Secondary Adjustment, New Uncertainty, and Double Taxation Potential

Minister of Finance Sri Mulyani Indrawati set a new regulation in early 2020 on the procedure for implementing the Advance Pricing Agreement (APA). One of the most popular provisions recently concerns the secondary adjustment related to transfer pricing between affiliated parties. 

A secondary adjustment is a follow-up correction from the primary correction (primary adjustment) on affiliated transactions or transfer pricing between business group members. 

Provisions on the secondary adjustment in Indonesia are contained in the Minister of Finance Regulation (PMK) Number 22/PMK.03/2020. This provision then becomes a reference or juridical basis for functional tax auditors in the field, by considering the primary audit of affiliated transactions as dividends that should be subject to income tax. 

The secondary adjustment practice is considered to create new uncertainty conditions for business actors instead. This is because, until now, the primary adjustment—which arises as a result of differences in perspective between PMK Number 213/PMK.03/2016 and the Director General of Taxes Regulation (PER) Number 22/PJ/2013—still often causes disputes between taxpayers and the Directorate General of Taxes (DGT). Those disputes oftentimes dragged on until the appeal process or judicial review at the Supreme Court. 

One example is the difference in applying the principles when selecting data and information for comparable companies in a transfer pricing analysis. According to the latest provisions (PMK Number 213/PMK.03/2016), taxpayers shall apply an ex-ante principle to test the arm’s length principle of affiliated transactions. In this case, the taxpayers shall use comparable data or information before or when the transfer pricing transaction is carried out.  

On the contrary, in reviewing the transfer pricing documentation, the tax authorities still adhere to the ex-post principle or comparable data or information after the affiliated transactions had been conducted. The guideline is the old regulations: Directorate General of Taxes Letter Number S-153/PJ.04/2010; Director General of Taxes Circular Letter (SE) Number 50/PJ/2013; and PER Number 22/PJ/2013. 

Until now, the mere differences in perspective have not found a solution or agreement between taxpayers and the DGT. Now, the taxpayers are faced with new uncertainty in the form of secondary adjustment instead, following the issuance of the Harmonization of Tax Regulations Law that revises many clauses in the Income Tax Law. 

In the Elucidation of Article 18 paragraph (3) of the Income Tax Law, the difference between the value of affiliated transactions and the arm's length price based on the tax authorities' assessment is also considered a dividend subject to income tax (constructive dividend) according to the laws and regulations in the field of taxation.   

However, until this article was published, no detailed instructions regulating the technical mechanisms of the provisions are available, including the corresponding adjustment mechanism for domestic affiliated transactions. 

Transfer Pricing Correction 

Based on Directorate General of Taxes Regulation Number PER-22/PJ/2013 and PMK Number 240/PMK.03/2014, there are three types of transfer pricing adjustments: (1) primary adjustment, (2) secondary adjustment, and (3) corresponding adjustment. 

The scope of primary adjustment is the difference between the price or profit of affiliated transactions and the arm's length price or profit. 

Meanwhile, the secondary adjustment is an additional adjustment that may occur due to a primary adjustment in affiliated transactions or adjustments to other tax object liabilities. For example, after a tax auditor makes a positive adjustment to a taxpayer's affiliated transaction, an overpayment to the affiliated party arises. For the overpayment, the tax auditor may make a secondary adjustment based on the applicable tax provisions. 

Furthermore, the corresponding adjustment may be made to the primary and secondary adjustments upon the taxable income of a taxpayer in a country or jurisdiction by the relevant tax authority. The corresponding adjustment is the result of a transfer pricing adjustment made by the tax authority of another country or jurisdiction (primary adjustment). As a result, the allocation of income in the two countries or jurisdictions is consistent, intending to eliminate double taxation. In practice, the corresponding adjustment should also be applied to domestic transactions. 

Double Taxation 

The Income Tax Law confirms that the Income Tax Article 26 withholding is final, including dividends in the context of the secondary adjustment. Therefore, the withholding tax on the dividend is not creditable in the counterparty’s country and will result in double taxation. 

The Organisation for Economic Co-operation and Development (OECD) has also warned of the potential for double taxation in the implementation of secondary adjustments. In the OECD Transfer Pricing Guidelines 2022, the potential for double taxation can be avoided if the corresponding credit or some other forms of relief is provided by the counterparty for the additional tax liabilities that may arise as a result of the secondary adjustment. If certain tax authorities continue to make secondary adjustments in the form of constructive dividends, any tax withholding may be irrevocable because no revenue is earned—if it is based on the domestic laws of other jurisdictions. 

In addition, based on the provisions in the Elucidation of Article 4 paragraph (1) letter g of the Income Tax Law, dividend, both real and disguised, is the portion attributable only to shareholders. This means that a secondary adjustment cannot be made by the tax authorities if the primary adjustment can be identified as an affiliated transaction or not a transaction with the shareholders (direct shareholders). 

Global Benchmark 

In the United States (US), the secondary adjustment may be made through two options or known as a conforming adjustment. The first option is through domestic procedures according to Rev. Proc. 99-32, which allow taxpayers to choose to transfer funds that have been issued/received related to affiliated transactions (commercial purpose). The reason is to align the tax purpose with the elective cash repatriation mechanism so that secondary adjustment efforts are unnecessary. 

The second option is through an inferential secondary adjustment mechanism, by assuming that one or more secondary transactions have occurred on the difference between the value of the affiliated transaction and the arm’s length value of the transaction. 

In the Netherlands, the law requires taxpayers to make secondary adjustments in order to recognize the impact of the secondary transactions carried out. These kinds of secondary transactions are mandatory. Referring to the relevant laws, options such as current account adjustments, constructive dividends, and constructive capital injections are feasible. 

However, the law excludes the application of secondary adjustment in the form of a constructive dividend if: (1) other countries do not recognize secondary transactions carried out by taxpayers and, as a result, taxpayers do not make adjustments regarding the tax withholding paid on dividends in the Netherlands; and (2) no abuse of law occurred in the avoidance of tax withholding payable on dividends. 

The case of BMC Software Inc. v. Commissioner of Internal Revenue can be an example of practical applications and implications of secondary adjustment provisions related to transfer pricing in the US. The conclusion of the case was that the taxpayer could deny the tax authority's allegations and could prove that the main affiliated transactions have complied with the arm's length principles. 

*Disclaimer: This article is the author's personal opinion and does not reflect the attitude of the institution in which the author works.

**The article was published in Kumparan, on 30 August 2022 

Kumparan

Disclaimer! This article is a personal opinion and does not reflect the policies of the institution where the author works.