Transfer pricing is a neutral concept. It refers to the pricing of transactions involving goods, services, intangible assets, or financial arrangements between related parties within the same corporate group.
The practice is inherent in multinational business operations. According to Rugman’s internalization theory, multinational enterprises may bring certain market functions within their corporate structures to reduce transaction costs and uncertainties associated with operating in the open market.
In an open market, companies face various external costs, including those associated with obtaining information, ensuring supply quality, and protecting innovation. To reduce these costs and risks, companies may adopt vertical integration, horizontal integration, or conglomerate structures.
Within these structures, transactions may occur between entities within the same corporate group. The prices applied to such intercompany transactions are known as transfer prices. Transfer pricing is therefore a legitimate business mechanism for setting prices and allocating resources within a corporate group.
Under-Invoicing
Concerns arise when profits or trade information are manipulated. This is why transfer pricing should not be confused with under-invoicing.
Under-invoicing, a form of trade misinvoicing, involves manipulating information in trade documents. For instance, the value, quantity, or specifications of goods may be deliberately misreported so that the transaction value stated in the documents is lower than the actual value.
The distinction therefore lies in what is being determined or manipulated. Transfer pricing concerns how related parties set transaction prices. Under-invoicing, by contrast, involves falsifying or manipulating information reported in trade documents.
The Arm's Length Principle
Related-party transactions are still often perceived as occupying a regulatory grey area. However, transfer pricing is a legitimate business practice as long as it complies with the arm’s length principle (ALP).
Tax risks arise when taxpayers exploit weaknesses in comparability analyses or select transfer pricing methods without sufficient economic justification in an attempt to reduce their tax liabilities.
Indonesia’s transfer pricing legal certainty was anchored by Minister of Finance Regulation (Peraturan Menteri Keuangan/PMK) Number 172 of 2023 (172/PMK.03/2023) concerning the Application of the Arm's Length Principle in Transactions Affected by Related Parties. The regulation revokes and consolidates provisions previously contained in PMK Number 213 of 2016, PMK Number 49 of 2019, and PMK 22 of 2020, while further aligning Indonesia’s rules with the Organisation for Economic Co-operation and Development (OECD) guidelines.
PMK Number 172/PMK.03/2023 requires taxpayers to apply the ALP using an ex-ante approach, meaning that the arm’s length nature of the price must be determined and documented before or at the time the transaction takes place. The regulation also broadens the definition of related parties and provides for corresponding adjustments in domestic transactions. Such a mechanism is intended to prevent double taxation when the tax authority adjusts one party to a transaction.
For certain complex related-party transactions, taxpayers must also conduct a preliminary stage. This requirement applies, among others, to service transactions, the use of intangible assets, loans, business restructurings, and cost contribution arrangements (CCAs). Taxpayers must establish the transaction's commercial rationale and economic benefits before assessing whether the pricing is at arm’s length.
Ensuring Client Compliance
For tax consultants, assisting clients with transfer pricing goes beyond fulfilling administrative requirements. Consultants should also guarantee that transactions have a clear economic rationale, comply with applicable tax regulations, and are supported by adequate documentation.
Several areas require particular attention. First, meeting transfer pricing documentation (TP Doc) requirements. Consultants should ensure that clients meeting the criteria and thresholds under PMK Number 172/PMK.03/2023 prepare their TP Doc completely and within the required timeframe.
The documentation comprises:
1. Local File, containing information on related-party transactions, comparability analyses, and arm’s length assessments for each type of transaction.
2. Master File, providing an overview of the group’s global organizational structure and business activities, ownership of intangible assets, and financing arrangements.
3. Country-by-Country Report (CbCR), presenting information on the allocation of income, profits, and taxes paid by group entities across jurisdictions.
Comprehensive documentation helps taxpayers demonstrate the basis for their pricing and their application of the ALP if the Directorate General of Taxes (DGT) audits their transactions.
Second, adopt an ex-ante approach (price setting). Consultants should encourage management to establish transfer pricing policies before transactions rather than justifying them only after the fact. One crucial requirement under PMK Number 172/PMK.03/2023 is applying an ex-ante approach to transfer pricing.
Article 17(1) of PMK Number 172/PMK.03/2023 requires a TP Doc to be prepared using data and information available when the related-party transaction takes place. This rule is consistent with paragraph 5.27 of the OECD Transfer Pricing Guidelines 2022, which emphasizes assessing the arm’s length based on information available when the transaction is undertaken.
In the past, taxpayers might have set transfer prices without sufficient analysis and assessed their arm’s length nature only after the fiscal year had ended by searching for comparable data (price testing). This approach no longer meets the requirements under PMK Number 172/PMK.03/2023.
Taxpayers must demonstrate that they established their transfer prices based on the analysis and data available at the time of the transactions. Otherwise, their TP Doc may be considered non-compliant, potentially allowing the DGT to determine the tax payable under its statutory authority and impose administrative penalties under prevailing regulations.
Third, establishing the economic substance of transactions. Complete documentation alone is insufficient if the underlying transaction's economic substance does not support it. Consultants should assess whether a transaction actually took place and whether it provided an economic benefit to the paying party.
For instance, in a management fee arrangement, a taxpayer should demonstrate that the services were actually provided, delivered a benefit to the recipient, and were priced consistently with the value of comparable services under market conditions. Assessing economic substance should therefore be an integral part of the compliance process, instead of merely a supporting exercise for documentation.
Fourth, assessing the commercial rationale of corporate structures. Consultants should also evaluate whether a company’s structure and its transactions with overseas related parties have a clear business rationale.
Using an entity located in a low-tax jurisdiction does not, by itself, constitute a violation. The risk increases, however, when the entity lacks sufficient economic activity and is primarily used to shift profits.
Consultants should identify such structures and transactions early and clearly communicate the associated risks to clients. The Automatic Exchange of Information (AEOI) also enhances tax authorities’ ability to obtain information about taxpayers’ overseas activities and assets.
Compliance From the Outset
Transfer pricing is a legitimate part of doing business. Problems arise when transfer prices are not established in accordance with the ALP, are used to shift profits artificially, or are accompanied by manipulation of trade documents, such as under-invoicing.
PMK Number 172/PMK.03/2023 provides a framework for taxpayers to apply the ALP and document related-party transactions appropriately. Compliance should not begin only after a transaction occurs. Taxpayers need to establish their transfer pricing policies based on the relevant economic circumstances and maintain appropriate documentation from the outset.
For tax consultants, the primary role is not to find regulatory loopholes, but to help clients establish defensible transfer pricing governance, which includes maintaining adequate documentation, applying an ex-ante approach, assessing economic substance, and evaluating the commercial rationale behind transaction structures.
By taking this approach, companies can reduce the risk of tax adjustments and ensure that related-party transactions comply with the ALP and applicable regulations. If you need help with transfer pricing and tax compliance, Ideatax can provide solutions tailored to your business needs while ensuring compliance with prevailing tax regulations.
Legal Basis
- Minister of Finance Regulation Number 172 of 2023 concerning the Application of the Arm's Length Principle in Transactions Affected by Related Parties
- OECD Transfer Pricing Guidelines 2022
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