The COVID-19 pandemic has caused significant business disruption around the world, cutting across industries and sectors. Indonesia, the largest economy in Southeast Asia, is not spared of the economic downturn. With a slowdown in economic activity, the Organization for Economic Co-operation and Development (OECD) predicts that in a worst case scenario Indonesia’s gross domestic product may contract by 3.9% in 2020. The Indonesian government enacted wide-ranging policies to protect people and businesses, including a strengthened healthcare system and social safety net, tax cuts and incentives, various capital injections and financing subsidies as part of an approximately $50 billion stimulus package (as of June 2020).
While the incentives announced are timely and much-needed, the consequence of the fiscal measures in these incentive packages will inevitably result in a ballooning of the Indonesian budget deficit. It is therefore likely that the government will be looking at controlling the expanded budget deficit by increasing its revenue sources, which may include, among other things, intense scrutiny and enforcement of tax compliances, especially with regard to cross-border transfer pricing arrangements.
What Indonesian taxpayers should expect
While the economic disruptions are set to negatively impact the year-end profit and loss outcome of local subsidiaries, losses and lower-than-usual profits could be a critical issue that businesses may need to address, especially for financial year 2020. The factors contributing to this could be manifold – funding/liquidity crises, supply chain disruptions resulting in higher costs, lower demand and sales, idle capacity and lockdown costs and excess inventory, to name a few. With the impact varying significantly across industries and sectors there are two commonly asked questions by multinational groups with a business presence in Indonesia:
- How will these losses be viewed by the Indonesian Directorate General of Taxes (DGT) from a transfer pricing perspective?
- What precautions will multinationals need to take to avoid potential transfer pricing challenges?
In an emerging market economy like Indonesia, where the profitability level of the company is one of the major considerations of the DGT while examining the arm’s length pricing of related party transactions, a decrease in the profitability could likely invite detailed scrutiny. While it is expected that the DGT would take cognizance of the economic situation while examining profitability in a transfer pricing context, it would be precarious to assume that the DGT would accept the generic arguments of economic downturn for significant variations in profit margins. In all likelihood, the DGT would be interested to know the specific areas of a taxpayer’s business impacted by the economic downturn, and the way that impact translates into financial (under)performance. The onus is on the taxpayer to explain and demonstrate with evidence.
The paragraphs below discuss some of the aspects that are generally examined by the DGT in a transfer pricing audit and which are likely to undergo even more detailed scrutiny in this current situation.
- Business facts: Discussions centered on the business situation, industry-specific economic circumstances, the functions and risks analysis and the contractual terms are expected to be at the forefront of the discussions. Evidently, the degree to which the businesses will be impacted will vary depending on the industry (e.g. hospitality vs FMCG), supply chain (e.g. global vs local) and the business model (e.g. online vs offline).
- Impact at group level: It would be important to review and explain how COVID-19 has impacted the group at large – the overall supply chain, group level financials, and the group’s (or parent/principal entity’s) third party buy and sell contracts. The DGT will likely examine how these changes cascaded onto the Indonesian subsidiary. The DGT has been increasingly making use of the exchange of information framework and other resources to obtain financial, qualitative and supply chain information about group companies.
- Limited risk structures: For limited risk entities, an important question that will need to be addressed is whether these entities should continue to earn a stable and assured profit for their routine functions, or whether they should shoulder the losses suffered by the group. Any drop in the profitability of limited risk entities would need to be carefully analyzed in light of the specific business facts, allocation matrix for functions and risks, the pre-COVID-19 arrangement, as well as the contractual terms.
- Business restructuring: While multinationals reorganize their business operations to adapt to the circumstances, it would be important to consider whether such reorganizations, right-sizing and renegotiations would constitute business restructuring that may warrant an exit charge or indemnification.
- Advance Pricing Agreements (APAs): Indonesia has an APA program in place since 2010, with the most recent regulation being issued in March 2020. Taxpayers who have signed APAs are required to prepare certain documentation on an annual basis to explain their compliance with the APA terms. It is important for such taxpayers to evaluate whether they would be able to achieve the agreed profitability during these times. If it is found to be untenable, initiating a review of the APA should be considered as early as possible to avoid potential corrections. Under the Indonesian APA regulations, a review of the APA could potentially be invoked if there are changes to the critical assumptions (which generally include assumption of stable business environment).
- Financing and liquidity: There has been an increasing focus of the DGT on intercompany financing arrangements and it will likely deepen amid the falling market interest rates. Taxpayers may need to revisit their financing arrangements to ensure they reflect current market conditions and that the costs Indonesian subsidiaries pay for financing is arm’s length.
What Indonesian taxpayers should do to be prepared
This section puts together some of the action steps taxpayers could consider to prepare for a transfer pricing audit.
- Revisit the transfer pricing arrangements and agreements: Taxpayers may need torevisit their intercompany pricing policies and agreements to realign with current market conditions. The key here would be to evaluate how third parties would respond in similar circumstances. This may lead to a renegotiation of the remuneration model and the intercompany agreements. In addition, contracting entities may look to invoke the force majeure clauses in the agreements, while bearing in mind the financial impact for the parties, the legal aspects, as well as potential responses from tax authorities in the case of an audit.
- Strong defense file: Building up a robust defense file consisting of tangible and demonstrable facts is an essential strategy anticipating a tax examination. Specific qualitative and quantitative analysis, supported by relevant documentary evidence, could help to a great extent. Taxpayers should identify and delineate the specific areas of business affected by the pandemic and the impact it has on financial statements.
- Ex-ante analysis: Indonesian transfer pricing regulations emphasize on the use of ex-ante approach, i.e. use of the data and information available at the time the intercompany transactions are entered into. As a corollary, testing the transfer pricing policies and budgets, coupled with documenting the reasons for the deviation of actual results from budgets, should be an acceptable approach from a technical standpoint. This could be further complemented by undertaking statistical analyses, such as simple regression or Monte Carlo simulations, to extrapolate the inter-quartile range of the comparable companies. It is well advised for taxpayers to start building the supporting documentation now “contemporaneously” rather than waiting until the statutory deadline for preparation of transfer pricing documentation.
- Tailor the documentation approach: A robust transfer pricing documentation will be the first line of defense when it comes to a transfer pricing audit. In situations where testing the transfer pricing policies is not feasible, economic adjustments may need to be considered to arrive at the real “operating” profits isolating the impact of the pandemic. This could include, for instance, adjustments for capacity underutilization, working capital, losses due to foreign exchange fluctuations and lockdown and other extraordinary costs, to name a few. Other viable options may include:
- Use of multiple year tested party results and comparison with historical profits;
- tailoring the benchmarking analysis by relaxing certain screening criteria;
- a transaction-by-transaction approach as against an aggregation approach which tests the company’s entity-level profitability; or,
- re-evaluation of the TP method used if the impact of COVID-19 is significant.
These are only few examples of the several possible strategies that could be considered for transfer pricing documentation.
- Controversy management options: While taxpayersprepare for the tax audit, they should also carefully evaluate their controversy management strategies. The domestic appeal route is always on the table; however it comes with a drawback of a prolonged timeframe and the tendency of the DGT to litigate until the Supreme Court level. To achieve certainty around transfer pricing matters in these disruptive times an APA, which is forward-looking and time and cost efficient, could prove to be more useful. A recently issued new APA regulation strengthened the overall APA framework in Indonesia, making it an even more attractive controversy management tool for taxpayers. Taxpayers may also explore the Mutual Agreement Procedure (MAP) to seek relief from double taxation, especially since the prevailing regulation allows taxpayers to pursue MAPs in parallel with the domestic dispute process.
While this pandemic situation has triggered several questions on the transfer pricing front, it has to be reckoned that the fundamental transfer pricing principles do not change and the consideration as to how independent parties would transact/react in similar circumstances should always be at the core of any analysis. There is no ‘one-size-fits-all’ defense strategy and it will have to be tailored to the specific facts. However, it is very important that taxpayers carefully weigh their options and maintain a balance between their past positions, present approach and the impact for years ahead.