The Sojourn of the Arm’s Length Principle

Jakarta, Ideatax -- In 2009, a professor from Michigan University, Reuven Avi-Yonah, wrote a law journal entitled "The Rise and Fall of Arm’s Length: A Study in the Evolution of US International Taxation." In the journal, Yonah wrote that the history of the Arm’s Length Principle in America began in 1988. At that time, the US Treasury Department published a study in the "White Paper," one of which contained the application of the Arm’s Length Principle (ALP) to assess transactions between parties that have a privileged relationship for tax purposes.

 

In its development, the US used the ALP prototype in its double taxation avoidance treaties. ALP is adopted in the US and UN Tax Treaty Models. However, along with the times, Yonah identified several weaknesses in the arm's length principle. First, it is often difficult to find comparable companies in terms of: function, assets, and risks. It is because technological developments allow companies to carry out their activities uniquely and differently from other companies. Second, parent companies that transfer property to their subsidiaries face different risks from unrelated parties. Another opinion states that the arm’s-length principle may be too complex to apply due to rapid and massive changes in business models.

 

The Indonesian government is keen to realize the weaknesses of the ALP. Therefore, at the end of 2023, the government issued Minister of Finance Regulation No. 172 of 2023 on the Arm's Length Principle application in transactions affected by privileged relationships. This provision also amends and updates several other regulations, including Minister of Finance Regulation Number 49 of 2019 concerning Procedures for Implementing Mutual Agreement Procedures, Minister of Finance Regulation Number 22 of 2020 concerning Procedures for Implementing Transfer Price Agreements, and Director General of Taxes Regulation Number 31 of 2011 concerning Amendments to Director General of Taxes Regulation Number PER-43/PJ/2010 concerning the Application of Arm’s Length Principle in Transactions Between Taxpayers and Parties with Privileged Relationships.

 

Through this regulation, the government regulates that the arm's length principle is a principle that applies to fair business practices and is applied as an independent transaction. In terms of a privileged relationship, this provision stipulates that three causes result in a privileged relationship:

1. A privileged relationship due to ownership or equity participation.
2. A privileged relationship due to control.
3. Privileged relations due to blood or consanguineous family relationships.

 

A privileged relationship due to ownership or equity participation is deemed to exist if the taxpayer has a direct or indirect investment of at least 25%. In addition, a privileged relationship is also deemed to exist if there is a taxpayer's investment of at least 25% in two or more taxpayers.

 

Furthermore, this provision also stipulates that a privileged relationship due to control occurs because one party controls the other party directly or indirectly, two parties are under the same control, one party controls the other party through control of management or technology, the same person is directly or indirectly involved in or participates in making managerial decisions, those who are commercially or financially known declare themselves to be in the same business group, and one party declares itself to have a privileged relationship with the other party. Meanwhile, a privileged relationship due to a family relationship is deemed to occur if there is a family relationship either by blood or by consanguinity in a straight line of descent to the side of one degree.

 

There are six key steps to be taken by taxpayers to ensure that the Arm's Length Principle has been applied:

1. Identify transactions that are affected by the privileged relationship.
2. Analyze the industry related to the business being run.
3. Identify commercial relationships between taxpayers and affiliates.
4. Conduct a comparability analysis.
5. Determine the transfer pricing method.
6. Apply the transfer pricing method.

 

To find out whether transactions are affected by privileged relationships, who are the parties involved in privileged relationship transactions, and what form of privileged relationship occurs, it is necessary to identify transactions affected by privileged relationships. Meanwhile, industry analysis is conducted to identify the following factors:

1. The type of product in the form of goods and services.
2. Industry and market characteristics, market segmentation, cycle, technology, and so on.
3. Competitors and the level of business competition.
4. The level of efficiency and location advantages of taxpayers.
5. There are economic conditions that affect business performance in the industry.
6. Regulations that affect or determine the success of the industry.

 

An analysis of transaction conditions is conducted to determine relevant economic characteristics such as contractual provisions, functions performed, assets used, risks assumed, characteristics of products transacted, economic conditions, and business strategies implemented.

 

Comparability analysis, as referred to in PMK 172 of 2023, is conducted to understand the characteristics of transactions affected by privileged relationships, identify the existence of independent transactions, determine the tested party, identify differences in conditions between the tested party and the party affected by the privileged relationship, make accurate adjustments, and determine the independent transactions that occur.

In the previous regulation, transfer pricing analysis in Indonesia only recognized five methods:

1. Comparable Uncontrollable Method (CUM),
2. Resale Price Method (RPM),
3. Cost Plus Method (CPM),
4. Profit Split Method (PSM), and
5. Transactional Net Margin Method (TNMM)

In the latest regulation, there are eight transfer pricing methods recognized:

1. Comparable Uncontrollable Method (CUM),
2. Resale Price Method (RPM),
3. Cost Plus Method (CPM),
4. Profit Split Method (PSM),
5. Transactional Net Margin Method (TNMM),
6. Comparable Uncontrolled Transaction Method (CUTM),
7. Tangible asset and intangible asset valuation, and
8. Business valuation.

 

However, the number of transfer pricing methods known and used by transactions can trigger uncertainty and differences in perceptions between tax authorities and taxpayers. Therefore, further arrangements are needed to minimize disputes and differences in interpretation between taxpayers and tax authorities.

 

In simple terms, the regulation of arm's length transactions in PMK 172 of 2023 can be seen in the following table:

Pokok Pengaturan	Pengaturan Baru	Pengaturan Sebelumnya
Arm’s Length Principle	There is no difference in the arm's length principle application for domestic transfer pricing and cross-border transfer pricing.	Similar
	Corresponding adjustment for domestic TP	Not regulated
Corresponding Adjustment for TP Domestic	SKP must be approved and no legal action taken; initiated by the counterparty taxpayer; Implemented through mechanisms: correction of annual tax returns, disclosure of untruths, and correction of SKP.	Not regulated
Secondary Adjustment	Secondary adjustment arises in the event of SKP or correction of the taxpayer's tax return; Secondary adjustment is considered non-existent in the event that the taxpayer makes a return or addition of funds and/or agrees to the SKP.	Not regulated
Value-added tax	The arm’s-length principle only applies to the sale or replacement price that is suppressed lower than the fair market price; Not a tax credit for the counterparty.	Not regulated
Transfer Pricing Documentation	TP Doc must be fulfilled by the taxpayer no later than one month since the request is submitted in the context of supervision or audit.	Not regulated
	Taxpayers are required to CbCR with a threshold of $11 trillion based on the tax year before the reporting year.	The 11 trillion threshold only applies to the relevant tax year.
Mutual Agreement Procedures	The Underpayment Assessment Letter becomes the basis for collection and refund at MAP.	MAP Decree followed up with correction of Article 16 of KUP Law
	STP takes into account the tax amount in SKPKB.	Not regulated
Advance Pricing Agreement (APA)	MoF Regulation 172, Year 2023, regulates multilateral APA with several tax jurisdictions; PMK 172 of 2023 also regulates the elimination of STP sanctions for the APA retroactive implementation.	Not regulated

 

This is an article about the Arm’s Length Principle application prevalence applicable in Indonesia. Although the principle has been applied for more than three decades and is seen as a principle that is approaching its demise, the taxation authority in Indonesia can update the principle to adjust to business and technological developments.

 

Related provisions

Law No. 7 of 1983 on Income Tax as last amended by Law No. 7 of 2021 on Harmonization of Tax Regulations.

Law No. 8 of 1983 on Value Added Tax and Sales Tax on Luxury Goods as last amended by Law No. 7 of 2021 on Harmonization of Tax Regulations.

Minister of Finance Regulation No. 172 of 2023 on the Application of the Arm’s Length Principle in Transactions Affected by Privileged Relationships.

Minister of Finance Regulation Number 49 of 2019 concerning Procedures for Implementing Mutual Approval Procedures;

Minister of Finance Regulation Number 22 of 2020 concerning Procedures for Implementing Transfer Price Agreements;

Director General of Taxes Regulation No. 31 of 2011 on the Amendment to Director General of Taxes Regulation No. PER-43/PJ/2010 on the Application of Arm’s Length Principle in Transactions between Taxpayers and Parties with Privileged Relationships.