The application of secondary adjustment by the Taxation Directorate General recently has become increasingly common for transfer pricing adjustments. Secondary adjustment is generally applied on deductible payments to related parties (i.e. purchase/sales transaction, interest, royalties and services), where the excess of the arm's-length amount will be considered a deemed dividend. While it is not deductible against the revenue, this deemed dividend also triggers a withholding tax at the applicable rates according to domestic law/tax treaties.

Prior to the issuance of the Harmonized Tax Law, the authority of the tax office to impose a secondary adjustment was not clearly stipulated in the law. Nevertheless, the concept of “secondary adjustment” is mainly laid out in audit guidelines in connection with related-party transactions, which the tax office often refers to when conducting audits on taxpayers.

However, the increase of secondary adjustment applications by the tax office is not in line with the tax court winning case. The absence of such authority in the law is often the primary consideration for the panel of judges during the appeal stage to drop the correction. Other prominent reasons are as follows:

The tax office imposed the secondary adjustment as a dividend to the related party transactions in which the counterparties are not a shareholder. It is against the dividend concept stipulated under elucidation of Article 4 letter g of the Income Tax Law as well as Article 71 of the limited liabilities company law, whereby the dividend is part of the shareholder's profit.

There is no evidence supporting the fact that the related payment is interlinked with the profit of the payor. Meanwhile, the law emphasizes that the dividend is part of the profit.

In most cases, the tax office is unable to identify the amount of deemed dividend entitled to each counterparty as well as the applicable rate based on the respective applicable treaty. This is due to the fact that the tax office performed primary adjustment on the certain related-party transaction, which consists of several foreign related parties located in different jurisdictions with different applicable tax treaty rates. Thus, the panel of judges dropped the correction by referring to the tax provisions and procedures law, where it highlights that the correction should be made by identifying the object and the amount of the correction.

In addition to the reasons above, it is pertinent to note that some countries reject secondary adjustments because of the practical difficulties they present. For example, suppose a primary adjustment is made between brother-sister companies. In that case, the secondary adjustment may involve a hypothetical dividend from one of those companies up a chain to a common parent, followed by constructive equity contributions down another chain of ownership to reach the other company involved in the transaction. Many hypothetical transactions might be created, raising questions over whether tax consequences should be triggered in other jurisdictions besides those involved in the transaction for which the primary adjustment was made.

The application of secondary adjustment also raises a dilemma for taxpayers since it causes a double taxation. Although the commentary on Article 10 of the OECD Model Tax Convention (MTC) already states in paragraph 28 that constructive dividends are covered by Article 10, any withholding tax imposed on such constructive dividends may not be relievable as there may not be a deemed receipt under the domestic legislation of the other country. This situation is also worsened by the fact that in performing the adjustment, the tax office often applies the 20 percent rate of withholding tax, assuming that the taxpayer is unable to satisfy the formality requirement to obtain the treaty benefit.

Indeed, constructive dividends result in an unintended and problematic situation for the taxpayer, since the current law enables the secondary adjustments to be automatically imposed following the transfer pricing primary adjustments, not to mention the applicable penalty/interest. Another problematic scenario might arise when the primary adjustment is imposed incorrectly (e.g. incorrect legal basis, the economic substance is disregarded, etc.) and adjusted at a whole amount instead of the excess between transaction value that is not arm’s length and transaction value that is arm’s length, which affects the materiality of the secondary adjustment. 

The commentary of Article 9 paragraph 2 of the OECD MTC notes that the articles does not deal with the secondary adjustments, hence neither forbids nor requires tax administrations to make secondary adjustments. However, it is suggested that in light of the foregoing problematic situation, tax administrations, when secondary adjustments are considered necessary, are encouraged to structure such adjustments in a way that the possibility of double taxation as a consequence thereof would be minimized, except where the taxpayer’s behavior suggests an intent to disguise a dividend for the purposes of avoiding withholding tax.

We would highly suggest that the tax office consider the abovementioned difficulties and administrative burden borne by the taxpayer. Furthermore, the tax office also needs to provide legal certainty that the double taxation that might arise due to the application of secondary adjustments will be eliminated in any possible way. One of the alternatives is through the establishment of a “dedicated” mutual agreement procedure (MAP) to eliminate double taxation specifically as a result of secondary adjustments that shortened the time-frame process, considering the current MAP rules need to be completed within 24 months.

However, it is worth noting that regardless of the MAP process, this might not be a solution as some countries, in fact, might refuse to grant relief in respect to other countries' secondary adjustments as they are not required to do so under Article 9. That being said, there might be a huge possibility that this law could put the taxpayer in a very unfavorable position, experiencing double taxation. Is it fair?

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Kartika Sukmatullah Hasanah is a transfer pricing consultant and graduate of Leiden University majoring in advanced international tax law. Sheylla Azka Saffanah is a transfer pricing consultant and graduate of Maastricht University majoring in international and European tax law.