Awareness needed to deal with transfer pricing

The Jakarta Post ,  Jakarta   |  Thu, 08/02/2007 12:26 PM  |  Opinion

Pahala Nainggolan, Jakarta

Foreign Direct Investment (FDI) does not always bring more tax revenue. FDI in labor-intensive industries such as garment and shoe making often utilizes transfer pricing to avoid tax.

Owners rent factories and facilities, while working capital is funded by loans from local banks, guaranteed by their parent companies overseas. Raw materials are imported from other affiliated companies. They enjoy duty and tax exemptions for their export-oriented products. Employees are paid at minimum salary levels, thus tax free since their salary levels are lower than the minimum taxable income.

Products are exported to another affiliated company overseas while the revenue is only enough to cover raw materials and labor costs. No business profits or their books suffer losses every year.

Transfer pricing is managed by setting the prices in advance at a worldwide level by charging a higher imported raw material cost, or setting the exported product price low. Another way is to charge affiliate companies in Indonesia for royalties, management fees or other associated levies.

The current income tax law has no details about transfer pricing. It only mentions, when a special relationship between two or more companies is detected, that prices set for purchasing and selling activities must refer to a fair or market price. The organization of Economic Cooperation and Development (OECD) called these ""arm's length transactions"", where companies set their product price as is determined by non-affiliated or independent companies. The problem is, how much is that arm's-length price?

The director general of tax in 1993 decided to apply the Advance Pricing Agreement (APA) to regulate transfer pricing practices. The main idea was to let government and companies set an agreed price in advance for the input and output of the process. When the fiscal year ended, companies were to file their tax returns based on revenue and expenses prepared using unit prices agreed in the APA.

Unfortunately, this decree had no technical details as guidance for implementation. The APA has never been realized and transfer pricing became unregulated. It seems that the directorate general of taxation does not see this as an urgent and serious matter to be resolved soon. Even worse, in the bill on income tax currently under deliberation at the House of Representatives law transfer pricing seems to have been completely ignored. Both government and parliament feel that the existing regulation is adequate.

A survey of the executives of multinational companies in 1999 showed that 60 of the respondents regarded transfer pricing an important thing in running their worldwide business. More than 80 percent of U.S companies' operations were linked with affiliated companies in other countries.

For them when they run a business in a country where transfer pricing regulations do not exist, the business risk in that country is higher. The absence of a detailed regulation on determining a fair arm's length price will increase the possibilities of tax officials abusing their power by imposing an unrealistic price.

When it happens, then they have to waste their resources dealing with the problem. At least they have to allocate time, human resources and funds to go through a tax audit process including the submission of objections and appeals to the tax court.

On the other hand, the absence of a detailed regulation could also be exploited for their benefit. Tax avoidance can be done by the arrangement of prices among affiliates worldwide. Tax auditors can detect this practice but imposing a tax penalty is not an easy job due to the absence of fair reference prices for various products and services.

Especially in those countries where corruption is widespread, MNCs will often take the risk of investing in countries where they can reserve some funds to deal with tax audits. In total, the benefit they get from tax avoidance is a lot higher than cost of dealing with a tax audit.

Understanding this complicated fact, Thailand has taken serious action to deal with it. Prior to the establishment of transfer pricing regulations, they sent some tax officials to get trained about international trade and taxation. It was years before the regulation was issued and implemented. They prepared human resources first as they understood that to handle transfer pricing needs both competent officers and strong legal basis as well. China did more or less the same thing. Now they enjoy a lion's share of their FDI to developing countries. The regulation about this was prepared a long time a go.

Regulations on transfer pricing should be added to the income tax bill. Many things could be done to promote certainty for taxpayers and increase tax revenue.

First, the application of a minimum tax. Smart companies could engineer their transactions with their affiliated companies or headquarters through their tax planning. They utilize and exploit loop holes in host countries' tax laws and adjust their transactions to utilize these weaknesses.

Imposing a minimum tax means that the government is still able to get tax revenues from them since they have to pay a certain percentage of tax based on their sales, not their bottom line. When they report losses, then it is the minimum tax that has to be paid, but when a gain is reported, the tax paid will be based on the actual amount of income. South Korea applies a minimum tax of 12 percent. This makes the transfer pricing arrangement lose its benefit.

Second, charges from headquarters or affiliate offices worldwide to their companies in Indonesia should be limited. Some South American countries apply this rule. Royalties, management fees and similar charges are not regarded as business expenses.

Third, capacity building of tax officers is a must. They should be trained and exposed to how international businesses are run and how they manage their tax liabilities. Some tax officers should be specialized in particular types of business. They could be trained on the nature of this specific business, key or main players in this business and markets where they do transactions, reference prices and so on.

This skill would enable them to impose or make any corrections to arrive at a fair arm's length price, and at the same time, the tax payer will not feel that they are abusing their power in price determination.

The writer is a postgraduate lecturer at Perbanas Business School in Jakarta. He can be reached at pahalanainggolan@gmail.com.

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