Sec. 482 foreign exchange considerations for U.S. distributor subsidiaries buying in foreign currency.

One of the more common inbound situations under Sec. 482 is a U.S. distributor subsidiary that buys tangible products from a foreign related party, such as a foreign parent. Since such purchases constitute related party, transactions, Sec. 482 requires that the prices on those purchases be at arm's length. Acceptable methods for determining arm's length prices are detailed within the Sec. 482 regulations, and have been updated under the proposed Sec. 482 regulations issued at the beginning of 1992.

The determination of arm's length transfer prices for tangible goods in inbound situations can be exceedingly complex, and may depend on any one or a combination of the following factors: the volume of products sold by the parent to related and/or unrelated parties; the different types of products sold; the contractual terms under which such sales are made; the levels of the market at which related and/or unrelated buyers operate; the amounts of advertising undertaken by the related and/or unrelated buyers; the incorporation of intangible property (such as trade names and trademarks) in the sales; physical differences in the sales; differences in the geographic markets to which sales are made; the profit margins earned by unrelated parties on the resale of similar property, the profit margins earned by the manufacturers of the products sold. In addition, foreign exchange considerations may be crucial in determining a correct arm's-length transfer price, and in certain situations may play a very large role in that determination.

More than ever, both U.S. and foreign multinational corporations are taking a proactive stance in managing their foreign exchange exposure. Such exposure includes not only that of a transactional nature, such as when accounts payable for inventory purchases are in a foreign currency, or of a translational nature, such as when foreign assets change in value due to foreign exchange fluctuations, but also those of a structural (or economic) nature. Structural foreign exchange exposure occurs when transactional and translational exposures have been accounted for, but profitability nevertheless continues to be influenced by changing foreign exchange rates. In general terms, structural foreign exchange exposure typically arises when a company's sales or purchases are made in different currencies than those of competitors. A good example would be a U.S. computer chip manufacturer that purchases all of its raw materials from U.S. suppliers (and thus in U.S. dollars) and sells all of its products to U.S. buyers (and thus in U.S. dollars), but all of whose U.S. competitors sell products manufactured in and purchased from Japan and Korea. Should the dollar rise against the Japanese yen and the Korean won, such competitors would be able to purchase and sell their product for fewer U.S. dollars, thereby increasing their profits while reducing revenues and profitability for the U.S. manufacturer.

Similarly, for a U.S. distributor subsidiary buying products from a foreign related party in a foreign currency, the question arises under Sec. 482 as to whether the IRS has the authority in certain situations to adjust transfer prices downward (to increase U.S. income) to reflect the existence of foreign exchange exposure. The simplest type of this situation is when the foreign parent sells the same product under the same terms and circumstances to both unrelated parties and related U.S. distributors. If the products are sold to both the U.S. distributor and unrelated parties at the same prices, but those sold to the unrelated parties are priced in their local currencies while those to the related U.S. distributor are in the seller's currency, the Service will likely attempt to adjust the prices to the distributor downward, and thereby increase its profit, in order to reflect the increased foreign exchange risk that it incurs. However, measuring this risk may not be easy, since it could have both transactional and structural elements. Similarly, determining the appropriate additional profit that should be earned by the subsidiary under Sec. 482 may not be easy, but in some cases it may be estimated by the costs of hedging such exposure (including all elements of that exposure). In other cases, if the foreign parent does not make unrelated-party sales, or if the unrelated-party sales are made under different terms and conditions than the related-party sales, the issue becomes much more difficult to resolve, since there may be many factors other than currency differences that would affect the related-party arm's-length price.

Further, the profits of a related U.S. distributor with foreign exchange exposure may be far greater or far less than for an equivalent distributor with no such risk. In particular, as the dollar declines relative to the foreign currency in which the related purchases are made, the U.S. distributor must pay more in dollars for the same amount of inventory. It is a common scenario for a U.S. distributor subsidiary to suffer declining margins under a declining dollar from purchases in foreign currency from a foreign related party. This situation was addressed in Letter Ruling (TAM) 9237008, which stated generally that under Sec. 482 the IRS had the right to make appropriate adjustments for foreign exchange exposure. In so doing, reference should be made to the appropriate industry standards in determining to what degree the price should be adjusted to reflect such exposure. In other words, the practices of independent companies in the industry of the related-party distributor should be considered in determining to what extent adjustments should be made to the prices of the distributor's related-party purchases to reflect foreign exchange exposure.

For instance, in industries where distributors generally rely on manufacturers to assume (or hedge) currency risk, section 482 should apply only where the taxpayer has departed from industry practice without being appropriately compensated, or to prevent abuse - for example, where the currency in question shows a historically predictable pattern, such as being hyperinflationary.

At the same time, the TAM overlooked the very common situation in many industries in which distributors negotiate and accept entirely different levels of foreign exchange risk, and make entirely different decisions on the amount of risk (if any) they will hedge. Further, the ruling failed to provide specific guidance as to how appropriate adjustments should be made, and also failed to address the situation in which an adjustment for foreign exchange was only one part of a larger adjustment that took into account several factors.

From a practical point of view, to illustrate some of the considerations to be taken into account with regard to this issue, assume a Swiss parent corporation similar to that actually used in the TAM) sells to a related U.S. distributor subsidiary. Further, the Swiss parent sells similar products in Swiss francs both to foreign unrelated distributors and to the U.S. distributor subsidiary. The sales of products to foreign unrelated parties do not constitute comparable uncontrolled prices under the Sec. 482 regulations, and thus cannot be used to determine (even after appropriate adjustments) correct related-party prices. (Note that this last assumption is not unrealistic, given that in many such cases the Service successfully undermines the use of unrelated-party prices as the determinants of related-party prices, and instead relies on the alternative pricing methodologies presented in the regulations. Such alternative pricing methodologies are generally based on considerations of profitability, rather than actual prices.)

Because the Swiss parent makes sales of similar products in Swiss francs to unrelated foreign distributors, it would be difficult for the IRS to argue that the U.S. distributor subsidiary should not be able to make purchases in Swiss francs as well, or that the U.S. subsidiary should not accept the foreign exchange exposure related to Swiss franc purchases. Nevertheless, under Letter Ruling 9237008, the Service may take into account such exposure in determining appropriate arm's-length prices for the U.S. distributor's purchases. As mentioned previously, the difficult part is determining appropriate arm's-length prices, especially when losses have occurred as a result of the foreign exchange exposure. Of course, if the foreign related distributor had perfectly hedged its exposure, it would be reasonable to adjust prices to reimburse the distributor for the cost of that hedging, just as an unrelated distributor engaged in perfect hedging would want prices adjusted to allow it to earn a normal arm's-length margin after the hedging costs were taken into account. However, in many cases, purchasers of products in foreign currencies undertake no (or only partial) hedging. Over the long term, economic theory would assume that such purchasers should earn a somewhat higher margin than if they assumed no foreign exchange risk. But in the short term, the same purchasers may have much higher or lower levels of profit, depending on changes in exchange rates. This, after all, is the nature of risk taking.

In our current example, there are no comparable uncontrolled prices from which to calculate arm's length related-party prices. Further, the distributor subsidiary had not undertaken any active form of hedging and had suffered significant foreign exchange-related losses as a result of a declining U.S. dollar relative to the Swiss franc (an actual scenario during certain years during the last decade). Since there are no comparable uncontrolled prices, alternative methodologies under the regulations must be considered. The first alternative, and the one which would most likely be used by the Service in a situation similar to the example, is the resale price method. Under the resale price method, the gross margins of unrelated distributors functionally comparable to the related distributor subsidiary would normally be used (provided there were no internal unrelated-party distribution margins), after adjustments, to determine an arm's-length gross margin for the related distributor subsidiary. Thus, if the profitabilities of comparable U.S. distributors that purchased their inventories in U.S. dollars were used, the gross losses of the related distributor that were incurred as a result of foreign exchange losses would have to be backed out. in essence, this would allow the determination of the related distributor's profitability if it had not suffered from foreign exchange losses to begin with.

Backing out such losses, however, may be a difficult exercise. For instance, if every time the falling dollar caused inventory costs to increase, and such increases could be passed along to customers, the effect of the falling dollar on margins would be nil. On the other hand, if these losses could not be passed to customers as higher prices, the foreign exchange losses would be maximized. Further, the extent to which such increased costs could be passed to customers depends on the competitive environment in which the related distributor operates, as well as on the foreign exchange posture of its competitors. In general, if all such competitors purchased their inventories in Swiss francs, they would all be able to raise prices. Since this will normally not be the case, however, the related distributor will, in this situation, suffer declining gross margins. In sum, the calculation of actual foreign exchange losses will depend on competitors' foreign exchange positions.

Once foreign exchange losses have been backed out, it still will be necessary to determine what additional income should be attributed under Sec. 482 to the related distributor to compensate it for its risk. As mentioned, an appropriate benchmark for determining this amount is the amount that it would cost to fully hedge the exposure. This is because, as noted, an unrelated distributor that received a discount equivalent to the hedging cost through its inventory purchase price would be willing to accept the foreign exchange risk, since it could nullify that risk at no additional expense. However, there may be alternative forms of hedging in many situations, and it may be appropriate to look at companies within the industry to see what types of hedging are typically undertaken at arm's length, and to determine the costs of such hedging.

Though a discussion of the actual calculations typically undertaken to back out foreign exchange losses in the situation discussed here, and to properly determine the amount of income that should be attributed to the related distributor for undertaking foreign exchange risk, is beyond the scope of this article, it is important to remember that foreign exchange factors, such as those discussed here, can be a difficult and material consideration under Sec. 482. Further, since the scenario in which U.S. distributors purchase inventory from foreign related parties is very common in those industries in which many products are imported (such as autos, consumer electronics and computers), these issues are likely to be raised with increasing frequency by the IRS in transfer pricing audits. As a result, related U.S. distributors that purchase products from related parties in foreign currency should consider their foreign exchange exposures in light of their transfer pricing policies.