On 30 April 2010, the Indonesian Directorate General of Taxation revised two key tax regulations, which have been the subject of much commentary for their implications on Indonesian tax structuring - see previous O'Melveny alerts here, here and here.
The New Regulations
Regulations PER-24/PJ/2010 and PER-25/PJ/2010 amend regulations PER-61/PJ/2009 and PER-62/PJ/2009 issued late last year. The revisions clarify three of the criteria, all of which must be met in order for an income recipient to be treated as a beneficial owner of the income for treaty purposes.
In short, the revised regulations provide welcome clarity to the
application of the beneficial ownership test, which significantly
increases certainty for structuring international transactions
involving Indonesian companies. The revised regulations are
generally encouraging both for offshore equity holding structures,
as well as the prospect of a well structured high-yield debt
issuance by an offshore holding company or subsidiary, where a
substantial portion of the issuance is used onshore.
This alert summarizes the clarifications to these criteria, and analyzes the possible implications with respect to the use of offshore holding companies and high yield issuances in Indonesia.
The key clarifications are as follows.
- The income recipient has an 'active operation or business'. This criterion may be evidenced by the foreign tax payer having business operations or activities in Indonesia that demonstrates costs incurred, work applied or effort directly associated with the business operations or activities in order to obtain, collect and maintain income, including significant efforts to main the business continuity of the entity.
- The income recipient is 'subject to tax in its jurisdiction of residence' on the Indonesia sourced income. This criterion is met if the foreign tax payer is subject to tax legislation generally in its jurisdiction of residence, but does not require that the foreign tax payer necessarily pays such tax, whether due to a zero percent (0%) domestic rate of tax, an exemption from taxation due to a specific concession subject to objective requirements, or does not bear the economic burden of taxation, including where this is due to tax withheld by a foreign government, deferred or not collected.
- Fifty percent (50%) or more of the Indonesia sourced income is not used to satisfy an obligation to another party in the form of interest, royalty or other reward. This criterion is met if not more than fifty percent (50%) of the foreign tax payer's total income, of any type or from any sources, as disclosed in the unconsolidated financial statements of the foreign tax payer, is used to meet obligations to third parties. This expressly excludes the payment of benefits to employees in the ordinary course of an employee-employer relationship, any other costs that are ordinarily incurred by the foreign tax payer in the conduct of its business and declaration of dividends to shareholders.
In addition, the revised regulations now accept the standard forms of certificate of domicile or tax residence letter generally issued by foreign tax authorities, and no longer require foreign tax authorities to certify the customised forms published under the previous regulations.
The new regulations answer a number of questions on the application of the new tax rules, although they are not without questions themselves. However, the revised regulations are generally encouraging both for offshore equity holding structures, as well as the prospect of a well structured high-yield debt issuance by an offshore holding company or subsidiary, where a substantial portion of the issuance is used onshore.
One particular difficulty of interpretation arises from the application of the fifty percent (50%) threshold to the offshore company's total income, as opposed to its income derived from Indonesia. This suggests the possibility that a large offshore company with significant debt outstanding may not qualify for treaty benefits whether or not any portion of that debt has been passed on to Indonesia. It would seem more consistent to apply the fifty percent (50%) test to income derived from Indonesia only, although this is not an obvious interpretation under the new regulations.
Offshore Holding Companies
The clarification that dividend distributions by the offshore company are exempted from the fifty percent (50%) requirement is particularly welcome for offshore holding companies, as is the clarification that offshore companies can obtain tax benefits notwithstanding that the Indonesian source income may be exempt from taxation under domestic tax rules. As a result, offshore holding companies incorporated in traditional jurisdictions such as Singapore will continue to be entitled to benefits under the Indonesia-Singapore treaty as long as they have an active business or operations which satisfies the substance test. This would reduce the effective tax burden to the ten percent (10%) withholding rate set out in the Indonesia-Singapore tax treaty, as Singapore exempts foreign sourced dividend income from domestic taxation.1
The new regulations expressly permit credits from withholding tax levied on interest income in Indonesia to reduce tax on that income to zero in the jurisdiction of the offshore company. This suggests the possibility of an efficient high-yield issuance structure if an Indonesian company has related operations in an appropriate jurisdiction. Jurisdictions such as Singapore and Hong Kong have sufficiently low corporate tax rates such that it may be possible to entirely offset domestic corporate tax on the interest income with tax credits from Indonesia. This would reduce the effective tax burden to the ten percent (10%) withholding rate set out in the relevant tax treaty. Alternatively a substantial Netherlands operating company may be entitled to the zero percent (0%) withholding rate under the Indonesia-Netherlands tax treaty, even if it utilises domestic tax elections to minimise the Netherlands tax burden.2
This type of structure would require an offshore company with an active business and operations, sufficient equity capital to satisfy the fifty percent (50%) rule and generally involve an objective reason for raising the financing itself, such as use of a portion of the proceeds for its own working capital, capital expenditures or acquisitions.
The revised regulations provide welcome clarity to the application of the beneficial ownership test, which significantly increases certainty for structuring international transactions involving Indonesian companies.
1. Note that the new Indonesia-Hong Kong tax treaty may result in Hong Kong being an even more efficient jurisdiction as it provides for a withholding rate of 5% on dividend income, and Hong Kong does not impose domestic tax on dividend income. The Indonesia-Hong Kong tax treaty has been signed but has not yet entered into force pending ratification by both countries.
2. As discussed in previous articles, it may be possible to utilise a fiscal unity election in the Netherlands to substantially reduce Netherlands domestic tax.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.