forex and transfer pricing

1. FOREX AND TRANSFER PRICING
Companies invest in other countries to enhance their profitability through increased sales,
economies of scale of operations, to reduce costs and to reach out customers along with diversified
products, services and operations.
Companies face four types of forex risks, namely Financial Risk; Translational Risk;
Transactional or Commitment Risk; and Economic, Operational, or Competitive Risk.
1. Financial Forex Risk:
Financial forex risk arises when a company holds foreign currency as an asset. The exchange rate
between the holding currency and functional currency, there arises the foreign exchange risk.
2. Translational Forex Risk:
Translational forex risk arises as a result of translating a company’s reported financial results
from the company’s functional currency to other currencies for informational or comparative
purposes.
3. Commitment Forex Risk
Commitment forex risk arises when a party agrees to purchase or sell goods at a specified foreign
currency price on one day, but does not actually make or receive payment until a later date. If the
forex rate changes during the intervening period, the price of the sale or purchase in functional
currency changes. Commitment forex risk arises when a party agrees to make unspecified future
purchases or sales at specified foreign currency.
4. Economic, Operational, Forex risk:
Economic risk, also known as operational risks, which arises when changes in forex rates alter the
competitive position of a business. This typically occurs when the business generates sales in one
currency and incurs costs in another currency.
With the globalization of business environment and the international monetary system of floating
exchange rates has brought higher volatility to currency markets. Thus foreign currency risk is
exposed all the business transactions. The foreign currency risks can mitigated by different ways,
like natural hedge, financial derivatives like forward covers etc
a)Natural hedging
Natural hedging refers to operational changes that mitigate or eliminate forex risk without the use
of financial instruments or derivatives. For example, multinational businesses are concerned about
depreciation of assets held in a foreign currency due solely to adverse Forex movements. They

2. can reduce this financial Forex risk by matching long-term liabilities with assets. If liabilities are
denominated in the same currency as assets, Forex fluctuations that cause asset values to fall also
cause liabilities to shrink. A match between assets and liabilities prevents loss of value, at least
partially, without the costs and complications of separate financial market transactions
The same matching principles applies to income and expenditures items. For example,
multinational companies with significant sales in a foreign currency may be concerned that the
sales currency will depreciate against their functional currency, causing a sudden reduction in
functional-currency earnings. If expenses are denominated in the same currency as the sales, the
impact on bottom line profitability from forex changes is reduced.
b. Hedging with Financial Instruments/ Derivatives:
The use of financial products to manage forex risk is common today. The large and growing
number of purchasers increased the depth and stability of the forex market. Such transactions may
be negotiated privately through a financial intermediary . Forex transactions include spot and
forward contracts, cross-currency swaps, and currency options. Exchange-traded instruments also
carry no counter-party credit risk because the exchange itself imposes strict credit requirements, a
significant consideration for businesses that do significant hedging.
One problem with financial-instrument hedges is that they may not perfectly offset the underlying
business exposure, leaving a residual speculative trading position. To exactly offset Forex impact
on earnings requires a precise forecast of the business exposure to be hedged, including the
expected earnings. Long-run exposure is normally especially difficult to predict.
The question to hedge or not to hedge is a complex and controversial one in financial risk
management. Natural hedges carry no explicit out of pocket cost and intrinsically form a better
offset to economic exposures and so generally are preferred to synthetic hedges. Synthetic hedging
can be likened to insurance, where the company incurs an explicit cost to reduce the risk or
volatility inherent in its business results.
Forex Risks and Transfer Pricing in India:
The forex gain or loss due to revenue and capital account transactions are treated differently in Indian
business environment. The accounting standards and regulations under company act and income tax act
are viewed differently. The companies act recognises the transaction risks as a periodical risks and written
off in the books of accounts, whereas in the income tax act the forex risk on account of capital items are
to be capitalised. The forex gain or loss on account of revenue items have to treated as income or
expenditure as the case may be.
However, in the transfer pricing working for arm length price ( ALP) comparisons the forex gain or loss is
to be treated differently. In deriving the margin of profit of an entity, the forex gain or loss to be
considered as part of income or expenditure in the normal course. Many courts have held that the forex
gain or loss to be considered for working out the ALP. In the case of safe harbour rules the department
has categorically excluded the forex gain or loss for working out the ALP.