SENNHEISER ELECTRONICS (INDIA) PRIVATE LIMITED TRANSFER PRICING DOCUMENTATION Analysis of International Transactions with Associated Enterprises FISCAL YEAR ENDED MARCH 31, 2009 Prepared on 25.09.09 Privileged & Confidential Prepared by MEHRA GOEL & CO Chartered Accountants 505, Chiranjiv Tower
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SENNHEISER ELECTRONICS (INDIA) PRIVATE LIMITED
TRANSFER PRICING DOCUMENTATION
Analysis of International Transactions withAssociated Enterprises
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
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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
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I. INTRODUCTION
A. Scope of the Study:
1.1 The transfer pricing provisions/regulations were introduced in the Income-tax
Act ('the Act') by the Finance Act, 2001, with effect from 1.4.2002 i.e.
assessment year 2002-03. The said provisions are contained in sections 92 to
92F of the Act read with Rules 10A to 10E of the Income Tax Rules, 1962
(‘the Rules’). The transfer pricing provisions provide for computing income
from ‘international transactions’ between ‘associated enterprises’ on ‘arm's
length basis’ as per the most appropriate method of the prescribed five
methods. The transfer pricing provisions also provide for onerous
documentation requirement to 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
Electronics( India)”}, a company incorporated under the Companies Act,
1956, is a subsidiary of Sennheiser Global Operations Gmbh. The company
is into wholesale trading of Headphones, Microphones (Wired
and RF wireless), Aviation headsets, Acoustic equipment etc.
It imports goods from Sennheiser Group Companies for
reselling through its Distributors in India.
1.1.2 Sennheiser Global Operations Gmbh is engaged in the business of
manufacturing and selling of headphones. The company has a centralised
logistics and delivery system through its subsidiary called Sennheiser
Logistics Services.
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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
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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
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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
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independent parties. The transfer pricing regulations as contained in the Act
empower the tax authorities to determine arm’s length price in respect of cross
border transactions in accordance with the transfer pricing provisions. The
statutory framework of transfer pricing regulations is contained in sections 92,
92A, 92B, 92C, 92D, 92E and 92F of Chapter X of the Act. Further, Rules
10A to 10E of the Rules provide, inter alia, factors and circumstances for
selection of the most appropriate method for determining arm's length price,
the manner in which the prescribed methods should be applied, the
information and documentation required to be maintained by the assessee for
the transfer pricing audit report etc.
1.3.1 The Organization for Economic Co-operation and Development (OECD), as
early as in 1970's realized the importance of transfer pricing and the OECD
Committee on Fiscal Affairs (CFA) made a study on issues arising due to
transfer pricing between related parties. The CFA issued the first major
landmark report in 1979 titled "Transfer Pricing and Multinational
Enterprises” which reaffirmed and elaborated the arm's length principle set out
in Article 9(1) of OECD Model Convention. This report defined the term
'Arm's length price' as the price 'which would be agreed between unrelated
parties in the same or similar transactions under the same or similar conditions
in the open market and prescribed methods for determining the arm's length
price.
1.3.2 Regulation 482 (which is the governing provision for transfer pricing in the
USA) was amended for the first time in 63 years, by the Tax Reforms Act of
1986 issued by the Internal Revenue Service of USA. The amendment
required that inter-company charges for the use of intangible property should
be commensurate with the income attributable to the use of the intangible
property. Since then, significant changes to the USA regulations have
occurred. In the light of this in the early 1990's, OECD reviewed the
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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
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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:
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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
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an international transaction shall be determined by 'the most appropriate
method' out of the five specified methods, namely, (a) Comparable
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
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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:
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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
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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