This article has been published in 6th Edition of Gagas Pajak Magazine
The term arm's length principle (ALP) is closely related to our understanding of transfer pricing, related party or associated enterprises, and tax avoidance. All these terms can be found in Article 18 paragraph (3) Indonesian Income Tax Law which is one of our anti tax avoidance rule.
The provision affirms that the Director General of Taxes is authorized to re-determine income and expenses as well as determine taxpayer debt as capital to calculate the taxable income for taxpayers who have affiliation with any other taxpayer in accordance with ALP which are not influenced by a related or associated parties relation with using the comparable uncontrolled price method, the resale price method, the cost-plus method or other methods.
As stated in the explanation, the purpose of this provision is to prevent tax avoidance, which can occur because of a related party transaction. If affiliate transactions exist, there is the possibility where taxpayer set the transaction price to minimize taxable income. For that reason, Income Tax Law makes Director General of Taxes to be authorized to re-determine income and expenses as if there is no related parties relation among taxpayers.
To implement the provisions of Article 18 paragraph (3) of Income Tax Law, the Director General of Taxes has issued a Director General of Taxes Regulation Number PER-43/PJ/2010 concerning the Application of Arm’s Length Principle Between Taxpayers With Related Parties Relation as amended by Director General of Taxes Regulation Number PER-32/PJ/2011.
Arm’s Lenght Principle and Related Party
That regulation give us understanding about the ALP as a principle which states that if the conditions in transactions between the associated parties are equal or comparable to the conditions in transactions between no associated parties relations as the comparables, then the price or profit in a related parties transactions must be equal to or be in the range of prices or profits in transactions carried out between the parties that have no related parties relation. This provision is in line with on the norms that the price or profit on transactions with no related parties relation are determined by market forces, so that the transaction reflects the fair market value.
Why is ALP adopted widely in transfer pricing issue? Based on OECD Transfer Pricing Guidelines, major reasons is that the ALP provided broad parity of tax treatment for members of MNE’s groups and independent enterprises. The ALP puts the associated and independent enterprises on a more equal footing for tax purposes, it avoids the creation of tax advantage or disadvantage that would otherwise distort the relative competitive positions of either type of entity.
So, we can understand that the application of the ALP can be applied to the transaction between taxpayers or parties who in associated party relationship. In other words, if the transaction is conduct by parties who are not in associated party relation, ALP does not need to be applied.
Well, the understanding of related or associated party relation is provided in Article 18 paragraph (4) of Income Tax Law and Article 2 paragraph (2) of VAT Law 1984. Base on Article 18 paragraph (4) of Income Tax Law, the related or associated party relation is deemed to exist if meets next condition:
a. a Taxpayer who owns directly or indirectly at least 25% of equity of the other Taxpayers or a relationship between Taxpayers through ownership of at least 25% of equity of two or more Taxpayers, as well as relationship between two or more Taxpayers concerned.
b. a Taxpayer who controls other Taxpayers or two or more Taxpayers are directly or indirectly under the same control.
c. a family relationship either through blood or through marriage within one degree of direct or indirect lineage.
However, the associated party term should be referred to tax treaty if there is no same meanings of related party between Indonesia and treaty partner country in case the other party is resident of our treaty partner. In Article 9 of OECD Tax Convention Model, associated enterprises arise where:
a. an enterprise of a Contracting State participate directly or indirectly in the management, control, or capital of an enterprise of the other Contracting State, or
b. the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and enterprise of the other Contracting State
and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profit which would, but for those conditions, have accrued to one of the enterprises, but, by reasons of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
Obligation to Conduct ALP
Taxpayers who conduct transactions above with other party who has related party relation obliged to apply the ALP by doing the following steps:
1. conducting comparability analysis and determine the comparables;
2. determining the appropriate transfer pricing method;
3. applying ALP based on comparability analysis and transfer pricing methods appropriate to the transaction made between taxpayers with related parties; and
4. documenting every step in determining the arm’s length price or profit in accordance with the tax regulations.
However, Taxpayers who have transactions with related parties with the entire transaction value does not exceed Rp10.000.000.000 (ten billion rupiahs) in 1 (one) tax year for each opponent transaction, are exempt from the obligation of applying ALP.
What is meant by comparability analysis is the analysis conducted by the taxpayer or the Directorate General of Taxes on the conditions in transactions between the taxpayer with the related parties which have to be compared with conditions in transactions between parties who do not have the related party relationship, and the identification of different conditions in both types of transaction above.
Meanwhile, transfer pricing is the determining prices in transactions between parties who have a related party relationship. Taxpayers should determine the appropriate method of determining transfer price for transactions conducted with related parties. There are several transfer pricing methods provided in this PER-43/PJ/2010 and amendment, namely:
a. Comparable Uncontrolled Price (CUP) Method. This method of transfer pricing is done by comparing prices in transactions between parties who have a related party relationship with the price in a transaction that is conducted between parties who do not have related parties relationship in comparable conditions or circumstances.
b. Resale Price Method (RPM). This method of transfer pricing is done by comparing the price of a product in a transaction conducted between related parties with the resale price of the product after deducting the reasonable gross profit, which reflects the function, assets and risks, on the resale of such products to others who do not have related parties relationship or resale of products made in fair condition.
c. Cost-Plus Method (CPM). This method of transfer pricing is done by adding a reasonable gross profit rate earned by a company from transactions with no related parties or a reasonable level of gross profit earned by another company of comparable transactions with no related parties in the arm’s length cost of goods sold.
d. Profit Split Method (PSM). This method of transfer pricing is based on transactional profit which is done by identifying the combined income of affiliate transactions that will be shared by the parties that have a related party relationship by using an acceptable economic basis that gives a proper estimate of profit distribution and can be reflected in the agreement between the parties that do not have related party relation.
e. Transactional Net Margin Method (TNMM). This is a method of transfer pricing that is done by comparing the percentage of operating net income to costs, sales, assets, or to any other basis for transactions between related parties with percentage of net operating income earned on comparable transactions with other parties who have no related party relation or a percentage of net operating income earned on comparable transactions undertaken by parties who have no related party relation.
According to PER-43/PJ/2010, the application of these methods is not an option but should be done hierarchically (hierarchy of method). Firstly begins by applying Comparable Uncontrolled Price (CUP) Method in accordance with appropriate conditions. If the CUP method is not appropriate to be applied, it shall apply the Resale Price Method (RPM) or Cost-Plus Method (CPM) in accordance with the appropriate conditions. If RPM or CPM is not appropriate to apply, Profit Split Method (PSM) or the Transactional Net Margin Method (TNMM) can be applied.
Well,Director General of Taxes Regulation No. PER-32/PJ/2011 corrected the usage of this method and replaced it with The Most Appropriate Method. Thus, taxpayers do not need to try each method of transfer pricing in a hierarchical manner, but directly using the most appropriate method according to appropriate conditions.
This change is actually in line with changes in the OECD Transfer Pricing Guidelines. Yes, the OECD through OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration July 2010 had indeed left the hierarchy of methods and switch to using the most appropriate method.
The practice of transfer pricing in Multinational Enterprisis (MNE’s) can potentially lower our tax revenues. Companies that operate globally with related party relationship can lower taxable income in Indonesia. To prevent this matter, Indonesia has actually had anti tax avoidance provisions related to transfer pricing in Article 18 paragraph (3) Income Tax Law. Its implementation is the Director General of Taxes Regulation No. PER-43/PJ/2010 as amended by PER-31/PJ/2011.
This regulation oblige taxpayers who doing transaction with related parties to apply the arm’s length principles by conducting comparability analysis and determine the comparables, determining the appropriate transfer pricing method, applying the arm’s length principles based on comparability analysis and transfer pricing method, and documenting every step in determining the arm’s length price or profit.
Law of The Republic of Indonesia Number 7 of 1983 concerning Income Tax as Lastly Amended Law Number 36 of 2008
Director General of Taxes Regulation Number PER-43/PJ/2010 concerning the Application of Arm’s Length Principle Between Taxpayers With Related Party Relation as amended by Director General of Taxes Regulation Number PER-32/PJ/2011
OECD Model Tax Convention on Income and on Capital, Condensed Version, 17 July 2008
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 22 July 2010