Transfer pricing in Indonesia: an overdue revamp

The past decade has seen Indonesia issuing transfer pricing regulations on an annual basis, making it one of the most advanced transfer pricing regimes and highly dynamic transfer pricing audit environments in the region. However, the recently issued Minister of Finance Regulation No. 172/2023 on the Implementation of the Arm’s Length Principle in Transactions Influenced by a Special Relationship (PMK-172) has posed more questions than it answers. This article explores the background to the regulation, significant changes, ambiguity, and next steps.

PMK-172, issued on December 29 2023, has revoked Minister of Finance Regulation No. 213/PMK.03/2016 on the Type of Additional Documents and/or Information which is Mandatory to be kept by Taxpayers who Conduct Transactions with Related Parties and Its Procedures, Minister of Finance Regulation No. 49/PMK.03/2019 on Guidelines on the Implementation of the Mutual Agreement Procedure, and Minister of Finance Regulation No. 22/PMK.03/2020 on the Implementation of the Advance Pricing Agreement.

PMK-172 covers a range of transfer pricing topics, with highlights being:

• The implementation of the arm’s-length principle;

• Transfer pricing documentation;

• Secondary adjustments;

• Domestic corresponding adjustments; and

• Mutual agreement procedures (MAPs) and advance pricing agreements (APA).

In applying the arm’s-length principle, PMK-172 has outlined that the price indicator (which may be price, gross profit, or net profit, both absolute value or ratio) of comparable transactions can be in the form of an arm’s-length point or an arm’s-length range. While the arm’s-length point refers to a particular point attributable to one or more comparables with the same indicator value, the arm’s-length range can be a full range (i.e., minimum to maximum value) if there are two comparables, or an interquartile range (i.e., between the first and third quartile) if there are three or more comparables.

While the use of an arm’s-length point or interquartile range has been around for a long time, the permissibility to use a full range or form an interquartile range with fewer than five observations under PMK-172 is new. This will afford flexibility in applying the arm’s-length principle.

However, from a practical point of view, there will always be doubts regarding whether adequate analysis has been done to justify the use of only two comparables rather than more of them.

The use of three comparables to form an interquartile range, as endorsed by PMK-172, is also against the commonly accepted statistical theory according to which at least five observations are needed for a reliable analysis, which was also previously affirmed by Tax Court and/or Supreme Court decisions in favour of at least five observations when using the interquartile range. This muddies the water and has caused more controversy, although its inclusion under PMK-172 for the purpose of implementing the arm’s-length principle may arguably mean that the matter is no longer up for debate.

The regulation seems to lean towards the use of single-year comparable data unless the use of multi-year comparable data can enhance comparability. This indicates a move away from the customary use of multi-year comparable data to offset the impact of a product and/or business cycle, which is also a practice widely accepted in many other jurisdictions.

The merit of using single-year comparable data is clear when applied on an ex post basis; i.e., when the comparable data used is consistent with the year of the controlled transaction(s) and is intended to test the actual outcome of the controlled transaction(s). This is, however, not the case under PMK-172, which represents a contrary position to the ex post approach. In addition, single-year comparable data has, more often than not, shown great fluctuations, and explanations for such fluctuations are usually not readily available.

A significant change has been introduced to how comparability analysis – specifically, comparability adjustments – should be carried out. PMK-172 requires that comparability adjustments, if needed, are now performed on independent comparables. This is a fundamentally contrasting viewpoint to comparability adjustments frequently being performed on the tested party/controlled transaction and represents a significantly differing position from the OECD, which does not limit the application of comparability adjustments to independent comparables. Taxpayers will likely face several challenges, with data constraints being at the forefront of them all.

Where there is more than one external comparable with the same level of comparability and reliability, PMK-172 requires that comparable(s) in the same country/jurisdiction as the tested party is/are used. Although the introduction of such a requirement is presumably intended to account for local market features that may enhance the reliability of the analysis, it may backfire if not implemented appropriately.

As the provision does not seem to prohibit the selection of only one comparable as long as it has the same geographic location as the tested party, even if a number of comparables located in other countries are available, there are doubts as to whether it is reasonable to expect the tested party to record the same profitability as a company that has been selected as the only comparable due to geographical preference in order to be considered as conforming to the arm’s-length principle.

PMK-172 reiterates the importance of appropriateness and reliability when selecting transfer pricing method(s) but has also provided a hierarchical order to the selection of such methods. The comparable uncontrolled price method and the comparable uncontrolled transaction method were preferred over other transfer pricing methods, while the cost plus method and the resale price method were preferred over the profit split method and the transactional net margin method.

Even though this is not vastly dissimilar from prior guidance, it is definitely a welcome addition. However, a lack of guidance over where tangible and intangible asset valuation, as well as the business valuation method, stands within the hierarchy may lead to controversy over their application, especially when their intended use seems to overlap with other transfer pricing methods.

PMK-172 provides clarity on how the arm’s-length principle will apply to taxpayers that qualify as a permanent establishment (PE). PEs will now be required to provide offshore transactional information to the Directorate General of Taxes (DGT). In the absence of such information, the DGT reserves the right to adjust the PE by implementing the arm’s-length principle.

Despite the issuance of comprehensive guidance on the application of the arm’s-length principle under PMK-172, questions remain over why much older pieces of guidance – such as DGT regulation PER-43, as was last amended by PER-32 – were not revoked. This is especially true given how certain provisions in older regulations contradict PMK-172, although one may argue that the former were perhaps superseded by PMK-172 anyway.

In line with the change in the arm’s-length principle, PMK-172 has also set forth additional requirements for transfer pricing documentation; in particular, the local file. Meanwhile, no material change has been observed with respect to master files and country-by-country reporting.

Among a number of changes instigated by PMK-172, none is as prominent as the requirement to apply the arm’s-length principle to transactions influenced by special relationships. Transactions influenced by special relationships are defined as transactions carried out by taxpayers with related parties and transactions carried out by independent parties where the related party(ies) of any of the parties to the transaction has/have determined the transaction counterpart and price.

As the concept is not exactly new, it should not come as a surprise that it is now in scope under PMK-172. The requirement to include independent transactions considered as influenced by special relationships in the local file has raised questions such as:

• What transactions will fall under the category;

• Whether a tripartite agreement and globally agreed contracts will qualify; and

• How it will interact with accounting rules.

However, there are grounds to argue that PMK-172 requires only transactions with related parties to be documented in the local file, thereby splitting opinions among taxpayers.

Like its predecessor, PMK-172 has outlined the requirement for the master file and local file to be prepared using data and information available at the time the related-party transaction(s) is/are carried out. However, it has also emphasised the need for the arm’s-length principle to be applied at the time the relevant transfer price is set and/or at the time the relevant transaction(s) influenced by a special relationship occurred.

In addition, the comparable data used will need to be the data available and closest to the time the relevant transfer price is set and/or the time the relevant transaction(s) influenced by a special relationship occurred. Alas, PMK-172 stopped short of referring to the ex ante basis, which would have provided clarity on several topics of debate over the past few years.

PMK-172 has also put a great emphasis on the need for a comprehensive industry analysis, intended for use when undertaking comparability analysis. Industry analysis should contain information that ranges from industry and market characteristics, efficiency and location advantage, and the regulatory environment, to economic factors such as the inflation rate and the interest rate. Similarly, detailed information previously reserved only for commodity transactions – such as product name, quantity, and price per unit – are now applicable for all related-party and independent-party transactions.

Meanwhile, the introduction of preliminary analysis as part of the implementation of the arm’s-length principle under PMK-172 is broadly consistent with the approach endorsed within the existing regulations, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, and what has happened in the field. Preliminary analysis involves proving the existence, commercial benefits, economic motives, actual substance, and a diverse range of other items considered necessary for an arm’s-length analysis relating to intercompany service; the use of, or right to use, intangibles; loans; other financial services; the transfer of assets; business restructuring; and cost contribution arrangements.

The need for an extensive industry analysis, transaction details, and an exhaustive preliminary analysis to be included in transfer pricing documentation, rather than being made available upon request by the DGT or even later during tax audits, may be perceived as highly demanding.

Despite all the challenges, every cloud has a silver lining. In this case, PMK-172 will apply to transfer pricing documentation obligations beginning fiscal year 2024. This is expected to provide taxpayers with ample time to prepare.

Along with the potential penalties and administrative sanctions that may arise as a result of primary adjustments made by the DGT due to non-compliance, PMK-172 reiterates that secondary adjustments will apply in the event of transfer pricing adjustments carried out by the DGT or taxpayers themselves.

Secondary adjustments will be in the form of a constructive dividend and will be subject to the applicable withholding tax rate under the prevailing Indonesian regulations or double taxation avoidance agreement (DTAA) rate if the taxpayers are eligible. However, secondary adjustments may be avoided if there are cash, or cash equivalent, transfers amounting to the transfer pricing adjustments prior to the issuance of the tax assessment letter and/or if the taxpayers agree to the transfer pricing adjustments.

While taxpayers can now breathe a sigh of relief upon the prospect of being able to avoid secondary adjustments, taxpayers are also aware of the likelihood that the DGT may expect similar transfer pricing adjustments for other open fiscal years once taxpayers have agreed to it. In addition, there is still no clarity as to how cash, or cash equivalent, transfers will be treated. If recognised as income and therefore taxable, they will effectively offset the benefit that taxpayers will obtain from the cancellation of the secondary adjustment.

PMK-172 also highlights that secondary adjustments will also take the form of VAT. This will apply for a transfer pricing adjustment on sales price or income received by the seller of VAT-able goods and services that is considered lower than the arm’s-length sales price or income. VAT secondary adjustments may also be applied in the event that a transfer pricing adjustment can be allocated and/or identified to the respective sales of VAT-able goods and services.

While the right to levy secondary adjustments is expected to deter taxpayers from engaging in profit shifting, the fact that a primary adjustment can be followed by several secondary adjustments, along with the administrative sanctions and penalties accompanying each of the primary and secondary adjustments, will be daunting for most, if not all, taxpayers.

Despite corresponding adjustments being an ever-present feature in many transfer pricing regulations that have been issued, no specific guidance has been provided to address how taxpayers can obtain corresponding adjustments relating to transfer pricing adjustments made on transactions between domestic related parties. PMK-172 has shed some light on how the transaction counterpart of taxpayers facing transfer pricing adjustments can now request corresponding adjustments to eliminate double taxation.

There is, however, a prerequisite that the taxpayer facing the transfer pricing adjustments will need to agree with the transfer pricing adjustments and not object to them. At the same time, the taxpayer’s transaction counterpart should not object to the item(s) for which a corresponding adjustment is sought.

While the above addresses the issue of double taxation with respect to corporate income tax, it does not provide any relief for VAT secondary adjustments. In this regard, PMK-172 provides that input VAT may not be eligible for credit when it is not accompanied by a tax invoice (as is likely going to be the case), as required under the prevailing law and regulations.

As one of the most commonly known dispute resolution mechanisms of recent years, PMK-172 has provided clarity that MAPs can be submitted along with lawsuits and reconsideration requests. However, in the event that the reconsideration request includes the object of the dispute submitted for a MAP, the DGT will use the Supreme Court decision as its position or stop the MAP negotiation process. PMK-172 also outlined that the Mutual Agreement Decree issued by the DGT will serve as the basis for a tax refund or tax collection.

Similarly, PMK-172 has clarified that taxpayers can now apply for a multilateral APA and waived administrative sanctions that may arise as a result of the implementation of an APA. Where taxpayers were previously able to apply for a unilateral APA in the event that negotiation on a bilateral APA results in a disagreement or where negotiation stops due to non-response by a DTAA partner’s competent tax authority(ies), taxpayers can now also apply for a unilateral APA when taxpayers withdraw bilateral or multilateral APA applications. This ensures that the time and effort spent negotiating on the APA are not lost and can still be fruitful, should taxpayers wish so.

While some of the provisions under PMK-172 represent significant change from prior regulations, taxpayers should ensure that careful consideration is given to the implementation of the arm’s-length principle. As the amount of information that needs to be included in the transfer pricing documentation, specifically the local file, keeps increasing, it is becoming more and more critical for taxpayers to juggle between the administrative burden of preparing them and demonstrating compliance.

With secondary adjustments becoming an absolute feature in transfer pricing adjustments, it is also of great importance that taxpayers deliberate over the various dispute resolution mechanisms available to obtain certainty, achieve optimal results, and/or eliminate double taxation.