In accounting, there is a principle of "substance over form". Simply put, formality or legality should not deny the substance of financial transactions. In reality, some naughty taxpayers deliberately manipulate their balance sheets to make them look good to avoid taxes.
Sometimes, the contents of a written contract or agreement on an affiliated transaction do not match the facts of the transaction in the field. For example, in a written agreement to provide IT services but in fact, there is a royalty payment.
Violating the principle of substance over form is just one of the many modes of tax avoidance that have become a global concern. Such practices generally take advantage of legal loopholes or weaknesses in tax regulations in many countries. Especially those related to cross-border transactions between related parties or those with special relationships.
Many countries are working to create anti-tax avoidance provisions to prevent the proliferation of such fraudulent practices.
There are legal approaches that are general or unlimited in subject and tax object (General Anti-Avoidance Rule/GAAR), and some are specific or specialized (Specific Anti-Avoidance Rule/SAAR).
Indonesia is one of many countries that have developed an anti-tax avoidance legal framework, although its scope is still limited or specific to certain tax subjects and objects (SAAR).
The application of SAAR in Indonesia, among other things, focuses on the arm's length principle, thin capitalization, controlled foreign companies, and hybrid mismatch rules.
Indonesia's commitment to strengthening the prevention of tax avoidance is legalized in the Law on the Harmonization of Tax Regulations (HPP). Then, the implementation guidelines are included in Government Regulation (PP) Number 55 of 2022 concerning Adjustment of Arrangements on the Income Tax.
One final option for preventing tax avoidance is to strengthen the GAAR instrument through the application of the principle of substance over form.
Article 32 paragraph (4) PP Number 55 of 2022 reiterates the DGT has the authority to redefine the amount of tax that should be payable based on the recognition of economic substance above its formal form. DGT can apply the principle of substance over form if other tax avoidance prevention mechanisms cannot be attempted.
However, in determining the amount of tax payable based on substance over form, the DGT must pay attention to the following conditions:
- limits of authority and implementation procedures;
- activities conducted by taxpayers are included in the scope of tax avoidance;
- stages of formal and material testing;
- quality assurance mechanisms; and/or
- protection of taxpayer rights.
Documentation and Evidence
The principle of substance over form is implied in the Income Tax Law's definition of taxable income object, especially on income derived from transactions between related parties. Specifically, it is related to the application of the arm's length principle (ALP), which includes the motive of affiliated transactions, the flow of goods, the role of each related party, and the tax implications.
The principles of accountability related to affiliated transactions must be implemented by parties conducting affiliated transactions by compiling and reporting local files according to Minister of Finance Regulation (PMK) Number 213/PMK.03/2016.
In addition to the local file, other transfer pricing documents that are also required to be held by related parties are the master file and the Country by Country Report (CbC Report). The three types of documents become evidentiary tools for taxpayers, which contain arguments, data, and facts related to affiliated transactions based on the arm's length principle and substance over form.
The local file is the most vital tool for proving the fairness of transaction pricing, demonstrating the existence of an economic substance in affiliated transactions and ensuring no tax avoidance motive. In addition, an explanation of the factual conditions of taxpayers that affect performance is also important to support the explanation of the transaction scheme and affiliated transaction conditions.
In addition, related parties also need to keep and archive valid supporting evidence of affiliated transactions, such as tax invoices, written agreements/contracts, benefits analysis, proof of visits, written reports, nominative lists, and so on. Such supporting evidence is a physical manifestation of the principle of substance over form, which is very useful in an audit to prove that the related party transaction actually occurred.
However, sometimes the provisions in the written agreement or contract do not necessarily represent the realization in the field. In fact, compliance with the fairness principle of an affiliated transaction is determined by its substance and economic reality, not depending on the name and juridical form of the transaction. These matters should be considered by all parties conducting affiliated transactions if they do not want to be accused of tax avoidance.
DGT's affirmation of the principle of substance over form should increase the attention and concern of related parties to organize and store transfer pricing documents, as well as archiving supporting evidence of affiliated transactions according to facts and reality. Do not forget corrections to affiliated transactions not only have the potential to increase the tax burden but also raise the risk of double taxation and secondary adjustments. (AGS)]
**Writers: Meiliana dan Choirunnisa Nadilla, Transfer Pricing Consultant MUC Consulting
**The Article was published in Kumparan.com, on 1 February 2023