2.Kristian Agung Prasetyo

13

JURNAL AKUNTANSI PEMERINTAH Vol. 3, No. 1, Oktober 2008

Hal 13 – 44

TRANSFER PRICING REGULATIONS IN INDONESIA: SOME THOUGHTS FOR REFORM

Kristian Agung Prasetyo∗

GradCertTax, PGradDipCom, MTax

Bambang Widjajarso∗∗

A b s t r a c t The twenty first century has witnessed an ever increasing rate of international trade as a result of globalisation and especially, the development of advanced information tech-nologies. As a result, transfer pricing policy plays a significant role, particularly in many multinational enterprises (MNEs). The term transfer pricing itself refers to the pricing policies in relation to goods or services exchanged between related business units. As part of their domestic anti-avoidance provisions, most revenue authorities have transfer pricing regulations in place to prevent the price manipulation and profit shifting to avoid taxation. The Organisation for Economic Co-operation and Development (OECD) has been involved in setting out guidelines and principles in addressing transfer pricing issues, which have been adopted widely.

Like other countries, Indonesia is also faced with the ever increasing rate of global trade. However – unlike others – the Indonesian taxation authority does not seem to have adequate provisions to tackle international transfer pricing abuse. Even though the principles of related-party transactions regulations are set out in the income tax legislation (currently being amended), they are broad and simple in nature and are not accompanied by detailed and up-to-date guidelines for taxpayers and its field auditors. This fact seems peculiar as companies are taxed progressively with the highest marginal rate of 30% (it has been proposed that it will be changed into a flat rate of 30%). In

∗ The author is a tax practitioner in Jakarta. He received a scholarship to study at a postgraduate level in Australia, where he earned his graduate certificate, postgraduate diploma, and master specialising in taxation law.

∗∗ The author is a lecturer in Public Finance for the Sekolah Tinggi Akuntansi Negara. Other publications included textbooks of “Public Finance”, “Government Finance Statistics” and “Governmental Accounting: Theory and Practice”; all published by the Institute for Public Finance and Governmental

JAP Vol.3, No.1, Oktober 2008

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relation to this, concerns regarding the lack of transfer pricing guidelines have been raised by members of parliament involved in the amendment process. This paper is intended to show that transfer pricing has become an important issue worldwide and it is likely that it will stay that way. Consequently, it is crucial for Indonesia to have strong transfer pricing regulations, especially as the Indonesian taxation authority is responsible for more than 70% of total government expenditure. The OECD transfer pricing guidelines will be used as a point of reference along with its application in Australia. In the end, it is expected that this paper will:

1. Show the importance of international transfer pricing and present some basic principles necessary to address its abuse;

2. Demonstrate that the Indonesian taxation authority does not have an adequate arsenal to deal with transfer pricing issues. Some possible suggestions will also be presented based on the OECD guidelines and Australia’s experience.

Transfer Pricing Regulations in Indonesia: Some Thoughts for Reform

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I INTRODUCTION

The avoidance of taxes is the only intellectual pursuit that still carries any reward.

– John Maynard Keynes –

The twenty-first century has witnessed an ever-increasing rate of international trade as a result of globalisation. Stiglitz defines globalisation as:

the closer integration of the countries and peoples of the world which has been brought about by the enormous reduction of costs of transportation and communication, and the breaking down of the artificial barriers to the flows of goods, services, capital, knowledge, and (to lesser extent) people across borders.1

As part of economic decision-making, taxation is also affected by the globali-sation.2 Simon James argues that techno-logical changes play an important role in shaping the future global tax environ-ment.3 The most important event asso-ciated with globalisation is the rapid development of the internet and the World Wide Web. This phenomenon has led to the birth of electronic commerce that enables goods and services to be exchanged across borders almost instantly, especially when the contents can be digitised, like music, films, and services. In addition, electronic commerce may cause problems as the flow of funds cannot easily be traced.

1 Joseph Stiglitz, Globalization and Its Discontents (2002).

2 Taxation is affected by a number of factors including social, economic, and political aspects.

3 Simon James, 'The Future of International Tax Environment' in Andrew Latymer and John Hasseldine (eds), The International Taxation System (2002) 105.

The revolution of information technology has enabled multinational enterprises (MNEs) to allocate their resources across nations easily. This phenomenon can be identified by the presence of MNEs worldwide to maximise their profit. This includes the tax minimisation motive, even though it certainly is not the only reason. The allocation of more profits to countries with lower tax rates can result in the minimisation of the worldwide tax payable and in turn, may lead to a higher net profit. This practice is widely known as transfer pricing, although that term actually is neutral in nature. 4 Obviously, tax systems have also taken advantage of this technological revolution. A noticeable example is the use of internet technology in tax return lodgement by taxpayers as applied in Australia, Canada, the USA, the Netherlands and – to some extent – in Indonesia.5

A. The Importance of Transfer Pricing

The history of transfer pricing provisions can be traced back to the World War I. As the war needed money, higher taxes and tighter regulations to discourage companies from entering into tax avoidance schemes by diverting profits away from high-tax countries are required. 6 Following the economic contraction in the 1930s, many developed nations came to understand that they might have problems in preserving their tax base

4 Jill C Pagan and J Scott Wilkie, Transfer Pricing Strategy in Global Economy (1993).

5 Liane Turner and Christina Apelt, 'Globalisation, Innovation, and Information Sharing in Tax System: The Australian Experience of the Diffusion and Adoption of Electronic Lodgement' in Rodney Fisher and Michael Walpole (eds), Global Challanges in Tax Administration (2005) 221.

6 Pagan and Wilkie, above n 4, 17.


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due to the rapid development of communication technologies in the 1970s. They responded by fine tuning their expertise in transfer pricing and attacking the use of tax havens using controlled foreign corporation provisions.7

Before the advent of globalisation and the advancement of communication technologies, most companies were restrictted to certain jurisdictions, taking advantage of specialisation and geogra-phical benefits. The reason is simple: they had more understanding of local markets. Later, they realised that they failed to take advantage of economies of scale and suffered losses due to duplication of resources. To be efficient, an MNE must consider centralising certain functions of their business such as research and development, financial management, and marketing. Also, they must be ready to set up the manufacturing functions in any place that offers cost-efficiency or an abundant, well-trained labour.8

When the choice of location involves different tax jurisdictions, the transfer pricing process comes into play. If a company has branches and subsidiaries across countries, the transfer pricing process does not only concern internal matters, but also involves other parties as well. A business unit that has facilities located in different tax jurisdictions has to take into account various aspects to arrive at the liability of tax that has to be paid in each jurisdiction.9 Therefore, there may be a motive to minimise the net profits of the business units located in high-tax juris-diction by shifting their profits elsewhere.

7 Ibid 17. 8 Ibid 25. 9 Jamie Elliott and Clive Emmanuel,

'International Transfer Pricing' in Andrew Latymer and John Hasseldine (eds), The International Taxation System (2002) 157.

As a result, the overall net profit of the MNE could be increased.

In today’s context, transfer pricing plays an increasingly important role. The need to address the income allocation between countries for tax purposes cannot be neglected as more tax jurisdictions are trying to have a ‘reasonable’ proportion of an MNE’s taxable income. Many governments address this problem by using a formal approach to legislate for transfer pricing provisions.10 It indicates that revenue authorities regard transfer pricing important and consider it potential to increase tax-based revenue.

The significance of transfer pricing be-comes more evident by looking at the fact that 60% of the world trade takes place within MNEs. 11 Additionally, a study of the taxable income of several companies in the USA point out that the taxable income of foreign-controlled companies operating in the USA is generally lower compared to those of the USA-controlled companies. This indicates that there are reasons to believe that the profits are shifted out of the USA, perhaps through transfer pricing arrangements.12

10 The countries that have recently put transfer pricing regulatory and administrative rules in place include Malaysia, Thailand, Taiwan, and India. Other countries like the USA and Canada tighten their transfer pricing regulations by issuing newer technical guidelines or imposing more audits. For further information, see Ernst and Young Global Transfer Pricing Survey available for download at www.ey.com/transferpricingsurvey.

11 John Neighbour, Transfer Pricing: Keeping it at Arm's Length (2002) OECD Observer <http://www.oecdobserver.org/news/printpage.php/aid/670/Transfer_pricing:_Keeping_it_at_arms_length.html> at 4 January 2006.

12 Willi Leibfritz, John Thornton and Alexandra Bibbee, Taxation and Economic Performance (1997).


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The Ernst and Young 2005 global transfer pricing survey reveals several findings: 13

1. More than 90% of the respondents consider transfer pricing an important issue.

2. Approximately 31% of the respon-dents believe that transfer pricing will be absolutely critical over the next two years.

3. More than 60% of the respondents have undergone transfer pricing audits in the last three years and 40% resulted in tax adjustments.

4. More than 80% of the respondents plan to devote more efforts for transfer pricing issues in 2006.

5. More than half of the respondents set aside a provision for transfer pricing risks in their financial statements.

6. More than 80% of the respondents believe that their transfer pricing policies have a high probability (more than 60%) of being challenged by tax authorities within two years.

Similar facts can be found in the 1995 and 2000 survey.14 This is also consistent with the 2003 survey that shows that most Australian outbound companies15 (76%) believed that transfer pricing is one of the most important tax issues that they may face over the period of the next

13 The latest survey was conducted in May and June 2005 involving 108 financial institutions in a wide range of countries including Australia, Canada, Continental Europe, Hong Kong, Japan, Singapore, South Africa, United Kingdom and the USA. The reports are available for download at www.ey.com/transferpricingsurvey.

14 Marika Toumi, 'Anti-Avoidance and Harmful Tax Competition: From Unilateral to Multilateral Strategies?' in Andrew Latymer and John Hasseldine (eds), The International Taxation System (2002) 83.

15 An outbound company refers to an Australian-controlled company that operates overseas.

two years. The percentage figure rises significantly compared to the 2001 survey results which reveals that transfer pricing is considered important by only 36% of the respondents. The 2003 survey also indicates that the risk of a transfer pricing adjustment audit, the potential penalties, and possible double taxation, needed to be managed in the overall company’s risk management strategies.16

The overall transfer pricing goal of an MNE is beyond tax minimisation per se. Abdallah reports that at least a transfer pricing policy serves a range of objectives, namely reducing the worldwide income tax burden, reducing tariffs, minimisation of foreign exchange risks, and avoiding potential conflicts with host govern-ments. 17 As a consequence, transfer pricing decisions are subject to various internal and external factors that may have competing objectives. Choi and Mueller identified four factors that may be responsible for the difficulties asso-ciated with a transfer pricing decision: 18

1. It occurs in a large scale environ-ment at an international level.

2. It is affected by various factors. 3. It varies from companies, indus-

tries, and countries. 4. It affects social, economic, and

political relationship aspects.

In relation to Indonesia, the significance of transfer pricing is apparent. In the 2006 fiscal year, the Directorate General of Taxes (DGT) – the Indonesian taxation authority – is responsible for more than 75% of the total Indonesian Government revenue. It represents a figure of Rp402.1 trillion (13.4% of the GDP). This is a continuing increase from 11.3%

16 David Lewis and Diane Lane, 'Transfer Pricing: Recent Practices, Perceptions, and Trends' (2004) 7(5) The Tax Specialist 249.

17 Elliott and Emmanuel, above n 9, 162. 18 Ibid 161.


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in 2003, 11.6% in 2004, and 12.6% for the last year’s figure.19

In spite of this, the DGT does not seem to have adequate provisions to tackle international transfer pricing abuse. Even though the principles of related-party transactions regulations are set out in the income tax legislation (currently being amended), they are broad and simple in nature and are not accompanied by detailed and up-to-date guidelines for taxpayers and its field auditors. This fact seems peculiar as companies are taxed progressively with the highest marginal rate of 30%, one of the higher rates in Asia (it has been proposed that it will be changed into a flat rate of 30%). However, the effective rate in reality is higher. The World Bank states that Indonesia has an effective tax rate of 38.8% of profits and ranks 19th out of 25 countries.20

As noted earlier, tax minimisation is one aspect of MNEs overall profit maximisation efforts. As a result, an inadequate anti-avoidance provision could be exploited. In relation to this, the Indonesian Finance Minister in November 2005 claimed that there were approximately 750 loss-making foreign companies that had evaded taxes, possibly through the use of transfer pricing arrangements. 21 Furthermore, Dradjad H Wibowo – a member of the Special Committee on Taxation Legislation

19 Nota Keuangan dan Rancangan Anggaran Pendapatan dan Belanja Negara Tahun Anggaran 2006 (2005) <http://www.depkeu.go.id/Script/DirectLink.asp?url=http://www.djapk.depkeu.go.id/APBN/NK%20RAPBN%202006.pdf> at 14 March 2006.

20 The Economist Intelligence Unit Ltd., Indonesia Risk: Tax Policy Risk (2006) Dow Jones Reuters Business Interactive LLC <http://global.factiva.com.dbgw.lis.curtin.edu.au/ha/default.aspx> at 27 March 2006.

21 Ibid.

Amendments of the House of Representatives – stated that a number of foreign-owned companies from at least five countries – including South Korea, the USA, Japan, Australia, and some European countries – have been involved in transfer pricing abuse. He added that the problem lied in the fact that there were no comprehensive technical guide-lines regarding the accounting and auditing procedures on transfer pricing arrangements.22

The transfer pricing regulations in Indonesia were first introduced in the 1983 income tax legislation as part of the general anti-avoidance provisions. Last amended in 2000 and beginning its implementation in 1 January 2001, the current income tax legislation sets out the transfer pricing provisions in Article 18(3) of the Law Number 17 of 2000 on Income Taxation. 23 In essence, this article provides that the Director General of Taxes is authorised to reallocate income or expenses to assure that the transactions between related parties resemble those of between independent parties. The methods for reallocating income and expenses include the use of comparable data, profit allocation based on function or participation of related taxpayer, and other methods.

The operation of Article 18(3) of the Law Number 17 of 2000 on Income Taxation is explained further by a brief circular letter number SE-04/PJ.7/1993 which seems to refer to the 1979 OECD transfer pricing guidelines. 24 In addition,

22 'PMA Nakal Harus Dikenai Sanksi Pidana Penghindaran Pajak Melalui Pola Pengalihan Keuntungan', Kompas (Jakarta), 28 November 2005.

23 Law Number 17 of 2000 24 Gunadi, 'Mampukah ASW Atasi Transfer

Pricing?' Bisnis Indonesia (Jakarta), 30 January 2006.


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commencing from 1 January 2002, tax-payers have been required to attach a statement related to their related party transactions in their tax returns. The information to be disclosed includes the type and value of the transactions, the transfer price, and the methodology that has been used to determine the transfer price. 25 There is also a provision in Article 18(3a) regarding the Advance Pricing Agreements (APA). This article authorises the Director General of Taxes to conclude an APA unilaterally – between a taxpayer and the DGT – or multilaterally, where the APA is concluded with a competent authority of a treaty country concerning the taxpayers of that country.26

However, the only technical guideline for transfer pricing provisions is the aforementioned circular letter, which is unfortunately old and predates the current legislation. As a result, there are many ‘grey areas’ that maybe subject to multiple interpretations. For example, taxpayers are likely to face considerable difficulties in fulfilling the disclosure requirements, especially with regard to the transfer pricing methodologies applied in each of the related-party transaction.27 Moreover, there are no detailed proce-dures to be used to settle a transfer pricing conflict between taxpayers and the DGT.28

25 Ernst and Young, Transfer Pricing Global Reference Guide (2005) Ernst and Young <www.ey.com/transferpricingreferenceguide> at 27 March 2006.

26 Above n. 23. 27 PricewaterhouseCoopers, Indonesian Tax

Flash (2003) PricewaterhouseCoopers <www.pwc.com/id> at 27 March 2006.

28 Darussalam and Danny Septriadi, 'Upaya Menangkal Praktik Penghindaran Pajak', Bisnis Indonesia (Jakarta), 12 December 2005.

B. The OECD Transfer Pricing Guidelines

In the 1970s, the OECD published three reports regarding transfer pricing.29 The first document – ‘Transfer Pricing and Multinational Enterprises’ – was published in 1979. This report outlined the arm’s length principle and the economic analysis underlying that concept. After being approved by the Committee on Fiscal Affairs, it was published in 1995 as ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Admi-nistrations’ (hereinafter the Guidelines), which is based on the arm’s length principle. Other reports discussed spe-cific issues within transfer pricing. These reports – ‘Transfer Pricing and Multinational Enterprises - Three Taxation Issues’ and ‘Thin Capitalization’ – were published respectively in 1984 and 1987.

The Guidelines are ‘intended to help tax administrations … and MNEs by indicating ways to find satisfactory solutions to transfer pricing cases, thereby minimizing conflict among tax administrations and between tax administrations and MNEs and avoiding costly litigation’. 30 According to Neighbour, it can be said that the purpose of the Guidelines is to ‘help corporations to avoid double taxation’ and to ‘help tax administrations to receive a fair share of the tax base of multinational enterprises’.31 As a result, the Guidelines can be regarded as an international standard in transfer pricing that the OECD members have agreed to be used.

29 OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration (2001).

30 Ibid. 31 Neighbour, above n 11.


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II THE PRINCIPLES OF TRANSFER PRICING

A. Transfer Pricing Defined Elliott and Emmanuel define transfer pricing as ‘the pricing policies and practices that are established when physical goods, intangible property, and services are charged between business units within a group’. 32 As has been noted, a transfer price itself is actually a neutral concept. The Guidelines itself defines transfer prices as ‘the prices at which an enterprises transfers physical goods and intangible property or provides services to associated enter-prises’. 33 Therefore, a transfer price is agreed between two business units and the structures are governed by commercial considerations34. A transfer price has to be able to motivate and guide managers in choosing their inputs and outputs.35 As a result, it plays many important roles ranging from securing competitive advantage for a new subsidiary to managing foreign currency fluctuations.36

A transfer pricing policy does not necessarily mean a tax fraud or a tax avoidance scheme, even though it can be used for such purposes. However, this term often has negative meaning because it induces the idea of a systematic price manipulation to reduce profits artificially, create losses, and avoid taxes or duties.37As explained, the overall goal of such scheme is to achieve the maximisation of after-tax profits by minimising worldwide tax payable. If goods, services or intangibles are

32 Elliott and Emmanuel, above n 9, 158. 33 OECD, above n. 29. 34 Pagan and Wilkie, above n. 4, 15. 35 Ahmed Riahi-Belkaoui, Significant Current

Issues in International Taxation (1998). 36 Elliott and Emmanuel, above n 9, 172. 37 Riahi-Belkaoui, above n 35, 96.

overpriced, the profit of the buyer in the group is reduced but the profit of the seller is increased (at the expense of the buyer). Nonetheless, the overall group profit is not affected because what happens is only a profit shift between members within that group.

B. Transfer Pricing Channels

Plasschaert modifies the model presented by Robbins and Stobaugh to describe the various channels in which money can flow within an MNE (figure 1).38 Channel 1 represents the payment of goods or services which is often regarded as the main financial flow as a result of a real commodity transfer. Channels 2 and 3 describe the payments related with the investment from the parent company. In essence, they consist of the initial invest-ments in the form of trade credits (channel 2) and equity contributions (channel 3) and then the subsequent dividend payments from the subsidiary (channel 4). Nevertheless – as dividends are paid from after-tax profits and therefore are not deductible – most companies tend to finance their subsidiaries using debts

38 Sylvain R.F. Plasschaert, Transfer Pricing and Multinational Corporations: an Overview of Concepts, Mechanisms, and Regulations (1979).

Figure 1 Payment channels within an MNE. Source: Plasschaert (1979)


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which are more flexible. 39 These are depicted in channel 5 (loans) and 6 (interests on loans). Lastly, channels 7 to 9 portray costs incurred in the parent company that are charged to the subsidiaries. They represent fees for intangible properties (channel 7), fees for specific and divisible services (channel 8), and overhead costs (channel 9). They are often unique in nature and hence, it can be difficult to find comparable transactions. As a result, it is usually hard for tax authorities to prevent transfer-pricing abuses for such payments. A more in-depth discussion on these specific channels (channel 7 to 9) will be covered in the next sections.

This model also reveals the possibility for a parent company to repatriate profits through the various channels. For example, rather than paying profits in the form of dividends, a subsidiary may prefer to use excessive payments for the transfer of goods and services transferred by the parent company, provided that the tax treatment is more favourable in the parent company’s host country. This abuse is continuously being challenged using transfer pricing provisions, which are mainly based on the arm’s length principle.40

C. Intangible Property

The payment for intangible property (channel 7) usually manifests in the form of royalty for the use of information, expertise, and know-how. 41 It includes

39 Even though using loans to finance a subsidiary seems advantageous, it may attract the operation of thin capitalisation rules if it is used excessively.

40 There are some countries — Brazil for instance — that do not rely on the arm’s length principle.


rights to use industrial assets such as patents, trademarks, trade names, designs or models. 42 The main concern is its deductibility. In addition, it also has to be determined that the payments are for the use of the property and that they correspond to its real value.

The problem in applying the arm’s length standard is the availability of comparables. Furthermore, this is exacerbated by the related developments in e-commerce where an increasing amount of value is both specialised and intangible. In this situation, an industry standard can be used. Adjustments can be made in respect of:

1. The prevailing industry rates. 2. The license terms. 3. The characteristics of the property. 4. The availability of supplementary

assistance, rights, and information. 5. Any profit potential for the licensee. 6. The benefits for the licensor.43

From the transferor’s view, it has to be examined at what price a comparable independent party is willing to transfer a similar property in a similar situation. From the transferee’s point of view, an independent entity may or may not be willing to pay for the transfer. It depends on whether the intangibles would have the sufficient value or usefulness for the transferee’s business.44

D. Intra-Group Services

As noted, the main reason behind the choice to be an MNE is to achieve synergistic effects. Therefore, it is common that some functions within an MNE are centralised to take advantage the economies of scale and then the parent

42 OECD, above n 29. 43 Pagan and Wilkie, above n 4, 115. 44 OECD, above n 29.


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company charges the subsidiaries for services provided centrally by the parent company. There are two main issues that have to be taken into account. Firstly, determining whether such services are actually provided and secondly, deter-mining the arm’s length charges.45

In the first instance, it has to be deter-mined whether such services have the value to enhance the recipient company’s position. Sometimes, this can be easily analysed, such as in a situation where intra-group services are provided to meet a specific need of a group member (channel 8). One example would be in cases where the parent company provides maintenance and support for the manu-facturing equipments of a group member. In other cases (channel 9), it is more difficult. This is true in the case of what the Guidelines refer as ‘shareholder activity’. This type of activity includes the costs relating to the juridical structure of the parent company (e.g. parent company’s shareholder meeting, super-visory board costs, and share issuance in the parent company), costs relating to the reporting requirements of the parent company, and costs of fund raising. They are performed for the whole members even though some members may not need them. In this situation, a charge to those recipient companies certainly cannot be justified. Moreover, a charge also cannot be justified if the recipient company only receives incidental benefits. One example would be in event like group reorganisation, acquisition of a new member, or a termination of a division. However, any centralised-administrative costs and some ‘on-call’ services would be justifiable. 46 Once it has been

45 Ibid. 46 An on-call service is eligible if a parent

company or a group service centre is on hand to provide certain services – such as technical, legal, financial or managerial

recognised that a service has been rendered, it is necessary to examine whether independent entities in similar situations would agree to such arrange-ments so that they can be constituted as arm’s length. 47 In this case, there are some aspects that need to be considered:

1. The basis for allocating expenses has to be reviewed in a regular basis.

2. The expenses have to in proportion with the benefits received by the chargee.

3. The review has to be able to be made available to the tax authorities.48

E. The Arm’s Length Principle49

One of the problems in setting a transfer price is that there are various bases for determining an applicable transfer price. A transfer pricing policy may rely on the internal accounting system (internal costs) or on market prices (external prices). The question arises as to which approach is preferred and how to reconcile the internal requirements with those of tax authorities. In addition, there are also problems when the business units within an MNE are located in different tax jurisdictions. This is because the tax base of one country may be increased at the expense of another. In this situation, an abusive transfer pricing occurs as income and expenses are improperly allocated with the purpose of reducing taxable income. It is this shift that is being challenged by many tax authorities using various transfer pricing provisions in their income tax legislation.

support – at any time because they would have the staff or equipments always available for that purpose.

47 OECD, above n 29. 48 Pagan and Wilkie, above n 4, 113. 49 This section draws heavily from the OECD

1995 Transfer Pricing Guidelines.


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The basis of these provisions is substituting the transfer price with a market value between a willing seller and a willing buyer that are unrelated to each other.50 The substituting price is commonly known as the arm’s length price, which is a result of an arm’s length transaction: a transaction between parties each of whom acts in their best interest.51 The authoritative statement regarding the arm’s length principle is set out in Paragraph 1 of Article 9 of the OECD Model Tax Convention.52 This paragraph states that if conditions between related enterprises are different from those between independent enterprises, profits which have accrued by reason of those conditions may be included in the profits of that enterprise and taxed accordingly. 53 Members of an MNE are treated as if they were separate entities rather that a part of a single unified business unit. As a result, it enables taxpayers or tax administrations analyse whether the results of those controlled transaction are comparable to those of between independent enterprises.

1 Comparability Analysis

The principle of the arm’s length principle is the use of comparisons using information from transactions between independent entities. For this to work, the characteristics of the transactions should be sufficiently similar so that both the controlled and uncontrolled transactions could be considered comparable. This means that the differences do not affect the condition

50 Unlike other countries, the Brazilian transfer pricing system is not based on a specific arm’s length standard. Taxpayers are free to choose any methods specified in the regulations so long as they have the required information.

51 OECD, above n. 32. 52 The explicit statement on the commitment to

the arm’s length principle is actually set out in Article 7 of the OECD Model Tax Convention.

53 OECD, Model Tax Convention on Income and Capital (2005).

being examined (e.g. price or margin) significantly. In addition, the effects of those differences can be eliminated using accurate adjustments.54

In establishing the degree of comparability and making adjustments, it is important to compare the attributes of the transact-tions. These include:

1. Characteristics of property or services

Differences of characteristics of property or services are often responsible for differences in their market value. Similarity is important when comparing prices but can be less important when comparing profit margins. Some characteristics to be considered include: the physical features, quality and reliability, the availability and volume of supply (in case of tangible property), the nature and extent of the service (in case of services), the form of transaction (e.g. licensing or sale), the type of property (e.g. patent or trade mark), the duration and degree of protection, and the anticipated benefits (in case of intangible property).

2. Functional analysis

In essence, this analysis tries to identify and compare the activities and responsibilities undertaken. The functions that might need to be considered include design, manu-facturing, assembly, or other functions. If one party provides a range of functions, it is the economic significance of these functions that matters.

Another important aspect is the risk assumed by the parties. If the differences in risks are so significant that appropriate adjustments cannot

54 OECD, above n. 29.


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be made, then that transaction will not be considered comparable. The types of risks to be taken into account include market risks – such as price fluctuations and failure in research and development – and financial risks, such as exchange rate fluctuation, interest rate variability, credit risks, and so forth.

3. Contractual terms

The contractual terms define the behaviour of the parties including the division of responsibilities, risks, and benefits between parties. In addition to the written contracts, these terms usually can also be found in the communications or correspondence between the parties. If there is no written contract, the relationship can be deduced using their conducts and the economic principles that generally govern such relationship.

4. Economic circumstances

These factors include geographic locations, the size of the markets, competition, the availability of a substituting product, consumer purchasing power, costs of productions, and so forth.

5. Business strategies

This includes innovation and new product development, diversification, risk aversion, assessment of political changes, and other aspects including a market penetration scheme. As an example, an entity claiming a market penetration strategy may have low income because it charges a lower price and high penetration expenses (e.g. advertising).

It is possible that the application of the arm’s length principle results in a range of figures. This is because it approximates the conditions between unrelated entities

or when several methods are applied to evaluate a certain controlled transaction. If the relevant conditions fall within this range, there will be no adjustment required. On the other hand, if the relevant conditions indeed fall outside the range asserted by the tax administration, the taxpayers have to demonstrate that their conditions satisfy the arm’s length principle. However, a substantial deviation among points indicates that the comparables being used in the analysis are probably not reliable.

2 The Acceptable Methods

As discussed, there are several methods preferred by the OECD. These methods are grouped into two categories: the traditional transactional methods and the transactional profit methods. The Guidelines express a preference over the first group and state that the profit-based methods should only be applied if there are practical difficulties that prevent the use of the transaction-based methods.

(a) Traditional transactional methods

The arm’s length condition can be established by substituting the price in the controlled transaction with the price of the comparable uncontrolled transaction. However – as valid comparables are not always available – sometimes it is necessary to use the less direct approach – such as gross margin comparison – to reflect the arm’s length conditions.

(1) Comparable uncontrolled price method (CUP)

In essence, the CUP compares the prices in a controlled transaction with the prices charged in an uncontrolled situation with similar circumstances. This method produces the most reliable result but requires a high degree of comparability in term of products and functions. Therefore, it is suitable in situations where there are the same or at least very similar products are sold to both related and


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unrelated parties. They have to be similar that any differences have no effect on its price or if such differences exist, they can be addressed using a number of adjustments.

Nevertheless, it is difficult to find comparable uncontrolled transactions because differences may cause significant effects on its price. As a consequence, some adjustments are usually required to reflect such differences in term of product quality, contractual terms, embedded intangibles, and foreign currency fluctuations.

For example, an Australian company sells fruit juice to its Indonesian subsidiary for $1 for each package. That company also sells the same product to an unrelated Malaysian company for $1.50 per package. Using the CUP, it is likely that the transfer price for the Indonesian contract will be changed into $1.50 per package.

(2) Resale price method (RPM)

The RPM can be applied to the transfer of both tangible of intangible property, especially when intangible property is sublicensed to a third party. The analysis is based on the gross margin obtained in comparable uncontrolled transactions. The transfer price is the uncontrolled resale price less an appropriate mark up to cover costs and profits. Therefore, the arm’s length price would be an applicable resale price less adjusted mark up percentage obtained comparable unrelated transactions. The result is adjusted to reflect any existing differences. This method is suitable in situations where the reseller does not add a substantial value to the products (simply a distributor).

For example, an Australian company sells fruit juice to its wholly-owned Indonesian subsidiary for $1 for each package which resales it to an unrelated

party for $1.50. If another independent distributor charges 10% for the sale and purchase of similar products, the arm’s length transfer price would be $1.35 ($1.50 less 10% commission).

(3) Cost plus method (CPM)

This method works based on the gross profits by comparing the full costs plus mark-up of a controlled transaction with the comparable uncontrolled transactions. The arm’s length price equals the cost of production plus a gross profit percentage from comparable uncontrolled transactions. The result is then adjusted to reflect any differences.

For example, the cost of manufacturing the fruit juice in previous example is $.95 per package. If another company produces similar product earns a gross profit mark up of 20%, then the arm’s length price is $1.14 (being $.95 plus 20% mark up).

(b) Transactional profit methods

The transactional profit methods consist of the Profit Split Method and Transactional Net Margin Method. Most countries usually prefer the Profit Split Method because it considers both parties and hence, generates a less extreme result.

(1) Profit split method (PSM)

This method is applied if the transactions are so closely interrelated that they cannot be analysed on transaction-by-transaction basis. There are two analysis under this method, namely contribution analysis and residual analysis. In the contribution analysis, the profit/loss in a controlled transaction is split based on the proportion of the contribution of each party. As it does not depend on the analysis of comparables, it can be used in situations where there is no comparables. The residual analysis works similarly with the contribution analysis but it requires a highly profitable intangible.


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(2) Transactional net margin method (TNMM)

This method examines the net profit margins in a controlled transaction relative to an appropriate base (sales, costs, or assets). The result is then compared with the net profit margins earned by a taxpayer in an uncontrolled situation or with the net profit margin earned by independent entities. As net profit margin is less affected by transactional differences, it is more tolerant to functional differences than gross profit margin.

3 The Appropriateness of the Arm’s Length Principle

(1) Theoretical and practical difficulties

The arm’s length principle contains both theoretical and practical problems. Firstly, it fails to acknowledge that an MNE’s business tends to be:

1. Highly integrated; 2. Conducted predominantly by

control rather than by contract; 3. Many risks and costs are

internalised.55

The first feature is critical to achieve synergy through economies of scale. However, the arm’s length principle does not recognise this. Instead, it assumes that entities within an MNE are capable of acting as if they were unrelated. It fails to acknowledge that an entity chooses to operate as an MNE because this structure enables it to achieve more as a whole compared to the aggregate of what all member-entities earn if they operate independently. 56 In Jerome

55 Jinyan Li, 'Global Profit Split: An Evolutionary Approach to International Income Allocation' (2002) 50(3) Canadian Tax Journal 823.

56 Lindsay C. Célestin, The Formulary Approach to the Taxation of Transnational Corporations: a Realistic Alternative? (Ph.D. Thesis, University of Sydney, 2000).

Hellerstein’s words, the OECD’s arm’s length principle turns reality into fancy and then pretends that it is the real word. It pretends that the integrated parts of an MNE are separate entities transacting independently.57 In short, the arm’s length principle ignores the synergistic effects which are fundamental within an MNE.

In the second feature, it is recognised that the relationship between members of an MNE is governed by control rather than by contract. Even if a contract exists, it cannot be effectively enforced. It can even be changed according to the will of the parent company. As a result, accepting such contract is questionable.

Lastly, internalisation of costs and risks makes an MNE able to operate efficiently and achieve synergy. A comparable arm’s length transaction will be very difficult to be found as the MNE drives away its competitors.58 As Lester notes, multinational companies are increasingly involved in transactions where there is simply no comparable uncontrolled transaction, especially in highly specialised services such as multinational banking industry. The problem is exacerbated by the fact that there is a lack of rules in setting an arm’s length price where there is an absence of comparables or in situations when related parties are involved in transactions that independent entities would not undertake.59

Furthermore, the traditional arm’s length methods fail to account for profits that arise as a result of integration within an

57 Kerrie Sadiq, The Fundamental Failing of the Traditional Transfer Pricing Regime - Applying the Arm’s Length Standard to Multinational Banks Based on a Comparability Analysis (2003) <http://pandora.nla.gov.au/pan/23524/20030305/Kerrie%20Sadiq.doc> at 28 April 2006.

58 Li, above n 55, 834. 59 Sadiq, above n 57.


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MNE. As mentioned, an MNE operates in an integrative way so that it can achieve more as a whole compared to the aggregate of what all member-entities earn if they operate independently. If this situation is approached using comparable unrelated transactions, the residual profit as a result of integration and economies of scale cannot be recognised as such profit does not occur in uncontrolled transactions.60 In addition, transfer-pricing arrangements increasingly become more complex as they involve services, intangibles, and unique properties. 61 Further, Li adds that the arm’s length principle violates internation equity principle 62 – as it tends to favour the parent company’s country of resident – and inter-taxpayer equity 63 as it may cause over-taxation due to inconsistent application or under-taxation if there is a transfer-price abuse. It also fails to satisfy the neutrality principle as a result of its subjectivity and uncertainty.64

(2) Comparable uncontrolled price method (CUP)

Viewed as the most direct way to arrive at the arm’s length price, this method is not without its flaws. Developed based on the manufacturing of raw materials into finished goods which prevailed from the mercantile era in the eighteenth century until the mid of twentieth century, this method might be unsuitable for today’s

60 Li, above n 55, 834. 61 Ibid, 835. 62 Inter-nation equity refers to a fair allocation of

tax revenue between countries. 63 Inter-taxpayer equity deals with the

distribution of tax burden among taxpayers. It is based on ability-to-pay considerations which is analysed in terms of horizontal equity (taxpayers with similar situations should be taxed approximately the same) and vertical equity (taxpayers with higher incomes should pay higher taxes).

64 Li, above n 55, 838-42.

situation. This is because the nature of current trade that consists of more specialised information which is unique and indivisible in nature. As a result, the CUP – which is based on transaction-by-transaction basis – would be unsuitable.65

In addition, it is often difficult to find the exact comparables in internal uncontrolled comparables, which is undertaken between members within an MNE or between an MNE and an independent party. For external comparables – transactions between two unconnected parties – two problems arise. Firstly, the MNE often does not have access to detailed information on such transactions and secondly, there are only few markets where external comparisons exist. This is because an MNE operates in a way that can maximise the integration and risk protection effects; if an MNE does not have an internal comparable, it is unlikely that its competitor does.66

(3) Resale price method (RPM) and cost plus method (CPM)

The RPM or CPM methods can be used in situations where the application of the CUP is either unrealistic or impossible. As discussed, these methods basically try to arrive at the arm’s length price by calculating gross margins from comparable transactions and then apply these margins to the controlled transactions. The RPM deducts the margins from the selling price whereas the CPM adds the margins to the costs of sales.

Célestin identifies several limitations of both methods.67 Firstly – as they are based on comparable uncontrolled transactions – they are subject to the limited availability of detailed information of the comparisons, the same as the CUP

65 Célestin, above n 56, 63. 66 Pagan and Wilkie, above n 4, 105. 67 Célestin, above n 56, 64-6.


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method. Secondly, they tend to be one-sided solutions because they allocate risks (profits or losses) on the hand of the purchaser (the RPM) or the supplier (the CPM). Finally, there are other difficulties:

1. It is difficult to convince that the uncontrolled transactions being used to calculate the mark-ups are adequately comparable.

2. The cost base calculation is often surrounded with uncertainties.

3. The problems in making the appropriate adjustments.

4. In relation to the arm’s length range, specific issues will still need to be solved.68

In relation to the CPM, additional problems may also arise regarding the nature of the relationship between the parent company and subsidiary. This kind of relationship can be seen as a continuum. On one end of the continuum, the subsidiary may only be a contract manufacturer which is subject to a strict technical and managerial assistance from the parent company. All products of the subsidiary are absorbed by the parent company. On the other hand, the subsidiary may have a degree of independence in relation to the technical control, management, and choice of sale outlets for the products. In this situation, the gross margins applicable for the more independent subsidiary should clearly be higher to cover the commercial risks.69 Such risk differences have to be taken into account in calculating the appropriate margins.

68 Ibid. 69 Pagan and Wilkie, above n 4, 107.

III INDONESIA: SOME THOUGHTS FOR REFORM

A. Current Transfer Pricing Regulation As discussed, the Indonesian transfer pricing provisions were first introduced in 1983. Article 18(3) Law Number 17 of 2000 authorises the Director General of Taxes to reallocate income or deductions between related parties and to characterise debt as equity. This article is explained through SE-04/PJ.7/1993 which seems to refer to the 1979 version of the OECD transfer pricing guidelines. The definition of related party is explained in Article 18(4) to include:

1. A direct or indirect ownership of at least 25% of equity in other taxpayers;

2. A taxpayer who controls other taxpayers or two or more taxpayers are controlled by the same person;

3. A family relationship through blood (for example parents and children) or marriage (for example parents in law, and stepson or stepdaughter).

In SE-04/PJ.7/1993, the Director General of Taxes states that non-arm’s length transactions may occur in the form of:

1. Selling price; 2. Buying price; 3. Allocation of administration expenses

and overhead cost; 4. Burden of interest on extending

loan by shareholder loan; 5. Payment of commission, license,

franchise, rental, royalty, repayment on management services, repayment on technical services and another repayment services;

6. Buying of enterprise property by shareholder loan or party who has lower special relationship than price market;

7. Selling to overseas party through third party who has lack/not business substantial (example dummy company,


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letter-box company or re-invoicing centre).

This circular letter confirms that the transfer pricing provisions can apply to both domestic70 and cross-border transactions between related parties, especially if the other party is located in a tax-haven country.71 It then provides some examples in how to work out the arm’s length price for each of the above category which basically refer to the CUP, CPM, or RPM. It also recognises the use of ‘comparable profits’ or ‘return on investment’ from comparable industries.

In relation to documentation, there is no formal documentation requirement although taxpayers are required to disclose their related-party transactions. The information to be disclosed includes the type and value of the transactions, the transfer price, and the methodology that has been used to determine the transfer price.72 In addition, there is no specialised audit that especially deals with transfer pricing issues. There are also no guidelines that characterise which taxpayers that may subject to a transfer-pricing audit. From a practical point of view, however, it is believed that taxpayers with the following characteristics may be subject to a transfer-pricing related audit:

1. A large number of related-party transactions;

70 The transfer pricing provisions apply to domestic transactions between related parties because grouping of tax losses is not recognized in Indonesia.

71 Tax haven is defined in this circular letter as a country which does not collect tax or collects a lower tax than Indonesia. According to the OECD, a tax haven has characteristics that include: no or only nominal taxes, lack of effective exchange of information, and lack of transparency in the operation of the legislative, legal or administrative provisions.

72 Ernst and Young, above n 25.

2. Losses for a period longer than two consecutive years;

3. A significant gross revenue without a considerable net profit increase;

4. Irregular profits and losses history; 5. Associated parties in tax havens; 6. A lower profit compared to the

industry average or other similar enterprises.73

B. Some Thoughts for Reform

Pagan and Wilkie argue that there are six aspects that need to be considered in searching for appropriate transfer pricing provisions:

1. The rules apply to which taxpayers. 2. The type of transactions that are

affected. 3. The basis to analyse the fair price. 4. Whether the transactions and/or

the price be adjusted. 5. Whether the focus is on flexibility

or certainty. 6. The compliance requirements.74

Each aspect will be discussed in the following sections.

1 The Taxpayers

This first aspect addresses the type of taxpayers to which the transfer pricing regulations apply. This usually can be found in the definition of related-party transactions. Generally, there are several patterns that emerge:

1. The rules apply to taxpayers that conduct business activities, for instance corporations, partnerships, or individual owning such structures.

2. Both foreign and domestic entities are included, although sometimes the rules may be limited to apply only to international transactions.

73 Ibid. 74 Pagan and Wilkie, above n 4, 43.


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3. There are rules that define whether one or more entities are considered to be related parties so that the transfer pricing rules can be applied.75

In relation to Indonesia, the related-party transaction rule applies to taxpayers defined in Article 18(4) of the Law Number 17 of 2000 to include:

1. A direct or indirect ownership of at least 25% of equity in other taxpayers;

2. A taxpayer who controls other taxpayers or two or more taxpayers are controlled by the same person;

3. A family relationship through blood (for example parents and children) or marriage (for example parents in law, and stepson or stepdaughter).76

Whilst the first condition clearly requires an equity ownership, the second condition is to wider. The elucidation of the Article 18(4) explains that a dependency relation-ship may be the result of an ownership of share or equity (condition 1), family relationship (condition 3) or a participation in management or technology (condition 2).

By contrast, the Australian definition of the associated party is wider. It can be found in Division 13 Part III section 136AD of the Income Tax Assessment Act 1936 (Cth) (ITAA 1936). 77 This division was introduced in 27 May 1981 to replace the former s. 136 which was repealed following the decision in FCT v Commonwealth Aluminium Corporation Ltd (1980) 11 ATR 42. 78 Division 13 does not self-executable even though it does not require a tax-avoidance motive. Additionally, it can be applied to any

75 Ibid, 46. 76 Above n 23. 77 Income Tax Assessment Act 1936 (Cth) 78 RL Deutsch et al, Australian Tax Handbook

2004 (2004).

transactions with various purposes in addition to tax motives.79

The related-party concept is defined in s. 136AD ITAA 1936 to include ‘any connection’ between any two or more of the parties to the agreement. The phrase ‘any connection’ is much wider compared to direct or indirect control contained in the Indonesian definition because it allows a facts and circumstances approach.80

It can be seen here that the Indonesian definition of related party requires an evidence of control, whether through an equity ownership, family relation, or managerial/technological presence. On the other hand, it is possible to use a wider approach that does not need such evidence, like the Australian version. Even though some may argue that it might be somewhat harsh, it covers more taxpayers.

2 The Transactions

Here, there are two strategies. Firstly, the general approach that covers as wide transactions as possible and then it is at the discretion of the tax authority to bring the transfer pricing provisions into play. Secondly, a specialist provision can be constructed for a certain type of industry, for instance the mining or financial industry. 81 There are several problems associated with the first approach.

The first difficulty is that an MNE may continue its operation even if it is not profitable. For example, a leading computer software manufacturer may still operate in a country with high rate of software piracy to strengthen and preserve its brand and customers’ loyalty. If its customers from other country with low piracy rate – which is the MNE’s target market – conduct business in this high-

79 Ibid. 80 Pagan and Wilkie, above n 4, 48. 81 Pagan and Wilkie, above n 4, 49.


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piracy country, the MNE can expect that these customers may still use the MNE’s products. Furthermore, the MNE can also expect that these customers would not switch to competitors’ products in their business in other parts of the world because they get the same level of service anywhere. If the MNE’s head office provides assistance – say by providing loan with a lower interest rate – to this type of non-profitable offices, the tax authority may see it as an abuse. As a result, the transactions may be adjusted and the taxpayer suffers. This example shows a tax authority’s incomplete understanding of an MNE’s operation and a failure to understand the benefits of such operation in term of employment and transfer of knowledge.82

The second problem arises where the adjustment is only targeted to situations where taxpayers’ profitability can be increased. This can be achieved in two ways: by drafting the legislation in such a way that it will only be applied if it results in an increased of profitability or granting the tax authority discretion to exercise the transfer provisions. It is likely that a tax authority will only use this power if it believes that profitability – and hence, taxable income – can be increased. In either situation, there is a failure to recognise that in the long run, two unrelated business entities doing business together tend to average out even though in the short run, one entity may be less profitable than another. Such entities may face problems if tax authorities invoke transfer pricing adjustments in times when profits are lower. That taxpayer may argue that for a certain period of time – say ten years – there is no substantial profit shift, but the result is often uncertain.83

82 Ibid. 83 Ibid, 52.

Regarding the specialised provisions for a certain industry, the choice depends on the nature of economic activities in that country. For example, a country like Norway that depends on the oil industry may have specialised tax provisions for the oil industry including specific transfer pricing rules. Other countries that depend on different type of industries like finance may also have similar rules.

In essence, the Indonesian transfer pricing provisions conform to the general approach to cover more transactions. The rules in Article 18 of the Law Number 17 of 2000 are basically the general anti-avoidance provisions. In addition, there are also specialised rules in relation to the taxation in mining ‘Contracts of Work’ (CoW), but the emphasis is on the applicable tax rates. The rates are locked over the life of investment and thus are protected against changes in income and royalty taxes. For example, the eighth-generation contract – beginning in 2000 – includes a tax rate of 30%.84

Article 18(3) grants the Director General of Taxes discretion to make the necessary adjustments to bring the transfer price to an arm’s length price. Of course the adjustments are likely to be made only if it can be assured that the new price increases taxable income. As a consequence, it is also subject to the problems outlined previously. In such situations, the Director General of Taxes has to base his review on a premise that the taxpayers – not the Director General of Taxes – are the expert in their business. Hence, Director General of Taxes has to deal with the facts and circum-stances as they exist and not as if they were conducted differently. The transfer pricing

84 The Economist Intelligence Unit Ltd., Indonesia: Tax regulations (2006) Dow Jones Reuters Business Interactive LLC <http://global.factiva.com.dbgw.lis.curtin.edu.au/ha/default.aspx> at 27 March 2006.


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provisions should only be used to substitute the transfer price and not the taxpayers’ business judgements.85

3 The Fair Price Determination

As discussed, the arm’s length principle endorsed by the OECD is the de facto standard adopted by most countries. However, there are differences in the details. There are two patterns that emerge: a practical businesslike approach and a detailed provisions approach.86 The first method chooses to approach the arm’s length principle on a case-by-case basis without the need to rely too much on detailed provisions. The statutory restrictions are kept at a minimum level but the tax officials are usually well-trained and aware of an abuse. In addition, it is usually complimented with continuing discussions between the tax authority and taxpayers to arrive at a common understanding on the acceptable transfer pricing policy. By contrast, the detailed-provisions approach arms tax officials with lengthy and detailed rules on what constitutes an arm’s length transaction.87

The main advantage of the first approach is that it is more flexible. It can be effective if the tax officials have good knowledge on the commercial practice of transfer pricing policies. Otherwise, they may be heavily exploited and as a result, the nation’s potential revenue could be harmed. On the other hand, the detailed-provisions approach may be inflexible but it can provide the tax authority the necessary arsenal to tackle a transfer pricing abuse. However, there is a growing trend in countries with a flexible approach to publish detailed guidelines and circulars that do not have the force of law. Australia for example published a range taxation ruling in

85 Pagan and Wilkie, above n 4, 89. 86 Ibid, 55. 87 Pagan and Wilkie, above n 4, 55.

relation to its transfer pricing regulations (Div. 13 ITAA 1936).88

In Indonesia, Article 18(3) of the Law Number 17 of 2000 authorises the Director General of Taxes to ‘…assure that the transaction are those which would have been made between independent parties’ (emphasis added). Furthermore, the elucidation of this Article says that the methods to be used include ‘…comparable data, profit allocation based on function or participation of related Taxpayer and other methods’.

Whilst it is believed that the problem lies in the details of the tax laws,89 the practical approach is unclear. The fact that Indonesia does not have detailed provisions on transfer pricing – other than a short circular letter SE-04/PJ.7/1993 – is possibly because it prefers to use the business like approach. The circular letter number SE-04/PJ.7/1993 is meant to be the implementing regulation, but its day-to-day practicality still faces difficulties, especially in relation to the availability of comparables.90

By comparison, the Commissioner of Taxation in Australia (the Commissioner) provides the following guidance in choosing the appropriate arm’s length methodology.91

88 The Commissioner of Taxation has published a number of public rulings including TD 92/103 (inter-company loan), TR 94/14 (basic concepts of Div. 13), TR 97/20 (transfer pricing methodologies) and other transfer-pricing related rulings.

89 Urip Hudiono, 'Tax laws still complicated, have grey areas: Analysts', The Jakarta Post (Jakarta), 16 November 2005.

90 Gunadi, above n 24. 91 Australian Taxation Office, TR 98/11: Income

tax: documentation and practical issues associated with setting and reviewing transfer pricing in international dealings (1998) The Australian Taxation Office <http://law.ato.gov.au/pdf/tr98-11.pdf> at 30 April 2006.


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This chart provides taxpayers ideas in choosing the appropriate methodology that is suitable for their situations. It can be contrasted to the Indonesia’s situation where taxpayers are ‘left in the dark’.

A weak provision in tax law against tax abuse and inadequate technical training for tax auditors evident in many developing countries are the main weaknesses which may cause failure to prevent profit diversion by foreign investors. 92 Therefore, it is essential for Indonesia to have more guidelines so that taxpayers as well as tax officials have common understanding and to reduce different interpretations. For taxpayers, the guidelines are important as a starting point in fulfilling the legal requirements. Tax officials also need such guidelines as guidance for transfer-pricing auditing activities. If they have common understanding and ‘speak with

92 Vito Tanzi and Howell Zee, Tax Policy for Developing Countries (2001) International Monetary Fund <http://www.imf.org/external/pubs/ft/issues/issues27/index.htm> at 27 March 2006.

the same language’, it is possible to reduce future disputes and at the same time, safeguard the national income.

4 Price or Transaction Adjustments

There are several ways for adjustments to be made:

1. Only the price that is adjusted. 2. The transaction is adjusted to

arrive at a fair price. 3. Interest payments are recategorised

as dividends. 4. Non arm’s length payments are

not deductible under other provisions.93

(a) Price-only adjustment

If goods or services are transferred at below an arm’s length price, the tax authority usually makes an upward adjustment. Hence, profitability and taxable income is increased. This approach is also preferred by Article 18(3).


Figure 2 Which methods? Source: TR 98/11


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(b) Transaction adjustment

In this instance, the tax authority tries to change the nature of the agreements as if the commercial agreements are conducted in different ways. For example, if an MNE grants an offshore company a licence to manufacture a product and then buy most of those products, this approach basically recategorise such transactions to be a contract manufacturing agreement as if the offshore company carries a very limited risk and completely dependent to the MNE. It does not take into account the actual terms of the contract and the independence level of the offshore company.94

(c) Interest payments are recategorised as dividends

In essence, these provisions treat excessive interest payments to associated-non resident company as dividend and therefore, not deductible. Such rules are also present in Indonesian anti-avoidance articles. Article 18(3) of the Law Number 17 of 2000 does not clearly states it, however, its elucidation provides that the Director General of Taxes is authorised to characterise debt as equity and hence, interest payment is treated as dividend. Nevertheless, there is no further explanation on how its practical mechanism and as a result, its application is unclear.

94 An example of this approach can be found in Sunstrand Corporation v Commisioner, a US case where the Internal Revenue Service (IRS) recharacterised the contract between Sunstrand Corporation and SunPac — its Singaporean subsidiary — to be a contract manufacturing agreement. The Court rejected the IRS’s contract manufacturing theory on the basis that the actual contract did not oblige the parent company to purchase the subsidiary’s products.

(d) Non-Arm’s length payments under other provisions

Whilst a transfer pricing provision clearly denies a non-arm’s length payment, it is possible that there may be other provisions in income tax legislation that also provides that such payments are not deductible. In such situation, taxpayers have to be aware the advantage of using one rule over another.

5 Certainty or Flexibility

Certainty means that taxpayers are able to know in advance what tax consequences they may face in relation to a certain business transaction. On the other hand, flexibility approach focuses on the facts and circumstances surrounding the transactions and therefore, it leaves a degree of freedom to an agreeable arm’s length transfer price.95 As a result, certainty and flexibility sometimes conflict. A country that emphasises certainty tends to have a detailed arm’s length provision compared to the shorter provisions in the flexible approach. However, as discussed previously, there is a tendency that flexible-focussed country begins to provide more detailed guidelines that do have the force of law. Such guidelines are merely aimed at providing guidance on the important aspects in a transfer pricing inquiry. This is usually accompanied with well-trained tax officials.

In this situation, the Indonesian approach is unclear. It does not have detailed transfer pricing provisions – which may be indicated as focusing on flexibility – and is without more detailed transfer pricing guidelines. 96 This may cause ‘grey areas’ that may be subject to multiple interpretations. This needs to be reduced. 97 Without strong legislative

95 Pagan and Wilkie, above n 4, 64. 96 Gunadi, above n 24. 97 Hudiono, above n 89.


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provisions and a proper training for tax officials, it is likely that developing countries – like Indonesia – are unable to prevent profit diversion.98

6 Compliance Requirements

There are two concerns relating to compliance requirements: the reporting requirements and a non-compliance penalty. 99 The first instance, some countries may require taxpayers to complete separate documentation listing all of the related-party transactions. Other countries may only rely on the annual standard tax return form. In relation to penalties, usually there are two types of penalties: a flat-rate monetary penalty and a percentage-based penalty.100 While the first type of penalty is usually insignificant in term of its monetary value, the second type of penalty can be more material.

In Australia for instance – in Taxation Ruling TR 98/11 – the Commissioner states that there are four reasons why documentation is important:

1. Statutory requirements; 2. Relevance to penalty considerations; 3. The burden of proof which rests

with taxpayers; 4. Practical advantages in reducing

the risk of tax audits and adjust-ments and in communicating your position to the ATO.101

The documents to be prepared extend from budgets, business plans and financial projections to all other documents required in preparing tax return. In addition, the ATO requires taxpayers to have contemporaneous documentation in relation to transfer pricing, especially

98 Tanzi and Zee, above n 92. 99 Pagan and Wilkie, above n 4, 67. 100 Ibid, 70. 101 Above n 91.

to justify the outcome of the transactions against the arm’s length principle. There is also a disclosure requirement for related-party transactions under Schedule 25A. The information to be disclosed includes:

1. Industry classification code; 2. Transaction type; 3. Amounts per transaction type; 4. Countries; 5. Percentage of transactions covered by

contemporaneous documentation; 6. Transfer pricing methodologies

selected and applied.

In Indonesia – even though the DGT may require taxpayers to produce invoices or agreements – there is no formal documentation requirement. However, commencing 1 January 2002, there is a disclosure requirement for the type of transaction, the value of the transaction, the transfer price and the methodology used to determine the transfer price.102 There is no deadline for documentation preparation and submission, leaving taxpayers with uncertainties as to what and when the documentations are required.

In relation to penalty, the applicable rates in Australia are as follows:

1. A penalty of 50% of the tax avoided for transfer pricing arrangements entered into with the sole or dominant purpose of enabling a taxpayer to pay no or less tax; reduced to 25% if the taxpayer has a reasonably arguable position (RAP) (s. 225(1)(d) ITAA 1936); or

2. A penalty of 25% of the tax avoided for other transfer pricing arrangements; reduced to 10% if the taxpayer has a RAP (s. 225(1)(e) ITAA 1936).

102 Ernst and Young, above n 25.


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The penalty can be increased by 20% if a taxpayer prevents or hinders the ATO’s transfer pricing audit (s. 226C(b)(i) ITAA 1936) or has been penalised under a scheme section in previous year (s. 226C(b)(ii) ITAA 1936). However, the penalty may be reduced by 20% if the taxpayer makes a voluntary disclosure after an audit is informed (s. 226D ITAA 1936). There is also an 80% reduction if the voluntary disclosure is made before the release of an audit notice (s. 226E ITAA 1936).

In Indonesia, there is a penalty of 2% per month up to a maximum of 48% for an underpayment (Article 13(2) of the Law Number 16 of 2000 on General Provisions and Tax Procedures). 103 However, there is no penalty reduction for taxpayers who make a voluntary disclosure. As a result, taxpayers are likely to wait the results of the DGT’s audit because making a voluntary disclosure in the event of an audit does not make any difference. Introducing a penalty reduction may increase taxpayers’ compliance.

C. Other Considerations

1 Transfer-Price Tests

Associated entities often deal with each other surrounded by motives other than pursuing commercial interests. As a result, it is necessary to evaluate whether the transfer prices are set in a fair manner.

In Australia, choosing the appropriate methodology is part of a four-step process (figure 3). 104 This chart shows that step 1 to step 3 do not flow linearly and is open to possible movements among these steps until the most

103 Law Number 16 of 2000 . 104 Above n 91.

appropriate method is selected and a proper outcome is produced.

By contrast, the Indonesian transfer pricing provisions are silent on such matters.

The elucidation of Article 18(3) states that there are some methods to allocate income and expenses including comparable data, profit allocation based on function or participation of related Taxpayer, and other methods and SE-04/PJ.7/1993 provides some examples. However, the overall process remains uncertain.


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2 Audit-Risk Assessment

Transfer pricing is complex and its audit involves an analysis of a wide range of factors. As it may threaten the national’s potential income, transfer pricing abuse may attract harsh penalties. A dispute between taxpayers and tax authorities may end-up in court litigations, which are usually long and costly. As a result, an assessment of a transfer pricing audit risk is important. In this context, taxpayers often require guidelines on how a tax authority approaches related-party transactions they may have.

The Australian approach in this matter can be found in TR 98/11. In this ruling, the Commissioner states that the ATO’s resources are allocated based on the perceived risk of taxpayers’ non-compliance with the arm’s length

standard.105 The ATO may proceed to an audit if it found that the dealings are structured in such a way that it is reasonable to believe that there may be a tax avoidance scheme. Some factors taken into account include:

1. The use of tax havens where little or no economic value is added;

2. The use of back-to-back arrangements to conceal the full consideration;

3. Complex and circular arrangements with little or no business purpose.

The following chart illustrates the ATO’s approach.106

105 Ibid. 106 Ibid.

Figure 3 The ATO’s four-step process. Source: TR 98/11


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The chart below shows the ATO’s risk guidelines in relation to a transfer pricing audit that may be faced by taxpayers.107

107 Ibid.

Figure 4 The ATO’s approach to arm’s length compliance. Source: TR 98/11


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In Indonesia, there is no specialised transfer pricing audit. Transfer pricing investigations are conducted as part of regular tax audits. However, it is unclear at what situation a taxpayer face a higher risk of transfer pricing audit and how it will be approached.

D. Alternative Methods

1 Cost-Based Approach

In this approach, the fair transfer price is calculated based on its cost. Chalmers suggests the following formula:

108 Kerrie Chalmers, International Transfer Pricing - Determining an Arm's Length Price (2003) <http://pandora.nla.gov.au/pan/23524/20030304/CHALMERS.doc> at 19 April 2006.

Figure 5 Audit risk assessment. Source: TR 98/11

Additional outlay costs per unit incurred to the point of transfer + Opportunity costs per unit to

the supplying division = Minimum transfer price108

JAP Vol. 3, No. 1, September 2008

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He further adds that there are four scenarios that may be encountered:

1. The appropriate transfer pricing methodology is the full cost if there is a competitive intermediate market and the supplying division has no idle capacity.

2. The transfer price consists of variable costs plus a negotiated portion of fixed costs if there is a competitive intermediate market and the supplying division has idle capacity.

3. The transfer price also consists of variable costs plus a negotiated portion of fixed costs if there is no market for the intermediate products.

4. If there is no competitive inter-mediate market and the supplying division has idle capacity, the aforementioned formula cannot be used. In such situations, a market has to be created possibly by reducing the price.109

2 Global Formulary Apportionment and Global Profit Split

The traditional arm’s length approach has both theoretical and practical difficulties and the formulary apportion-ment methodology could be an appro-priate alternative. This is because it accepts the firm-integration concept and proposes a workable solution that provides each jurisdiction with tax revenue based on economic activities that take place in that jurisdiction. Additionally, it can be used as a mean to solve the ‘source-state base erosion’ by employing factors such as sales in the jurisdiction of consumption. 110 Moreover, it offers certainty and simplicity.111

109 Ibid. 110 Arthur J. Cockfield, 'Formulary Taxation

Versus the Arm’s-Length Principle: The Battle

However, the formulary apportionment may not be the universal remedy, as evident for income from intangible properties. In addition, it is also argued that the formulary apportionment can lead to more aggressive tax planning activities. For example, a firm may hire independent contractors to exclude salary and wages in the calculation of a profit portion for a jurisdiction. In addition, determining what constitute a unitary enterprise can be difficult and may increase compliance and enforce-ment burden.112 It may not be accepted on tax-sovereignty basis as well as it would oblige participants to comply with formulas and tax rules set at a supranational level. It is often unrealistic to expect that a country would willingly abandon its self-interests for the benefits of others.113

Broadly, the mechanic is as follows:

1. The entire net income for a whole MNE is computed.

2. Income not related to the unitary business is deducted from the entire income.

3. The remaining is the taxable income to be apportioned among jurisdictions.

In relation to this, Jinyan Li proposes the ‘Global Profit Split’ (GPS) which is similar to the formulary apportion-ment.114 The term ‘global profit split’ is chosen to avoid the use of ‘formulary taxation’ which is considered ‘dirty’ in some international tax circles.115

Among Doubting Thomases, Purists, and Pragmatists' (2004) 52(1) Canadian Tax Journal 114.

111 Célestin, above n 56, 379-80. 112 Cockfield, above n 110, 117-8. 113 Ibid, 120. 114 Li, above n 55, 844. 115 Cockfield, above n 110, 116.


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Under the GPS, an ‘integrated business’ has to be identified first. This definition is crucial as it provides the parameters of profit to be split. Li states that there are two tests available for this purpose: the flow-of-value test and the operational-interdependence test. A business is integrated under the first test if there is a flow of value among associated entities. Under the latter, a business is integrated if there is a significant amount of ‘interdependent basic operations’ under-taken in different jurisdictions.

Once an ‘integrated business’ has been defined, the ‘global profit’ needs to be determined. The global profit ascertains the size of profit to be split among participants. Only revenue derived from independent third-parties that would be included. Lastly, the profit is allocated among participants based on a certain formula. The variables to be used may include payroll, sales, tangible and/or intangibles assets. Each participant has a portion of the global profit represented as a percentage in proportion to its share of payroll, sales, tangible property, and other intangibles.

Li argues that the GPS is superior compared to the existing system because it promotes inter-nation equity, it is consistent with economic theory, it can overcome the tax haven problems, and it supports the simplicity principle. 116 However, she also recognises that it also has the weaknesses of traditional formulary apportionment.

Firstly, there is a potential double taxation if a consensus on the definition of ‘integrated business’ and ‘global profit’ or on the measurement and location of the variables in the formula could not be reached. Secondly, it endorses an arbitrary allocation, and

116 Li, above n 55, 851.

lastly, there may be transitional difficulties because it requires changes in legislations and international treaties. In addition, it requires strong political will.

Li asserts that the first problem could be dealt with by improving uniformity. The second weakness can also be addressed using a well thought-out design of the apportioning formula. However, the last difficulty could be more complicated as it involves a strong political will. Nevertheless, Li believes that the current application of formulary apportionment in Canada and the USA and the adoption of a global accounting standard have provided some precedents. Further, she believes that if formulary apportion-ment were adopted in European Union countries, others would certainly follow. Besides, the GPS actually stems from the historical evolution of the arm’s length principle and the application of the existing formulary apportionment in many situations. These conditions would support the implementation of GPS internationally.117

In summary, the formulary apportion-ment is a compromised approach. To be applied successfully, it requires signifi-cant international efforts. 118 As for Indonesia, one possible way would be to bring it forward through the ASEAN level.

IV CONCLUSION

Recent international surveys have shown that transfer pricing issues are considered fundamental by most respondents. Transfer pricing is defined as the pricing policies and practices that are established when physical goods, intangible properties, and services are

117 Ibid, 855-7. 118 Célestin, above n 56, 303.


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charged between business units within a group. Within an MNE, transfer prices take several forms: payments of goods, trade credits, equity contribution, dividend payments, loans, interests, fees for intangible property, fees for specific divisible services, and overhead costs. Originally carrying a neutral meaning, transfer pricing is often perceived negatively as it induces an idea of profit diversion.

The OECD transfer pricing guidelines plays a significant role in this matter which is based on the arm’s length principle. These guidelines introduce several methods in analysing related-party transactions. Broadly, these methods can be grouped into the traditional transactional methods (CUP, RPM, and CPM) and transactional profit method (PSM and TNMM). The OECD expresses its preference on the first group.

Increasingly adopted as the de facto standard, the arm’s length principle is not without weaknesses. The main flaw is that it ignores the synergistic effects within an MNE. In addition, it relies heavily on comparable transactions. As long as the comparable are available, the arm’s length principle can result in an unbiased and precise standard. However, finding such comparables is often difficult. Moreover, the application of the RPM and the CPM tend to produce one-sided solutions as they allocate risks (profits or losses) on the hand of the purchaser (the RPM) or the supplier (the CPM).

Analysing transfer pricing provisions in income tax legislation generally involves a discussion of a number of factors: the taxpayers, the transactions, the fair price determination, the price or transaction adjustments, certainty and flexibility issues, and the compliance requirements. In addition, there may other factors to be considered including the transfer price

tests, risk assessment, and its application in banking and financial industry. A number of proposed suggestions include a wider definition of related-party transaction, reducing ‘grey area’ that may be subject to multiple interpretations, and a penalty reduction to increase taxpayers’ compliance. It is also suggested that the DGT introduces its approach on transfer pricing audits to gives taxpayers more certainty and knowledge on what to expect in the event of such audits. Additionally, a guideline that enables taxpayers to assess their own situations in relation to a transfer-pricing audit risk may be necessary.

In cases where comparables are unavailable, it has been shown that the traditional arm’s length methods may not apply. In this case, it is argued that other methods should be applied. The Australian Commissioner of Taxation chooses to approach such transactions using profit based method or other indirect arm’s length methods, even though he asserts his preference over the traditional arm’s length methodologies. By contrast, the Indonesian approach is unclear. However, the elucidation of Article 18(3) opens a possibility to use methods other that the traditional approaches. In such situations, the formulary apportionment method or cost-based method can be considered.

In conclusion, while transfer-pricing regulations are clearly not new for Indonesia, it is the view of this paper that Indonesia could still benefit from more detailed regulations as evidenced by the Australia’s approach to transfer pricing rules and guidelines. After all – according to an Indonesian economist, Faisal Basri – ‘[t]he devil is in the details…’.119

119 Hudiono, above n 89.


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BIBLIOGRAPHY

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Documents

2.Kristian Agung Prasetyo