Wednesday, March 12, 2014

Transfer Pricing - Arm's Length Profit for Corporate Spin-off in Indonesia

A case of an automotive company brought to the Indonesian Tax Court has raised questions about the possibility to use arm's length principle for corporate spin-off or generally for business restructuring. In this case, tax authority has challenged the arm's length profit of a company after the spin-off of a certain business unit as part of the domestic business restructuring of the Indonesian company.

The company, let's call it A Corp., has been audited by Directorate General of Taxation (DGT) and during the audit the tax authority found that the company's profit after the spin-off has decreased with the following facts:
-a division was spun off from its previous company, X Corp, and became a separate entity, a new company, A Corp.
-After the new company, A Corp., was established, it was later found out that the X Corp's gross margin has decreased significantly and even if the gross margins of the A Corp and X Corp are combined, the overall gross margin is even still lower before the spin-off. 
-The tax authority challenged it and raised questions about the arm's length profit. Tax authority also believes that it might be due to royalty and non arm's length purchase price.
-DGT is of opinion that spin-off should not lower the gross margin before the spin-off. DGT compares A Corp.'s  gross margin  with competitor's gross margin and decides that A Corp.'s gross margin is lower. 
-A Corp has related party transactions with its related entity in Indonesia and other country.
-The transfer price, which is allegedly not arm's length, will be able to avoid higher indirect tax i.e. VAT. It is noted, based on the audit, that A Corp has sold its manufactured products to its related parties, in Indonesia and abroad, below the arm's length price to decrease the profit.

Having seen the facts above mentioned, we are likely to conclude that DGT is pursuing arm's length profit before and after the business restructuring.

After hearing process, the Tax Court has to decide on this case and after the decision is made, the taxpayer is still able to pursue judicial review from the Supreme Court.  

Looking at the facts, some questions need to be answered.  

Since domestic related party transactions also take place between related parties in Indonesia, does the domestic transfer pricing rule apply? Pursuant to DGT Regulation No. PER- 32/PJ/2011 about arm's length principle, it is stated on Art.2 that domestic transfer pricing rule applies on (i) certain business sector whose final and non final income tax is applied, (ii) sales tax on luxury goods, and (iii) production sharing contract for oil and gas.  Further, it is stated in the DGT Regulation No. PER-22/PJ/2013 about transfer pricing audit guide which states that domestic transactions could be used for profit shifting due to differences of tax rate between domestic companies.

The basis for transfer pricing rule is Art. 18(3) of Income Tax Law which mentions that DGT has the authority to re-determine the amount of incomes and reduction as well as to re-determine debts as capital to calculate the amount of taxable incomes for taxpayer possessing special relation with other taxpayer in accordance with equity and common practice of business that is not influenced by a special relation by means of price ratio method among independent party, re-sale price method, costs-plus method, or other methods. 
Also based on the elucidation, there is no wording which is likely to say that spin-off should be part of transfer pricing rule.

This off-the-beaten-path case reminds me of other case inIndia which has made many people wonder about the use of transfer pricing rule for share issuance.

The author has no information on how the Tax Court decided on this case but this story has been reported on a national daily newspaper last year. 

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