Final Draft Report

SENNHEISER ELECTRONICS (INDIA) PRIVATE LIMITED

TRANSFER PRICING DOCUMENTATION

Analysis of International Transactions withAssociated Enterprises

FISCAL YEAR ENDED MARCH 31, 2009

Prepared on 25.09.09

Privileged & Confidential

Prepared by

MEHRA GOEL & COChartered Accountants 505, Chiranjiv Tower

Nehr PlaceNEW DELHI – 110019

[email protected][A member firm of KS International]

mailto:[email protected]

TRANSFER PRICING ANALYSIS – FINANCIAL YEAR 2009

I N DE X

CONTENTSClauses of

Rule 10(D(1)

Paragraph Page No.

I. IntroductionA. Glossar & termsB. Scope of the Study C. Summary of ApproachD. Framework of Transfer Pricing

Regulations

1.1-1.1.51.2-1.2.51.3-1.3.24

34,55-77-15

II. Group OverviewA. ObjectiveB. Ownership StructureC. Group OverviewD. Company Overview

(a),(b),(c),(d) 2.1-2.1.1

2.22.3-2.3.82.4-2.9

1616

17,1819,20

III. Industry ScenarioA. ObjectiveB. The Global Consumer Electronics

Market ScenarioC. Indian IndustryD. Competitors profile

(c)3.1-3.1.1

3.2.1-3.2.103.2.11-3.2.253.2.26-3.2.23

20-2121-25

25-3132-36

IV. Functional AnalysisA. ObjectiveB. Functions performed by Associated

IndustriesC. Risks assumedD. Assets employedE. Characterization

(e)4.1-4.1.5

4.2.1-4.3.2

4.4-4.4.84.5-4.5.14.6-4.6.1

37-4040-41

41-4343-4444-45

V. Economic AnalysisA. ObjectiveB. Prerequisite to analysisC. Legislative background relating to

selection of the most appropriate methodD. Application of transfer pricing method

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

5.15.2

5.3-5.3.28

5.4-5.4.14

4545

45-57

58-61

SENNHEISER ELECTRONICS INDIA PRIVATE LIMITED MEHRA GOEL & CO.

CHARTERED ACCOUNTANTS

2


E. Conclusion 5.5-5.5.4 61-62

GLOSSARY AND TERMS USEDOECD Organisation for Economic Cooperation and DevelopmentTP Transfer Pricing CUP Comparable Uncontrolled Price Method RP Retail Sale Price Method PS Profit Split Method TNMM Transactional Net Margin Method CP Cost Plus Method USA United States of AmerikaR&D Research and DevelopmentAE Associated Enterprises GP Gross ProfitPLI Profit Level IndicatorFAR Functions Performed, Assets Employed, Risk AssumedTV TelevisionLCD Liquified Crystal DisplayCEA Consumer Electronics AssociationCEAMA Consumer Electronics Appliances Manufacturers AssociationDTH Direct To HomeGDP Gross Domestic Product



3


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 support the transfer prices of such transactions.

These documents are to be supported by a report from an Accountant 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.



4


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

account 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



5


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 account 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

advertisement 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



6


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 terms 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



7


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



8


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 Administration' 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



9


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 terms of sub-

section (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:



10


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 terms of the relevant transaction are

determined in substance between such other person and the associated

enterprise.

(b) Computation of Arm’s Length Price:

1.3.12 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 relation to



11


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 account of

differences, if any, and the assumptions required to be made for

application of a method.

(c) Comparability Analysis:



12


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 account 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 account. 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 account assets used and risks assumed),

the contractual terms, 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;



13


Functions performed, assets employed and risks assumed;

Contractual terms of the transactions;

Market conditions - geographic allocation and size of the markets;

Cost of labour and capital;

Economic development; and

Level of competition.

(d) Evaluation of Separate and Combined Transactions:

1.3.18 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 terms 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.



14


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) Documentation:

1.3.23 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. However, even in such



15


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 accountant 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 terms '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.



16


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:

100%

A. Group Overview:

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

2.3 Sennheiser Global Operations Gmbh., headquartered in Hannover, Germany

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 Germany, 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



17

Sennheiser Global Operations Gmbh.(99.9%) Sennheiser

Electronic GMBH & Co., Germany(0.1%)

Sennheiser Electronics

( India)


research and development specialists converted their university institute,

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 family-

owned 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 Vertriebs-

und Entwicklungsgesellschaft (loudspeakers and studio monitors) and the

Denmark -based joint 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 Germany and an

R&D center in California to ensure that the company maintains its

technological lead.



18


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.



19


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 accounts for the year ended 31.3.2009 is as under:

(Figures in INR)

Profit & Loss Account For year ended March 31, 2009

Sales and services(A) 157,611,603

Other income 543,675

Total of Revenue(B) 158,155,278

Cost of goods sold (C ) 91,163,767

Operating and other expenses 96,496,017

Depreciation 1,219,104

Total Expense (D) 188,878,888

Gross Profit E=(A-C) 66,447,836

(i.e. 42% of Sales)

Net Profit/(Loss) before Tax F= (B-D) (30,723,610

)



20


(19% of Tot. Revenue)

Taxes (G) 752,101

Net Profit/(Loss) after Tax H=(F-G) (31,475,711)

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

Global Industry

3.2.1 The consumer electronics market consists of the total revenues generated

through the sale of audio, video, and games console products designed



21


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-panel 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



22


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

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

download 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, designing and manufacturing semiconductor chips and

LCD screens, while companies specialising in device manufacture are less



23


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

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 user interfaces. It was then able to leverage these strengths in

order to produce the iPod.



24


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

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 terms 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.



25


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-panel 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 account for around 30% of all colour TVs sold in India, domestic



26


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,

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



27


have been contributing a major part to the growth, suggesting the structural

transformation within the Indian economy.

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



28


Analogue products like VCRs, cassette decks and analogue camcorders

virtually disappeared from the retail market in India during the review period.

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



29


upward movers included Sony, Apple (with its iPod brand), Acer and Tata

Sky. In contrast, brands losing share included Philips and Videocon.

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 export-

promotion 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.



30

http://www.eetindia.com/ART_8800454740_1800006_NT_f8a376ac.HTM


EMS and ODM companies in India have been associated with several design

companies, although such relationships represent an extension of their global

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.



31


The Present & Future of Indian Economy

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



32


3.2.26 Sony India Pvt. Ltd.

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.



33


Apart from giving its global campaign “Sense and Simplicity”

an Indian touch, Philips also plans to introduce a new range

of 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 account 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 user 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 user

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



34


music, which always has an emotional impact on the listener.

Most of the business comes from word of mouth

(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 support from India. The company does

branding through select press advertisements. 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 panel

consisting of the contact 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



35


media, technology magazines, supplement of daily

newspapers are used specially for its multimedia speaker and

PC related product range. The electronic media, TV (news

and other general entertainment channels) is used to

advertise 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 supported 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



36


standard precedent of using it’s microphone model SM58 is

also followed here.

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 support for their customers through a well

trained staff and strategically located branch offices across

all metro towns.



37




Direct Employment of 3.58M

Indirect Employment of additional 5.77M

$1B opportunity for EDA and Design players

>$10B invested in physical infrastructure of

industryBuild 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.

38

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


IV. FUNCTIONAL ANALYSIS

A. Objective:

4.1 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

account, 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 account 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 account 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:



39


"1.20 In dealings between two independent enterprises, compensation

usually will reflect the functions that each enterprise performs

(taking into account 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 administrations might

need to identify and compare include, e.g., design,

manufacturing, assembling, research and 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 terms of their frequency,

nature, and value to the respective parties to the transactions

that is important.



40


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



41


by currency exchange rate and interest variability; credit risks;

and so forth.

1.25 The functions carried out (taking into account 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:



42


Overview:

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:

Support service and product warranty services:

4.2.2 Sennheiser Logistics Services Gmbh. also bears the support 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.



43


C. Risks assumed:

(i) Marketing Risk:

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

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) Credit risk:

4.4.1 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) Foreign Exchange risk:

4.4.2 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.

(iv) Technology risk :

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.



44


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:

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) Price risk:

4.4.8 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

(as on 31.3.2009)

Leasehold Land -

Leasehold improvements -



45


Computer Peripherals,Software &

Networking Equipments

10,01,559

Office Equipment 313,060

Furniture & Fixtures 21,480

Tools & Testing Equipment 12,84,217

Total 26,20,316

Intangible Assets:

4.5.1 Sennheiser Electronics India deploys skilled manpower, infrastructure

facilities and necessary administrative 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 Participation of Sennheiser Electronics

( India)

Participation of Sennheiser

Logistic Services Gmbh.

Functions performedStrategic Planning ●● ●●Product/ Technology development, R&D, etc.

● ●●●

IT Enabled Services ●● ●●Sales & Marketing ● ●●●Training ●● ●●Quality control ● ●●●Administration, purchase, infrastructure, etc.

●●● ●

General Management Functions ●● ●●Risks Assumed



46


Marketing risk ●●●●Credit risk ●●●●Foreign exchange risk ●● ●●Technology risk ● ●●●Manpower risk ●●●●Price risk ●● ●●Service Warranty/Rework Risk ● ●●●Assets EmployedTangible assets ●● ●●Intangible assets ●●●●

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. Prerequisite to analysis :



47


5.2 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.

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) Comparable uncontrolled price method (CUP method)(b) Resale price method (RP method)(c) Cost Plus method (CP method)(d) Profit Split method (PS method)(e) Transactional Net Margin method (TNMM)

5.3.1 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 account, 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 account



48


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;

(e) the extent to which reliable and accurate adjustments can be made to account 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 account 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



49


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 account 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.

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) TNMM -

5.3.7 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



50


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 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



51


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

on reasonable comparability of functions, risks, property employed and

financial results of the relevant transaction.

(b) CUP Method – Why Applied:

5.3.9 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 terms 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.



52


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.

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) Resale Price Method – not applied and Why:

5.3.12 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



53


such functions. Therefore, comparability under this method is particularly

dependent on similarity of functions performed, risks borne, and contractual

terms, or adjustments to account 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.

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 accounting 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



54


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) Cost Plus Method:- not applied and Why:

5.3.17 CP 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

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 terms, or adjustments to account 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 CP 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 accounting

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 non-

operating expenditure including financing expenditure) is the method used for



55


recognising these expenses and accountancy 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 CP method requires a high level of comparability between

the tested party and the comparable companies used in terms 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.

5.3.20 Under CP 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. CP

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, CP 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) Profit Split Method – not applied and Why:

5.3.22 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



56


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

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 terms 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 terms 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 terms 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



57


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

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 support 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



58


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

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

YYYNN

N

CUP METHOD ( applied)

Identification of price paid to related party. Identification of price paid to/charged from non-

associated 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).

YY

Y

Y

COST PLUS METHOD (not applied) Identification of the transaction. Y



59


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) .

YNN

NN

N

PROFIT SPLIT METHOD (not applied) Identification of function of Sennheiser Electronics

( India) . Identification of function of AE. Determination of the integration of the function of

Sennheiser Electronics ( India) . Determination of FAR of Sennheiser Electronics

( India) . Determination of comparable of Sennheiser

Electronics ( India) Determination of comparable of AE. Identification of adjustments. Application of method to Sennheiser Electronics

( India) .

Y

NN

Y

N

NNN

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) .

YNY

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:



60


I. CUP method is applied on the following transactions:

5.4.1 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:

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



61


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.

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:



62


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.

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 account 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



63


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.

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

France, 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 terms 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. Conclusion:

5.5 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.



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http://en.wikipedia.org/wiki/Turkey

http://en.wikipedia.org/wiki/France

http://en.wikipedia.org/wiki/Brand


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.

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 terms 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



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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.

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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Documents

Final Draft Report