Many tax jurisdictions around the world have now agreed that to achieve a fair division of taxing profits, and to resolve double taxation in transactions between related parties should be treated for tax purpose by reference to the amount of prices or profits that would have been accrued if the comparable transactions have been performed by independent parties under comparable circumstances. This is the arm’s length principles.
In the application of arm’s length principles, transfer pricing method play vital role to establish and calculate arm’s length price or profit from transactions between related enterprises. Most jurisdictions across the world including Indonesia, have in their regulations a guidance with regard to transfer pricing methods that can be used to test the arm’s length nature of price or profit from the controlled transactions. Article 18 paragraph (3) of the law number 36 Year 2008 concerning income tax (income tax law) provides transfer pricing methods in Indonesia that can be applied to test the arm’s length nature of the controlled transactions consisting of comparable uncontrolled transactions, (2) cost plus method, (3) resale price method, or other methods.
Directorate General of Taxes regulation number PER-32/PJ/2011 (concerning the application of the arm’s length principles in transactions between related taxpayer) and Directorate General of Taxes regulation number PER-22/PJ/2013 (concerning the guidance of transfer pricing audit) fully adopt 5 (five) OECD recognized methods. According to OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG), transfer pricing methods are divided into traditional transaction methods and transactional profit methods. Traditional transaction methods consist of comparable uncontrolled price method (CUP method), cost plus method (CPM), and resale price method (RPM), while transactional profit methods comprise of transactional net margin method (TNMM) and profit split method (PSM). Although TNMM and PSM are not clearly stated in the income tax law, the use of TNMM and PSM are still permitted under the provision of other methods as stated in the regulation.
The most crucial part of transfer pricing methods in Indonesia that lead to several disputes between tax administrations and taxpayers is selection of methods. During the era before 2011 under Directorate General of Taxes decision number KEP-01/PJ.7/1993 (KEP-01) and Directorate General of Taxes regulation number PER-43/PJ/2010 (PER-43), Directorate General of Taxes (DGT) adopted hierarchical selection of transfer pricing methods, and the era from 2011 to present, Indonesia is fully in line with latest revision of OECD TPG that utilize the most appropriate method. Under hierarchical, the selection of methods is based on hierarchy of transfer pricing methods start from the most direct method, CUP method, to the lesser direct method, CPM or RPM, TNMM, and profit split. With this approach, tax examiner or taxpayer must prove first the applicability of CUP method, if CUP method is proved inapplicable, the analyses continue to prove the applicability of CPM or RPM up to the less direct method TNMM and PSM. Under the most appropriate method the tax examiner or taxpayer are not required to perform analyses under more than one method or prove that a particular method does not apply. Although the most appropriate method in OECD TPG no longer requires taxpayer or tax examiner to prove that a particular method is not suitable under circumstances, the Guidelines still views that traditional transaction methods are preferable over transactional profit methods (Paragraph 2.3 OECD TPG).
To find the most appropriate method from transfer pricing methods in Indonesia as stipulated under article 11 paragraph (8) PER-32 and Paragraph 2.2 OECD TPG, the selection process should take into account of (a) the respective strengths and weaknesses of each method; (b) the appropriateness of the method considered in view of the nature of the controlled transaction, determined through a functional analysis; (c) the availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods; and (d) the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them.
The following part provides detail description of traditional transactional methods and transactional profit methods, strengths and weakness of each method, and best application of each method to the controlled transactions.
A. Comparable Uncontrolled Price Method
CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. The following are summarizes the respective strengths and weaknesses of CUP method.
Strengths and Weaknesses of CUP Method
Most direct and reliable way to apply the arm’s length principle.
• High degree of comparability required
• In practice, it’s difficult to find uncontrolled transactions comparable enough to controlled transactions under review.
• When there are internal comparables (the same product is bought/sold from/to affiliated enterprise and independent enterprise(s).
• When there are external comparable (independent enterprise buys/sells the same product as the affiliated enterprise in comparable circumstances)
• For commodities and financial transactions.
B. Resale Price Method
The resale price method begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price (the resale price) is then reduced by an appropriate gross margin on this price (the “resale price margin”) representing the amount out of which the reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product (e.g. customs duties), as an arm’s length price for the original transfer of property between the associated enterprises.
An uncontrolled transaction is comparable to a controlled transaction for purposes of the resale price method if one of two conditions is met: (a) none of difference (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the resale price margin in the open market; (b) reasonably accurate adjustments can be made to the eliminate material effects of such differences.
Strengths and Weaknesses of RPM
Less product comparability compared to CUP method because this method focus on function similarity. Product differences are less likely to have material effect on RPM than on CUP.
• Gross profit margin are affected by management efficiency which may have an impact on profitability
• Accounting consistency important for comparability purposes.
• Resale price will be less reliable when the reseller adds significant value to products sold.
• Marketing operation/distributor which not adding significant value to products sold.
C. Cost Plus Method
The cost plus method begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to related purchaser. An arm’s length cost plus mark-up is then added to this cost, to make an arm’s length gross profit in light of the functions performed, assets used, and risks assumed.
An uncontrolled transaction is comparable to a controlled transaction for purposes of the cost plus method if one of two conditions is met: (a) none of difference (if any) between the transactions being compared or between the enterprises undertaking those transactions could materially affect the resale price margin in the open market; (b) reasonably accurate adjustments can be made to the eliminate material effects of such differences.
Strengths, Weaknesses, and Best Applied of CPM
Since greater focus on functions performed, less product comparability required compared with CUP method.
• Costs incurred has not always discernible link with arm’s length prices / profit margin.
• Difficult to find appropriate cost base.
• Accounting consistency important for comparability purposes.
• Service provider
• Contract manufacturer
• Contract R&D
D. Transactional Net Margin Method
The Transactional Net Margin Method (TNMM) examines net profit (earning before interest and taxes and extraordinary items) relative to appropriate base (e.g. sales, cost, assets) that a taxpayer realized in a controlled transaction (or transactions that are appropriate to aggregate). The denominator or base should be ideally free of controlled transaction,
Ideally TNMM should be applied in transaction-by-transaction, however there is a condition where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis. TNMM operates in a manner similar to the cost plus method. This means that in order to be applied reliably, TNMM must be applied in a manner consistent with the manner in which the resale price or cost plus method is applied.
Strengths and Weaknesses of TNMM
• Net profit indicators are less affected by transactional differences than price.
• Net profit indicators may be more tolerant to some functional differences than gross profit margins.
• Net profit indicators avoid problem of lack clarity in public data as regards the classification of expenses above or below the gross profit line.
• Net profit indicators can be influenced by factors that may not have significant effect on price or gross margins, making accurate and reliable determinations of arm’s length net profit indicators difficult.
• Taxpayers may not have access to enough timely, specific information on the net profits attributable to comparable uncontrolled transactions.
• Contract manufacturer
• Service provider not adding significant unique intangibles
• Distributor not adding significant value to the product
• Manufacturer if reasonably reliable comparables for cost plus or cost based TNMM unavailable.
E. Profit Split Method
Unlike TNMM which necessary to analyze net profit of tested party, PSM is two sided analysis therefore net profit realized by a taxpayer and related party must be tested. The transactional profit split method first identifies the profits to be split for associated enterprises from the controlled transactions in which associated enterprises are engaged. It then splits those combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length.
There are a number of approaches for estimating the division of profits, based on either projected or actual profits, as may be appropriate, to which independent enterprises would have agreed, two of which are discussed in the following paragraphs. These approaches – contribution analysis and residual analysis – are not necessarily exhaustive or mutually exclusive.
1) Contribution analysis
Under a contribution analysis, the combined profits, which are the total profits from the controlled transactions under examination, would be divided between the associated enterprises based upon a reasonable approximation of the division of profits that independent enterprises would have expected to realize from engaging in comparable transactions. This division can be supported by comparables data where available. In the absence thereof, it is often based on the relative value of the functions performed by each of the associated enterprises participating in the controlled transactions, taking account of their assets used and risks assumed. In cases where the relative value of the contributions can be measured directly, it may not be necessary to estimate the actual market value of each participant's contributions.
2) Residual analysis
A residual analysis divides the combined profits from the controlled transactions under examination in two stages. In the first stage, each participant is allocated an arm’s length remuneration for its non-unique contributions in relation to the controlled transactions in which it is engaged. Ordinarily this initial remuneration would be determined by applying one of the traditional transaction methods or a transactional net margin method, by reference to the remuneration of comparable transactions between independent enterprises. Thus, it would generally not account for the return that would be generated by any unique and valuable contribution by the participants. In the second stage, any residual profit (or loss) remaining after the first stage division would be allocated among the parties based on an analysis of the facts and circumstances.
Strengths and Weaknesses of TNMM
• Offers flexibility by taking into account specific, possibly unique, facts, and circumstances of the related enterprises that are not present in independent enterprises.
• Tend to rely less on information about independent enterprises.
• Less likely that either party to the controlled transaction is left with an extreme and improbable profit result, since both parties to the transactions are evaluated.
• Two sided approach may also be used to achieve a division of the profits from economies of scale or other joint efficiencies that satisfies both the taxpayer and tax administrations.
• Often difficult to have access to information from foreign affiliates, especially where the foreign affiliate is the parent company or a sister company rather than a subsidiary of the taxpayer.
• Difficult to measure combined profits for all the associated enterprises participating in the controlled transactions, which would require stating books and records on a common basis and making adjustments in accounting practices and currencies.
• When applied to operating profit, it may be difficult identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and the associated enterprises and other activities.
• Transaction where both parties make unique and valuable contributions to the transaction.
• Highly integrated transactions, e.g. global trading of financial instruments.