Reintroducing DER

To follow up tax holiday regulation ( see post Safeguards on  the new Tax Holiday) that needs DER implementation, Indonesian Minister of Finance (MoF) reintroduced the Thin Capitalization Rules in Indonesia on 9 September 2015 through MoF Regulation Number 169/PMK.010/2015 (“MoF-169”) regarding Determination of Company’s Debt and Equity Ratio for Income Tax Calculation Purpose that will be applied for FY 2016. The MoF is intended to counter thin capitalization practice.

Thin capitalization

Generally a company will be financed through a mixture of debt and equity. In the situation where a company is financed through a relatively high level of debt compared to equity, this condition is well known as thin capitalization (“thin cap”). Thin cap is popular because a company  by having the higher level of debt will enable to deduct more interest and will have lower taxable profit. For this reason, debt is often  a more tax efficient method of finance compared to equity. Multinational or nationals groups  are often to restructure their financing arrangement to maximize this benefit.

For this reason, tax administrations of every country  try to introduce rules that place a limit of the amount interest to be deducted for calculating taxable income, such as US that introduced thin cap rule in 1969. Thin cap rule is intended to prevent or counter cross-border profit shifting through excessive debt and to protect country’s tax base.

Thin cap rule in Indonesia

Pursuant to Article 18 (1) Income Tax Law,  MoF is authorized to issue a regulation on debt equity ratio for the purposes of computing tax payable in accordance with Income Tax Law. Elucidation of that article provided that:

This law authorizes the Minister of Finance to prescribe the ratio of the company's liabilities to the company's equity, which shall be valid for tax purposes. In a commercial business, there is a certain level of arm's length debt equity ratio. If debt equity ratio of a company is higher than the arm's length debt equity ratio, in general the company is economically not in good condition. In such case, this law considers it as disguise equity for the purpose of computation of taxable income.

The term "equity" shall be referred to the term equity in accordance with the general accounting principles, and the term arm's length or ordinary business means fairly engage in business activities

Historically, in October 1984, the  MoF through Decision Number 1002/KMK.04/1984, had issued a regulation that stipulated a debt-to-equity ratio (DER) of 3:1 as a legal basis for the determination of deduction for interest expenses as part of the corporate income tax calculation. Six months later, MoF through Decision Number 254/KMK.04/1985 dated 8 March 1985, postponed (without limitation) the implementation of the regulation based on the view that the regulation might hamper the investment climate in Indonesia.

Thin cap rule is now reintroduce by the issuance of MoF-169 that revoked  the aforementioned regulations.

Brief summary of MoF-169 :

• This regulation essentially limits the amount of tax-deductible borrowing cost arising from the debt to a maximum DER of 4:1.
• This ratio will be effective from Fiscal Year 2016.
• PMK-169 has defined equity to include equity as defined by GAAP and shareholder’s free interest loan.  It has also defined debt to include  short term loan, long term loan, and interest bearing account payable.
• Cost of borrowing is defined to include:

1. Interest;
2. Discount and premiums in connection with the debt;
3. Additional costs incurred in relation to the arrangement of borrowings;
4. Finance charges on lease financing;
5. Guarantee fee; and
6. Foreign exchange differences arising from loans in foreign currencies as long as the differences are adjustments to the interest expense and other expenses (as referred to in b, c, d and e.)

•  Any borrowing cost on debt which exceeds this ratio will not be tax deductible for corporate income tax purpose. For example, if the Taxpayer’s DER is 5:1, one fifths of the borrowing cost will be non-deductible for income tax calculation. It is applied to both related- and third-party debt, whether foreign or domestic.

• The calculation of the debt or equity itself will be based on the average debt or equity balance at the end of each month in the relevant fiscal year
• Exemption for certain sectors which are guided by special rules, such as:

1. Banks;
2. Financing institutions;
3. Insurance and re-insurance companies;
4. Mining, oil and gas enterprises that are bound by Production Sharing Contract, Contract of Work or Coal Contract of Work which itself governs the DER. If the contract does not include a provision for the DER or the contract has expired, MoF-169 will prevail;
5. Companies subject to Final income tax; and
6. Infrastructure companies.

• Administrative requirement is added that taxpayers with foreign private debt also need to submit a report on the amount of the debt to the DGT. Failure to comply will result in a disallowance of the borrowing cost attributed to the foreign private debt. The DGT will issue an implementing regulation separately for the procedure to report foreign private debt

  

Comments

MoF-169 is well designed compared to former 1984 regulation.  The new ratio of 4:1 is under common practice (see table below ). Indonesia employs ratio that is the range, from the lowest, New Zealand that employs ratio of 0.75:1, and  the highest, Switzerland that employs ratio of 6:1 . Although MoF-169 adopts single ratio that does not take into account specific market or situation, but the rule is simple to implement and provides a great deal of certainty.

MoF-169 also put anti avoidance provision by using average amount of  loan  and equity in one year to calculate DER. This approach will counter what is well know as “bread and breakfast” practice. This refers to a practice when the debt level is reduced immediately before the end of financial statement reporting period  and then increased again after the reporting period. 

DER is also related to transfer pricing therefore MoF-169 requires  that the application of DER to related party has to follow arm’s length principle. For instance, if a company that has DER of 2:1 and want of maximize DER to 4:1 by lending unnecessary loan to related parties, DGT will make an adjustment for the interest expense in accordance with arm’s length principle guidance.

Source of table : IMF Working Paper 1412

Safeguards on the new Tax Holiday

In August 2011, Minister  of Finance (MoF)  introduced Regulation No. 130/PMK.011/2011  (“PMK-130”) which comes under Government Regulation No. 94/2010 regarding tax holidays for large scale investments. Such exemptions are granted for FDI projects of at least IDR 1 trillion in areas such as petrochemical refineries and renewable energy projects. The regulation will also apply to those businesses set up one year prior to the announcement of the tax holiday.

In August 2015, four years after PMK-130, MoF issue regulation no. 159/PMK.010/2015 (“PMK-159) that revoke PMK-130. Under PMK-159, tax holiday is given in the form of tax reduction rather than tax exemption.

New things

The procedure of filing tax holiday is simpler in the PMK 159 (through One Stop Services/ OSS in Investment Coordinating Board office).The company applying for the tax holiday will be determined by a verification committee and MoF will issue a decree for eligible taxpayers based on Verification Committee’s recommendation and no need to consult to the President. It will speed up the process and it will provide certainty whether the application is accepted or rejected.

PMK-159 extends the number of pioneer industry from 5 to 9 industries.  Those 9 pioneer industries are upstream metal industry; oil refinery industry; organic basic chemicals derived from petroleum and natural gas industry; machinery industry that produces industrial machinery; agriculture, forestry, and fishery products-based manufacture industry; telecommunication, information and communication industry; marine transportation industry; manufacture industry that is the main industry in Special Economic Zones (KEK); and/or economic infrastructure other than the ones applying Cooperation between Government and Business Entity (KPBU) scheme.

By adding  more pioneer industries and simplifying the procedure,  PMK-159 is expected to attract more investors. However, considering that tax holiday will generate tax loss to the country, PMK-159 has been equipped with safeguards provision to avoid abuse of the facility such as obligation to submit regular report, prohibition to transfer assets or ownership, collection of related party transaction data, obligation to apply Advance Pricing Agreement, etc.   In short, PMK-159 is well designed to anticipate the negative impact of tax holiday.

Below is the comparison between the old and  the new tax holiday regulation :

PMK-130 (Old)	PMK-159 (New)
Criteria ·         Corporate taxpayers that are newly established after 15th August 2010 ·         The capital investment is minimum of 1 trillion IDR ·         Taxpayers with a minimum of 10% of the investment held as a deposit on a bank account in Indonesia ·         Be involved in ‘pioneer industries’ namely any industries  which possessing extensive interrelatedness, providing high value added and externalities, introducing new technology, and possessing strategic value for  national economy.	Criteria ·         Corporate taxpayers that are newly established on or after 15 August 2011 ·         The capital investment is minimum of 1 trillion IDR, except for telecommunication, information, and communication industry which introduce high technology. ·         Taxpayers with a minimum of 10% of the investment held as a deposit on a bank account in Indonesia ·         Be involved in ‘pioneer industries’ namely any industries  which possessing extensive interrelatedness, providing high value added and externalities, introducing new technology, and possessing strategic value for  national economy. ·         Comply with the Debt to Equity Ratio (DER)  regulation ·         In case the newly established corporation is owned directly by domestic corporation (except for public company or state /local government owned company) or a permanent establishment (PE), the owner should obtain tax clearance  from DGT
Tax Facilities ·         An exemption from corporate income tax (100%)  for a period from 5 and up to 10 years, beginning from the first date of commercial production ·         After the initial ‘tax holiday’ period expires, an additional incentive of a 50% reduction in the amount of corporate income tax payable may be made available for an additional two year period. ·         After  7 years,  other additional years may be  granted by Minister of Finance considering the strategic value of a certain industry and competitiveness of national industry. (unclear time limit)	Tax Facilities ·         A reduction from corporate income tax (from 10% to 100%) for a period from 5 and up to 15 years, beginning from the first date of commercial production, ·         For telecommunication, information, and communication industry  that invest more than IDR 500 billion but less than IDR 1 trillion will be granted income tax  reduction maximum of 50%. ·         After  15 years,  other additional years may be  granted by Minister of Finance considering the strategic value of a certain industry and competitiveness of national industry but maximum to 20 years ·         The amount of tax reduction is given in equal percentage every year ·         The facilities are given to the income derived from main activity in pioneer industry.
Facility utilization Eligible taxpayers  may be utilize tax holiday provided that :  The taxpayers have fully realized the investment plan The taxpayers have initiated commercial production. Note : commencement of commercial production will be assessed by DGT.	Facility utilization Eligible taxpayers  may be utilize tax holiday provided that :      The taxpayers have initiated commercial production.           The taxpayers have fully realized their  investment plan at the time of commercial production  Note : commencement of commercial production, suitability of investment plan, and investment realization will be assessed by DGT.
Eligible industries  Basic metal industries, oil refinery and /or oil gas sourced basic organic chemical  machinery, renewable resources industries, communication equipment. This list can be extended by Minister of Finance (open list)	Eligible industries  Upstream metal industry, oil refinery industry  organic basic chemicals derived from petroleum and natural gas industry, machinery industry that produce industrial machinery, telecommunication, information, and communication, agriculture,  forestry, and fishery products-based manufacturing industry, marine transportation industry manufacture industry which is the main industry in Special Economic Zone (KEK) economic infrastructure other than those the ones applying the Cooperation Government-business entities scheme.   (closed list) Note : renewable resource is under tax allowance scheme, not tax holiday anymore
Procedure  Taxpayer’s application shall be submitted to Minister of Industry of Head of Investment Coordinating Board  After examination (including tax sparing in investor’s home country), the application will be forwarded to Minister of Finance to be reviewed by Verification Committee within 3 years starting from PMK 130 entry into force. Based on Verification Committee recommendation, MoF will issue a decree concerning approval of tax holiday, after consultation with President.	Procedure  Taxpayer’s application shall be submitted to Minister of Industry of Head of Investment Coordinating Board  After examination (no need tax sparing in investor’s home country ), the application will be forwarded to Minister of Finance to be reviewed by Verification Committee within 3 years starting from PMK 159 entry into force. Based on Verification Committee recommendation, MoF will issue a decree concerning approval of tax holiday (no need consultation with President).
	Safeguard Taxpayers granted for tax holiday are prohibited to: ·        Import or buy second-hand capital goods ·        Conduct main business that is not in accordance with investment plan ·        Transfer assets or company ownership, except for replacement of asset to be more productive, or transfer the ownership to other taxpayers that already obtained tax clearance, or transfer the ownership through IPO. ·        Relocate investment to other province or overseas starting from the utilization of tax holiday facilities until 5 years after the end of tax holiday period ·        Change bookkeeping method to shift profit or loss from tax holiday period to non-tax holiday period, vice versa. ·        Abuse tax holiday facility in order to avoid or evade tax such as inappropriate transfer pricing application. In addition, taxpayers granted for tax holiday are obliged to: ·         Submit regular report to DGT and Verification committee regarding fund utilization report deposited in domestic bank, audited investment realization report, production report during tax holiday period ·         Fulfill DGT request for related party transaction data ·         Apply for Advanced Pricing Agreement (APA) In the event that taxpayers are entitled for tax holiday and receive other income such as interest, royalty, rent, capital gain etc., those income will be   excluded from tax holiday facility and will be taxed accordingly.
Reference Investment Law No 25 Year 2007 Government Regulation No 94 Year 2010 MoF Regulation No 130/PMK.011/2011 DGT Regulation No PER-44/PJ/2011 DGT Regulation No PER-45/PJ/2011	Reference Investment Law No 25 Year 2007  Government Regulation No 94 Year 2010 MoF Regulation No 159/PMK.011/2015

Tax Holiday in the beginning

Tax holidays in Indonesia has been introduced for the first time in Investment Law No 1 Year 1967.  At that time, the government intended to attract foreign direct investment which had been closed under Soekarno administration. In 1967, income tax is governed under Income Tax Ordinance 1925 where the corporate income tax rate is 45%. Exempting high income tax for certain period was believed will attract FDI.

However, statistic for FDI (figure 1) shows that there was no significant impact of tax holiday from 1978 to 1984.  Indonesia, in 1984, reformed taxation from Income Tax Ordinance to Income Tax Law. One of milestone in the reformed is corporate income tax rate is reduced from 45% to 35%.  The other milestone is tax holiday was revoked considering that corporate income tax rate of 35% will be competitive enough to attract FDI. As shown in the Figure 1, FDI increase dramatically after Income Tax Law entry into force. 

source : Using Tax Incentives to Compete for Foreign Investment: Are They Worth the cost ?, Foreign Investment Advisory Service (FIAS) Occasional Paper No 15, 2001

However, in 1996, second generation of tax holiday has been introduced through the issuance of Government Regulation (GR) 45 Year 1996.  Although Income Tax Low does not accommodate tax holiday, GR 45 tried to cover the incentive through tax  borned by Government  mechanism for 10 years. In substance, tax borned by the government is similar with tax holiday.  Unfortunately, this incentive is given to the companies that have close relationship with the authority, not by criteria stated in GR 45 since it is subject to President approval.

 It was not long to be applied because in 2000, the Parliament approved amendment of Income Tax Law No 17  Year 200o and tax incentive for new investment only available in the form of Investment Allowance (accelerated depreciation, lower dividend tax, longer useful life for depreciation, and additional deduction for investment cost).  As consequence, GR-45 was revoked by GR 148 Year 2000.  

Pro and contra of tax holiday

Tax holiday is still debatable whether it is an effective scheme to attract foreign investment.  According to IMF Paper “Revenue Mobilization in Developing Countries”,   Tax holidays are time-limited exemptions from the CIT, which may or may not be renewable. They are widely regarded as a particularly ill-designed form of investment incentive, and one that poses considerable dangers to the wider tax system among others :

•    Unless offered for periods so long that investors are likely to doubt their credibility, they are most attractive to the most footloose firms, which are those likely to bring the least benefit to the wider economy (such as textiles and assembly of light manufacturing goods).

•    They are open to abuse, undermining tax revenue by providing entrepreneurs with a strong incentive to use transfer pricing and financial arrangements to shift taxable profits into holiday enterprises: by arranging, for example, for taxpaying companies (able to deduct the interest payments) to borrow from holiday companies (not taxable on interest received). Such devices can operate across national borders, and also between domestic firms. However clever the legal provisions crafted to address this risk, experience suggests that companies will prove adept in finding ways to avoid them. Even the most developed tax administrations have great difficulty dealing with such abuse. 

In  IMF working paper no WP/08/129,  they stated that  GR 45 which provided tax holidays to newly incorporated firms “operating in certain industries” for up to 10 years  presented serious administrative challenges to a tax agency as they introduce the possibility for taxpayers to transfer profits from operations that do not qualify for the holiday to those that do.

Table below shows that Tax Holidays in GR 45 did not relate directly with the incremental of Foreign Direct Investment.  

The experience in other countries indicates that tax holidays have small effects on long-term investment relative to their fiscal cost.  Although there is considerable evidence that differences in international taxation affect the volume, location, and character of FDI in developed economies the evidence on tax holidays in emerging markets is more negative. (IMF Working Paper No WP/08/207) . In the paper also stated that are most attractive for footloose industries that tend to exit the country at the end of the holiday period. These industries are likely to bring the smallest benefit to the overall economy. Instead, firms investing in long-lived assets whose revenues may not fully recover costs during the period of the holiday, benefit least from tax holidays.

New Investment Law

In 2007, there is a new Investment Law No 25 Year 2007 that revoke Investment Law No 1/1967.  The tax holiday provision still exist and rewrite. Considering the push from the parties  who support for tax holiday, the government issued GR 94 Year 2010 as the implementing regulation of 4^th amendment of Income Tax Law.  Although tax holiday is not accommodate in the 4^th amendment of Income Tax Law, GR 94 provides space for tax holiday referred to Investment Law 25/2007  as the basis.

Safeguards

Realizing the negative impact on tax holiday for tax revenue, tax authority actually resist to adopt tax holiday again. However, because the government  already issued GR 94, tax authority has to find ways to mitigate the impact.

In 2011, when MoF issued PMK-130, there is a safeguard for tax holiday implementation by requiring a tax sparing in the home country. Tax sparing will guarantee that income exempted in Indonesia will not be taxed in the home country otherwise the home country will enjoy benefit from  tax on income derived from Indonesia which has been exempted.

Unfortunately, the effectiveness of tax sparing is debatable  similar with tax holidays.  In tax treaty signed by Indonesia,  not all tax treaty accommodate tax sparing provision. For example,  Tax treaty Indonesia-Japan provides tax sparing provision while Tax treaty Indonesia-China is silent.  The absence of tax sparing provision will restrict investor from China, one of the biggest  investor in Indonesia,  to obtain tax holiday as one of requirement in PMK-130.

In 2015, the new tax holiday (PMK-159)  adds more industries that  eligible for tax holiday to make it more attractive. In other hand, tax sparing as the safeguard is changed to  a set of safeguard such as obligation to submit regular report, prohibition to transfer assets or ownership, collection of related party transaction data, obligation to apply Advance Pricing Agreement, etc.

Hopefully the new tax holiday regulation will achieve its mission to attract more investors and  to be successful in minimizing the negative impact of tax holiday. 

Extended list of withholding tax on Services

To expedite tax revenue stream from Income Tax, Minister of Finance (MoF)  has issued MoF Regulation number 141/PMK.03/2015 (“PMK-141”) to be effective on 26 August 2015. The MoF has added some types of services that are categorized as “Other Services” referred to in Article 23 of the Income Tax Law (ITA 23).

Article 23 Paragraph (1) Letter (c.2) of Income Tax Law provided that compensation in connection with technical, management, construction, consultation and other services, except those that have been withheld under Article 21 are subject to withholding at 2% of the gross amount.

Under PMK-141, the MoF has added more than 35 types of services provided by service providers that are subject to ITA 23. Previously ITA 23 on services as regulated in MoF Regulation No.244/PMK.03/2008 only covered 27 other services and 19 support services for geothermal, oil and gas.

LIST OF SERVICES

Below is the list of other services that is subject to ITA 23 under PMK-141. The new items are in bold. 

·         Appraisal
·         Actuary
·         Accounting, bookkeeping and attestation
·         Design
·         Drilling for oil and gas mining except for those performed by a Permanent Establishment
·         Support for geothermal, oil and gas mining
·         Support for general mining (i.e, other than geothermal, oil and gas)
·         Flight and airport support
·         Forest felling
·         Waste processing
·         Labour Supply/outsourcing
·         Intermediary/agency
·         Security trading, except for those performed by stock exchange, KSEI and KPEI
·         Sound dubbing
·         Film mixing
·         Computer-related (i.e, software, hardware or system)
·         Installation (e.g, electricity, machinery, or telephone equipment) except for those rendered by licensed construction companies
·         Toll manufacturing (maklon)
·         Investigation and security
·         Event organization
·         Provision of space and/or time in mass media, outdoor media and other media for the dissemination of information, and/or advertising
·         Pest eradication
·         Cleaning
·         Cateringh
·         Packaging
·         Legal
·         Architecture
·         City planning and landscape architecture
·         Creation of film promotion tools, advertisements, posters, photos, sliders, banners, pamphlets, and billboards
·         Website development
·         Internet
·         Storage, processing, and/or distribution of data, information, and/or programs
·         Maintenance of vehicle and/or land, marine, and air transportation means
·         Suction of septic tank
·         Pool maintenance
·         Freight forwarding
·         Logistics
·         Document handling
·         Loading and unloading
·         Laboratory and/or testing, except for those performed by educational institutions in academic research
·         Parking management
·         Soil test for construction
·         Land preparation and/or cultivation
·         Seeding and/or seeds planting
·         Plant maintenance
·         Harvesting
·         Processing of agricultural, plantation, fishery, livestock, and/or forestry products
·         Decoration
·         Printing/publishing
·         Translation
·         Freight/expedition, except for those subject to Article 15 Income tax
·         Port-related matters
·         Transport via pipelines
·         Child care
·         Training and/or course
·         Delivery and loading money to ATM
·         Certification
·         Survey
·         Tester
·         Services other than those mentioned above which payment is charged to central or regional government budget

PMK 141 also extents the list of  support services in geothermal and oil & gas  industry from 19 to 43 types of services.  Below is the complete list and items added or changed are in bold:

Ø  Primary cementing

Ø  Remedial cementing

Ø  Sand control

Ø  Matrix acidizing

Ø  Hydraulic

Ø  Nitrogen and coil tubing

Ø  Drill steam testing

Ø  Reda repair

Ø  Installation and maintenance

Ø  Equipment/material replacement

Ø  Mud logging

Ø  Mud engineering

Ø  Well logging and perforating

Ø  Stimulation and secondary discovery

Ø  Well testing and wire line services

Ø  Offshore navigation control related with drilling

Ø  Drilling maintenance

Ø  Drilling mobilization and demobilization

Ø  Directional drilling and surveys

Ø  Exploratory drilling

Ø  Location stacking/positioning

Ø  Preliminary study

Ø  Land acquisition

Ø  Preparation of drilling field

Ø  Installation of rig equipment

Ø  Primary hole manufacture and opening of rig hole

Ø  Primary hole drilling with little drill machine

Ø  Secondary hole digging

Ø  Wells placement management and transportation access

Ø  Service line and communication

Ø  Water system

Ø  Rigging up and/or rigging down management

Ø  Man labor, tools, equipment  and other support supply

Ø  Diving and/or welding

Ø  Completion process

Ø  Pump fees

Ø  Drill equipment lifting

Ø  Oil content testing

Ø  Business legality management

Ø  Auction

Ø  Seismic reflection studies

Ø  Geomagnetic survey, gravity, and other survey

Ø  Other services related with drilling, production and/or closing of oil and gas field

TAX BASE

      PMK-141 defining gross income as the basis for withholding ITA 23 as follow:

a.   Gross income for catering services is the entire income  with any name and  form  which is paid or provided to be paid or due to payment.

b.   Gross income for non-catering services is the entire income with any name or form of payment which is paid or provided to be paid or due to payment, exclude:

1.   Salary, wage, honorarium, allowance and other payments as compensation in connection with the work that paid by a manpower supply company to the man power who provide services, according to the contract services;

2.   Any payment related with goods or material purchase to the service provider;

3.   Payment to the third party that paid by service provider;

4.   Reimbursement cost to the third party that paid by service provider.

Exclusion from gross income for items above should be supported by:

1.   Contract and salary payment list, wage, honorarium, allowance and other payment related with the work ;

2.   Invoice of material purchase 

3.   Invoice from third party vendor attached with contract ,

4.   Invoice or payment receipt for the amount  paid by service provider to the third party vendor .

Failing to provide those supporting documents, ITA 23 will be withheld from the gross amount.

PMK-141 also defines some type as service i.e. toll manufacturing, event organizer, and freight forwarding service and gives examples of computation in its attachment. 

Comments

Referred to DGT Annual Report 2012, the revenue from withholding ITA 23 is not significant compared with other withholding tax. Extending the list of withholding tax will expedite the tax revenue since it is prepaid tax, but it will not increase tax revenue as  a whole.  Probably the government intend to secure that all companies providing service to other companies are registered as taxpayers. It is based on assumption that a company who paid for a service should withhold ITA 23  at 4% withholding rate  (100% penalty from original rate 2%) for vendors who are not registered as taxpayers.  From this mechanism, DGT will ensure that taxpayers under withholding mechanism are registered in the system and DGT can cross check the amount withheld by withholding agent to the amount reported in the tax return by the service providers.