Transfer Pricing Methods in Indonesia Taxation

Certain taxpayers who conduct transactions with related parties (“transfer pricing”) are required to apply the arm’s length principle in transfer pricing, prepare and maintain transfer pricing documents (“TP Documentation”). We have described certain taxpayer criteria in our other articles (read here), we also write about the tax provisions regarding transfer pricing transactions in our other articles (read here). In this article, we will discuss the method of determining transfer pricing in the context of applying the principles of business normality and fairness (arm’s length principle on the transaction).


Transfer Pricing Methods in Indonesia Taxation


The obligation to apply the arm’s length principle includes the obligation to perform the comparability analysis. Comparability analysis is an analysis of the conditions related to transactions and looking for comparisons that have comparability with the transactions that occur. After obtaining the conditions for the transaction and a suitable comparison (through comparable analysis), the taxpayer then determines the method used in determining the transaction price (transfer pricing).


Tax regulations related to the method of determining transfer pricing

The tax regulations relating to the related transaction pricing method are as follows:


  1. Law Number 36 of 2008 concerning Income Tax Article 18

  2. Director General of Taxes Regulation No. 43 of 2010

  3. Director General of Taxes Regulation No. 32 of 2011


The transfer pricing method is a way of setting an arm’s length price or profit from transactions between related companies. Transactions between related companies for which an arm’s length price will be determined are referred to as "controlled transactions". The application of the transfer pricing method helps to ensure that transfer pricing transactions are in accordance with the arm's length principle.


According to the UN Guidelines for Transfer Pricing Practices, although transfer pricing methods often use the term "profit margin", companies may also have valid reasons to report reasonable losses. Moreover, the transfer pricing method is not a single determining factor. If a related company reports taxes at an arm's length amount of income, without explicit use of any of the recognized transfer pricing methods, it does not mean that the transaction price is automatically deemed unreasonable.


According to the Income Tax Law, the methods that can be used by taxpayers in determining transfer pricing are as follows:


A. Traditional Transaction Method

  1. Price comparison method between independent parties ("comparable uncontrolled price method")

  2. Resale price method ("resale price method")

  3. The cost-plus method (“cost plus method”), or


B. Transaction Profit Method

The transactional profit methods are as follows:

  1. Profit-sharing method ("profit split method")

  2. Transactional net margin method ("transactional net margin method")


The application of transfer pricing methods shall be performed in the hierarchy


According to PMK 43/2010, in applying the Transfer Pricing Method, the following must be considered:

  1. The application of the Transfer Pricing method is carried out hierarchically starting with the application of the comparable uncontrolled price (CUP) method in accordance with appropriate conditions;

  2. If the comparable uncontrolled price (CUP) method is not appropriate to apply, the resale price method (RPM) or the cost-plus method (cost-plus method / CPM) must be applied in accordance with the right conditions. ;

  3. In the event that the resale price method (RPM) or the cost-plus method (cost-plus method / CPM) is not appropriate, the profit split method (PSM) or the transactional net margin method can be applied. method / TNMM).


In the section below, we will briefly discuss the method of determining transfer pricing one by one using references from the 2017 OECD Transfer Pricing Guideline and the 2017 UN Practice Manual on Transfer Pricing.


1. Comparable Uncontrolled Price Method

The Comparable Uncontrolled Price Method (CUP) is a method that uses price comparisons between transacted goods and other goods using internal comparisons (between one of the affiliated parties and an external party) or external comparisons (transactions between independent parties).


The CUP method is most appropriate for commodities or goods that are available in the market and have a non-unique character. The CUP method is used when there is a comparable product with comparable conditions.


According to the Taxation Regulations in Indonesia, taxpayers are required to apply the CUP method for the first time before applying other methods.


(Read more about CUP Method here)


2. Resale Price Method

The Resale Price method uses a comparison of the gross profit margin between companies that transact in transfer pricing and the gross profit margin of the comparable transaction (from the other companies that are independent parties). The type of company that is the subject of comparison in the resale price method is a company that has functions as a sales agent.


The resale price method is most suitable for companies that function as sales agents of a product, which do not add value to the product. The resale price method is applied as an alternative to the CUP method if the CUP method cannot be used, or the Cost-Plus method (described below) cannot be used.


(Read more about RPM here)


3. Cost-Plus method (Cost plus method)

The Cost-Plus method is used by manufacturing companies or those performing production functions and can also be used for service providers. The Cost Plus method determines the transfer price by adding a reasonable cost-plus markup (as profit for the entity) to the production of costs of the goods being transacted. Thus, the indicator used is the gross profit margin of the manufacturing company, which makes it different from the Resale Price method which takes the gross profit margin from the selling company.


The difficulty faced in applying the cost-plus method is the difference in function between the tested company and its comparable, especially if there are elements of the use of intangible assets that might affect the product price. Another thing that adds to the difficulty in applying the cost-plus method is the consistency of accounting practice. There is a possibility of differences in cost accounting between companies, for example, research costs are recorded as part of the cost of goods sold, while in other companies these costs are recorded as a general operating expense.


In situations where there are operating costs that need to be considered for comparability, the Transactional Net Profit method, in general, will be more reliable than the Cost-Plus Method.


(Read more about cost-plus method here)


4. Transactional Net Margin Method (TNMM)


The Transactional Net Margin Method  (TNMM) method uses a certain profit level indicator (PLI) to be compared between tested party and comparable independent party. The comparison used in this method is the net margin against a certain component (assets, sales, or costs) of similar companies (line of business, functions, and risks). Profit level indicators that are commonly used are Return on Assets, Operating Margin, Return on Total Cost, or Berry Ratio (a more detailed explanation will be discussed in our other article).


The Transactional Net Margin Method or TNMM method is the method that most widely used in determining the arm’s length transfer pricing. The selection of the Profit Indicator Rate (PLI) depends on the facts and circumstances of the particular case of the tested company. 


It would be useful to consider the use of several different PLI. If the results of applying several levels of the earnings indicator tend to be close to the same value, it is an indication that the results are reliable. Conversely, if there are significant differences between the result coming from different PLI, we suggest conducting a review if there are significant functional or structural differences between the tested party and the independent party being compared.


According to the OECD Transfer Pricing Guideline 2017, it would be inappropriate to apply the transactional net margin method across companies if companies undertake different transfer pricing transactions that cannot be compared exactly in the aggregate with those undertaken by independent companies.


(Read more about TNMM here)


5. Profit Split Method

The Profit Sharing method begins by identifying the profits to be allocated between the companies that involve in the controlled transactions. Furthermore, this profit is shared among associated companies based on the relative value of each company's contribution, which reflects the functions performed, the risks incurred, and the assets used by each company in related transactions.


Allocation of profit (percentage of profit sharing) for the tested entity will be compared to the external data (the percentage of profit sharing among independent companies with comparable functions, assets, and risks). The Profit Sharing method can be used in cases involving highly interrelated transactions which cannot be analyzed separately. The Profit Sharing method is appropriate for transfer pricing that involves tangible assets, intangible assets, trading activities, or financial services.