Preventing Tax Avoidance, PP 55/2022 Adopts New Borrowing Cost Provisions

To prevent tax avoidance practices, Indonesia, through Government Regulation (PP) Number 55 of 2022, adopted a new method of limiting the imposition of interest cost related to tax calculations.

This method will compare earnings before deducting interest, taxes, depreciation and amortization (EBITDA) or Earning Stripping Rules (ESR).  This method is also known by other terms, such as Fixed Ratio, Interest-to-Profits Ratio.

However, the government has not specifically set a ratio limit using this method. The reason is that more detailed arrangements regarding the use of the ESR method will be stipulated in the Minister of Finance Regulation.

The ESR method will complement the method that has been applied so far, namely the Debt to Equity Ratio (DER) stipulated in the Minister of Finance Regulation (PMK) Number 169/PMK.010/2015.

Read: Understanding Three New Transfer Pricing Methods in Government Regulation Number 55 of 2022

In the regulation, the government limits the DER value of each company to no more than a ratio of 4:1.  If it is above the specified comparison value, then the interest costs on the debt cannot be recorded as an expense which is a deduction from income.

The government argues that generally, companies that have debts above normal practice thin capitalization and the company may be in an unhealthy state.

Tax Avoidance Practices

Thin capitalization schemes by companies are commonly carried out, one of which is through company funding schemes.

In general, companies often use two funding sources in carrying out their operational activities. First, using funds from equity or and second, from debt or loans.

The impact of using the two schemes is very different. This includes the implications for corporate tax obligations.

If the funding comes from equity, the company must provide compensation in the form of dividends. Meanwhile, if it comes from debt, the compensation that must be paid by the company is in the form of interest.

Read: Understanding the Arm's Length Principles and its Consequences in Transfer Pricing

In the tax context, interest payments can be charged as an income deduction, while dividends cannot be used as an income deduction. Thus, especially multinational companies, have a tendency to prefer using debt fund schemes.

The tax authorities suspect that this lending scheme is widely used by multinational companies as covert equity participation to reduce the company's tax burden. In particular, loans are made between affiliated companies located in countries with high tax rates by companies located in countries with low tax rates.

This situation will be detrimental to the country where the company receiving the loan (the debtor) is because its tax base is eroded due to the imposition of the excess interest cost.

However, the use of DER to limit interest expenses that can be charged in tax calculation is actually not recommended by the Organization for Economic Co-operation and Development (OECD). Because it is considered not strong enough to counteract the erosion of the tax base.

OECD Recommendation

For information, the use of the ESR method was previously recommended by the Organization for Economic Co-operation and Development (OECD) and the G20 in the Based Erosion and Profit Shifting (BEPS) Action Plan 4.

According to the OECD, the limit of ESR that countries can implement is between 10%-30%.

In practice, several countries have used the ESR method, such as the Netherlands and Japan, with various ratio values set. In Japan, the applicable ESR value is 20%, down from the previous 50%.  While in the Netherlands, the applicable ESR value is 30%.

ESR at Business Group Level

The use of the ESR method can also be combined with the Group Ratio Rule approach, which is the threshold for the ratio of borrowing costs to EBITDA at the business group level.

With this combination, when a company has interest expenses that exceed a predetermined ESR limit, it can charge 'excess' interest costs up to the Group Ratio Rule threshold of its business group.

In addition, the OECD also recommends any excess interest expense on debt that does not come in as a deduction from income can be carried or taken into account in the next tax year or carry forward.

Another OECD recommendation is that companies with low risk related to tax base eroding practices can be given special treatment. For example, excluding interest expense o debt used to finance activities in the public interest from calculating ESR.

We surely expect that using this new method can encourage taxpayer compliance and provide legal certainty for taxpayers regarding the imposition of debt interest costs. For this reason, we hope that in determining the technical provisions, the government can consider all factors and business conditions in Indonesia.  (ASP/KEN)