Transfer pricing audits in Indonesia and the conundrum of secondary adjustments
Charles Setia Oetomo, Felic Setiawan and Wirawan Sasongko of GNV Consulting Services outline the development of Indonesia’s transfer pricing landscape, uncertainty surrounding secondary transfer pricing adjustments and how taxpayers may address it.
As has been the trend globally, transfer pricing is becoming an increasingly familiar facilitator for tax controversies in Indonesia. The recent mandate on the application of secondary adjustment in transfer pricing controversies has only raised the stakes for Indonesian taxpayers and the Directorate General of Taxes. This article explores the background to these controversies, current trends, secondary adjustment as well as the potential remedies available for taxpayers in the highly dynamic Indonesian transfer pricing audit environment.
Transfer pricing audit framework and development
Transfer pricing (TP) audits in Indonesia are usually carried out as part of the corporate income tax (CIT) or VAT audit. Routine audits are typically triggered by tax overpayment and may take around 12 months, while non-routine audits are carried out selectively with potentially a much longer timeline.
The execution of such TP audits is centered around Article 18 of the Income Tax Law and Article 2 of the Value Added Tax on Goods and Services and Sales Tax on Luxury Goods Law, both of which were last amended by the Tax Regulations Harmonization Law (HPP Law) of 2021. Meanwhile, Directorate General of Taxes (DGT) regulations, namely PER-22 and SE-50, outline the steps that tax auditors need to take in TP audits and the technical positions that they should adopt when evaluating TP issues.
They have however raised more questions than answers. Conventional disputes (which have been lingering long before the issuance of the new regulation) relating to disagreements on benchmarks and comparables between the DGT and taxpayers are still frequently observed. Meanwhile, contrasting opinions on the appropriateness of transaction-by-transaction or aggregate analysis remains contentious. Other recurring areas of TP controversy include the use of segmentation, selecting the most appropriate TP method(s), applying the ex-ante analysis, the sufficiency of supporting documentation and the validity of comparability adjustments.
Recent cases have shown new trends, with disputes around marketing expenses incurred by taxpayers which are considered excessive and/or contributing to the development of intangible properties not owned by Indonesian taxpayers. In many cases, such marketing expenses have either been disallowed or deemed reimbursable. However, none have presented more cause for concern to taxpayers than the mandatory secondary TP adjustment introduced by the HPP Law.
A primary TP adjustment is usually carried out based on the difference between the price or profit of a particular controlled transaction and an arm’s length price or profit. The excess profits resulting from a primary adjustment may be treated as having been transferred in some other form (as it would have been in an arm’s length transaction), which gives rise to a secondary transaction. The imposition of the applicable tax on such secondary transactions results in a secondary TP adjustment. The secondary transaction is therefore essentially a constructive transaction which is asserted following a primary adjustment. A secondary adjustment is intended to ensure that the actual allocation of profits is consistent with the primary adjustment, and it is also expected to have a deterrent effect (such as discouraging tax avoidance). Such secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans.
Given how such secondary adjustments are an increasingly common feature of TP controversies, countries like the US, the Netherlands, Canada and Germany have adopted them. However, many others have decided against applying them due to the practical difficulties of executing them or the fact that their respective domestic legislations do not permit it. If it is permitted by legislation, the applications may vary between countries, which brings its own complications.
Secondary adjustment was earlier introduced in Indonesia’s legislation through PER-22 and SE-50, which allows the DGT to apply a secondary adjustment following a primary adjustment in a TP audit. However, they do not provide further guidance on, among other things, the circumstances under which such secondary adjustment should be applied and the form which it should take. As a result, the application of such secondary adjustments are not yet frequently encountered. If they arise, they are often strongly challenged and highly debated.
At the time, taxpayers’ objections were prevalent in cases where a secondary adjustment pertaining to a constructive dividend is applied in a controlled transaction between associated enterprises with no parent-subsidiary or shareholding relationship where a dividend may be payable. Meanwhile, there was also a fundamental question on whether the Indonesian domestic legislation allowed for the taxation of transactions which were constructive in nature and therefore not considered as actual transactions.
Ministry of Finance regulation known as PMK-22 decrees that a secondary adjustment must take the form of constructive dividend. Even though the regulation is arguably relevant only for the purpose of advanced pricing agreements (APA), the DGT has used it as guidance in applying secondary adjustment. In some cases, PMK-22 has been used as the legal basis in making adjustments in TP audits.
Since then, secondary adjustments have become an additional area of dispute for taxpayers. Its application was still inconsistent as the DGT had been known to not apply such secondary adjustment time and again. Where a secondary adjustment takes the form of a constructive dividend, there is a likelihood that any withholding tax which is then imposed by the DGT may not be relievable in other jurisdictions. This is because there may not be a deemed receipt under the other country’s legislation and will result in double taxation for taxpayers.
Article 18 of the Income Tax Law and PP-55 seems to have completed the puzzle. If PMK-22 does not provide the closure required for secondary adjustment, the HPP Law and PP-55 have clarified that such secondary adjustment should be applied and should take the form of a constructive dividend. As it now becomes compulsory, such secondary adjustment has become and is expected to be an ever-present feature of any TP disputes.
An official memo issued by the DGT has also shed light on how such secondary adjustment will apply for domestic controlled transactions as well as controlled transactions involving associated enterprises which are not shareholders. When deemed as a constructive dividend, the excess profits resulting from a primary adjustment relating to a cross-border controlled transaction will likely be subject to a 20% final withholding tax, which may be reduced based on the applicable tax treaty. Meanwhile, the excess profits resulting from a primary adjustment relating to a domestic controlled transaction are likely subject to a 10%-15% withholding tax, as exemption may not be applicable. This is because such dividends are neither based on general meetings of shareholders nor qualify as interim dividends, as required under the regulations.
Notwithstanding the above, complications are likely to persist as there will be questions around beneficial ownership issues (i.e., whether the recipient of such constructive dividend is indeed the beneficial owner) and therefore the applicable tax treaty rate(s). From a practical point of view, the lack of clarity on the controlled transactions being subject to such primary adjustments (as is often the case in tax audits) may mean that the recipient of such constructive dividend becomes difficult to determine, thereby posing an additional problem to what is already a complex situation. On a more positive note, with the application of such secondary adjustment in the form of a constructive dividend, the official memo issued by the DGT also provides guidance on how VAT relating to the purchase of taxable services from outside of Indonesia can be credited, subject to meeting the prescribed requirements.
Some jurisdictions that have adopted secondary adjustments in their legislation also give the taxpayer receiving the primary adjustment an option to avoid the secondary adjustment. The said taxpayer may arrange for the multinational enterprise group of which it is a member to repatriate the excess profits to enable the taxpayer to conform its accounts to the primary adjustment. In such cases, taxpayers may elect to repatriate a cash advantage as an interest-bearing account receivable or account payable so that no secondary transaction is deemed to take place and therefore no secondary adjustment is required, subject to meeting the requirements of the jurisdictions. Such an option is unfortunately not yet available in Indonesia.
Similar to the primary adjustments, secondary adjustments will likely lead to double taxation issues for taxpayers involved in domestic and cross-border controlled transactions, unless a corresponding credit or some other form of relief is provided by the other country. On top of that, penalties are likely to be applied on such primary and secondary adjustments, further exacerbating the issues for taxpayers.
Several domestic and international remedies are generally at the taxpayers’ disposal. As part of domestic remedies available to taxpayers, they may normally seek to file for tax objection and appeal. While the tax objections are usually reviewed by the DGT, the tax appeal processes are held at tax courts and attended by a panel of judges.
Taxpayers may also apply for corresponding adjustment, as provided within the prevailing regulations. One of the international remedies available to taxpayers is the mutual agreement procedure (MAP) which allows them to pursue a corresponding adjustment to eliminate double taxation. MAP is an administrative procedure stipulated within the applicable tax treaties intended to resolve issues pertaining to the application of tax treaties. It involves agreement between the DGT and tax authorities of the tax treaty partner. However, guidance on how taxpayers can access such corresponding adjustment mechanisms relating to domestic controlled transactions are not yet available.
As a preventive measure and a means to obtain greater certainty, taxpayers may also consider applying for an APA. This is an agreement that determines, in advance of the controlled transactions and applicable over a fixed period of time, an arm’s length transfer price, including an appropriate set of criteria required for the determination of such transfer price. Where domestic regulation permits, such is the case for Indonesia, roll-back may be requested subject to fulfilling certain requirements. While this does not entirely eliminate the risk of TP disputes, once an APA has been agreed, it certainly helps to mitigate such risks while also saving taxpayers’ time and costs from having to deal with such disputes. Nevertheless, a bilateral/multilateral APA remains taxpayers’ best chance of eliminating risks of double taxation when it comes to cross-border controlled transactions.
Against the backdrop of the COVID pandemic, the constantly changing TP audit environment in Indonesia is likely to give rise to new disputes between the DGT and taxpayers. As the stakes are higher, and in the face of new uncertainties surrounding secondary adjustments, robust TP documentation and appropriate planning becomes more important than ever, and taxpayers should ensure that they are in order. If this does not go to plan, various domestic and international remedies remain accessible as taxpayers’ last line of defence, although careful deliberation should be undertaken before deciding on the most appropriate form of dispute resolution.