Indonesia’s vital breakthrough with the BEPS two-pillar solution

Over the past decade, the world has seen a rational reconstruction of international tax governance following the initiation of the OECD BEPS project in 2013.

The BEPS 1.0 phase was completed with the delivery of the 15 Action Plan in October 2015. The Plan marks the beginning of a new chapter for governments in reforming their domestic tax legislation, and for global businesses, the remapping of their organisational structure and compliance needs.

More significant reform efforts were made by Indonesia after the beginning of the BEPS 2.0 phase. This was marked by the establishment of the OECD/G20 Inclusive Framework (IF) in 2016, and the subsequent publication of the Interim Report in 2018. The report set out the direction of work agreed in the IF on digitalisation and international tax rules up to 2020. Being a member of the OECD/G20, Indonesia saw an opportunity to align its legislation with OECD standards in order to implement the BEPS 15 Action Plan.

Backed by the OECD statistics and database, Indonesia’s participation in the BEPS project and adherence to the 15 Action Plan has been regarded as positive overall. In general, the OECD made the following observations:

• Indonesia is recognised as “not harmful” regarding the existence of harmful tax regimes, relevant to Action 5;

• Indonesia is recognised to have implemented the exchange of information on tax rulings, also relevant to Action 5;

• Indonesia is recognised as having a domestic legal framework in place for country-by-country (CbC) reporting, as well as an activated information exchange network pursuant to Action 13;

• Indonesia is recognised as having an effective dispute resolution mechanism under Action 14; and

• Indonesia has entered the Multilateral Instrument (MLI) pursuant to Action 15, which is designed for governments to close loopholes in international tax treaties.

In addition, Indonesia also has an established domestic legislation framework which closely aligns with other aspects of the BEPS 15 Action Plan, including Action 3 on controlled foreign company rules, Action 4 on interest reduction, Action 6 on preventing tax treaty abuse, Action 7 on avoidance of permanent establishment status, and Actions 8 to 10 on transfer pricing-related substance issues. For Action 1 on the digital economy, Indonesia delivered its legislation in 2020 following the spread of COVID to formalise the implementation of a VAT regime on foreign e-commerce players.

Counting on its commitment, the OECD recognised that Indonesia’s participation in the BEPS project has contributed to the removal of bank secrecy for tax purposes and requirements to disclose beneficial ownership information. In turn, this has reduced opportunities for corruption and money laundering.

As BEPS 2.0 evolves, the OECD has pursued a two-pillar solution to address the tax challenges caused by the digitalisation of the economy. Pillar one starts with a redistribution of taxation rights and nexus, and pillar two is intended to secure a certain minimum level of taxation.

The two-pillar solution was integrated into a work programme announced by the OECD in May 2019 for which a global consensus was expected to be reached by 2020. With only a minor delay, a significant milestone was reached on July 1 2021 when 134 member jurisdictions, including Indonesia, authored a statement providing a framework for the reform of the international tax rules. The statement was finalised with an implementation plan in October 2021, known as the IF Statement.

Prior to the statement, Indonesia had already legalised the direct tax rules of the digital economy on a conceptual level, via its landmark Omnibus Law.

In the same month as the IF Statement, Indonesia enacted the Harmonization of Tax Regulations (HPP Law). Article 32A of the HPP Law on income tax stipulates that the government has the authority to implement tax-related agreements with partner countries or partner jurisdictions, both bilaterally and multilaterally. The law stated this could be within the framework of the avoidance of double taxation and prevention of tax evasion, the prevention of tax base erosion and profit shifting, the exchange of tax information, tax collection assistance, and any other tax cooperation. 

In December 2022, the government issued its much-awaited Government Regulation No. 55 (GR-55) to implement the income tax law amendments under the HPP Law. The GR-55 covers two international tax topics: anti-tax-avoidance measures, and international tax agreements. It also acknowledged that a new concept of allocating taxing rights has been designed to give broader taxing rights to the source country, with the concept built on a new business model without the need for a physical presence. Meanwhile, there are other solutions designed to end profit shifting to no-tax or low-tax jurisdictions and to ensure multinational enterprises (MNEs) pay a global minimum tax as stipulated in the agreement.

GR-55 serves as a legal basis to adopt the two-pillar approach as follows:

• Pillar one: MNEs that satisfy certain criteria determined in an international tax agreement (such as consolidated turnover and profit level) are considered to fulfil tax obligations and therefore, are subject to tax in Indonesia; and

• Pillar two: the group of MNEs that fall within the scope of the international tax agreement will be subject to a global minimum tax collected in Indonesia based on said agreement.

Detailed implementation of the two-pillar solution in Indonesia will be regulated further via Ministry of Finance (MoF) regulations.

Pillar one aims to adapt the international income tax system to new business models through changes in profit allocation and applicability of nexus rules to business profits. The result of pillar one would be to shift some taxing rights for multinationals from their state of origin to the markets in which they do business and generate profits, regardless of whether the companies have a physical presence there. The implementation of pillar one on a global scale is not an easy task, as the origin states of multinationals are typically unreceptive to unilateral taxation imposed by market states. Therefore, global consensus is crucial to the success of pillar one, while not jeopardising the political interests of relevant states.

The revolutionary Omnibus Law contains a major legislative reform designed to accelerate the implementation of taxation in the context of the digital economy. It became a pressing need for the government to set the relevant rules as well as top-up tax revenue in light of the pandemic. Article 6 of the Omnibus Law specified the provisions for a digital economy tax, consisting of VAT and income tax or electronic transaction tax.

While the VAT on the digital economy has been implemented quite successfully over the past three years (as of December 2022, 134 foreign companies operating through e-commerce have been appointed as VAT collectors, contributing a very significant amount of income in the total amount of approximately $674 million), the income tax provisions have not been quite as successful, as the government has been waiting for the global consensus to be reached.

Article 6 of the Omnibus Law stipulates that the income tax obligation will be applicable for foreign digital players with a “significant economic presence” in Indonesia, as they will be deemed to have a permanent establishment. If a permanent establishment cannot be discerned due to an existing tax treaty, an electronic transaction tax will be imposed on direct sales or sales through the marketplace. No implementing regulation has been issued in this context thus far. However, the provisions are not in line with those provided under the IF Statement, which specifies in-scope companies that are multinationals with global turnover above €20 billion (approximately $21.7 billion) and profitability above 10% and tax certainty on Amount A.

One of the agreements reached under the IF Statement was that participating parties are required by the Multilateral Convention (MLC) to remove all digital services taxes and other similar measures with respect to all companies, and to commit to not introducing such measures in the future. As per the IF Statement, no newly enacted digital services taxes or other similar measures will be imposed on any company from October 8 2021 until December 31 2023, or the coming into force of the MLC. Given the issuance of the GR-55, it is likely that the government will either postpone the electronic transaction tax implementation or coordinate a subsequent removal, as further MoF regulations are also likely to be issued to prioritise the implementation of the GR-55.

Based on available studies, between 2016 and 2020 there was an average of 119 in-scope corporations each year for which Indonesia serves as the market state. While the potential corporate income taxes derivable are considerable, significant challenges remain regarding the reliability and source of information, further adjustment provisions on Amount A as well as administration of the compliance if the multinationals have no permanent establishment in Indonesia.

Meant to address any remaining BEPS challenges, pillar two is designed to ensure that large multinationals pay at least 15% income tax, regardless of where they are headquartered or operating. Based on the IF Statement, the in-scope multinational groups are those with total consolidated group revenue of €750 million or above (this is aligned with BEPS Action 13 for CbC reporting) in the previous year.

Pillar two rules are divided into global anti-base erosion (GLoBE) rules, and subject to tax rules (STTR).

Under the GLoBE directives, there are two interlocking domestic rules:

• An income inclusion rule (IIR), the principal mechanism, which imposes top-up tax on a parent entity in respect of the low taxed income of a constituent entity; and

• An undertaxed payment rule (UTPR), which denies deductions or requires an equivalent adjustment to the extent the low tax income of a constituent entity is not subject to tax under an IIR.

STTR is a treaty-based rule that complements GLoBE. It targets cross-border structures that carry out intragroup payments, exploiting certain provisions of the treaty to shift profits from source countries to payee jurisdictions, where those payments are subject to no or low rates of tax. In such situations, the taxing rights of the income are reallocated to source jurisdictions. The taxing right will be limited to the difference between the minimum rate and the tax rate on the payment. The minimum rate for the STTR will be 9%.

In general, the GLoBE rules under pillar two will have a more substantial impact on Indonesia than the STTR. The effect of the GLoBE rules in Indonesia can primarily be divided into three areas.

This is an indirect yet positive impact for Indonesia as a developing country. The relevant database shows that there are more than 500 multinationals in-scope with subsidiaries operating in Indonesia.

The impact may vary to an extent depending on the information available, as there are very few companies identified based on available studies that qualify to contribute potential top-up tax.

If the starting effective tax rate was 16.5% and subsequently reduced to 8.25% by an incentive, the global minimum tax then could apply to increase the effective tax rate to 15%, which would nullify most of the benefit provided by the incentive. A reform to the current tax incentive scheme in Indonesia should be considered to anticipate such impact.

The IIR and UTPR complement each other to ensure the taxes paid under pillar two reach the minimum tax rate. The IIR could generate top-up tax opportunities and result in substantial additional tax revenue for Indonesia if there are considerable multinationals within scope that also have overseas operations. However, based on available research, such multinationals are limited, and it is extremely difficult to collect complete and accurate information to formulate the tax implications. The UTPR could also achieve the same result as the IIR but in a more passive manner – it applies where the multinational is held or headquartered in a country with no IIR regulations or is situated in a low tax country and has operations or a subsidiary in Indonesia.

On the other hand, the GLoBE rules could have an indirect adverse impact on Indonesian tax revenue. This is due to a tax holiday scheme which offers a 50 to 100% income tax cut to certain multinationals with substantial investments.

Unlike the IIR and UTPR, the STTR does not have many tax implications for Indonesia since Indonesian tax treaties usually provide for rates over 9%, except for technical services in some instances.

Indonesia currently applies a 22% corporate income tax rate which is higher than the minimum tax rate agreed in pillar two (15%). However, Indonesia provides tax incentives which can lower the effective tax rate of the multinationals as a group. Given the substantial number of multinationals that have large investments and subsidiaries in Indonesia, and assuming they are also granted with tax incentive schemes, there are considerable tax forgone risks if Indonesia does not redesign these schemes to limit the tax advantage.

There are several aspects to be considered in mitigating the tax forgone from pillar two implementation, such as the de minimis exclusion rule, the GloBE safe harbour rule, and the substance-based income exclusion in tax holiday provisions. Here are some potential mitigating measures:

• The government should identify multinationals that have exceeded such rules and ensure the effective tax rate of subsidiaries operating in Indonesia is not lower than 15%;

• Referring to the OECD’s recent guidance on what constitutes a safe harbour jurisdiction, Indonesia should ensure it fulfils the requirements to minimise tax forgone risks from pillar two implementation; and

• Indonesia should consider substance-based income exclusion when providing tax holidays, in which it can restrict the tax advantage to entities that have a large tangible asset and employee cost base.

Pillar two offers abundant opportunities for Indonesia to improve its tax performance and even upgrade its tax architecture, especially from the application of GloBE rules.

However, challenges are substantial in every respect, with hurdles including technical grounding, administration, domestic foreign direct investment, and tax incentive policy reform. The primary challenges in implementing the GLoBE rules lie in:

• The availability of frequently specific data and information requirements;

• Adjustments in requisite computation which are not in line with the generally accepted accounting principles; and

• The usage of formulas in relation to people and assets are even more difficult to ascertain in the case of UTPR profit allocation.

Based on estimates from the OECD, pillar two will generate additional annual tax revenue of $150 billion and pillar one will result in tax reallocation to the extent of $100 billion, in favour of market jurisdictions. Indonesia would likely stand to be one of the beneficiaries of this global tax reform. The quick evolution of its domestic legislation to march along with the BEPS movement shows its determination in steering towards a globally coordinated tax reform plan to tackle tax avoidance, improve coherence of international tax rules, ensure a more transparent tax environment and address the tax challenges arising from the digital economy. This would represent a much needed breakthrough for the country given its historically low tax-to-GDP ratio compared to peer countries and its global reputation as being more susceptible to BEPS problems.

Though a legal basis is now present for the implementation of the two-pillar solution, its practical adoption into domestic legislation will likely take place in 2024. This is later than the predicted timeframe of 2023, as the government needs to roll out further regulations. On a global scale the MLC also needs to be signed and ratified. Moreover, coordinating efforts among the IF members are also expected to finalise the future plans.

Meanwhile, the digital income tax proposal under the Omnibus Law is likely to become temporarily redundant as the IF Statement mandates the removal and suspension of all digital services taxes and other similar measures. This would likely not impact the existing unilateral VAT collector scheme given that it is backed by the destination principle.

Despite many challenges, overall, the two-pillar mechanism poses a substantially practical solution to the various complexities of international taxation in the 21st century. Indonesia, as the host of the 2022 G20 and being one of the largest emergent economies, will have more responsibilities to take and roles to play in this globally coordinated construction of a fair tax system.

It will be interesting to observe the country’s legislation efforts to further enforce the two-pillar implementation while balancing the domestic investment climate - especially with regard to tax incentive policy and forgoing the electronic transaction tax proposal, perhaps with certain intentional twists.