Covid-19: Impact on Foreign Exchange Fluctuations
“The increased risk aversion on account of Covid-19 has resulted foreign investors pulling out money from the emerging markets. This has caused the rupee to depreciate against the dollar. This exceptional change in foreign currency rates exposes business enterprises to foreign exchange (FX) risk and impact transfer pricing analysis. The article focuses on the treatment of FX gain or loss and emphasise under which situation it should be considered as a part of profitability analysis or treated as an abnormal item that require economic adjustments. Economic crisis generated by Covid-19 has more varied effects on industries or markets and therefore, the prospects of finding appropriate comparables would be difficult and therefore, in such circumstances, it is important that taxpayer maintains robust transfer pricing documentation to justify such economic adjustments. Read on to know more…”
Background
The increased risk aversion on account of Covid-19 has resulted foreign investors pulling out money from the emerging markets. This has caused the rupee to depreciate against the dollar. The data indicates1 that the rate of USD was INR 71.75 as on December 01, 2019 which has gone as high as INR 76.97 on April 21, 2020. However, the Indian Rupee surged to INR 75.33 after Prime Minister Narendra Modi announced a 20 trillion-rupee economic package to help the country cope with the extended corona virus crisis.
This exceptional change in foreign currency rates exposes business enterprises to foreign exchange (FX) risk. FX risk relates to the potential variability of profits that can arise because of changes in foreign exchange rates. Business enterprises that regularly transact in and convert multiple currencies to meet contractual obligations are particularly vulnerable to this risk and may suffer significant financial losses as a result.
There are three types of FX risk: (i) transaction risk – risk of exchange fluctuation between the time transactions are committed and settled; (ii) translation risk - conversion of the financial statements of a foreign subsidiary into the reporting currency of the parent and; (iii) policy risk - caused by the effect of unexpected and unavoidable currency fluctuations when there is a time lag between entering into a contract and actual transaction. Illustrative examples are given below:
| Transaction risk | Translation risk | Policy risk |
|---|---|---|
| Company A entered into an agreement with Company B for import of 100 products. At the time import of goods USD 1 is equivalent to INR 50 and if the rupee depreciated to INR 60 at the time of settlement, then the Company A will need to pay INR 6,000. The transaction risk resulted in a loss of INR 1,000. | Indian Parent company made a profit of INR 5,000 and the foreign subsidiary, reported loss of USD 100. Currently, USD 1 is equivalent to INR 50. However, before the parent company consolidates its financial reports, the rupee depreciated to INR 60. Now, parent company reports a consolidated loss of INR 1,000 instead of Nil. | Company A entered into an inter-company agreement with Company B for import of 100 products @ USD 50 during the year 2020. At the time of contract USD 1 is equivalent to INR 50. However, at the time of actual import rupee depreciated to INR 60. The policy risk resulted in a loss to Company A amounting to INR 1,000. |
Often, business enterprises may counter the foreign exchange risk using hedging instruments. The two-primary method of hedging are (i) forward exchange contracts and (ii) currency option. A forward exchange contract is an agreement under which a business agrees to buy or sell a certain amount of foreign currency on a specific future date and protect itself from subsequent fluctuations in a foreign currency’s exchange rate. On the other hand, currency option gives business enterprises the right, but not the obligation, to buy or sell a currency at a specific rate on or before a specific date. They are similar to forward contracts, but business enterprise is not forced to complete the transaction when the contract’s expiration date arrives.
In the subsequent paragraphs, the article discusses the Indian transfer pricing regulations, international guidelines and important points that need to be considered while analysing FX risk and its impact on transfer pricing analysis:
Indian Transfer Pricing Regulations
The Transfer Pricing Regulations under Rule 10B(1)(e), which explains the methodology of applying Transactional Net Margin Method (TNMM), provides that net profit margin should be determined in relation to costs incurred or sales effected or having any other relevant base. This rule compares the net profit of taxpayer and comparable companies and consider all the direct and indirect costs attributable to a transaction while determining the net profits.
The above rule does not lay down guidelines for treating the expenses as operating or non-operating in determining the net profit margins. This gives both tax administration and taxpayers an option to consider the FX gain or loss as operating or non-operating according to their convenience.
In September 2013, the Government of India notified Safe Harbour Rules (SHR) that provides circumstances in which the tax authorities shall accept the transfer price declared by the taxpayer. While determining operating profit margins under SHR, it has been provided that income or loss arising out of translation of foreign currency items should be excluded from operating revenue or operating expenditure. While laying down such guidelines, the safe harbour rules do not provide the rationale as to why the same needs to be considered as non-operating item, however, relying on the above rules, the tax administration treats the FX fluctuation as non-operating expense.
OECD Transfer Pricing Guidelines (‘TPG’)
TPG in para 2.88 under Chapter III (Transactional Profit Methods) discusses about the inclusion or exclusion of FX gain or loss in determination of net profit level indicator and highlighted two important points: (i) ascertain whether the foreign exchange gains or losses are of a trading nature (e.g. exchange gain or loss on a trade receivable or payable) and tested party2 is responsible for them; and (ii) any hedging of foreign currency exposure on the underlying trade receivable or payable also needs to be considered and treated in the same way in determining the net profit.
Comparability Analysis
It is the cardinal principle of Transfer Pricing that attempt should be made to select comparable companies as close to the tested party, since it minimizes the need of making economic adjustments for sieving out material differences between the comparable companies and the tested party. In para 2.97 of TPG, it has been provided that where foreign exchange fluctuation materially affects the comparison, the key is to compare like with like and follow the same accounting principles for the tested party and for the comparables.
Important Consideration
The above rules and guidelines raise the following important points that needs to be addressed while analyzing the impact of foreign exchange fluctuation on an international transaction and comparing the same with an uncontrolled transaction:
- Whether FX gain or loss is of a trading nature and if yes, whether tested party bears FX risk?
- Whether FX gain or loss is arising from current year transaction or earlier years?
- Whether FX gain or loss arise from hedging relates to business earning transaction or otherwise?
- Whether FX gain or loss should be treated as operating or non-operating expenses?
- Whether reliance placed by tax administrations on SHR is correct?
- Whether adjustment would be required for abnormal or extraordinary fluctuations in FX rates?
Seeking answers to the above questions, we have analysed various judicial precedence pronounced by High Courts (HC) or Income Tax Appellate Tribunals (ITAT) that may serve as an important guide in taking the right course of action is tabulated hereunder.
Judicial Pronouncements
| Consideration | Case Law | Ruling |
|---|---|---|
| Whether FX gain or loss is trading in nature? |
Pr. Commissioner of Income Tax vs. Ameriprise India Pvt. Ltd. (Delhi High court - ITA No. 206/2016) |
The Hon’ble Court upheld that FX gain earned in relation to trading items and emanating from international transactions cannot be treated as non-operating losses and gains |
| Similar view has been adopted by following jurisdictional High Courts in the matter of: (i) Pr. Commissioner of Income Tax vs. B.C. Management Services Pvt. Ltd. (Delhi High Court – ITA 1064/2017 & CM No. 43177/2017) and (ii) Pr. Commissioner of Income Tax & The Deputy Commissioner of Income-tax vs. Guhring India Pvt. Ltd. (Karnataka High Court - ITA No. 357/2016). There are other HC & ITAT rulings on this issue, however, the same has not been discussed due to brevity of space. | ||
| Whether tested party bears FX risk? |
DCIT vs. Tilda Riceland Pvt. Ltd. (ITA No. 6592/Del/2015) |
The Hon’ble ITAT upheld DRP’s direction that FX gain or loss pertains to the operations of sale transactions and thus directed to adopt a uniform approach to include FX gain or loss in operating revenue of both tested party and as well as the comparables. Also, placed reliance on OECD guidelines for inclusion of FX gain or loss in TNMM to a transaction in which FX risk is borne by the tested party |
| Whether FX gain or loss pertains to current year? |
DCIT vs. Sunway Construction India Pvt. Ltd (IT(TP) A No. 1190/ Bang/ 2012) |
The Hon’ble ITAT directed that if sale has taken place in the present year then the corresponding FX gain should be considered to compute the operating profit margin because such turnover is part of the denominator |
| Whether FX gain or loss arising out of hedging transactions? |
Pr. Commissioner of Income-tax & The Deputy Commissioner of Income-tax and M/s Indigra Exports Private Ltd. (High Court of Karnataka – ITA No. 322/2016) |
The Hon’ble Court upheld that FX gain or loss could have been considered as non-operational only if the Assessing Officer could show that such gain or loss came out of hedging and transactions which were independent of the business revenue earning transaction |
|
SAP Labs India Pvt. Ltd. vs. DCIT (ITA No 2883/Bang/2018) |
The Hon’ble ITAT referred the matter back to the file of Commissioner Appeal and directed to pass speaking order when the receipt of FX gain by Assessee is on account of conversion of sales proceeds from export of services whereas the FX gain in the case of comparable is on account of an additional function of treasury activity which is in the nature of hedging | |
| Whether premium paid on FX contract is trading in nature? |
Ambattur Clothing Ltd. v. JCIT (ITA Nos.1436 & 1643/Mads/14 & ITA No.910/Mds/2015) |
The Tribunal held that when premium on forward exchange contract is on account of proximity with the export turnover, the same should be taken as part of the operating profit margin |
| Whether Safe Harbour Rules needs to be considered during normal TP audit? |
Vaildor Capital India Pvt. Ltd. vs. ITO (ITA No. 1961/Del/2015) |
The Hon’ble Tribunal upheld that the safe harbor rules are like presumptive taxation and has been made applicable only from 18th September, 2013 and therefore, same are not applicable to the present assessment year. Even otherwise they are to be opted by the Assessee and if not opted those are not binding on Assessee |
|
Digital Group Infotech Private Limited (ITA No. 475/Pun/2017) |
The Hon’ble ITAT placing reliance on the Hon’ble Delhi High Court in the case of B.C. Management Services (P) Ltd and rejected the plea of Transfer Pricing Officer and Dispute Resolution Panel to consider FX gain as non-operational income by relying solely on Rule 10TA | |
| Whether adjustment on account of abnormal and huge fluctuation in FX rates may be allowed in determining the arm’s length price? |
Honda Trading Corporation India Pvt. Ltd. vs. ACIT (ITA No 5297/Del/2011) |
The average exchange rate of Thai Bhat during October, 2005 to March 2006 was 100 Thai Bhat equivalent to INR 110 and after considering said average exchange rate, price of sale of goods agreed upon with the customers. However, during April 2006 to September 2006 at the time of purchase, the exchange rate of Thai Bhat was substantially increased to 100 Thai Bhat = INR 119. The Hon’ble ITAT upheld that the said fluctuation in FX rate must be removed and the margin thereon needs to be adjusted for arriving at the credible comparable through the requisite adjustments |
|
Mercedes Benz India Pvt. Ltd. vs. DCIT (ITA No. 514/Pun/2014 & ITAT No. 566/Pun/2014) |
The Hon’ble ITAT noticed that there was fluctuation in the rate of Euro / INR rates compared to the previous year and the market witnessed around 14.10% increase in Euro/ INR rates. The Hon’ble ITAT relying on the ruling of Demag Cranes & Components (India) Pvt. Ltd (ITA No.328/PN/2014) directed exclusion on foreign exchange loss while computing PLI of the Assessee. | |
Concluding Thoughts
It seems that controversy revolves around treatment of FX gain or loss which has more or less settled from the court decisions as they have laid down a simple rule that FX fluctuation should be considered as operating item when it emanates from the international transactions and tested party bears that risk which is similar to the principle enshrined in TPG.
The Indian TP regulations under Rule 10B(3) prescribe the differences materially affecting the comparison that will need to be adjusted to the extent, these adjustments are reasonable, reliable, and improve comparability. This rule has been given due importance by Hon’ble ITAT while upholding that abnormal fluctuations in currency rates need to be adjusted. However, economic crisis generated by Covid-19 has more varied effects on industries or markets and therefore, the prospects of finding appropriate comparables would be difficult. In such circumstances, it is important that taxpayer maintains robust transfer pricing documentation that entails detailed industry overview including macro-economic factors, price setting policy, and the collation of information and documents that justify FX adjustments based on the comparable uncontrolled transactions.
1 https://www.exchangerates.org.uk/USD-INR-exchange-rate-history.html
2 Tested party will most often be the one that has the least complex functional analysis
Under Rule 10B(3) and OECD TPG, taxpayers must substantiate abnormal exchange volatility through rigorous economic adjustments and comprehensive TP documentation.