A Practical Approach for understanding Arm's Length Principle for Transfer Pricing in Indonesia

The application of the Arm’s Length Principle (ALP) for transfer pricing in Indonesia is a multi-step process, grounded in Minister of Finance Regulation (PMK) No. 172 of 2023, which revokes and replaces previous regulations like PMK 213/2016. This principle is fundamental for ensuring that transactions between entities with a “special relationship”—a term that has been broadly defined to include influence beyond direct ownership—are priced as if they were conducted between independent parties under comparable conditions. The regulations aim to enhance fairness and legal certainty in tax matters involving related-party transactions, aligning Indonesia’s transfer pricing framework with international best practices from the OECD.

The detailed steps of applying the ALP in Indonesia are as follows:

Identify and Analyze Special Relationships and Controlled Transactions
The taxpayer must first identify all transactions with parties with a “special relationship.” According to PMK 172/2023 Article 2, a special relationship is defined as a “state of dependence or attachment” between parties, which may arise due to :
- - Ownership
    A Special relationship due to ownership or equity participation is deemed to exist if:
    - a Taxpayer has direct or indirect equity participation of a minimum of 25% (twenty-five percent) in another Taxpayer; or
    - the relationship between the Taxpayer with equity participation of a minimum of 25% (twenty-five percent) in two or more Taxpayers.
- - Control, management or technology
    The special relationship due to control is deemed to exist if:
    - one party controls another party or one party is controlled by another party, directly and/or indirectly;
    - two or more parties are under the control of the same parties, directly and/or indirectly;
    - one party controls another party or one party is controlled by another party through management or use of technologies;
    - there are the same people who are directly and/or indirectly involved or participating in managerial or operational decision-making on two or more parties;
    - parties that are commercially or financially known or claim to be in the same Business Group;
    - or one party claims to have a special relationship with another party.
- - Relationships influenced by family or marriage
    The special relationship due to family relationship by blood or marriage is deemed to exist if there is a family relationship either by blood or by marriage in one degree of direct lineage vertically and/or in one degree of direct lineage horizontally.
Exercising Industry Analysis
According to PMK 172/2023 Article 6, Industry analysis is an integral and foundational part of the broader comparability analysis. It serves to provide context and support the selection of comparable companies or transactions, ensuring that the Arm’s Length Principle (ALP) is applied correctly. Analysis to identify factors including:
- - - the type of products in the form of goods or services;
    - industry and market characteristics, such as market growth, market segmentation, market cycle, technology, market size, market prospects, supply chain and value chain;
    - competitors and level of business competition;
    - the level of efficiency and superiority of the Taxpayers’ location;
    - economic conditions that affect business performance in the industry, such as inflation rates, economic growth, interest rates and exchange rates;
    - regulations that affect and/or determine success in the industry; and
    - factors other than the factors referred to in subparagraph a to subparagraph f that affect business performance in the industry.
The results of the industry analysis are used to identify differences between the conditions of the Transaction Affected by the Special Relationship being tested and the conditions of the potential comparable transactions when conducting a comparability analysis.
- - - Contractual Terms
      Analyzing explicit and implicit contractual terms between the related parties (e.g., payment terms and conditions, responsibilities, warranties, volume commitments, and duration).
    - Functional Analysis (FAR Analysis)
      Ensuring the functions performed, assets used, and risks assumed by the potential comparable are similar to those of the tested party. This includes:
      - Functions: R&D, manufacturing, distribution, marketing, administration, etc.
      - Assets: Tangible assets (e.g., machinery, property), intangible assets (e.g., patents, trademarks), financial assets, as well as market access and level of control in Indonesia.
      - Risks: Market risk, inventory risk, R&D risk, credit risk, operational risk, foreign exchange risk, etc.
    - Characteristics of Property or Services
      Identify the specific characteristics of the goods or services being transacted significantly influence pricing in the open market. This includes:
      - Tangible Goods: Physical features, quality, volume, reliability, availability, brand name.
      - Services: Nature and extent of the services, skill and expertise required, responsibility undertaken.
      - Intangible Assets: Form of asset, type of right protected, expected benefits, exclusivity, geographical scope, duration, stage of development.
    - Economic Circumstances
      Understanding the market conditions, geographical location, size of the market, competition, and regulatory environment affecting the economic conditions of:
      - the parties to the transaction; and
      - the market in which the parties conduct the transaction.
    - Business Strategies
      Reviewing the business strategies pursued by the related parties, such as innovation, market penetration, cost leadership, or niche market focus. Identification of Transactional Conditions
      As regulated in PMK 172/2023 Article 7, An in-depth analysis of the controlled transactions is required to understand the commercial and financial relationships. This is a crucial foundational step, and for certain complex transactions like services, financial transactions, or business restructuring, a preliminary analysis is also mandated. This includes:
Perform a Comparability Analysis
Comparability analysis is required to determine the similarity between controlled transactions and independent transactions. A transaction is considered comparable if:
- - The conditions are the same or similar,
  - The conditions are different, but the differences do not affect the pricing, or
  - The conditions are different, and the differences do affect the pricing, but sufficient adjustments to the Independent Transactions can be made to eliminate the material impact.
The comparability analysis is done through the following stages:
- - understanding the characteristics of the Transaction Affected by a Special Relationship being tested based on the identification of commercial and/or financial relationships between the Taxpayer and the Affiliated Party and determining the business characteristics of each party to the transaction;
  - identifying the existence of Independent Transactions that serve as reliable comparables;
  - determining the party whose pricing indicator is being tested, if the method used is a profit-based method in accordance with the Transfer Pricing method;
  - identifying differences in conditions between the Transaction Affected by a Special Relationship being tested and the potential comparables;
  - making appropriate, accurate adjustments to the potential comparables to eliminate the material impact of differences in conditions on the transaction price indicators; and
  - determining the Independent Transactions that serve as the selected comparables.
The parties whose price indicators are tested are parties in Transactions Influenced by Special Relationships that have simpler functions, assets, and risks, taking into account:
- - the application of the Transfer Pricing method; and
  - the availability of data,
which is the most reliable and usable.

Further, the process involves searching for comparable internal (between the taxpayer and independent parties) or external (between two independent parties) transactions. If both are available and equally reliable, internal comparables are prioritized. The selection must be evidence-based, considering factors like data reliability and geographical location. The regulation also reinforces the ex-ante approach, emphasizing that pricing should be set based on information available at the time of the transaction, though practical application remains subject to interpretation.
Select the Most Appropriate Transfer Pricing Method
Based on the outcome of the comparability analysis, the taxpayer must select the most appropriate transfer pricing method to determine the arm’s length price or profit. Indonesian regulations, in alignment with OECD guidelines, recognize several methods, this includes:
- Comparable Uncontrolled Price (CUP) Method:Preferred for commodities and transactions where highly comparable uncontrolled transactions exist.
- Resale Price Method (RPM):Suited for resale transactions.
- Cost Plus Method (CPM):Applicable for manufacturing or service transactions.
- Transactional Net Margin Method (TNMM):The most commonly applied method in practice, particularly for less complex functions.
- Profit Split Method (PSM):Used for highly integrated transactions where a profit split approach is most reliable.
Prioritize Methods: While all methods are available, the CUP and PSM methods may be preferred under specific circumstances. The selection must be justified based on the reliability of the outcome, considering the specific transaction type and the nature of the functions and risks involved.

The method chosen must be the one that provides the most reliable measure of the arm’s length price or profit, considering the specific facts and circumstances.
Apply the Method and Determine the Arm’s Length Range
Once the most appropriate method is selected, the taxpayer must calculate the arm’s length price or profit and establish the arm’s length range, this includes:

- Calculate the Price/Profit:The taxpayer must apply the chosen method using the comparable data to determine an arm’s length price or profit indicator.

- Establish the Range:PMK 172/2023 specifies how to determine the arm’s length range. A full range is used if two reliable comparables are found, while an interquartile range is used for three or more comparables.

- Adjust if Necessary:If the controlled transaction’s price falls outside the arm’s length range, the DGT can adjust the price, often to the median of the range. For example:

- - Identifying Material Differences: After selecting comparables, identifying any material differences (e.g., differences in accounting practices, working capital levels, risk profiles, market characteristics) that could impact the comparability.
  - Quantifying Adjustments: Where material differences exist and can be reliably quantified, appropriate adjustments are made to the financial data of the comparables or the tested party to enhance comparability (e.g., working capital adjustments, adjustments for different accounting policies).

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