Final Draft Report 3r2h1n

SENNHEISER ELECTRONICS (INDIA) PRIVATE LIMITED

TRANSFER PRICING DOCUMENTATION

Analysis of International Transactions with Associated Enterprises

FISCAL YEAR ENDED MARCH 31, 2009 Prepared on 25.09.09 Privileged & Confidential Prepared by

MEHRA GOEL & CO Chartered ants 505, Chiranjiv Tower Nehr Place

2 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

NEW DELHI – 110019 [email protected] [A member firm of KS International]

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I N DE X CONTENTS

Clauses of Rule 10(D(1)

I. Introduction A. Glossar & B. Scope of the Study C. Summary of Approach D. Framework of Transfer Pricing Regulations II. Group Overview A. Objective B. Ownership Structure C. Group Overview D. Company Overview

(a),(b),(c), (d)

III. Industry Scenario A. Objective B. The Global Consumer Electronics Market Scenario C. Indian Industry D. Competitors profile

(c)

IV. Functional Analysis A. Objective B. Functions performed by Associated Industries C. Risks assumed D. Assets employed E. Characterization

(e)

V. Economic Analysis A. Objective B. Prerequisite to analysis C. Legislative background relating to selection of the most appropriate method D. Application of transfer pricing method E. Conclusion

(f),(g),(h). (I).(j),(k). (l) & (m)

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Paragraph

Page No.

1.1-1.1.5 1.2-1.2.5 1.3-1.3.24

3 4,5 5-7 7-15

2.1-2.1.1 2.2 2.3-2.3.8 2.4-2.9

16 16 17,18 19,20

3.1-3.1.1 3.2.1-3.2.10 3.2.113.2.25 3.2.263.2.23

20-21 21-25

4.1-4.1.5 4.2.1-4.3.2

37-40 40-41

4.4-4.4.8 4.5-4.5.1 4.6-4.6.1

41-43 43-44 44-45

5.1 5.2 5.3-5.3.28

45 45 45-57

5.4-5.4.14 5.5-5.5.4

58-61 61-62

25-31 32-36

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GLOSSARY AND USED OECD TP CUP RP PS TNMM USA R&D AE GP PLI FAR TV LCD CEA CEAMA DTH GDP

Organisation for Economic Cooperation and Development Transfer Pricing Comparable Uncontrolled Price Method Retail Sale Price Method Profit Split Method Transactional Net Margin Method Cost Plus Method United States of Amerika Research and Development Associated Enterprises Gross Profit Profit Level Indicator Functions Performed, Assets Employed, Risk Assumed Television Liquified Crystal Display Consumer Electronics Association Consumer Electronics Appliances Manufacturers Association Direct To Home Gross Domestic Product

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I.

INTRODUCTION

A.

Scope of the Study:

1.1

The transfer pricing provisions/regulations were introduced in the Income-tax Act ('the Act') by the Finance Act, 2001, with effect from 1.4.2002 i.e. assessment year 2002-03. The said provisions are contained in sections 92 to 92F of the Act read with Rules 10A to 10E of the Income Tax Rules, 1962 (‘the Rules’). The transfer pricing provisions provide for computing income from ‘international transactions’ between ‘associated enterprises’ on ‘arm's length basis’ as per the most appropriate method of the prescribed five methods. The transfer pricing provisions also provide for onerous documentation requirement to the transfer prices of such transactions. These documents are to be ed by a report from an ant in Form 3CEB of the Rules and the documentation is to be in place before the due date of filing of income-tax return.

1.1.1 Sennheiser

Electronics

(India)

Private

Limited

{“Sennheiser

Electronics( India)”}, a company incorporated under the Companies Act, 1956, is a subsidiary of Sennheiser Global Operations Gmbh. The company is into wholesale trading of Headphones, Microphones (Wired and RF wireless), Aviation headsets, Acoustic equipment etc. It imports goods from Sennheiser Group Companies for reselling through its Distributors in India. 1.1.2 Sennheiser Global Operations Gmbh is engaged in the business of manufacturing and selling of headphones. The company has a centralised logistics and delivery system through its subsidiary called Sennheiser Logistics Services.

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6 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 1.1.3 Sennheiser Global Operations Gmbh has its business presence over the Asian, European and all the sophisticated American market.

Transactions under Scanner 1.1.4 During the Financial Year 2008-09, Sennheiser Electronics (India) Private Limited has international transactions with its Associated Enterprises on of expenses aggregating to Rs.8,46,68,904 as per Annexure- A. Also included in the Annexure are transactions with Associated Enterprises reflecting income of the Assessee amounting to Rs. 3,89,91,082. 1.1.5 The objective of this study is to examine whether the ‘international transactions mentioned in the preceding paragraphs are at arm's length price, having regard to the transfer pricing provisions. This study provides an analysis of cross border transactions entered into with associated enterprises during the financial year 2008-09 and includes an overview of the operations and organization structure of Sennheiser Electronics ( India) , it’s relationship with the associated enterprise, industry analysis, analysis of the functions performed, assets utilized and risks assumed by the associated enterprises and establishment of arm's length price as per the most appropriate method. This study also serves as a facility for compliance with the statutory obligations relating to maintenance of the requisite documentation, etc. 1.1.6 Analysis of the cross border transactions is subject to the assumptions and limitations as enumerated in this study. B.

Summary of Approach:

1.2

On the basis of functional analysis, the international transaction of Rs. 12,36,59,985 (Rs.3,89,91,082 towards income and Rs.8,46,68,903(Refer

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7 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Annexure-A) towards expenses) by Sennheiser Electronics ( India) from the associated enterprises, are covered under the transfer pricing regulations, and are required to be tested for arm’s length pricing. 1.2.1 In determining the most appropriate method, the methods prescribed under section 92C of the Act were evaluated, based on the function, asset and risk analysis and on the basis of availability of data. The results of the transfer pricing analysis in respect of the aforesaid international transactions are summarised as under: 1.2.2 During the financial year 2008-09, Sennheiser Electronics ( India) has entered into international transactions on of imports and reimbursement of expenses from/to its associated enterprise(s). During the relevant previous year, Sennheiser Electronics (India) has paid a total consideration of Rs.8,46,68,904. To determine the arm’s length characteristics of the international transactions as aforesaid, For import made from Sennheiser Logistics

Services,

Gmbh.

An

Associated

Enterprise,

Comparable

Uncontrolled Price Method (CUP) was applied as the most appropriate method to justify the arm’s length price of such international transactions. The transactions of reimbursement are against expenses incurred on behalf of the assessee and being on actual subjected against proper bills and management approval. There being no underlying element of profit shifting, in our view these transactions are self explaining as to its arm length and do not warrant for a benchmarking. 1.2.3 Apart from above, not included in the analysis, are service revenue aggregating to Rs.38,991,082/- consisting of mainly the reimbursement of ment cost and warranty bonus recovery etc. While the warranty bonus recovery is equal for all enterprise across the Sennheiser Group, as explained to us, the company includes a mark up of 5% on the bill for reimbursement. Since the arrangement is a revenue favour, we are of the view

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8 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 that the underlying economic benefit of such transactions is self justifying of the arm’s length character. Also included in above, Rs. 14,859,461 is the service revenue received from Associated Enterprises. As explained to us, this income is for facilitating the AE(s) to make direct sales to third party customers. Sennheiser India, under the arrangement charges a service fees of the price differential of its listed sales price and the imported price. The arrangement being revenue favour and there not being any element of price shifting, it do not call for a bench mark analysis. 1.2.4 For application of CUP, The product price catalogue of Sennheiser Logistics Services Gmbh. was studied. The price at which similar product supplied by Sennheiser Logistics Services Gmbh to other unrelated enterprise was benchmarked with the price at which the same product was imported by Sennheiser Electronics ( India). 1.2.5 As the Purchase price of Sennheiser Electronics (India) on controlled transactions, is well below standard price at which similar products are sold by Sennheiser Logistics Services Gmbh to other comparable uncontrolled enterprises It is within the safe harbour of the transfer pricing regulation. The international transactions of import of products by Sennheiser Electronics ( India) from Sennheiser Logistics Services Gmbh are, therefore, considered being at arm’s length applying the Comparable Uncontrolled Price Method (CUP), which is identified as the most appropriate method in of section 92 of the Act (Refer Annexure-B). C.

Framework of Transfer Pricing Regulations: General:

1.3

Transfer pricing refers to the price at which related parties enter into transactions of transfer of property, goods or services, which may take place under conditions or prices different from those taking place between

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9 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 independent parties. The transfer pricing regulations as contained in the Act empower the tax authorities to determine arm’s length price in respect of cross border transactions in accordance with the transfer pricing provisions. The statutory framework of transfer pricing regulations is contained in sections 92, 92A, 92B, 92C, 92D, 92E and 92F of Chapter X of the Act. Further, Rules 10A to 10E of the Rules provide, inter alia, factors and circumstances for selection of the most appropriate method for determining arm's length price, the manner in which the prescribed methods should be applied, the information and documentation required to be maintained by the assessee for the transfer pricing audit report etc. 1.3.1

The Organization for Economic Co-operation and Development (OECD), as early as in 1970's realized the importance of transfer pricing and the OECD Committee on Fiscal Affairs (CFA) made a study on issues arising due to transfer pricing between related parties. The CFA issued the first major landmark report in 1979 titled "Transfer Pricing and Multinational Enterprises” which reaffirmed and elaborated the arm's length principle set out in Article 9(1) of OECD Model Convention. This report defined the term 'Arm's length price' as the price 'which would be agreed between unrelated parties in the same or similar transactions under the same or similar conditions in the open market and prescribed methods for determining the arm's length price.

1.3.2 Regulation 482 (which is the governing provision for transfer pricing in the USA) was amended for the first time in 63 years, by the Tax Reforms Act of 1986 issued by the Internal Revenue Service of USA. The amendment required that inter-company charges for the use of intangible property should be commensurate with the income attributable to the use of the intangible property. Since then, significant changes to the USA regulations have occurred. In the light of this in the early 1990's, OECD reviewed the

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10 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 implications of the regulation and issued a "Report on Inter-company Transfer Pricing Regulations under Sec. 482 Temporary and Proposed Regulations", in December 1993. The CFA, thereafter, in 1993 began to revise the landmark 1979 OECD report as supplemented by the 1984 OECD report and issued guidelines titled 'Transfer Pricing Guidelines for Multinational Enterprises and Tax istration' in 1995, which focuses on both transaction oriented and profit oriented approach for arriving at arm's length price and provides guidelines on a wide range of topics for determining arm's length price. 1.3.3 The Indian Transfer Pricing Legislation to a great extent embodies the principles enshrined in the OECD guidelines on transfer pricing. Arm's Length Principle: 1.3.4 The arm's length principle, which is the cornerstone of OECD transfer pricing guidelines, is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which forms the basis of bilateral tax treaties involving OECD Member countries and an increasing number of non-Member countries. 1.3.5 As per Article 9, when conditions are made or imposed between two associated enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly. Thus, it is sought to adjust profits to bring them to a level that would prevail when independent enterprises would enter into comparable transactions during comparable conditions. 1.3.6

Section 92 of the Act provides that any income arising from an international transaction shall be computed having regard to the arm's length price. Income arising from an international transaction, allowance for any expense or interest

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11 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 or allocation or apportionment of any cost incurred in connection with benefit, service or facility provided by two or more associated enterprises shall be determined having regard to the arm's length price of such benefit, service or facility, as the case may be. 'Arm's length price' as defined in section 92F(ii) of the Act means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions. Associated Enterprises: 1.3.7

Sub-section (1) of section 92A of the Act defines the term 'associated enterprise', in relation to another enterprise, to mean an enterprise which participates, directly or indirectly through one or more intermediaries, in the management or control or capital of the other enterprise, in respect of which one or more persons who participate, directly or indirectly, or through one or more intermediaries, in its management or control or capital are the same persons who participate, directly or indirectly, or through one or more intermediaries, in the management or control or capital of the other enterprise. This part of the definition is similar to the one established by OECD guidelines and article in Indian tax treaties addressing transactions with associated enterprise also has similar definition.

1.3.8 Sub-section (2) of Section 92A of the Act further provides the circumstances in which enterprises shall be deemed to be associated enterprises at any time during the previous year for the purposes of sub-section (1) of that section. 1.3.9

In order that the parties involved in an international transaction be termed as associated enterprises, the relationship shared by such parties should be one as enumerated in sub-section (2) of section 92A of the Act. In of subsection (2) of section 92A of the Act, an enterprise would be deemed to be an "associated enterprise" in relation to another, inter alia, in case of:

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12 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 ♦ equity holding of at least 26 per cent in the other enterprise; ♦ control over appointment of more than half of the Board of Directors of the other enterprise; ♦ advancing of loans (at least 51 percent of book value assets) or providing of guarantees (10 percent of total borrowings) to the other enterprise. ♦ wholly dependent on know-how, patent, business, or commercial rights etc. provided by the other enterprise. ♦ supply of 90% of raw materials, required for manufacture of finished products by the other enterprise and effective influence of the other enterprise to determine price and other conditions. (a)

International Transaction:

1.3.10 International transaction" as defined in section 92B of the Act is of wide amplitude. The essential requirement for a transaction to come within the ambit of section 92B of the Act is that it should be between two or more associated enterprises, either of whom is non-resident. It includes all transactions/ arrangements having a bearing on the profits, income, losses or assets of such enterprises. 1.3.11 It is further provided that a transaction entered into by an enterprise with a person other than an associated enterprise shall be deemed to be a transaction entered into between two associated enterprises if there exists a prior agreement in relation to the relevant transaction between such other person and the associated enterprise, or the of the relevant transaction are determined in substance between such other person and the associated enterprise. (b) 1.3.12

Computation of Arm’s Length Price: The method of computation of arm's length price is provided for in

section 92C of the Act. The section provides that the arm's length price in

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13 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 relation to an international transaction shall be determined by 'the most appropriate method' out of the five specified methods, namely, (a) Comparable Uncontrolled Price Method; (b) Resale Price Method; (c) Cost Plus Method; (d) Transactional Net Margin Method and (e) Profit Split Method. The methods are similar to the methods prescribed by OECD. In a case where more than one price can be determined by the most appropriate method, the arm's length price shall be the arithmetical mean of such two or more prices. Section 92C (1) of the Act does not provide for any preference of methods. In fact, it permits adoption of any of the prescribed methods, which is the most appropriate method, similar to the U.S Internal Revenue Service concept of "best method rule". 1.3.13

'The most appropriate method' is defined in sub-rule (1) of Rule 10C of

the Rules as the method which is best suited to the facts and circumstances of each transaction and which provides the most reliable measure of arm's length price. The most appropriate method is to be selected having regard to the nature of transaction and class of transaction or class of associated persons or functions performed by such persons. Rule 10C of the Rules inter-alia, provides for the factors which are to be considered in selecting the most appropriate method. The major considerations in this regard have been – ♦ availability, coverage, and reliability of data necessary for application of the method; ♦ the degree of comparability existing between the international transaction and the uncontrolled transaction and extent to which reliable and accurate adjustment can be made on of differences, if any, and the assumptions required to be made for application of a method. (c)

Comparability Analysis:

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14 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 1.3.14

Application of the arm's length principle is generally based on a

comparison of the conditions in a controlled transaction with the conditions in an uncontrolled transaction between independent enterprises. In order for such comparisons to be useful, the economically relevant characteristics of the situations being compared must be sufficiently comparable. To be comparable means that none of the differences, if any, between the situations being compared, could materially affect the condition being examined in the methodology (e.g. price or margin), or that reasonably accurate adjustments can be made to eliminate the effect of any such differences. 1.3.15

As per OECD guidelines, while applying any of the prescribed transfer

pricing method, adjustments must be made on of differences between controlled and uncontrolled situation that would significantly affect the prices charged or received by an independent enterprise. 1.3.16

OECD guidelines provide that in making these comparisons, material

differences between the compared transactions or enterprises should be taken into . In order to establish the degree of actual comparability and then to make appropriate adjustments to establish arm's length conditions, it is necessary to compare attributes of the transactions or enterprises that would affect conditions in arm's length dealings. Attributes that may be important include the characteristics of the property or services transferred, the functions performed by the parties (taking into assets used and risks assumed), the contractual , the economic circumstances of the parties, and the business strategies pursued by the parties. 1.3.17 Sub-rule (2) of Rule 10B of the Rules refers to comparability of transactions. Following the lead of OECD guidelines, the following factors are prescribed in this regard: ♦ Characteristics of the property or services; SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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15 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 ♦ Functions performed, assets employed and risks assumed; ♦ Contractual of the transactions; ♦ Market conditions - geographic allocation and size of the markets; ♦ Cost of labour and capital; ♦

Economic development; and ♦ Level of competition. (d)

1.3.18

Evaluation of Separate and Combined Transactions:

The OECD guidelines provide that in order to arrive at the most

precise approximation of fair market value, the arm's length principle should, ideally be applied on a transaction-by-transaction basis. However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis. Examples may include (a) long-term contracts for the supply of commodities or services (b) rights to use intangible property, (c) pricing a range of closely-linked products (e.g. in a product line) when it is impractical to determine pricing for each individual product or transaction. Another example would be the licensing of manufacturing know-how and the supply of vital components to an associate manufacturer; it may be more reasonable to assess the arm's length for the two items together rather than individually. 1.3.19

Combining more than one transaction becomes all the more necessary

where there exists an intentional set-off - one associated enterprise provides a benefit to another associated enterprise which is balanced to some extent by different benefits received from that enterprise in return. In such situation the enterprises may claim that the benefit received should be set-off against the benefit each enterprise has provided as full or part payment of those benefits and only net gain or loss of the transaction need to be considered.

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16 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 1.3.20

The Indian transfer pricing regulations also provide for the evaluation

of combined transactions. The term transaction has been defined in clause (v) of section 92F of the Act to include the arrangement, understanding or action in concert whether or not such arrangement, understanding or action is formal or in writing. Similar transactions include a number of closely linked transactions. (e)

Arm's Length Range:

1.3.21 Application of a method may give range of results, which are at arm's length, but section 92C of the Act requires computation of arithmetical mean in cases where more than one price is arrived at by the application of most appropriate method. 1.3.22

Further, the law provides flexibility to the taxpayers to adopt any

prices falling within (+/-) 5% of arithmetic average of price determined by the most appropriate method meaning thereby that the tax authorities would not make any adjustment to the arm's length price adopted by the taxpayer if such price is 5 % less or 5% more than the arm's length price determined by the assessing officer. (f) 1.3.23

Documentation: The transfer pricing regulations provide onerous obligation on the

assessee to maintain prescribed documentation. Section 92D of the Act provides that every person who has undertaken an international transaction shall keep and maintain such information and documents as may be specified by rules made by the Board. The documentation would have to be produced within 30 days from the receipt of the notice, which is extendable for further 30 days. The documentation required to be maintained has been prescribed under Rule 10D of the Rules. The documentation requirement prescribed in the rules does not apply in a case where the aggregate value of international transactions as recorded in the books does not exceed Rs. ten million.

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17 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 However, even in such cases arm's length price in relation to income arising from international transactions is required to be substantiated on the basis of material available with the assessee. 1.3.24 The assessee, who has entered into an international transaction, is also required to furnish along with the return of income transfer pricing audit report from an ant in Form No. 3CEB of the Rules.

II.

GROUP OVERVIEW

A.

Objective:

2.1

The transfer pricing provisions contained in Chapter X of the Income-tax Act (‘the Act’) provide that any income or allowance for any expense or interest, relating to an 'international transaction' between 'associated enterprises', shall be computed having regard to the arm's length price. Section 92A and 92B of the Act define the 'associated enterprise' and 'international transaction'. Clauses (a), (b), (c) and (d) of sub-rule (1) of rule 10D of the Rules, as part of documentation requirements oblige an assessee to, inter alia, provide description of its ownership structure and interests, profile of the multinational group of which assessee enterprise is a part, broad description of business of the assessee and broad description of 'international transactions' entered into with the associate enterprises, etc.

2.1.1 This part of the study provides an overview of the Sennheiser Electronics (India) and the multinational group of which it is a part.

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18 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 B.

Ownership Structure:

2.2

Sennheiser Electronics (India) , a private limited company, was incorporated as a subsidiary company of Sennheiser Global Operations Gmbh. which holds 99.9% of equity, represented by 6,993,000 equity shares of Rs.10 each (fully paid-up) in Sennheiser Electronics ( India) . The ownership pattern of Sennheiser Electronics ( India) is shown as under: Sennheiser Global Operations Gmbh.(99.9%) Sennheiser Electronic GMBH & Co., (0.1%)

100% Sennheiser Electronics ( India) A.

Group Overview: (Source: the company website www.sennheiser.com)

2.3

Sennheiser Global Operations Gmbh., headquartered in Hannover, Sennheiser Global Operations Gmbh. found its way into the business world way back in 1945 by Dr. Fritz Sennheiser manufacturing tube voltmeters.

2.3.1

Sennheiser Global Operations Gmbh., a company incorporated in , is engaged in the business of distribution of headsets, Sound listening devices. The range of products offered includes headphones, microphones, wireless microphones and monitoring systems, conference and information systems as well as aviation and audiology products. History

2.3.2

About 62 years back, in 1945, Dr. Fritz Sennheiser together with seven engineers and technicians set out on the venture to found a new company. The research and development specialists converted their university institute,

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19 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 which had been moved during the war to the small village of Wennebostel, into what became known as "Labor W", and it was there that they began to build measuring instruments. Less than a year later, microphones were added to their product range, and soon the resourceful team became extremely successful in numerous fields of audio technology. Now, for more than 60 years, the name Sennheiser has been synonymous with top-quality products and tailor-made complete solutions for every aspect of the recording, transmission and reproduction of sound. 2.3.3

Sennheiser Electronics, now, is a worldwide group of companies operating in 90 countries around the world with more than 2,000 employees and one of the world´s leading manufacturers of complete audio solutions. Still a familyowned company, Sennheiser has made a name for itself above all in the development and manufacture of high-quality microphones, wireless RF technology and headphones. Conference and information technology, infrared systems, products for the hearing impaired and aviation headsets round off the comprehensive product portfolio. The Sennheiser Group also includes the studio microphone specialist Georg Neumann GmbH, Berlin, K+H Vertriebsund Entwicklungsgesellschaft (loudspeakers and studio monitors) and the Denmark -based t venture Sennheiser Communications, which develops headsets for the PC, office and call center markets.

2.3.4

There have been constant innovations made by Sennheiser, such as the invention of open-back headphones in the 1960s, infrared transmission technology in the 1970s, groundbreaking innovations in multi-channel wireless transmission in the 1980s, head-based surround sound systems in the 1990s and intelligent audio information systems in the new millennium.

2.3.5

The group has its major research and development division in and an R&D center in California to ensure that the company maintains its technological lead.

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20 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 2.3.6

Numerous patents and awards, including two German Innovation Awards, a Scientific and Engineering Award, an Emmy and a Grammy, are evidence of the company´s capacity for innovation.

2.3.7

The headquarters of Sennheiser electronic GmbH & Co. KG are in Wennebostel, which is a part of the municipality of Wedemark. The company also has production sites at its second German location in Burgdorf (electronics manufacturing, wireless technology), as well as in Tullamore, Ireland (headphones production) and Albuquerque, USA (wireless technology for the American hemisphere). Sennheiser´s products are sold by a worldwide network of long-standing sales partners and subsidiaries.

2.3.8

In 2008, the Sennheiser Group had sales of approximately EURO 385.8 million, which experienced a nominal decline in turnover of 2.4% as compared with the previous year.

D.

Company Overview: Introduction:

2.4

Sennheiser India was set up on January 11, 2007 with an operational service centre in India. The assessee is into wholesale trading of Headphones, Microphones (Wired and RF wireless), Aviation headsets, Acoustic equipment etc. It imports goods from Sennheiser Group Companies for reselling through Distributors in India.

2.5

Sennheiser India distributes all brands of the Sennheiser group, namely Sennheiser, Sennheiser Communications, Neumann and Klein and Hummel.

2.6

Its service centre is located in Haryana and it services products within and outside warranty. It also import spares from Sennheiser group Companies. Its major product range includes:



Microphones, Aviation headphones, Spares. SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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21 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Earphones, Headphones, Headsets. Wired Microphones. Box/Speakers.

   2.7

Sennheiser Electronics ( India) procures all the electronic components for the trading operations from its associated enterprises(AE). The assessee does not purchase any goods from any 3rd party vendor. However, there is no sale to any AE by Sennheiser Electronics (India) i.e. the ultimate customers for the traded products are unrelated parties alone. The majority of the sales take place in the Indian Territory. The customers include Production Studios, Airlines, Audio & TV Channels, Call Centres in India.

2.8

The AE sells goods to the assessee at a price list which is same for all the other fellow subsidiaries. The Assessee sells goods to distributors or other “middle men” at an average price of over 42% margin of sales.

2.9

A summary of the financial s for the year ended 31.3.2009 is as under: (Figures in INR) Profit & Loss Sales and services(A) Other income Total of Revenue(B) Cost of goods sold (C ) Operating and other expenses Depreciation Total Expense (D) Gross Profit E=(A-C)

For year ended March 31, 2009 157,611,603 543,675 158,155,278

91,163,767 96,496,017 1,219,104 188,878,888 66,447,836 (i.e. 42% of Sales)

Net Profit/(Loss) before Tax F= (B-D)

Taxes (G) SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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(30,723,610 ) (19% of Tot. Revenue) 752,101

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22 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 (31,475,711)

Net Profit/(Loss) after Tax H=(F-G)

III. INDUSTRY SCENARIO A.

Objective:

3.1

As per the documentation requirement provided under the transfer pricing regulations (section 92D read with Rule 10D(1)(c)) every person who has entered into an international transaction is required to keep and maintain information and documents regarding the industry in which the assessee operates. As per clause (d) of sub-rule (2) of Rule 10B comparability of an international transaction with an uncontrolled transaction is to be judged, inter alia, with reference to conditions prevailing in the market in which the respective parties to the transaction operate, including the geographical locations and size of markets, overall economic development and the level of competition etc. OECD Transfer Pricing Guidelines (para 5.22) provides that "for the purpose of determining the transfer pricing, general, commercial and industry conditions affecting the taxpayer also may be relevant. Relevant information could include information explaining the current business environment and its forecasted changes; and how forecasted incidents influence the taxpayer's industry, market share, competitive conditions, regulatory framework, technological progress and foreign exchange market.”

3.1.1 The current industry scenario, in which the company is operating, to the extent considered relevant, is discussed in this part of the study. B.

The Consumer Electronics Market Scenario

3.2.1

Global Industry The consumer electronics market consists of the total revenues generated through the sale of audio, video, and games console products designed primarily for domestic use. The audio sector consists of hifi systems, cassette, CD, Minidisc and MP3 recorders and players, personal stereos, and radios.

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23 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 The video sector consists of CRT and flat- television sets, videocassette and DVD players and recorders (standalone and integrated with TV sets), camcorders, digital cameras, and set-top boxes. Games consoles consist of all hand-held and plug-in consoles. The market is valued at retail selling price (RSP) with any currency conversions calculated using constant 2006 annual average exchange rates. 3.2.2

The consumer electronics industry is a global business. In recent years, the consumer electronics industry is in the midst of a new wave of change, witnessing a phenomenal growth. It is ushering in a dawn of convergence, of technologies, products and markets. Consumer electronics appliances such as digital televisions, portable media players and educational toys are in a state of constant flux. The convergence of digital-based audio, video and information technology is a major reason. These changes began nearly two decades ago and have resulted in an avalanche of state of the art electronic devices in the market. The demand for a multitude of portable, in-home or in-car consumer electronic items with multiple functions has increased tremendously.

3.2.3

Digitalization, miniaturization and mobility are the key elements for modern consumer electronic products. Digitalization transformed the consumer electronics sector, delivering new and exciting entertainment products that have changed the way we live. It paved the way for digital devices such as camcorders, DVD player/recorder, still camera, computer monitor and LCD TV. The computer industry has also benefited, making its way into the family living room. Miniaturization also accelerates the growth of the consumer electronics industry. Fundamentally, the changes in the consumer electronics industry are not being driven by product evolution, but by fluctuations in the industry's business models. Companies that are capable of change and those that develop branding will be most successful.

3.2.4 Consumer electronics companies producing computers, televisions, DVD SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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24 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 players and other household electronics face the same challenges as other consumer goods companies. The lifecycle of consumer electronics products is shrinking along with severe price deflation, a factor that makes demand, pricing and promotions management even more challenging. Innovation, differentiation and flexibility are critical to a company’s survival in the consumer electronics market. The rapidly falling prices and improved functionality provided by convergence are influential forces behind the growing consumer demand for electronic items. 3.2.5

By definition, the buyers of consumer electronics are individual consumers. The presence of large numbers of small customers in this market immediately implies low buyer power, since the effect of any individual decision to buy or not to buy has negligible impact on revenues for players in this market. Also, as it is most unlikely that potential customers will choose to make their own electronic products means that the threat of backwards integration can be neglected. However, buyer power is seen in the low switching costs incurred by consumers if they decide to change their supplier. (There may be switching costs if one manufacturer's music player is incompatible with certain content sites.) In developed-economy markets, brand loyalty may diminish buyer power, but price sensitivity may outweigh brand awareness in less affluent societies. Overall, the global market has moderate buyer power.

3.2.6

Consumer electronics devices are manufactured using both commodity and customized parts. Some large players (eg Sony, Philips, Samsung) are already integrated backwards, deg and manufacturing semiconductor chips and LCD screens, while companies specialising in device manufacture are less prone to move forwards into making consumer products in their own right: it would require a radically new set of competencies and major investment in new production facilities. PC and mobile phone makers commonly use EMS

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25 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 firms, like Flextronics, but this kind of outsourcing is currently relatively rare for consumer electronics companies, which view manufacturing as a core competency. The strongest card in the hand of any supplier is the need of manufacturers to source low-cost, good quality components, in quantities which reflect fluctuations in consumer demand. Going forward, the increasing levels of digitalization in consumer products may mean greater amounts of power being ceded to chip manufacturers such as Texas Instruments and National Semiconductor. However, at present, supplier power in this market is weak. The major players have been household names for many years. Their scale economies - for example, the financial muscle to develop innovative products, build brands, and operate in diverse geographical markets - are considerable. But the barriers to market entry are not insurmountable. To circumvent costly R&D processes, a new company may gain access to technology through royalty payments to the developers. Rather than aim for a prestigious brand identity, a company can compete fiercely on price. In many developed economies, the growth of nonspecialist distribution channels, such as hard discounters and supermarkets, offers opportunities to manufacturers offering low-cost, weakly branded products. In the UK and US, for example, it is not unknown for supermarkets to sell DVD players for less than $40. 3.2.7

At the high end of the market, players with core competencies in areas such as computers are also entering the market, with the convergence of computer, telecommunications, and consumer electronics technologies a significant driver. Apple is a prime example of this trend. It is notable that Apple spent more than two decades developing its competencies in striking visual design and innovative interfaces. It was then able to leverage these strengths in order to produce the iPod. In less mature markets, the prospect of rapid growth in revenue may be set against the risks of counterfeiting, and the cost of import tariffs or the need to establish manufacturing bases, in order to assess the likelihood of the

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26 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 incumbents facing new competitors. Overall, the threat of new entrants in the global market is strong. 3.2.8

Consumer electronics may be priced very favorably in comparison to products with entertainment applications, such as home PCs, or service providers such as cinemas. This reduces the impact of these substitutes. It is unusual for developed-economy households not to own a television, for example, even though similar content is available through other media, and although these markets are mature there is little sign that people are ceasing to replace or upgrade their consumer electronics.

3.2.9 The global market is highly competitive. Although the major players operate in diverse businesses, consumer electronics forms a key segment of their revenues. Product differentiation is challenging. Much of the underlying technology is mature, and innovation is rapidly imitated; at a purely technical level, the performance of existing products is already good. Furthermore, consumers are free to change their brand allegiances at little cost to themselves. In the mature markets, demand creation is vital, through the strengthening of brand identity, and differentiating products in of visual design, while price competition can be particularly important in markets where consumers have lower disposable incomes. 3.2.10 The consumer electronic market has gained consistent growth over the last 4 years. As per the study carried out by Consumer Electronic Association (CEA), due to the Global recession the market will fill the pinch and experience fall in the next two years.

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27 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

Indian Industry 3.2.11 The consumer electronics market consists of the total revenues generated through the sale of audio, video, and games console products designed primarily for domestic use. The audio sector consists of hifi systems, cassette, CD, Minidisc and MP3 recorders and players, personal stereos, and radios. The video sector consists of CRT and flat- television sets, videocassette and DVD players and recorders (standalone and integrated with TV sets), camcorders, digital cameras, and set-top boxes. Games consoles consist of all hand-held and plug-in consoles. The market is valued at retail selling price (RSP) with any currency conversions calculated using constant 2006 annual average exchange rates.Asia-Pacific comprises Australia, China, Japan, India, Singapore, South Korea and Taiwan. 3.2.12

Although approximately 40% of India’s population live in serious

poverty, the growing middle class forms a large potential customer base for consumer electronics. However, levels of disposable income for consumers in this class may still be low relative to those expected in fully developed economies. This means greater price sensitivity in the Indian market.

A protectionist history has led Indian companies in retaining significant share in several market segments. For example, while the multinationals LG and Samsung for around 30% of all colour TVs sold in India, domestic players BPL and Onida sell over 20% of the total. The scale economies of the leading incumbents - for example, the financial muscle to develop innovative products, build brands, and operate in diverse geographical markets, so protecting overall revenues - are considerable. Indian import tariffs are high,

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28 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 although falling. If new entrants are to offer products with competitive retail prices in this price-sensitive market, they must be able to keep their own costs low enough to absorb the impact of import duties, or else invest capital in developing manufacturing facilities in India. There can be difficulties in reaching all potential customers, as distribution networks can be limited, especially in rural areas. Although these barriers are not insurmountable, India may be a more difficult market to enter than many others. 3.2.13 Consumer electronics may be priced favorably in comparison to products with entertainment applications, such as home PCs, or service providers such as cinemas. This reduces the impact of these substitutes. Counterfeit products and grey imports may also be seen as substitutes from the point of view of manufacturers attempting to compete more straightforwardly. 3.2.14 The Indian market is highly competitive. Although the largest players operate in diverse businesses, consumer electronics forms a key segment of their revenues.

Product differentiation is challenging. Much of the underlying

technology is mature, and innovation is rapidly imitated; at a purely technical level, the performance of existing products is already good. Furthermore, consumers are price-sensitive and free to change their brand allegiances with no cost to themselves. Prospects: The consumer electronic market has huge unexploited potential considering the growth potential of the following complementary industries. 3.2.15 The Indian economy has been growing at an average growth rate of 8.8% since the past 4 years (2003-04 to 2006-07).The Industrial and service sectors have been contributing a major part to the growth, suggesting the structural transformation within the Indian economy.

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29 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 The real GDP growth was better than expected in the 1st quarter of 2008, growing at 8.8% on year-on-year basis. The slow growth in agricultural and manufacturing sector was mitigated by surge in trade, hospitality, transportation and telecommunication sectors, which represent 30% of the economy. India has been one of the fast growing economies in the world economy, but rapid rising inflation and complexity of it’s democratic structure is proving the biggest challenge. Like other countries in the world, India has also been facing testing times in 2008. The inflation reached above 11% and even touched the highest level seen for a decade. The rising cost of oil, food and other resources such as steel, cement etc are all playing a negative part. The foreign reserves have decline in recent years but remained sizable over $300 billion USD and the external debt is also at 13% after appreciating to 11% in 2007, and the rupee depreciating since beginning of the year 2008, loosing over 20% against the USD.

3.2.16 Economic downturn slows sales growth Retail sales growth in the consumer electronics sector slowed in India in 2008 as the global economic crisis brought with it a credit squeeze, making consumer financing less available and reducing sales of such big ticket items as LCD and plasma TVs, laptops and in-car DVD players. Sales of white goods, such as refrigerators and washing machines, seem to have fared better than sales of consumer electronics during the 2008 festival season (September/October).

3.2.17 Old technologies disappear Analogue products like VCRs, cassette decks and analogue camcorders virtually disappeared from the retail market in India during the review period.

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30 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 There was dwindling demand and retailers saw no need to stock these products. Analogue cameras and in-car cassette players are expected to experience reduced sales over the forecast period, with sales likely to continue for only a couple more years before they too disappear from retailers’ shelves. The switch from analogue to digital products has led to significant changes in the structure of the Indian consumer electronics market. During the review period, mobile phones replaced analogue televisions as the single largest product in the market. 3.2.18

Falling retail prices get consumers’ attention-Emerging product subsectors, like portable multimedia players, digital TVs and projectors, saw volume sales increase significantly in 2008 over prior year as falling retail prices enticed consumers to buy these once-expensive new products. As well, lower duties, increased competition and cheaper technology costs contributed to the good deals many customers got when purchasing consumer electronics products. Parallel imports and the grey market generate significant retail sales. These unauthorised imports typically have lower prices than legitimate retail products, based on importers evading taxes and under-invoicing. Grey market activity has also resulted in lower prices, especially for portable and in-car consumer electronics products.

3.2.19

Nokia leads a highly fragmented market- The grey market and direct imports are also responsible for some of the fragmentation in the Indian consumer electronics market. The only brand with a double-digit percentage share in the Indian market is Nokia, through its dominance of the mobile phone sector. Nokia is not present in any other sector. On the other hand, brands like Sony and Philips are present in all of the major product sectors, and this has helped boost their overall share. In 2008, strong upward movers included Sony, Apple (with its iPod brand), Acer and Tata Sky. In contrast, brands losing share included Philips and Videocon.

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31 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 3.2.20

Expanded distribution is critical-In order to tap semi-urban and rural demand, companies are expanding their distribution networks in these areas. The move has positively impacted sales for companies opting for rural expansion. However, rural consumers have not been as brand-conscious as their urban counterparts. Due to the lower prices of unbranded products, rural consumers have been inclined to buy these products, although they often have poor quality. As the awareness among rural consumers rises, they are expected to show a preference for branded products. This is reflected by the fact that established players are reporting higher sales of products in rural areas.

3.2.21

Domestic manufacturing to expand- iSuppli research expects domestic manufacturing to be a key characteristic of this growth in the years to come. Although electronics production has remained a miniscule portion of overall Indian manufacturing for a long time, the trend is gradually changing. The government has been focusing increasingly on developing the manufacturing sector by developing infrastructure, rationalising duties and creating exportpromotion zones. This is in alignment with India figuring into the plans of several companies that want to cater to the domestic and export markets. Domestic consumption is reaching significant size to trigger manufacturing in the electronics sector. India also is assuming a significant place in the global plans of several major electronics manufacturers, thereby positioning it also as an export base. Furthermore, fabless companies are suitable to cater to such development because they can assist in moving the industry up the value chain by creating design-service opportunities for the Indian market. EMS and ODM companies in India have been associated with several design companies, although such relationships represent an extension of their global

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32 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 relationships. However, some local partnerships also are appearing, such as Flextronics' deal with inSilica for the development of SoC devices. Currently, such instances are few and far between. As the local market gains size, these associations will become more common. 3.2.22

Significant challenges remain-iSuppli believes that there are still challenges facing the India consumer electronics industry as the sector tries to realise its full potential. These include declining margins for many players; inverted duty structure; expansion of distribution reach; creating awareness about new technologies and products and low affordability level of consumer products among the rural masses. However, these challenges are gradually being addressed. And looking ahead, iSuppli believes that India will continue to grow as an important market for the global consumer electronics industry. The future of India's market is indeed bright.

3.2.23

Long-term growth still expected to be strong-Sales growth in the consumer electronics sector over the forecast growth is not expected to be as strong as that experienced during the review period. This is attributed, in part, to the economic slowdown that is expected to continue until 2010. As well, several products that are reaching their saturation points in India’s urban markets will need to make an impression in the country’s rural markets, and that may be more difficult than some anticipate. High-growth subsectors over the forecast period are likely to be receivers for DTH broadcasting, digital TVs, portable multimedia players and portable DVD players. Sales of mobile phones are expected to continue to grow based on increased consumer demand in rural areas. The Present & Future of Indian Economy

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33 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 3.2.24

The CEAMA (Consumer Electronics Appliances Manufacturers Association) predicts India to lead in steady growth in Consumer

Electronic

markets

amongst

the

Developing

Countries.

Source: CEAMA 3.2.25

Research suggests the Indian Electronic Consumption will grow to US $ 150 Billion by 2015. This leaves remarkable opportunities of investment and employment in the sector.

Competitors Profile 3.2.26

Sony India Pvt. Ltd.

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34 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Sony India is said to have 25% market share in the consumer electronics market in India. And is expected to increase the same to 30% with new product launches, increase in retail presence,

competitve

pricing,

promotions

and

focussed

market approch. As per industry analysts, Sony is likely to make investments in LCD, audio hometheatre, digital imaging and laptop segments. In India, like other players Sony is also feeling the brunt of higher duty structures on imports and the depreciating rupee which are coming in the way of making Sony select product range more affordable. 3.2.27

Philips Electronics India Pvt Ltd.

Philips Electronics India limited intend to position itself as market driven and people centric company, as part of its vision 2010 strategy. The company plans to unveil the new range of life style products in India, which will include a gamut of products like shavers, home appliances and high end LCD televisions. Philips has been operating in the Indian market for over 75 years and has a high brand recall in the consumer’s minds. The company is focusing on healthcare, lighting and consumer durables being its growth segments for the coming year. It had integrated its erstwhile consumer electronics, domestic appliances and personal care businesses into single lifestyle portfolio. Apart from giving its global campaign “Sense and Simplicity” an Indian touch, Philips also plans to introduce a new range of

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35 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 products

across

categories

like

audio-

video,

domestic

appliances, personal care and lighting solutions. Philips is also looking at new product areas, where it will create the customized products and introduce global product lines into the country. It also plans to strengthen its existing distribution network, which is its key strength compared to other market players. 3.2.28

Bose

Bose Corporation has presence in 5 verticals namely: home, professional,

automotive,

noise

reduction

and

scientific

product division. In India, institutional sales for large chunk of its revenue. Bose products were by large perceived to be at the vanguard of the technology, and the brand was perceived as an aspiration brand. Initially, its products were sold door-to-door and later the company established a network of exclusive outlets called Bose Stores, and shop-in shops in the multi band outlets. Unlike its competition the Bose stores have limited product portfolio. Bose strategies primary focus on the product, ensuring all its products are simple and friendly. Its product strategy is to offer superior sound and develop a range which is small, elegant looking and easy to use. As part of its strategy it relies on human factor – engineer to access human need, design interface and evaluating the usablity of the products. Bose is not away from criticism too, which is mostly centred around its high prices. The success of the company is said to lay on the fact that Bose products are able to create the feel of live music, which always has an emotional impact on the listener. Most

of

the

business

comes

from

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36 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 (recommendation from the customers). Bose is looking aggressively at India to expand. The company has 16 exclusive company owned stores in 9 cities spred across the country. It plans to increase the number of its retail outlets in the country by expanding into tier 2 and tier 3 cities as well. It does not plan for setting up a manufacturing facility but looking for IT from India. The company does branding through

select

press

ments.

Bose

is

heavily

advertising in all print media for its QC 3 range of noise cancellation product range including daily newspaper across metros towns and other key cities. Bose has also released ads in vancular languages like Gujrata and Hindi to create more regional impact as a brand. For first time Bose has released a consumer offer on its QC3 range, with its dealer consisting of the details of the Bose stores across the country

for

the

magazines

and

the

regional

specific

information for the vanaculars. 3.2.29

Creative

In India, Creative brand has a strong presence in the PC & multimedia industry. Creative is expanding its product range with wide range of interactive PDE products that includes MP3 players, portable media centers, multimedia speakers and headphones, digital and web cameras, graphic solutions, music key boards and PC keyboards and peripherals. To create brand awareness in the Indian market, Creative has been advertising in both print and electronic media. In print media,

technology

magazines,

supplement

of

daily

newspapers are used specially for its multimedia speaker and

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37 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 PC related product range. The electronic media, TV (news and other general entertainment channels) is used to its complete range of products and specifically the headphone range. 3.2.30

Panasonic

Panasonic India Pvt. Ltd, was established, with the purpose of unifying all Panasonic operations in India and to provide its customers

with

a

combined

value,

synergizing

all

the

strengths of their various organizations into one. Its various businesses include manufacture, import, marketing and sales of kitchen appliances and small domestic appliances.. Panasonic will continue to increase its portfolio of product offering with increasing its presence across various types of outlets in India. The key thrust has been to establish and develop their exclusive Brand-shops, currently, 47 such exclusive brand-shops are operating in various parts of the country. Panasonic plans to reach 200 nos. of such shops in the coming years. Panasonic in India is also ed by a wide dealer and service network. As far as headphones are concerned, they are sold and marketed only as accessories and there is not much focus on this category. 3.2.31

Shure/Sun Infonet

Shure is traditionally being distributed through Sun Infonet, on an all India basis. The global trend of strong presence of Shure is also followed in India and created over the years the standard precedent of using it’s microphone model SM58 is also followed here.

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38 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Sun Infonet is a conglomerate of companies which are into diverse businesses, audio, video, security systems, broadcast &

professional

equipment,

medical

and

healthcare

technologies. It represents many brands in India, to name a few, Honeywell, Sony, Allen & Heath, Nexo, Camco, Fischer Amps, etc. Thus, they can act as a systems integrator and do a lot of planning for their customers through a well trained staff and strategically located branch offices across all metro towns.

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Manufacturing in India: Impact Assumption: $150B manufactured in India @ same level of value addition as Taiwan today.

$1B opportunity for EDA and Design players Direct Employment of 3.58M Indirect Employment of additional 5.77M >$10B invested in physical infrastructure of industry Build up of patent assets Indirect revenue impact of $250B

The Industry end state at 2015 depends on our collective actions now Source: Frost and Sullivan.

Source: Frost and Sullivan.

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IV. FUNCTIONAL ANALYSIS A. 4.1

Objective:

As per the documentation requirement in the transfer pricing regulations (section 92D read with clause (e) of sub-rule (1) of Rule 10D) a description of functions performed, risks assumed and assets employed or to be employed by the assessee and by the associated enterprise involved in the international transaction is required to be maintained. For selection of the most appropriate method, clause (b) of sub-rule (2) of Rule 10C provides for taking into , inter alia, the class or classes of associated enterprises entering into the transaction and the functions performed by them, assets employed or to be employed and risks assumed by such enterprises. Further, for the purpose of determining the arm’s length price as per section 92C read with clause (b) of sub rule (2) of Rule 10B, comparability of an international transaction with an uncontrolled transaction shall be judged with reference to, inter alia, the functions performed, taking into the assets employed or to be employed and the risks assumed by the respective parties.

4.1.1

Functional analysis is the key for analyzing the nature of international transactions, for determining where in a group of controlled entities economically significant activities are performed, as well as to evaluate the comparability of an uncontrolled and controlled transaction.

4.1.2 OECD Guidelines define functional analysis as "an analysis of the functions performed (taking into assets used and risks assumed) by associated enterprises in controlled transactions and by independent enterprises in comparable uncontrolled transaction". 4.1.3

OECD Guidelines further explain the process of functional analysis as follows:

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41 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 "1.20 In dealings between two independent enterprises, compensation usually will reflect the functions that each enterprise performs (taking into assets used and risks assumed). Therefore, in

determining

whether

controlled

and

uncontrolled

transactions or entities are comparable, comparison of the functions taken on by the parties is necessary. This comparison is based on a functional analysis, which seeks to identify and to compare

the

economically

significant

activities

and

responsibilities undertaken or to be undertaken by the independent and associates enterprises.

For this purpose,

particular attention should be paid to the structure and organisation of the group. It will also be relevant to determine in what judicial capacity the taxpayer performs its functions. 1.21

The functions that taxpayers and tax istrations might need

to

identify

manufacturing,

and

compare

assembling,

include,

research

and

e.g.,

design,

development,

servicing, purchasing, distribution, marketing, advertising, transportation, financing, and management.

The principal

functions performed by the party under examination should be identified.

Adjustments should be made for any material

differences from the functions undertaken by any independent enterprises with which that party is being compared. While one party may provide a large number of functions relative to that of the other party to the transaction, it is the economic significance of those functions in of their frequency, nature, and value to the respective parties to the transactions that is important.

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42 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 1.22

It may also be relevant and useful in identifying and comparing the functions performed to consider the assets that are employed or to be employed. This analysis should consider the type of assets used, such as plant and equipment, the use of valuable intangibles, etc., and the nature of the assets used, such as the age, market value, location, property right protections available, etc.

1.23

It may also be relevant and useful in comparing the functions performed to consider the risks assumed by the respective parties. In the open market, the assumption of increased risk will also be compensated by an increase in the expected return. Therefore, controlled and uncontrolled transactions and entities are not comparable if there are significant differences in the risks assumed for which appropriate adjustments cannot be made. Functional analysis is incomplete unless the material risks assumed by each party have been considered since the assumption or allocation of risks would influence the conditions of transactions between the associated enterprises. Theoretically, in the open market, the assumption of increased risk must also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised.

1.24

The types of risks to consider include market risks, such as input cost and output price fluctuations; risks of loss associated with the investment in and use of property, plant and equipment; risks of the success or failure of investment in research and development; financial risks such as those caused

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43 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 by currency exchange rate and interest variability; credit risks; and so forth. 1.25

The functions carried out (taking into the assets used and the risks assumed) will determine to some extent the allocation of risks between the parties, and therefore, the conditions

each

party

would

expect

in

arm's

length

dealings…………" 4.1.4 Purpose of functional analysis is to assess the role/contribution to the economic value by each of the associated enterprise in an international transaction. The compensation earned by each participating associated enterprise in an international transaction should correspond to their respective contribution of functions performed, exposure to risk and assets utilised. The functional analysis focuses on critical functions performed, assets utilised and risks assumed in performing the functions by each of the entities (associated enterprises involved). Comparability and economic analysis for determining the arm's length price is based on the conclusion drawn from the functional analysis of the enterprises. 4.1.5

Section 92C of the Act provides for determination of arm’s length price in relation to an 'international transaction' by any of the methods provided therein, having regard to, inter alia, the nature of the transaction or class of transaction. Nature and structure of the transaction actually undertaken is the basis for transfer pricing study. Nature is the characterisation, and structure, the form. Functional analysis results in characterisation of enterprises participating in the 'international transaction' in relation to each other.

B.

Functions Performed: Overview:

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44 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 4.2.1 Sennheiser Logistics Services Gmbh. is supplying the "Electro Acoustic Products" to Sennheiser India. Sennheiser Logistics Services Gmbh. also provides the following services to it’s customers: service and product warranty services: 4.2.2 Sennheiser Logistics Services Gmbh. also bears the services including the product quality, replacement and technological obsolescence in respect of which Sennheiser India grants the product warranty to the end consumers.

Functions performed by Sennheiser Electronics ( India) / Sennheiser Logistics Services Gmbh.: Sennheiser Electronics (India) Private Limited (“Sennheiser Electronics India”) is engaged in selling the product to the ultimate customers in India. 4.3.1

Role of Sennheiser Logistics Services Gmbh. Sennheiser Logistics Services Gmbh. is responsible for the manufacturing of product, development and maintenance of technical upgrades, creation of brands and market demands.

4.3.2

Role of Sennheiser Electronics India

Sennheiser Electronics India is responsible for the altimate consumers in India. It also is responsible for providing after sales service and to a marginal extend bears the warranty responsibility.

C.

Risks assumed: (i)

4.4

Marketing Risk:

Market risk arises for a business due to the uncertainty in the structure of the

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45 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 market, demand patterns and needs of customers, costs, pricing etc. Market risk represents standard risk borne by any enterprise in market driven transactions and would include the risk associated with failure of the services/products in the market. Sennheiser Global is solely responsible for creating market presence by soliciting business in international market and is exposed to normal marketing risk. Sennheiser Electronics (India) does not have any significant exposure to this risk. (ii) 4.4.1

Credit risk:

This is the risk arising from non-payment of dues by customers. As Sennheiser Electronics ( India) supplies to the ultimate customer, it faces considerable risk arising out of non-payment of dues from customers. (iii)

4.4.2

Foreign Exchange risk:

This risk arises from any adverse revaluation of assets and liabilities due to fluctuation in exchange rates, which would eventually have a negative impact on the profitability of the enterprise.

4.4.3 In respect of invoices raised by Sennheiser Logistics Services Gmbh.. On Sennheiser Electronics (India). Sennheiser Electronics ( India) bears foreign exchange risk as such invoices are denominated Foreign currency. Technology risk:

(iv)

4.4.4

This risk arises if the market in which the company operates is sensitive to introduction of new services/products and variants. Hence, in that case, business units may face loss of potential revenues arising from obsolete Stock or un saleable products.

4.4.5

All such risks related to change in technology are borne by Sennheiser Global except to the unsold stock in the hands of Sennheiser India. (v)

Manpower risk:

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46 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 4.4.6

Any enterprise, which is greatly dependent, for its success, upon quality personnel with required technical knowledge, is faced with this risk. Competitive market forces expose such an enterprise to the risk of losing its trained personnel.

4.4.7 Sennheiser Electronics ( India) has a skilled workforce to perform the various functions relating to it’s operations and is, therefore, exposed to the manpower risk. (vi) 4.4.8

Price risk:

This risk arises as a result of price pressures in the market. With increased competition, excess capacities worldwide and prevailing recession, the Consumer Electronics Market has become extremely price sensitive. No price risk is borne by Sennheiser Global as the altimate responsibility of sales is casted on Sennheiser Electronics ( India).

D.

Assets Employed:

4.5

Any business requires utilisation of tangible as well as intangible assets to perform various functions so as to earn revenues. In the business carried on by Sennheiser Electronics (India), the following tangible/intangible assets have been utilised: Type of fixed assets

Gross block at cost

Leasehold Land Leasehold improvements Computer Peripherals,Software

(as on 31.3.2009) 10,01,559

&

Networking Equipments Office Equipment Furniture & Fixtures Tools & Testing Equipment Total

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313,060 21,480 12,84,217 26,20,316

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47 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

Intangible Assets: 4.5.1

Sennheiser Electronics India deploys skilled manpower, infrastructure facilities and necessary istrative assets for carrying out its business. However, Sennheiser Electronics India does not own any valuable non-routine intangibles. Sennheiser Electronics India does not spend any significant amounts in research and development. Any improvements in processes or techniques arising out of execution of assignments / projects for Sennheiser Electronics is the exclusive property of Sennheiser Global.

F.

Characterisation:

4.6

Summary of Functional Analysis: Particulars

Functions performed Strategic Planning Product/ Technology development, R&D, etc. IT Enabled Services Sales & Marketing Training Quality control istration, purchase, infrastructure, etc. General Management Functions Risks Assumed Marketing risk Credit risk Foreign exchange risk Technology risk Manpower risk Price risk Service Warranty/Rework Risk Assets Employed Tangible assets Intangible assets

Participation of Sennheiser Electronics ( India) ●● ●

●● ●●●

●● ● ●● ● ●●●

●● ●●● ●● ●●● ●

●●

●● ●●●●

●●●● ●● ● ●●●● ●● ●

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Participation of Sennheiser Logistic Services Gmbh.

●●

●● ●●● ●● ●●● ●● ●●●●

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48 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

4.6.1 In view of the above analysis of functions performed, risks assumed and assets employed by Sennheiser Electronics ( India), it is possible to characterise Sennheiser Electronics ( India)

under as low-risk-bearing consumer

Electronic Product selling company. Sennheiser Global Operations Gmbh can be classified as the ultimate supplier, owning significant intangibles and entering into contracts with third parties, wherein it acts as a full fledged, high-risk bearing product seller.

V.

ECONOMIC ANALYSIS OF TP METHODS & THEIR APPLICABILITY

A.

Objective:

5.1

Economic analysis refers to application of the most appropriate method to establish arm's length price in relation to an international transaction entered into between associated enterprises. Clauses (g), (h), (i), (j), (k), (l) and (m) of rule 10D of the Rules read with section 92D of the Act require the assessee entering into an international transaction to keep and maintain, as part of transfer pricing documentation working of arm's length price, analysis performed for comparability and adjustments etc. to determine the arm's length price of international transactions.

B. 5.2

Prerequisite to analysis: On the basis of functional analysis, the international transaction of purchase of consumer electronics goods by Sennheiser Electronics ( India)

from the

associated enterprise(s) (aggregating to a sum of 123.66 million), are covered under the transfer pricing regulations, and are required to be tested for arm’s length pricing.

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49 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 C.

Legislative background relating to selection of the most appropriate method:

5.3

Section 92C of the Act provides that arm's length price in relation to an international transaction shall be determined by any of the following prescribed methods, being the most appropriate method, having regard to the nature or class of transaction or class of the associated enterprise or functions performed by the entities participating in the transactions. (a) (b) (c) (d) (e)

5.3.1

Comparable uncontrolled price method (CUP method) Resale price method (RP method) Cost Plus method ( method) Profit Split method (PS method) Transactional Net Margin method (TNMM)

Rule 10C of the Rules provides guidelines for selecting the most appropriate method as follows: “10C (1) For the purposes of sub-section (1) of section 92C, the most appropriate method shall be the method which is best suited to the facts and circumstances of each particular international transaction, and which provides the most reliable measure of an arm’s length price in relation to the international transaction. 2) In selecting the most appropriate method as specified in sub-rule (1), the following factors shall be taken into , namely: -(a) the nature and class of the international transaction; (b) the class or classes of associated enterprises entering into the transaction and the functions performed by them taking into assets employed or to be employed and risks assumed by such enterprises; (c) the availability, coverage and reliability of data necessary for application of the method; (d) the degree of comparability existing between the international transaction and the uncontrolled transaction and between the enterprises entering into such transactions;

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50 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

(e) the extent to which reliable and accurate adjustments can be made to for differences, if any, between the international transaction and the comparable uncontrolled transaction or between the enterprises entering into such transactions; (f) the nature, extent and reliability of assumptions required to be made in application of a method." 5.3.2 Regulation 482 of IRS regulations in USA also provides several methods for determining transfer price, and requires that 'The Best Method' be applied to determine compliance with the arm's length standard for the controlled transactions or operations. 'The Best Method' is defined under the USA regulations as the method which produces the most reliable measure of an arm's length result for the controlled transaction, considering all of the relevant facts and circumstances (Reg.1.482-1(c)(1)). There are two primary considerations that must be taken into to determine which method is the best method.

The first consideration is the degree of comparability

between the controlled transaction or operation and uncontrolled comparable transaction, and the second consideration in determining the best method is the quality of the data and assumptions used in the analysis. 5.3.3 The 'Best Method' rule does not provide for a strict priority in the application of the specified methods, and no method necessarily will be considered invariably more reliable than another. There may be several methods that a taxpayer may use to establish an arm's length benchmark against which its transfer prices can be measured, or to corroborate the results achieved from the application of other methods. 'The Best Method' rule is a rule of relative comparability and reliability, and attempts to take into all the facts and circumstances, including the considerations described above with respect to the application of a specified method, in determining which method is likely to produce the most reliable measure of an arm's length result.

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51 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.3.4 The Indian regulations provide no priority of methods. Rather, the selection of the pricing method to be used to test the arm's length character of a controlled transaction must be made under the 'Most Appropriate Rule', which under the facts and circumstances of the transaction under review, provides the most reliable measure of an arm's length result. 5.3.5 The transfer pricing methods described in the transfer pricing regulations are analytical tools designed to test the arm's length character of transfer pricing results between controlled parties. No method is itself right or wrong for any given set of facts and circumstances. The most appropriate pricing method to be used to determine the arm's length character of a controlled transaction is one which, under the facts and circumstances of the transaction under review, provides the most reliable measure or best estimate of an arm's length result. 5.3.6 The transfer pricing methods that were reviewed on a checking of all the relevant controlled transactions and operations and the relative reliability of each specified method applied to the transactions and operations under review are summarized below: (a) 5.3.7

TNMM -

TNMM examines net profit margin relative to an appropriate base, (e.g., cost, sales, assets) that the tested party realizes in a controlled situation with that of the uncontrolled comparables. The OECD guidelines explain the TNMM method and its strengths in the following paras: "3.26 The transactional net margin method examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realises from a controlled transaction (or transactions that are appropriate to aggregate under the principles of Chapter I). Thus, a transactional net margin method operates in a manner similar to the cost Plus and resale price methods. This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale

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52 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 price or cost Plus method is applied. This means in particular that the net margin of the taxpayer from the controlled transaction (or transactions that are appropriate to aggregate under the principles of Chapter I) should ideally be established by reference to the net margin that the same taxpayer earns in comparable uncontrolled transactions. Where this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of the associated enterprise and, in the latter case, the independent enterprise is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results. b)

Strengths and weaknesses 3.27 One strength of the transactional net margin method is that net margins (e.g., return on assets, operating income to sales, and possibly other measures of net profit) are less affected by transactional differences than is the case with price, as used in the CUP method. The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of net profits. 3.28 Another practical strength is that it is not necessary to determine the functions performed and responsibilities assumed by more than one of the associated enterprises. Similarly, it is often not necessary to state the books and records of all participants in the business activity on a common basis or to allocate costs for all participants. This can be practically advantageous when one of the parties to the transaction is complex and has many interrelated activities or when it is difficult to obtain reliable information about one of the parties. …. "

5.3.8

TNMM was not selected as the most appropriate method for justifying the arm’s length price of such transactions. Transaction based methods - CUP method could produce a reliable measure of an arm's length result. Sufficient comparability to uncontrolled comparables could only be achieved by application of a directly comparable method, such as the CUP which is based

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53 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 on reasonable comparability of functions, risks, property employed and financial results of the relevant transaction.

(b) 5.3.9

CUP Method – Why Applied:

CUP method evaluates whether the amount charged in a controlled transaction is at arm's length with reference to the amount charged in a comparable uncontrolled transaction to provide a direct estimate of the price the parties would have agreed to, had they resorted directly to an open market alternative to the controlled transaction. Similarity of services/products in the controlled and uncontrolled transactions will have the greatest effect on comparability under this method. Minor differences in contractual or economic conditions could materially affect the amount charged in an uncontrolled transaction. The method becomes a reliable substitute for arm's length dealings if all significant characteristics of the uncontrolled transactions are comparable. Thus, the results derived from applying CUP method generally will be the most direct and reliable measure of an arm's length result for the controlled transaction, if an uncontrolled transaction has no differences as compared to the controlled transaction that would affect the price, or if appropriate comparability adjustments can be made for such differences.

5.3.10

Where there are no differences, or where differences can be adequately quantified, then, section 92C read with rule 10C of the Rules permits CUP method to be used. If, however, there are significant differences for which reliable adjustments cannot be quantified, CUP method will not produce a reliable measure of an arm's length result. In addition, the reliability of the results derived from CUP method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to apply the method.

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54 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.3.11

CUP method could be applied for benchmarking the international transactions as there were internal comparable available so as to apply CUP method as Sennheiser Logistics Services entered into similar transactions with unrelated parties. CUP method was therefore applied in respect of such transactions. (c)

5.3.12

Resale Price Method – not applied and Why: RP method compares gross profit margin earned in a controlled

transaction to gross profit margins earned in similar uncontrolled transactions. The resale price method is primarily intended to measure the value of the services performed by a buyer/reseller of services/goods acting as a pure provider/distributor. Ideally, the provider/distributor should not add a significant amount of value to the products they resell or valuable non-routine intangible that may affect the profits earned on the products they resell. 5.3.13

Under RP method the reseller's gross profit provides compensation for

the performance of resale functions related to the transactions under review, including an operating profit in return for the reseller's investment of capital and assumption of risks. The comparison provides an estimate of the gross profit margin the tested party could have earned had it performed the same functions with independent enterprises and, therefore, provide an estimate of the price that would have been paid/charged at arm's length for performing such functions. Therefore, comparability under this method is particularly dependent on similarity of functions performed, risks borne, and contractual , or adjustments to for the effects of any differences in these factors. Comparability under RP method is less dependent on close physical similarity between the products in the controlled and uncontrolled transactions than under CUP method. Substantial differences in the services/products may, however, indicate significant functional differences between the controlled and uncontrolled transactions.

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55 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.3.14

The reliability of profit measures based on gross profit may be

adversely affected by significant differences in the value of the services provided and differences in cost structures, business experience, and management efficiency. Accordingly, material differences in these factors affect the reliability of the results derived. If there are material differences between the controlled and uncontrolled transactions that would affect the gross profit margin, adjustments must be made with respect to the uncontrolled transaction. If such adjustments cannot be made with sufficient accuracy to improve the comparability of the results, the reliability of RP method is reduced. 5.3.15

In addition, the reliability of the results under RP method is affected by

the completeness and accuracy of the data used and the assumptions made. In particular, the degree of consistency in ing practices employed by the controlled party as compared to the uncontrolled party affects the reliability of the results. For example, the controlled party and the uncontrolled comparable should be consistent in their reporting of items (such as discounts, returns and allowances, rebates, insurance, and packaging) as between cost of services provided and operating expenses. 5.3.16

RP method is generally applied in cases of where service provider also

provides services to uncontrolled and not associated firms wherein reseller/provider of goods/services acting as a pure distributor/provider does not add significant value to the product for resale. Hence, application of RP method was not applied in the present case. (d) 5.3.17

Cost Plus Method:- not applied and Why: method evaluates whether the amount charged in a controlled

transaction is at arm's length with reference to the cost Plus mark up realized in comparable uncontrolled transactions or operations. A producer's cost Plus mark up provides compensation for the performance of the functions under

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56 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 review, including an operating profit for the producer's investment in capital and assumption of risks and thus provides an estimate of arm's length price for performing such functions. Therefore, comparability under this method, like RP method is also dependent on similarity of functions performed, risks borne, and contractual , or adjustments to for the effects of any differences in these factors and is less dependent on close similarity between the services in the controlled and uncontrolled transactions than under CUP method. Material differences in these factors affect the reliability of the results derived. If there are material differences between the controlled and uncontrolled transactions that would affect the gross profit margin, adjustments must be made with respect to the uncontrolled transaction. If such adjustments cannot be made with sufficient accuracy to improve the comparability of the results, the reliability of method is reduced. 5.3.18

In addition, the reliability of the results under method is affected by

the completeness and accuracy of the data used, and the reliability of the assumptions made. In particular, the degree of consistency in ing practices employed by the controlled party as compared to the uncontrolled party affects the reliability of the results derived. An important consideration while comparing costs (direct and indirect) and expenses (operating and nonoperating expenditure including financing expenditure) is the method used for recognising these expenses and ancy practices. The controlled and the uncontrolled party must be consistent in their reporting of costs as between cost of service provided and operating expenses. 5.3.19

The application of method requires a high level of comparability

between the tested party and the comparable companies used in of the intensity of functions performed, particularly in the level of operating expenses incurred. This again is subject to wide variation because of the varied nature and mode of operations in the service sector.

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57 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

5.3.20

Under method, the arm’s length transfer price is determined by

identifying the costs incurred by the provider of the services provided and adding an appropriate gross profit mark-up to the cost. This mark-up is usually established with reference to comparable uncontrolled transactions. 5.3.21

With regard to the significant international transaction of Import of

Consumer Electronic Goods from Sennheiser Global Operations Gmbh and is not to be regarded as service contract and is not remunerated on a cost Plus basis. method, therefore, could not technically be applied as the most appropriate method. Again, cost Plus method is also a profit-based method and does operate in a manner similar to that of TNMM. Having regard to the discussion in the preceding paragraphs, method was ruled out as the most appropriate method to determine the arm’s lengthy price of the ‘international transactions’ of import of Consumer Electronic Goods by Sennheiser Electronics ( India) and RPM was applied as the most appropriate method. (e) 5.3.22

Profit Split Method – not applied and Why: PS method evaluates whether the allocation of the combined operating

profit or loss attributable to one or more controlled transactions is at arm's length by reference to the relative value of each controlled party's contribution to that combined profit or loss. The relative value of each controlled party's contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each party in the relevant business activity. A "comparable profit split" is derived by reference to the combined operating profit of uncontrolled parties whose transactions and activities are similar to those of the controlled parties in the relevant business activity.

Another

variant, i.e. "residual profit split method” first allocates the profit to the controlled parties based on their respective routine operations, and the residual

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58 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 profit is allocated based on each controlled party's contributions of non-routine intangibles. 5.3.23

PS method is based on comparison of profit margins between

independent and associated enterprises as a means to estimate the profits that one or both of the associated enterprises could have earned had these dealt solely with independent enterprises and the payments/receipts for use of their resources in controlled transactions would have been on arm's length basis. Comparability under this method is particularly dependent on the similarity of activities and transactions between the controlled and uncontrolled parties. In addition, because the contractual of the relationship among the participants in the relevant business activity is a principal determinant of the allocation of functions and risks among them, comparability under PS method depends particularly on the degree of similarity of the contractual of the controlled and uncontrolled transactions. The reliability of the results derived from PS method depends particularly on the degree of similarity of the contractual of the controlled and uncontrolled transactions and is affected by the quality of the data and assumptions used to apply the method. 5.3.24

PS method may be applicable when the various entities involved in an

inter-company transaction perform highly integrated operation, sharing more or less proportionately the risks associated with their respective businesses. Also, in general, PS method relies primarily on the internal data and assumptions pertaining to each party to the controlled transaction instead of relying on comparable uncontrolled transactions as market benchmarks, thus making the use of the PS method ordinarily less reliable than the other methods. 5.3.25

Sennheiser Global Operations Gmbh. is the economic and legal owner

of significant intangible assets and does not share their ownership with Sennheiser Electronics ( India) . Therefore, any allocation of the combined SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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59 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 profits or losses attributable to the transactions between Sennheiser Global Operations Gmbh. and Sennheiser Electronics ( India) according to sales, assets, expenses or any other allocation measure is likely to result in Sennheiser Electronics ( India) receiving either too much or too little profit depending on the overall profitability of the consolidated transactions. As a quality improvement services provider, Sennheiser Electronics ( India) should achieve an amount of profit that is consistent with the other comparable service provider. 5.3.26

In addition, since Sennheiser Global Operations Gmbh is engaged in

transactions with multiple related and unrelated parties, application of PS method would require segmenting Sennheiser Global Operations Gmbh.’s financial statements to reflect only transactions relevant to the business of Sennheiser Electronics ( India) and consolidating these financial statements with Sennheiser Electronics ( India) ’s financial statements. Performing this type of segmentation and consolidation would be extremely difficult and unreliable. 5.3.27

PS method was rejected as the most reliable measure of an arm's length

result with respect to the transactions or operations under review, for the following reasons: (i) the two associated enterprises do not share integrated operations, equivalent intangibles and does not perform similar functions or assume similar risk and intangibles that it would be appropriate to consider a profit split; or (ii) the operations of Sennheiser Electronics India and Sennheiser Electronics US are distinct such that there is no difficulty in evaluating either entity separately. 5.3.28

The following table provides the factors in order to compare and

analyse the applicability of each method. TABLE - A SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED

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60 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Factors determining the applicability of the methods.

Applicability to Sennheiser Electronics ( India)

TRANSACTIONAL NET MARGIN METHOD (not applied)       

Identification of function of Sennheiser Electronics ( India) Identification of appropriate base Identification of comparable Identification of the appropriate margins to be applied. Identification of adjustments Adjustment of net margins on the basis of the above adjustments. Application of method to Sennheiser Electronics ( India)

Y Y Y Y N N N

CUP METHOD ( applied)  

 

Identification of price paid to related party. Identification of price paid to/charged from nonassociated entity for the same services as procured from related party. Identification of price paid for similar services procured by other party. Application of method to Sennheiser Electronics (India).

COST PLUS METHOD (not applied)  Identification of the transaction.  Determination of cost base for the transaction.  Identification of similar service provider.  Identification of direct/indirect cost of similar service provided in similar transaction.  Identification of gross margin in similar transaction  Identification of adjustments to be done with Sennheiser Electronics ( India) .  Application of method to Sennheiser Electronics ( India) . PROFIT SPLIT METHOD (not applied)  Identification of function of Sennheiser Electronics

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Y Y Y Y

Y Y N N N N N

Y

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61 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

      

( India) . Identification of function of AE. Determination of the integration of the Sennheiser Electronics ( India) . Determination of FAR of Sennheiser ( India) . Determination of comparable of Electronics ( India) Determination of comparable of AE. Identification of adjustments. Application of method to Sennheiser ( India) .

N N function of Electronics Sennheiser

Y N N N N

Electronics

RESALE PRICE METHOD (applied)  Identification of services provided.  Identifying the function as provider of services.  Identification of internal/external data to determine ALP.  Application of method to Sennheiser Electronics ( India) .

Y N Y N

D.

Application of Transfer Pricing Methods by Sennheiser Electronics India

5.4

Following is a summary description of the application of the most appropriate method applied by Sennheiser Electronics (India) with respect to the international transactions under review for the financial year 2008-2009: I.

5.4.1

CUP method is applied on the following transactions:

Sennheiser Electronics (India) has entered into international transactions with Sennheiser Global Operations Gmbh an associated enterprise, during the financial year 2008-09 for import of trading goods. The total consideration paid is Rs.81,443,102.

II.

Application and meaning of CUP method:

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62 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.4.2 CUP examines the price of product or services involved in the transaction between the associated enterprises with the price of similar transactions entered by the associated enterprises with an unrelated enterprise on similar set of condition and equivalent economic conditions. 5.4.3 The first step in applying CUP is to choose one of the parties to the controlled transaction or operation under review as the "Tested Party". The Tested Party is usually the participant in the transaction or operation for which profitability most reliably can be ascertained and for which reliable data on comparable can be found. The next step is to characterize the Tested Party based on the functional analysis and undertake a search for comparable engaged in similar functions as the Tested Party. The third step is to determine an arm's length price based on the price with respect to the price on a similar uncontrol transaction with non AE after suitable adjustment for dissimilar functions, risk factors economic conditions and product quality attributes etc. If the Tested Party's price are favourable to the benchmarked uncontrolled price, the transfer prices are deemed to be in compliance with the arm's length standard. (a)

Selecting the Tested Party and its characterization:

5.4.4 The Tested Party is the enterprise whose prices/profit margin would be tested or benchmarked using the most appropriate method. USA regulation 482 provides that one of the parties to the controlled transactions to be tested under CUP will be the party whose price can be verified using the most reliable data and requiring the fewest and most reliable adjustments and for which data regarding uncontrolled comparables can be located. Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.

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63 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.4.5 Sennheiser Global Operations Gmbh is involved in complex business operations and is engaged in several businesses. It has diverse transactions with several unrelated parties, is engaged in complex R&D operations and owns

valuable

intellectual

property

rights.

Therefore,

comparability

adjustments that would be required for, segregation of (i) costs/profits and (ii) net operating assets/receipts of Sennheiser Global Operations Gmbh that are attributable solely to related party transactions with Sennheiser Electronics ( India) , would be complex and unreliable, if Sennheiser Global Operations Gmbh were to be selected as the Tested Party. The costs incurred and the operating assets owned by Sennheiser Electronics (India) are, on the other hand, generally easily segregated and identified.

5.4.6 For purposes of this study, Sennheiser Electronics (India) is selected to be the Tested Party because their operating profit attributable to the controlled transactions or operations could be reliably verified and requires fewest adjustments. Sennheiser Electronics (India) has been characterized as service provider as determined by the results of the functional analysis. Sennheiser Electronics ( India) is engaged in substantially routine and less complex operations involving insignificant R&D as compared to Sennheiser Global Operations Gmbh and does not own unique or valuable tangible or intangible property, which might distinguish it from potential comparables. c)

Search of comparables:

I.

Search of Internal Comparables for Application of CUP :

5.4.11

For application of CUP for benchmarking the international transactions

entered into by an entity, both internal as well as external comparable can be used. However, the use of external comparables is advisable only in case where the entity does not enter into similar transactions with unrelated third parties in similar economic environment of the transactions under scanner.

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64 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.4.12

Clause (a) of Sub-rule (1) of Rule 10B

of the Income-tax Rules

provides for manner of application of Comparable Uncontrolled Price Method as under: “(i) the price charged or paid for property transferred or services provided in a comparable uncontrolled transaction, or a number of such transactions, is identified; (ii) such price is adjusted to for differences, if any, between the international transaction and the comparable uncontrolled transactions or between the enterprises entering into such transactions, which could materially affect the price in the open market; (iii) the adjusted price arrived at under sub-clause (ii) is taken to be an arms length price in respect of the property transferred or services provided in the international transaction;” 5.4.13

The OECD guidelines, too, provide in this regard as under:

Comparable Uncontrolled Price (CUP) method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. Comparability between a controlled and uncontrolled transaction exists when there are no differences between these transactions or, if there are differences, when such differences do not have a material effect or for which reasonable adjustments can be made. Hence, an at arm's length transfer price can be determined through a comparison with the sales price between two unrelated corporations executing a (comparable) transaction However, the fact that virtually any minor difference in the circumstances of trade (billing period, amount of trade, branding, etc.) may have a significant effect on the price makes it exceedingly difficult to find a transaction--much less transactions--that are sufficiently comparable.

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65 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 Should they exist, such comparable transactions fall into two categories: external comparables and internal comparables. The former is a comparable uncontrolled transaction in the purest sense of the term--if Company A, in , sells widgets to its subsidiary A(sub) in Turkey, then an external comparable transaction would be the sale of widgets from an unrelated French Company B to an unrelated Turkish Company C on comparable as the trade between Company A and its subsidiary A(sub). An internal comparable transaction, then, would be either the trade of widgets between Company A and an unrelated Company C, or the trade of widgets between an unrelated Company B and Company A's subsidiary, with the term "internal" referring to the fact that one of the parties involved in the tested transaction is also involved in the comparable uncontrolled transaction E. 5.5

Conclusion:

Sennheiser Global Operations Gmbh entered into contract with related party customer for the supply of earphones and performs marketing function and undertakes significant marketing risks. While Sennheiser Electronics (India) also performs the marketing function, it does not undertakes significant corresponding risks.

A substantial function relating to such quality

maintenance, product improvement, technical upgradation etc. are performed by the AE which also assumes enterprise risk, such as, marketing risk, credit risk, etc. As Sennheiser Electronics (India) operates as a contract retailer , it does not undertake such enterprise risk. 5.5.1 Further, under the Indian Transfer Pricing Regulations, proviso to sub-section (2) of section 92C of the Act provides that assessee has an option to take the arm’s length price determined by applying the most appropriate method at a variance of +/(-) 5% of the arithmetic mean of the prices determined applying such method.

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66 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 5.5.2 The price at which Sennheiser India imports form its AE were compared with the catalogue price of AE to other entities (Detailed comparison refered in Annexure-B). It was observed that Sennheiser imports at a much cheaper price than its counter part. Hence it can be concluded that Sennheiser India is within the safe harbour of arm’s length pricing applying the CUP method. 5.5.3

Having regard to the aforesaid analysis, the international transactions

of import entered into by Sennheiser Electronics (India) with Sennheiser Global Operations Gmbh. are considered being at arm’s length applying the CUP method which is identified as the most appropriate method in of section 92 of the Act. 5.5.4

Further, it is recommended for Sennheiser Electronics India to make

review of and frame its pricing policy accordingly based on the significant changes in the functions or economic character surrounding this study that are the subject matter of arm’s length character of inter company pricing.

ASSUMPTIONS AND LIMITATIONS 1.

The analysis in the transfer pricing study are based on review of the company's relevant business and financial data, information and explanations as provided by the company officials subjected to our limited verification of the same.

2.

The transfer pricing study is based on our reasonable interpretation of the Indian Transfer Pricing Regulations and are not binding on the tax authorities.

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67 TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009 The study should not be taken as assurance that the tax authorities would agree with the conclusions arrived at in the report. 3.

Chapters of the report regarding Industry Scenario is based on published information and interviews conducted with the company official.

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