As President Susilo Bambang Yudhoyono works to improve the investment climate in Indonesia, regulatory surprises have slowed his progress, reinforcing the impression that Indonesia is an unpredictable place to do business.
Twice this year Indonesian legislation has caught the market unprepared, forcing market participants to grapple with an unexpected regulatory development.
Most recently, Indonesian tax authorities issued a regulation taking effect on Jan. 1 that increases withholding tax on interest and dividend payments, leaving US dollar bondholders and investors scrambling to understand its implications.
Earlier in the year, a law requiring all contracts with Indonesian parties to be in the Indonesian language disrupted the market as deal teams were required to prepare Indonesian language documents for cross-border deals previously documented only in English.
Both the tax regulation and the language law caught the business community unaware, engendering uncertainty and confusion. Fortunately, this kind of surprise is easy to avoid and there is a terrific example of how to do it better right at home in Indonesia.
Bapepam LK, the Indonesian capital markets and financial institutions supervisory agency, shows the way. Before enacting a new regulation, Bapepam first posts it in draft on its excellent website. This approach gives advance notice of pending legal changes, enabling market participants to adjust.
Bapepam also seeks comment on the draft regulation, minimizing the risk of obvious inconsistencies or unintended consequences. The Bapepam rule-making approach increases the predictability that business loves and ought to be replicated throughout the Indonesian bureaucracy.
Not having the benefit of the Bapepam approach, the tax regulation - Regulation 62 on Prevention of Tax Treaty Abuse - caught business unaware. Regulation 62 denies the use of reduced withholding tax rates under Indonesia's tax treaties, invalidating structures using offshore single purpose vehicles (SPVs) that reduce or eliminate withholding tax on interest payments for Indonesian bond issuers as well as dividends and capital gains paid to investors in Indonesian private companies. The resulting tax increases are significant, increasing withholding taxes from 10 percent or less under the tax treaties to 20 percent when the treaties don't apply.
But the substance of Regulation 62 is not the problem. The regulation is largely aligned with international practice in attempting to disallow purely tax-driven structures. No, the reason Regulation 62 jolted the market was because of the way it was issued and the way it enters into force.
First, it was issued out of the blue, with no prior notice or discussion.
Second, the seven week grace period between its Nov. 5 issue date and its Jan. 1 effective dates is too short given the substantive and procedural changes Regulation 62 and a sister tax regulation make.
Third, the regulation is retroactive in application: From Jan.1 not only future structures will be caught in the tax net but existing structures will be caught as well.
For evidence of how unprepared the business community was for Regulation 62, look no further than the issuance of bonds in October by state-owned Indonesian utility Perusahaan Listrik Negara (PLN). The PLN bond uses an SPV borrowing affiliate that likely will not give the intended tax benefits once Regulation 62 takes effect. PLN doubtless would have reconsidered the use of the SPV had it been aware of the impending issuance of Regulation 62. Similarly, dozens of existing US dollar bonds and equity holding company structures may have to be restructured as a result of Regulation 62.
Had Regulation 62 been introduced Bapepam-style, there would have been no surprise and the seven week grace period probably would have been adequate. It is also possible that comments of market participants would have convinced Indonesian tax authorities to grandfather existing SPV structures.
The other regulatory surprise arrived quietly on July 9 in the form of omnibus Law 24 of 2009 re "National Flag, Language and State Symbol and National Anthem". Buried in the law is a provision requiring all contracts with Indonesian parties to be in the Indonesian language.
Although the ambiguous langue of Law 24 leaves room for doubt regarding the intentions of the draftsmen, mainstream legal practice overnight has become that all contracts with Indonesian parties in cross-border transactions need to have an Indonesian version as well as an English version. Failure to do so may mean un-enforceable documents.
Again, the substance of Law 24 was not the problem - a case can be made that contracts with Indonesian parties should be in the Indonesian language, increasing the likelihood that the parties fully understand what they are signing. Many countries have such a law.
No, the problem is the way the law was announced, with no advance notice and taking immediate effect.
Law 24 also caught the market totally unaware. In the weeks following its issuance and effective date of July 9, several big Indonesian deals were documented using only English language documents. Why was this risk taken, given that non-Indonesian language documents may not be enforceable under Law 24? Because none of the parties involved was even aware that Law 24 had entered into force.
Both Regulation 62 and Law 24 would have caused less market indigestion had people known they were being proposed and had there been an opportunity to comment on the drafts. The Bapepam approach of posting draft regulations for comment is best practice for rule-making and would have minimized the disruption.
Fortunately, the Bapepam approach can be readily replicated across agencies in Indonesia. Doing so would minimize disruptive regulatory surprises such as Regulation 62 and Law 24 and make Indonesia a more predictable place to do business.The writer is an American lawyer, a partner in the Singapore office of Latham & Watkins LLP.