquidity advisory at RBS. The loan service falls under the scope of fi nancial services in the new VAT system.

In an entrust loan arrangement, a bank acts as agent for an entrusted fund from a corporate depositor and lends the funds on to a borrower designated by the depositor. This arrangement has formed the basis of cash-pooling practices in China, and for compliance reasons it is still the most popular way to concentrate cash in China.

As much as its popularity and effectiveness are cited by many treasurers managing corporate liquidity in China, cash pooling under the entrust loan structure carries a major taxation pitfall. As it’s considered a form of indirect lending, the entrust loan was, before the reform, subject to the 5% BT on interest income.

As The Corporate Treasurer reported in May, China’s VAT reform may relax corporate tax burdens by billions of dollars annually as VAT is calculated on a net basis for inter-company transactions, in contrast to the BT system, under which such

transactions were taxed on a gross basis. So, what are the tax implications of the

VAT reform on a renminbi cash-pooling structure? Domestic renminbi cash pooling is, in many cases, performed under an umbrella zero-balance structure which contains a parent account and a series of corresponding sub-accounts. Since the owners of sub-accounts and parent account are not under the same legal entity, fund sweeping between the parent account and the sub-account must be recorded as the drawdown or repayment of an entrust loan.

In addition, since fund sweeping usually takes place frequently in a cash pool, the company may need to leverage the cash pooling report (including the daily accrued interest amount) generated by its cash management bank to further calculate the output VAT.

Acording to Xiong, if sub-account A swept Rmb10,000 to the parent account at the end of the day, this would be recorded as the one-day entrust loan drawdown by the parent account. On the same day, the parent account swept Rmb5,000 at the end of the day to sub-account B, which similarly would be interpreted as sub-account B taking out a one-day Rmb5,000 entrust loan from the parent account.

Xiong explained it as follows:

• Assume the cash-pool interest rate is 3%. For example, for the parent account, the output VAT of the daily accrued entrust loan interest income is Rmb5,000 × 3% × 1 ÷ 365 ÷ (1 + 6%) × 6% = Rmb0.0233.

• Since the outstanding entrust loan amount in the cash pool fl uctuates every day, the parent account needs to accrue the output VAT based on the daily accrued entrust loan interest income, then deduct the input VAT within the same taxation period and pay the net amount. In the same manner, sub-

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compare your poolCash management is a big focus of the

account A should calculate its output VAT upon the corresponding daily accrued interest income to be paid by the parent account.

• However, the interest expenses of the parent account arising from the Rmb10,000 entrustment loan from sub-account A is not applicable for tax deduction according to the new VAT rules. It means the new VAT rules do not address the issue of the historical tax burden inherited from BT.

• It is clearly stated that the loan interest expense could not be part of input VAT for deduction purposes and the entrust loan interest income is still taxable. As a result, the tax burden associated with the traditional zero-balance cash pooling structure in China is not changed materially.

“If the corporate has not done so, it is highly recommended to transform the traditional zero-balance cash pooling structure into some type of tax-saving cash-pooling structure (e.g., sweeping on demand, or without a parent account structure…) to reduce the overall tax expense for the group,” warned Xiong.

“It is highly recommented to transform the traditional zero-balance... structure into some type of tax-saving structure”Xiong Yi

account, which reflects the overall group-level liquidity onshore. However, net outflows from cross-border cash pools remain suspended, and the new VAT rules are posting higher tax charges for ZBAs than under the business tax system. If corporates have not done so, they are advised to transform the traditional ZBA cash-pooling structure into a system that offers more tax savings (see structures 2, 3 and 4 below).

structure 2: sweep as requiredSummary: Carries low tax costs; offers poor cash concentration on a group level; inefficient when it comes to sweeping across borders.

The sweep-as-required arrangement is similar to the traditional ZBA structure, in that there is a header account and each member company has a bilateral loan relationship with the header account’s holding entity. But unlike the ZBA structure, sub-accounts can lend to each other, and not all the balances at the sub-account have to be swept to the header account. As a result, the overall inter-company transaction size and volume are smaller than structure 1, which means lower tax costs for the company.

However, as not all the balances in the sub-account have to be swept to the header account, this structure provides a relatively poor reference to group-level liquidity, hence does not work well with cross-border pooling arrangements, which are more often linked to a single header account.

structure 3: centralised, tax-efficient cash poolSummary: Carries low tax burdens; offers good cash concentration on a group level; works well for cross-border arrangements; a lot of corporates favour and are shifting to this structure.

Unlike structures 1 and 2, each sub-account company in this structure has a bilateral loan relationship with other sub-account companies. Besides a header account, which absorbs all positive sub-account balances, there is also a dummy account owned by the agent bank via which the header company can cover negative balances in sub-accounts.

The overall outstanding entrust loan in this structure is smaller than in structure A, meaning fewer tax expenses.

daily responsibilities of many treasurers and CFOs, and provides some of their best opportunities to add value.

That is especially the case for foreign multinationals whose China operations are a key revenue generator, and Chinese companies that need to fund overseas expansion. The need to manage excess and deficit cash positions across borders makes cash pooling in China the tool of choice to transfer funds out of the country.

And VAT reform is not the only recent policy change that may have steered treasurers towards rethinking how their cash pools are designed.

To name one, earlier this year, China made a U-turn on its well-publicised cross-border renminbi cash-pooling policy and suspended net outflows of money from treasury cash pools. To date, the suspension is still in force.

To cope with these changes, it is critical to understand the nuances of different cash pool designs. Some structures bear heavy tax costs, while some others deliver less optimal visibility of group-level liquidity.

Again, with the invaluable help of Xiong, The Corporate Treasurer has provided a guide to managing liquidity in China via cash pools, pinpointing their merits and pitfalls.

structure 1: traditional ZBaSummary: The zero-balance account (ZBA) carries high tax burdens; offers great cash concentration on a group level; works well for cross-border arrangements; now at risk from the ban on cross-border renminbi outflows from cash pools and VAT rules.

The most traditional form of physical pooling, the ZBA requires the establishment of a header account at group level to absorb or release liquidity to the sub-accounts held by member companies. Each member company has a bilateral loan relationship with the header account’s holding entity. After end-of-day (EOD) sweeping, each sub-account should have a zero balance.

As the entrust loan is subject to VAT, using ZBA cash pooling – which generates the biggest inter-company transactions by size and volume among the four options – would be the most expensive structure in terms of tax costs.

A ZBA system does provide good support for cross-border cash pooling, due to the establishment of a header

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cash pooling

This is the option recommended most highly for companies that intend to save tax while desiring centralised liquidity management, such as those looking to sweep cash offshore.

structure 4: tax-efficient cash pool Summary: Carries the lowest tax cost; offers no cash concentration on a group level; inefficient for cross-border arrangement

Unlike the other structures, there’s no header account. Sweeping is through a dummy account by the agent bank, and each sub-account retains its own balances. Like structure 3, each sub-account company has a bilateral loan relationship with other sub-accounts.

The overall outstanding entrust loan in this structure is the smallest among the four structures, meaning it is the most cost effective option in terms of tax. But due to the lack of a header account, it offers no cash concentration on a group level and works badly for cross-border arrangements. n

comparison

Daily outstanding entrust loan amount

When aggregated balance of whole pool is positive

When aggregated balance of whole pool is negative

Structure 1 140 80

Structure 2 90 50

Structure 3 90 50

Structure 4 50 30

Assumption: entrust loan interest rate is i% (VAT inclusive). VAT rate is 6%The daily accrued output VAT=daily outstanding entrust loan amount *i% *1 /365 / (1+6%) *6%

Daily accrued output VAT amount

When aggregated balance of whole pool is positive

When aggregated balance of whole pool is negative

Tax saving benefit

Structure 1 =140* i% *1/365/ (1+6%)*6%

=80* i% *1/365/ (1+6%)*6% none

Structure 2 =90* i% *1/365/ (1+6%)*6%

=50* i% *1/365/ (1+6%)*6% Good

Structure 3 =90* i% *1/365/ (1+6%)*6%

=50* i% *1/365/ (1+6%)*6% Good

Structure 4 =50* i% *1/365/ (1+6%)*6%

=30* i% *1/365/ (1+6%)*6% Better

Please note: l is lender, B is borrower. A, B, C and D are sub-accounts, e is the header. We assume the header account has a balance of Rmb10 before cash sweeping when the overall pool runs a surplus, and –Rmb10 when in deficit. Source: Xiong yi

centralised tax efficient cash pool (By percentage)l Before eOD sweeping: Overall pool surplusl All subs become ZBA after eOD sweepingl Header keeps remaining balance

l Before eOD sweeping: Overall pool deficitl All subs become ZBA after eOD sweepingl Header incurs extra OD

e

a B c d

1050

(before eOD sweeping)

(after eOD sweeping)

l/B e A B C D ƩeA 26.67 16.67 16.67 60B 13.33 8.33 8.33 30CDƩ 40 25 25 90

l/B e A B C D Ʃe 10 10 20A 10 10 20B 5 5 10CDƩ 25 25 50

O/S entrusted loan = 25+25+40=90 O/S entrusted loan = 25+25=50

600

300

-250

-250

40

60 30 25

25

e

a B c d

-10-30

(before eOD sweeping)

(after eOD sweeping)

200

100

-250

-250

20 10 25

25

20

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