Will Volatile Foreign Exchange Rates Impact Your Arm’s Length Range?07 February 2023
Given the current volatile currency exchange rate landscape, and the approaching year-end for many, taxpayers should take the time to consider what implications it may have on transfer pricing.
The first step is to review your intercompany agreements, and ensure they are aligned with how exchange rates are being handled operationally. In other words, do your transfer pricing policies treat foreign exchange the same way that you’re booking transfer pricing entries in your accounting system?
The second question to ask is does this reality mesh with what a tax authority would expect to see based on your representation of the facts in you transfer pricing documentation?
Let’s take the example of a U.S. distributor selling goods purchased from its German parent company. If we characterize the U.S. entity as a limited-risk distributor in our IRS and German tax administration’s documentation, but the goods are being purchased intercompany in euro, we have a mismatch that the tax authorities can and will question—especially when advantageous for the particular country in question. The tax authority may argue that a limited-risk distributor should not bear the foreign exchange risk, based on the fact pattern of goods being purchased in euro (i.e. COGS) and the subsequent local sales into the U.S. in dollars.
Furthermore, when the dollar is strong against the euro, the distributor’s margin may increase in the example above, and potentially bring the distributor higher within (or above) the arm’s-length range. As I mentioned before, it’s important to check your operational transfer pricing mechanisms to ensure this is not the case, so you don’t have an unwelcome surprise after you close your books at the end of the year.
The current environment definitely presents an opportunity for the savvy taxpayer, one who does not want to assume unnecessary risk, to review the various components of their internal transfer pricing system–intercompany agreements, transfer pricing policy, ERP/accounting system, and transfer pricing documentation–and ensure they are all aligned.