Currency exchange risk can be especially acute. Take a look at key performers in 2018, for example. Compared to the front-running U.S. dollar, the Canadian dollar fell 8.5%, the British pound plunged 6.4% and the euro was down by 4.8%. Meanwhile, the uncertainty surrounding Brexit and the North American trade scene continue to loom large.
There are three main ways currency exchange risks can impact your company:
- Transaction exposure — when the currency exchange rate fluctuates after a contract has been locked in
- Translation exposure — when a percentage of corporate assets are denominated in a foreign currency and fluctuations lead to gains or losses on your home currency books
- Operating exposure — when your competitors are sourcing labour or materials from countries with a more beneficial exchange rate, leading to lower operating costs and more competitive pricing.
How to set up a transfer pricing strategy that plays well with currency risk
Transfer pricing refers to the ways companies price transfers, or transactions, of goods and services with related companies. Think, for example, of a parent company buying goods from an overseas affiliate. Currency value is one of the many variables that affect a company's prices. As a result, a sound transfer pricing strategy is one of the many items companies need to navigate when dealing with fluctuating currency values.
When setting up a transfer pricing strategy, keep these three key points in mind:
Companies should keep in mind the economic environments where they do business. If currency volatility has become the norm where your company is located, this should be reflected in your policy. The same goes for any long-term changes in the exchange rate: a long-term appreciation in Singapore dollars should be considered, for example, while reviewing the transfer pricing policy of a Singapore-based distributor that commonly incurs expenses in Singapore dollars and receives cash flow in U.S. dollars.
Companies can enter into an advance pricing agreement (APA) with their tax administration, settling on a pricing methodology for transactions over a fixed period of time. When assembling this agreement ahead of time, consider including a provision that allows you to revise in future years to mitigate the effects of uncontrolled economic circumstances, such as significant changes in currency exchange rates.
Companies often shift currency risk to specific subsidiaries they own—sometimes by hedging the risk to mitigate exposure.
The transfer pricing challenge comes if business leaders don't consider risk when allocating profits. Take, for example, a Vancouver-based multinational that has its Brazilian subsidiary assume significant foreign exchange risk. At the same time, the parent company shares profits equally among its five global subsidiaries. This strategy may fail both the common sense and transfer pricing test: the Brazilian operation experiences the greater pain of currency risk; it may be subject to greater compensation from its parent company for the significant risks it bears.
Beyond transfer pricing: Living day-to-day with currency risk
Transfer pricing strategy keeps companies on the right side of tax authorities–but it won't protect business leaders from the business end of currency fluctuations.
To get the business fluctuation-ready, companies can take these steps:
- Evaluate exchange risk throughout the entire supply chain. A company may buy steel from a Mexican supplier under a U.S. dollar contract, but the price will actually be calculated by the supplier using the underlying value of the Mexican peso. Only by understanding the full extent and details of such risk can plans be put in place to hedge against currency fluctuations.
- Evaluate cash flow risk. A company purchasing materials overseas under a contract that requires payments in a foreign currency over several years might buy futures contracts to protect against that risk.
- Establish governance procedures. Develop procedures to ensure that contracts with currency exchange terms cannot be signed off on without approval from the firm's CEO or controller.
- Sell in local currency. It's easier for foreign companies to do business with overseas firms when they can write contracts in their local currency. Firms also tend to add on an extra charge to convert local prices to U.S. dollars, and that fee typically exceeds the cost of hedging currency risk.
Uncertainty and change are always uncomfortable—but especially when something as serious as your corporate finances are at stake. Companies with smart transfer pricing policies that reflect the current global economic state are better equipped to navigate this ever-shifting environment.
Contact one of our transfer pricing professionals today to get started on a strategy that covers your foreign exchange risk.
The information in this publication is current as of July 3, 2019.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.