Intercompany transactions are often priced in one currency, while the costs and revenues of the entity earning the return are denominated in another. Exchange rate fluctuations can therefore affect profitability, sometimes materially. The transfer pricing question is not simply which entity records the gain or loss, but whether the allocation of foreign exchange risk reflects the parties’ actual conduct, decision-making authority and financial capacity.
Risk Allocation Follows Control
Under the OECD approach, contractual allocation is only the starting point. The analysis must establish which entity makes decisions to assume, manage or mitigate the risk and has the financial capacity to bear its consequences. An entity that merely performs administrative treasury activities does not necessarily control the risk. Equally, the absence of an in-house treasury function does not, by itself, establish that an entity cannot assume foreign exchange risk. The actual decision-making and conduct of the parties remain central. <Cite refs={["turn956384search36","turn956384search38"]}/>
Invoicing Currency and Pricing Mechanics
The currency in which an intercompany transaction is denominated determines the initial exposure, but the contractual pricing mechanism also matters. Independent parties may negotiate currency adjustment clauses, exchange rate collars or periodic price revisions, depending on the commercial circumstances.
A fixed-price arrangement without an adjustment mechanism is not automatically inconsistent with the arm’s length principle. However, where exchange movements are significant, the group should be able to explain why the agreed arrangement reflects the parties’ commercial interests and how the resulting exposure is managed.
Foreign Exchange Treatment in Profitability Analysis
The treatment of foreign exchange gains and losses can materially affect the operating margin tested under the transactional net margin method (TNMM). Their classification should depend on the nature of the underlying transaction and the foreign exchange exposure, rather than accounting presentation alone.
Exchange differences arising from trade receivables and payables may be closely linked to operating activities, whereas those arising from loans, investments or financing arrangements may require separate treatment. The tested party and comparable companies should be assessed consistently, with appropriate adjustments where differences in classification or exposure materially affect comparability.
Hedging Costs and Centralised Treasury
Where foreign exchange exposures are hedged through a centralised treasury function, the allocation of hedging costs and results should reflect the services performed, risks controlled and benefits received by the relevant entities.
A subsidiary should not automatically bear central treasury costs merely because it participates in group transactions. The allocation should be supported by evidence of the exposure being managed, the benefit received and the basis on which an independent enterprise would compensate the service provider. Both gains and losses should be considered consistently.
Documentation Considerations
Documentation should identify the currency of significant intercompany transactions, the contractual allocation of exposure, the entity responsible for risk-management decisions and the treatment of exchange differences in the financial results.
Where exchange movements are material, sensitivity analysis can help demonstrate their effect on profitability and explain whether the reported margin is consistent with the entity’s actual risk profile.
Conclusion
Foreign exchange risk should be allocated in accordance with the parties’ actual conduct, control and financial capacity. Groups should ensure that their contractual arrangements, treasury practices and profit measurement reflect that allocation. Consistent treatment of exchange differences between the tested party and comparable companies is equally important to a reliable arm’s length analysis.
