Transfer pricing and inspection of imports

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.