The current economic situation in Mexico and around the world has been affected by the COVID-19 health contingency. The medium and long-term consequences are still uncertain. However, businesses should have to uphold a plan to adjust to the new circumstances and ensure its continuity.
Some of the effects that we perceive with immediate consequences for companies, although there are many more, are:
• Reduced consumer demand;
• Impact on supply chains; and
• Impact on financial markets.
Therefore, it will come as no surprise that this year and in subsequent years that companies and Multinational Enterprises (MNEs) declare financial and tax losses, have a greater need for financing (mainly intragroup financing), carry out business restructurings in functions, risks and possibly assets, among other effects.
In this bulletin, we will focus on some consequences of exposure to fluctuations in the exchange rate that companies and MNEs will have, their relation to potential foreign exchange losses, and transfer pricing considerations.
In periods of economic recession and uncertainty, it is common to have unusual foreign exchange fluctuations regarding other currencies. The volatility is an important factor that affects, among other things, the financial liabilities recorded in foreign currency, which will possibly generate foreign exchange losses (or reduced profits) when the functional currency is depreciated. Depending on the volatility of these fluctuations, the consequences can be important for financial purposes.
For companies that acquire supplies in foreign currency, the risk of exchange rate exposureis increased, and it will have an impact in the financial result for the related year.
On the other hand, faced with the contingency situation, the companies of a MNE may present a lack of liquid assets and require additional funding from their related parties.
Regarding the above, it is possible that due to exchange rate losses, the projection for the tax result of 2020 and following years is significantantly reduced.
Nevertheless, it would be of utmost importance to define whether the foreign exchange losses are dedutcible for tax purposes under the limitations provided for by the domestic tax law, such as thin-capitalization and base erosion involving interest deduction (30% of tax-EBITDA).
For transfer pricing purposes, since the exchange rate effects are recorded financially after the operating financial profit or loss, the following factors are relevant for measuring their impact in the comparability analysis in transfer pricing :
a) How do the company under analysis and comparable companies treat exchange rate gains or losses for accounting purposes?
b) What impact do the exchange rate effects have on the profitability of the company under analysis?
c) What are the functions, assets, and risks of the company under analysis? and
d) Should the company under analysis assume the risk of exchange rate considering its classification for transfer pricing purposes (e.g., limited risk)?
For instance, it will be relevant to identify whether the Mexican entity under analysis takes economic decisions or controls the treasury, whether it controls the risk that arises as a result of its activity; or if these risks are assumed by a related party. In the latter case, the contractual terms would be the starting point to verify whether adverse fluctuations in the exchange rate are being considered by the company that takes the decisions. Otherwise, it would be relevant to demonstrate that independent third parties, under similar circumstances, agreed under the same conditons.
In general, the adverse effects of an economic crisis make it difficult to find appropriate comparable transactions for a reliable transfer pricing analysis. Therefore, the possibility of applying reasonable adjustments that improve comparability should also be considered to identify the impact of the exchange rate.
On the other hand, it is important to mention that the foreign exchange rate fluctuation is a factor that companies must consider to evaluate or establish policies for inter-company transactions, budgets, financial projections, review of contract terms, among others. Under the uncertainty faced, companies should evaluate modifying their intercompany policies or budgets, which implies significant changes in their business model and continuity. For example, in those cases in which the entities assume the exposure to the exchange rate in the acquisition of goods, without being able to modify the sale price, it may create accounting and tax losses.
Finally, if the company requires new or additional financing from another related party, the interest rate must reflect said circumstances, including assessing whether the legal terms of the contract in force adequately reflect this situation.
Given the above, our recommendation would be to closely monitor the impact that exchange rate fluctuations may have on your company in these times of crisis, to take the necessary measures for transfer pricing, legal and tax purposes.