Exchange risks

Written by Dinesh Supekar | Updated: Feb 14 2014, 06:04am hrs
The unprecedented fluctuation in the value of the Indian rupee in the current financial year could significantly impact the profitability of corporates having foreign exchange transactions. From approximately 54 to a dollar in April 2013, the rupee depreciated to 68 to a dollar by September 2013, and thereafter gradually appreciating to approximately 62-63 to a dollar at present. Therefore, while net foreign exchange earners, say for instance in the IT sector will gain, net importers such as those in the automobile industry may witness a considerable profitability squeeze.

A number of such corporates would have foreign exchange transactions with their overseas related parties, requiring demonstration of their arms length nature as per the transfer pricing regulations in the Income Tax Act, 1961.

For those whose profitability may decline due to the rupee depreciation, an important question arises whether the overseas group companies should offer to bear the exchange risk, and if so, to what extent. For this, the specific facts such as the transfer pricing policies, inter-company agreements and past transfer pricing documentation methods need an examination. Typically, based on accepted transfer pricing principles, the overseas entity should bear such risks where based on the inter-company agreements, and the Functions, Assets and Risks (FAR) profile, the Indian entity can be characterised as a low-risk entity performing routine functions, with all the significant people functions and ability to control and manage key risks residing outside India.

In case of Indian entities which are in the nature of entrepreneurs/licensed manufacturers, the management and control of such exchange risks would typically be in India and hence, the group companies may not agree to bear these risks. In such a situation, especially where profit margins are low, it is possible that the tax authorities question whether the import prices should have been negotiated downwards. Where companies are following transfer pricing policies based on Comparable Uncontrolled Price (CUP) method, it may theoretically be possible to contend that irrespective of low margins, the international transactions are at arms length, if the import price and the associated terms and conditions are comparable to third-party transactions. But, in practice, demonstrating that CUP continues to be the most appropriate method may not be easy, and would need to be supported by strong documentation in the course of assessments.

Where such CUPs are not available, one alternative could be to test the profit margins of the overseas entity from transactions with the Indian entity. However, if this is not technically feasible and there is no practical alternative but to test the profit margins of the Indian entity, the situation becomes quite challenging from a transfer pricing documentation and defence perspective. Any solutions would be intricate and quite fact-specific and would need to be analysed upfront before finalisation of annual accounts and not while tax-return filing. It is noteworthy that the Delhi Bench of the Income Tax Tribunal, in the facts of CIT vs Honda Trading Corporation (ITA No 5297/Del/2011), agreed in principle, to an exchange rate fluctuation adjustment for a credible comparison with comparables. The exact methodology was however not mentioned, which tax payers, would need to develop based on their specific facts.

A converse situation would arise for net exporters, where the higher profit margins fall beyond the inter-quartile range, triggering the overseas group companies (which are answerable to transfer pricing authorities in their own jurisdiction) demanding a downward revision of transfer prices charged. It is imperative that any such exercise is carefully reviewed from an Indian transfer pricing perspective to ensure compliance with the transfer pricing regulations and avoid potential disputes.

With inputs from Rahul Mehta, manager, Price Waterhouse &Co

The author is partner, Price Waterhouse & Co