TP on Foreign exchange fluctuations

AN INTRODUCTION
The advent of globalization has changed the economic landscape whereby the businesses have penetrated across various countries more than ever before. Owing to the same, the multinational enterprises are confronting various transfer pricing (“TP”) matters. The Indian TP scenario has witnessed mammoth litigation till date with respect to diverse TP issues. In India, as the profit based methods [Transactional Net Margin Method (“TNMM”) in specific] are intemperately used, the same call for the computation of operating profit margins of tested party and comparables companies in order to identify the arm’s length nature of transactions undertaken by a taxpayer with its overseas group entities. Thus, one of the issues which are inherent to the use of profit based methods is with regard to the classification of few expenses/ incomes as operating/ non-operating.

An incorrect classification of expenses/ incomes may impact the profit margins of the entity adversely. Another important aspect in this connection is with regard to the consistency in classifying income or expense as operating or non-operating in case of both the taxpayer as well independent comparable companies in order to achieve a reliable comparability analysis. The repugnance in classification of such expenses and incomes as operating or non-operating, as the case may be, will tantamount to incorrect determination of arm’s length price of the international transaction. One such key area of concern that has always been in limelight and which has been talked over in this article is in relation to the classification of foreign exchange fluctuation gains/ losses.
At the outset, it is globally accepted that incurring profit or loss while dealing in foreign currency transactions is a normal business phenomenon which cannot be avoided while being engaged in import/ export business. In the modern system of floating exchange rates, the price of one currency relative to another is determined by supply and demand together with an endless array of economic and geopolitical events. Thus, the fluctuations in exchange rates are continual and often defy explanation, at least in the short run.
OECD GUIDELINES – TREATMENT OF FOREIGN EXCHANGE FLUCTUATION GAIN/ LOSS
Deciding whether foreign exchange fluctuations are operating in nature or not, is a subjective matter, and the same has to be observed not only at micro level (i.e. the from the standpoint of the business and commercial perspective of the taxpayer) but also should be carefully watched over at macro level (i.e. from the outlook of industry to which the taxpayer cater to, political, economic and financial stability of the country etc.). The OECD TP Guidelines, 2010 (“the Guidelines”), on the contrary, do not talk anything specific about the categorization of foreign exchange gain/ loss as operating or non-operating. The Guidelines also do not seek to provide an exhaustive catalogue of operating/ non-operating expense.
However, Para 2.75 and 2.77 TO 2.85 of the Guidelines discusses the mechanism of computing the net profit of the tested party and provides a general guidance that that only those items which are directly or indirectly related to the controlled transaction and are of an operating nature should be taken into account while computing the operating margins for the application of TNMM. In the context of inclusion / exclusion of foreign exchange gains / losses while determining margins of tested party, the Guidelines require the need of analyzing the nature of foreign exchange gains / losses and whether the tested party is responsible for them. It goes on to conclude that foreign exchange loss / gain should be consistently accounted for, if TNMM is applied as the method of choice, and where the tested party assumes foreign exchange risk.
In summary, the OECD guidance on inclusion / exclusion of foreign exchange gains / losses is rather vague and ought to be based on the circumstances of the case and on the functions being undertaken and risks being borne by the tested party.
INDIAN TRANSFER PRICING JURISPRUDENCE RELATING TO FOREIGN EXCHANGE FLUCTUATIONS
Prior to the introduction of Safe Harbour Rules in Indian TP legislation (discussed separately further in this article), there was no specific citing of treating any expenses/ income as operating or non-operating while computing the margins of the companies for the application of TNMM. Consequently, the tax authorities were treating the few items of income and expenses as operating or non-operating as per their convenience. As far as the assortment of gains or losses arising on account of foreign exchange fluctuations as operating or non-operating is concerned, the only guidance was initially plied by the rulings adjudicated by various appellate authorities [i.e. Income Tax Appellate Tribunal (“ITAT”/ “the Tribunal”) and above]. In such rulings, the Courts elementarily focused on the reason for occurrence of such foreign exchange gains/ losses and its connection with the main operations of the taxpayer.
Adverted below are few rulings wherein the Indian Courts have held the foreign exchange gains/ losses to be considered as operating in nature while computing the operating margins:

Bangalore Tribunal, in the case of IGEFI Software India P.Ltd.[1]and “NXP Semi Conductors India Pvt. Ltd.”[2] adjudicated that the foreign exchange fluctuation gains should be treated as operating income, since the same were arisen as a consequence of realization of revenue from main operations of the taxpayer i.e. of software exports;
In case of “Airbus India Operations Private Limited”[3], the Bangalore ITAT judged that to the extent of gain on actual realization in connection with the business of rendering software development services by the taxpayer to its associated enterprise (“AE”), the foreign exchange fluctuation at the time of realization of the payment for rendering such services has to be considered as operating revenue while computing the profit margin of the taxpayer.

In addition to the above, similar view was upheld in the following rulings:

M/s. Westfalia Separator India Pvt. Ltd. vs. ACIT [ITA No.4446/Del/2007];
M/s. Cisco Systems Services B.E. India Branch vs. ADIT [ITA(TP) No.270/Bang/2014];
M/s. Kenexa Technologies Pvt. Ltd. Vs. Dy.CIT [ITA No.243/HYD/2014];
M/s S Narendra vs. Addl CIT [ITA No. 6839/Mum/2012];
M/s Sumit Diamond (India) Pvt. Ltd. vs. Addl CIT [ITA No. 7148/Mum/2012];
M/s Bearing Point Business Consulting Pvt. Ltd. vs. DCIT [ITA No. 1124/Bang/2011];
M/s Trilogy E-Business Software India Pvt. Ltd. vs. DCIT [ITA No. 1054/Bang/2011];
M/s Brigade Global Services Pvt. Ltd. vs. ITO [ITA No. 1494/Hyd/2010]; and
M/s Capital IQ Information Systems (India) Pvt. Ltd. vs. DCIT [ITA No. 1961/Hyd/2011]

A wayward stand was also taken by the Indian Courts wherein it has been extended that foreign exchange gains/ losses are considered as non-operating. In case of”DHL Express (India) (P.) Ltd.”, it was held by the Mumbai ITAT that foreign exchange fluctuations do not form part of the operational income, since these items have nothing to do with the main operations of the taxpayer. Likewise, the ITAT in case of “NetHawk Networks India Private Ltd” had directed the Assessing Officer to exclude the foreign exchange loss pertaining to the interest from the operating cost for working out the operating margins of the taxpayer.
Without prejudice the above, there are few other rulings[4] which endorsed the need to adjust, based on sound economic principles, for the foreign exchange rate fluctuations which could have material impact on the determining the reliable analysis of the transfer price of the transaction between the taxpayer with its AE from an arm’s length perspective. However, in such rulings, the decisions of the tribunals fell short of outlining the mechanics to compute the aforesaid adjustment.
THE SAFE HARBOUR RULES, 2013 – ERA OF MECHANICAL EXCLUSIONS
For the very first time, the Safe harbor rules (“SH Rules”), notified by Central Board of Direct Taxes (“CBDT”) in September 2013 in Indian TP regulations, provided an exhaustive list of certain items to be considered as operating expenses/ income. The Income or loss arising out of foreign exchange fluctuations is one such expense which according to the SH Rules shall be treated as non-operating expense while computing the profit margins.
Vide letter dated December 20, 2013, the CBDT had issued an internal guidance to the field officers to the effects that SH Rules need not be followed in situations of normal transfer pricing audits.
The directions are particularly relevant, especially since the mandate of SH Rules, as laid down by Section 92CB, is merely to establish situations where the income tax authorities shall accept the transfer price as declared by the taxpayer.
It’s common knowledge that that the provisions of the Act are supreme and the Rules framed there-under can by no means extend the taxation or non taxation as mandated under the Act. Thus, the provisions of SH Rules, with respect to operating /non operating income or expenses, ought not be considered as mandate of the law while determining net profit margins in case of normal transfer pricing assessments. However a reference to such provisions, for the sake of guidance, cannot be ruled out.
However, post notification of safe harbor rules, the transfer pricing assessment landscape, in context of foreign exchange gains / losses, appears to be mechanically tilted for their exclusion from the margins of the tested party and comparable companies.
While following the position as per SH rules, even genuine situations of inclusion of foreign exchange gains / losses in the operating margins are being consistently ignored, despite host of favorable decisions from the jurisdictional tribunal. The lower level of tax authorities are reluctant to accept foreign exchange gain / losses as operating even if the facts of the tested party and the functions performed and risk assumed by tested party warrant inclusion of foreign exchange gains / losses while computing their net profit margins.
Such unilateral and mechanical application of safe harbor rules for the purposes of exclusion of foreign exchange gains/losses is in contradiction to general principles of transfer pricing analysis, which is based on circumstances of the cases, functions performed and risks assumed by the parties to the transactions.
CONCLUDING REMARKS
A panorama in every direction to appraise the very nature of foreign exchange gains/ losses leads to a conclusion that there exists lack of clarity with regards to its classification as operating or non-operating. As a matter of fact it is significant to note that where plethora of judgments by the Indian Courts proclaimed foreign exchange gains/ losses to be operating in nature, the tax authorities on the other hand, almost in every case, are taking a stand that the same should be treated as non-operating in nature.
To emphasize, if judicial precedents, as cited earlier in this essay, are analyzed profoundly, it becomes apparent that only those foreign exchange gains/ losses have been considered operating which are direct outcome of the purchase or sale transactions entered in connection with the main operations of the business of the taxpayer, since the same partakes the similar character as that of the transaction to which it relates. The essence of the matter is that any gain or loss arising out of change in foreign currency rate in respect of transaction for import or export is nothing, but inherent part of the price of import or the value of export.
Accordingly, while computing the operating margins, such foreign exchange gains/ losses should also be treated as operating.
In order to bring certainty and to put to rest the issues relating to foreign exchange fluctuation some guidelines are required to be issued by the CBDT, specifically in the instances wherein the taxpayer does not opt for the Safe Harbour route. Meanwhile, the guidance to consider the classification of expenses as operating or non-operating in nature may also be postulated by analyzing Sections 30 to 37 of the Income-tax Act, 1961, wherein all those expenses which are of non-operating nature are specifically disallowed while computing the business/ professional income of the taxpayer. The same, in itself, clarifies that such expenses should not be considered operating for the purposes of analyzing the arm’s length nature of international transactions from the Indian TP perspective.