Switzerland: Transfer pricing implications of exchange rate movements

Switzerland: Implications of exchange rate movements

The abandonment of the exchange-rate cap between the Swiss franc (CHF) and the euro (EUR) not only has a direct impact on the financial situation of a company, but it may also have short-term and long-term tax and transfer pricing implications.

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Immediate impact on foreign currency loans

Foreign currency loans, especially those in EUR or U.S. dollars (USD), granted by Swiss companies have lost approximately 15% of their value. For a company that may have neglected to hedge its foreign currency loans, the depreciation of currencies against the Swiss franc directly translates into losses affecting the tax base of the Swiss company.

Taxpayers need to address this aspect carefully as over the last year. Cantonal and the Swiss federal tax authorities have been raising more and more questions around loans granted by Swiss companies to related parties denominated in foreign currencies, such as EUR or USD. 

In particular, there have been challenges with respect to whether a Swiss company would have granted foreign currency loans to unrelated parties at such conditions, with the implication being whether the applied interest rate is at arm’s length or not. Such questions have even arisen when the applied interest rates were in line with the safe-harbor interest rates for loans in foreign currencies annually published by the tax authorities themselves. 

Considering the latest developments, it is anticipated that this topic will continue to be a focus of the tax authorities and that losses of Swiss companies due to foreign currency loans will be challenged.

On the other hand, Swiss groups that have granted intra-group loans to their subsidiaries in CHF may be confronted with similar challenges of tax authorities in their subsidiaries’ countries. Additionally, in situations when the optimal level of debt funding has been determined based on local thin capitalization rules, the appreciation of the CHF may lead to a part of the debt to be reclassified as deemed equity, resulting in interest charges not being fully tax deductible at the subsidiaries.

Reconsidering the treatment of intra-group FX risks going forward

In the last years, exchange rate risk between CHF and EUR was mostly treated as a possibility with low to average likelihood. As a result, little effort was wasted on the question whether the allocation of the foreign exchange (FX) risks truly corresponds to the functional and risk profile of the parties concerned from a transfer pricing perspective. 

Going forward, and especially under the accelerated base erosion and profit shifting (BEPS) discussions, the connection between risk allocation and the people managing the risk has become much closer. This begs the question whether allocating the risk to entities, which despite contractual arrangements do not actually have the resources and competences to manage this risk, is defendable from a tax and transfer pricing perspective.

Hedging activities

The aspect of managing foreign exchange risks is also related to hedging activities. In most groups, hedging activities are performed on a group level, based on consolidated financials. This may leave individual group companies with the impact of the current exchange rate fluctuations, e.g., in cases when natural hedges exist at group level which is why positions have not been hedged in the local entities’ books.

However, hedging activities in most cases eliminate risks from exchange rate fluctuations and lock in profits. If no hedging activities are performed on a legal entity level, it may be possible to enter into contractual agreements that allocate the gains or losses from the exchange rate fluctuations among the legal entities of a multinational group. This could reduce fluctuations in the legal entity results.

KPMG observation

In light of these exchange developments, some actions to consider include:

  • Prepare an inventory of intra-group transactions that are affected by the exchange rate changes
  • Examine expected impact on profitability for the involved entities
  • Check the alignment of functional and risk profiles as well as the adequate personnel to manage the functions and risks
  • Examine the impact of the exchange rate fluctuation regarding thin capitalization rules
  • Consider preparing documentation now depending on size and nature of the transactions

 

Read a February 2015 blog posting by the KPMG member firm in Switzerland: Impact of exchange rate movements on transfer pricing

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