Transfer pricing and inspection of imports

Vincent Lingga, Senior Editor, The Jakarta Post, Jakarta

Businesspeople may be apprehensive about the sweeping allegation by a senior tax official last week that about 3,400 or 70 percent of registered foreign corporate taxpayers in Indonesia, which did not pay income tax last year because they lost money, were suspected of unlawful transfer pricing practices.

Though the Jakarta tax chief, Muhammad Said, himself acknowledged that it is extremely difficult to establish transfer pricing, and thus far not a single case of such a corporate fraud had been uncovered, the sudden airing of the issue could cause a sense of foreboding.

Big questions arose as to why the tax directorate general suddenly brought up that issue, warning that 252 foreign companies that did not supplement their annual income tax returns with audited financial reports were being investigated.

Does the tax directorate general's suspicion have anything to do with the target of a 26.5 percent increase set for income tax receipts for the 2003 fiscal year? Does this portend 'harassment' of large taxpayers by overzealous tax officials who are notorious among business people for their corrupt mentality?

Has not transfer pricing been among the subject of examination in routine tax audits?

There is nothing wrong, nor unlawful in transfer pricing in trade between individual entities in multi-entity corporations or trans-national companies (TNCs) as long as the transaction is conducted at an arm's-length basis.

In fact, according to a study by the United Nations Conference on Trade and Development, around one third of world exports were intra-firm trade or internal transactions between affiliate firms of TNCs.

This is the natural consequence of economic globalization. TNCs have steadily expanded their international production networks by choosing locations with appropriate combinations of high labor productivity, low wages, low cost infrastructure and, sometimes, including large domestic markets.

Transfer pricing refers to the practice of related entities that do business across international boundaries and seek to maximize their profit in low tax areas and minimize their profit in high tax areas.

For example a company in Hong Kong, a low tax area, which has an affiliate entity in Indonesia, a high tax area, might try to maximize profit in Hong Kong and minimize profit in Indonesia.

The transfer pricing policy that is adopted by TNCs usually has a significant effect on the amount of profit or loss in each of the countries in which they do business. For this reason, the issue of transfer pricing is important not only for the multinational groups but also for tax authorities around the world.

No wonder, the large international accounting firms usually offer advice on transfer pricing and the tax liabilities.

The opportunities for transfer pricing occur in the provision of goods and services and in borrowing and lending. If a company has an affiliate entity in a high tax area it would be advantageous for the group if the goods and services supplied by the head office to the affiliate entity are priced high and if loans are made expensive so that the taxable income of the affiliate entity is minimized.

For these reasons the tax authorities in most industrialized countries require that cross border trading and financial transactions between affiliated entities should be conducted according to the "arm's-length" standard.

This means that when the head office or a branch supplies goods or lends money to another branch or an affiliated entity then the terms of sale and the terms of lending and borrowing should be the same as if the transactions had been between completely independent parties.

The "arm's-length" standard is internationally recognized and used by taxation authorities around the world. It is a standard that is promoted and developed in particular by the Organization for Economic Co-operation and Development (OECD).

It might simply be a coincidence that the transfer pricing issue arose at the same time Minister of Trade and Industry Rini Soewandi disclosed last Wednesday that she had recommended to President Megawati Soekarnoputri to reintroduce a system of pre- shipment inspection of imports (PSI).

The recommendation was prompted by manufacturers' complaints of unfair import competition caused by foreign goods entering the country either through physical smuggling but mainly through under-invoicing of import prices to minimize duty and tax payments.

But the PSI system can also be an effective way of preventing unlawful transfer pricing by companies that use imported inputs, parts or components from their affiliates overseas.

Between 1985 and 1995, when Indonesia used PSI that was conducted by an independent surveyor company, the possibilities for transfer pricing on goods supplied from a foreign entity to an affiliate entity in Indonesia were minimized.

Because, in addition to verifying the declared customs value, the surveyor also compared the prices charged for the goods with the normal export market prices in the country of export.

The normal export market price is a similar concept to the "arm's length" standard.

However, if transfer pricing is to be properly addressed by PSI, then the PSI should also apply to goods exported from Indonesia to ensure that goods exported from the country be fairly priced in accordance with the arm's length standard and not undervalued so as to minimize the profit of the Indonesian entity.

It is primarily the responsibility of the tax office to ensure that individual and corporate taxpayers properly pay all legal taxes due, and transfer prices that are not charged at arm's length are one of the items that should be examined in tax audits.

The recent establishment of the Large Taxpayers' Office in Jakarta which is staffed by officials with salaries competitive to private-sector auditors is designed to handle big companies, including foreign firms, with complex transactions.

But examining transfer prices in intra-company trade requires special expertise to compare market prices formed in complex transactions around the world. This is still lacking among tax officials. The task also needs networking with many institutions overseas for data cross-checking.

Hence, the PSI system proposed by Minister Rini could simultaneously achieve many objectives: Preventing unfair import competition and unlawful transfer pricing, safeguarding state revenues from import duty and tax payment and verifying the rules of origin of imports within the ASEAN Free Trade Area beginning in January.

Under AFTA, where import tariffs for most goods with a minimum ASEAN content of 40 percent will be very low, ranging from zero to 5 percent, Indonesia may find itself inundated by imports from other ASEAN countries.

Customs officials, who are notorious among most businesspeople for their incompetence or high venality, will simply not be capable of verifying such a complex matter as rules of origin for input contents of industrial products.

An independent surveyor company with international networks that are adequately supported with laboratory testing equipment and staffed by specially-trained commodity surveyors should do their job until the customs and tax services acquire enough competence and have the adequate resources to take over.