The reduction in corporate tax rates and extension of its tax bases has become a common policy that tends to be applied in industrialized countries in last recent years. In fact, this trend is a natural reaction of tax authorities to face inter country capital mobility and an increasing number of multinational companies. One of reasons that the existence of multinational companies impacted to national corporate tax systems is because they may shift profits across countries without changing the location of their real investment by using thin capitalization scheme (Fuest and Hemmelgarn, 2003). Due to globalization, thin capitalization issues have become challenging both from international tax policy perspective and managers' perspective.
In many high tax rates countries, tax authorities allow interest expenses deduction from corporate tax base, whereas equity returns to investors are not tax-deductible. Therefore, companies generally increase debt to equity ratio to relish benefit from deduct-able interest expenses in order to minimize corporate tax base (Mintz and Smart, 2001). Moreover, this unequal treatment of usage of financing form provides incentive to management to increase debt financing in their capital structure. In addition, companies thus trade-off tax advantages of debt against its non-tax costs, where the latter arise primarily from an increased risk of financial distress and the resulting agency costs due to conflict of interest between debt and equity owners (Myers, 2001)
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Multinational companies decisively have the ability to create a strategic tax planning of its financial structure. Besides using foreign debt, they may also internally use inter-company loans. Therefore, tax authorities in many countries often respond by applying thin-capitalization rules. This policy is widely imposed amongst European and OECD countries (Buettner, Overesch, & Schreiber, 2008).
Thin capitalization rules can be generally classified as objective (debt to equity ratio limitation rule) or subjective (interest stripping rule). The objective rules would limit the interest deduction if the company has a debt-equity ratio more than certain applied debt to equity ratio (for example, Japan has applied 3:1 safe haven debt to equity ratio). Otherwise, subjective rules would limit the interest deduction if the amount of the loan, the repayment terms, and the interest rate offered by company were not similar to what a bank would offer. Some countries use modified subjective rules, which are subjective rules with a quantitative measure or ï¿½safe harborï¿½ embedded therein. (Farrar, & Mawani, 2008).
Based on thin capitalization rules, the Indonesian Tax Authorities (ITA) authorized to determine debt-to-equity ratio (DER) for tax purposes. For instance, they may reallocate debt reduction as well as to determine the amount of capital to recalculate taxable income related to affiliated-parties to set the arm's-length transaction. However, in practice, Indonesia does not have specific thin capitalization rules to implement it, neither interest stripping rule nor debt to equity ratio limitation
This research conducted to investigate the implementation of objective rule (debt to equity ratio limitation rule) in Indonesia, especially to determine fixed DER and arm's-length DER for multinational companies in Indonesia.
2. Research Problem
Indonesia, as a developing country, with its strong advantages in both political situation and macroeconomic policy become an attractive destination for Foreign Direct Investment (FDI) (Ferry and Partner, 2011). To support this situation, government has enticed foreign investors with tax incentives and benefits for certain industries or business area (Delloitte, 2011). As the result, FDI in Indonesia tends to increase from year to year (CEIC Indonesia Premium Database, 2011). But, nevertheless, Jusuf Anwar, Minister of Finance, said that there were still hundreds of foreign companies did not pay corporate taxes in lastly five years because they suffered losses on their business, although, they were a good and performed companies (TempoInteraktif, 2005). In addition, Fuad Bawazier, ex Minister of Finance, said many foreign companies has been cheated to pay their corporate taxes through transfer pricing and window dressing schemes (Kalteng Pos, 2012).
Empirically, clearly indicated that financial policy plays an important role in the process of shifting profits within a multinational company occurs through a variety of schemes. Moreover, these practices of shifting international debt denote that multinational companies pay substantially lower tax than domestic companies (Grubert, 2003; Mintz, 2004).
As mentioned before, Indonesian Tax Authorities does not have clear thin capitalization rules. So that, the practices of international debt shifting by multinational companies cannot be properly supervised and controlled by the tax authorities. Thus, the practices of this cross border profit shifting is potentially inflicting to tax revenue losses to Indonesian government.
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3. Significant of the Study
This research has both practical and academic significances; providing reference and suggestion to Indonesian Tax Authority when they set regulation on thin-capitalization rules, especially on determining fixed DER and arm's-length DER, as well as by Indonesian Tax Court in order to examine tax dispute cases. In addition, this research also can be used by companies to set arm's-length DER for corporate tax calculation; furthermore, the study can be referenced by taxpayers to determine their capital structure policy as well as on setting their transfer pricing documentation related to affiliated-parties. For academic purpose, it enriches knowledge and contribute the literature on international taxation, particularly in transfer pricing and thin capitalization.
4. Research Objectives
The research conducted to investigate the implementation thin capitalization rules in Indonesia, investigate to how clearly the ITA implements thin capitalization rules and how companies responses on its rules. This study also aims to investigate and determine fixed DER and arm's-length DER for overall multinational companies in Indonesia. Moreover, specifically, the study also to determine fixed DER and arm's-length DER for each business sector on multinational's companies.
The objective of this study is to evaluate the implementation of Indonesian Thin Capitalization Rules. This research objectives are as follows:
a. to reveal how The Indonesian Tax Authorities has performed Thin Capitalization Rules;
b. to identify how companies response to Thin Capitalization Rules
c. to determine fixed DER and armï¿½s-length DER for Multinationalï¿½s Companies;
5. Research Question
The major research question is ï¿½To what extent Thin Capitalization Rules has been implemented by Indonesian Tax Authoritiesï¿½. The minor questions consist of the following:
a. to what extent fixed DER and armï¿½s-length DER has been regulated by The Indonesian Tax Authorities;
b. how large armï¿½s-length DER should be applied to multinational companies in Indonesia;
c. is it necessary to regulate fixed DER and armï¿½s-length DER for each business sector to multinational companies.
6. Literature Review
There are several research papers on thin capitalization. However, more significant amongst it written by Christoph Kaserer (Kaserer, 2008), Tim Edgar, Jonathan Farrar, and Amin Mawani (Edgan, Farrar, & Mawani, 2008) and Jonathan Farrar and Amin Mawani (Farrar, & Mawani, 2008). This research is inspired by these three research papers.
Goritzer (2010) and the 1987 OECD Report (2000) discussed that multinational company should be powered by capital from the shareholders called as equity. On the other hand, shareholders typically also provide loans to the company in order to replenish it's financing. Therefore, they need to take into account of taxation impact on equity or debt financing from its affiliated companies. Interest expense due to debt financing is usually tax-deductible in almost every country and thus, of course significantly reduces the taxable income of the company. In contrast, Haufler (2008) explained that the equity returns to investors are not tax-deductible. So that, this unequal treatment, fundamentally has prompted the company to be highly dependent on debt financing. For multinational companies this incentive is further strengthened by the possibility to use internal debt as a means to shift profits from high-tax to low-tax countries.
HMR & C UK (2005) stated that thin capitalization is the financial branch of transfer pricing which looks to apply the arm's-length principle to company funding - to treat companies which are in a special relationship, for tax purposes, as if they were independent of each other and acting only in their own separate interests. Farrar (2008) illustrated that a business is said to be thinly capitalized if it is financed with a high proportion of debt relative to equity. The rules that limit the amount of interest deductions in these situations are known as thin capitalization rules. They typically apply where a domestic subsidiary is owned or controlled by a foreign parent. Atila (2008) define that thin capitalization is capital, considered foreign and amenable to taxation. Usually institutions hide its gains by sham transactions whose effect evades any tax assessment. In response to this the Turkish government has developed the concept of thin capitalization as a check against tax evasion. The basic aim of this concept is the prevention of decreased taxation of the partner's landing money during the investment process, thereby increasing the interest accruing there from.
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According to Buettner, Overesch, & Schreiber, (2008) and Bacellar (2011), thin-capitalization rules are effective in curbing tax planning via inter-company loans. However, investment is found to be adversely affected. More specifically, Edgan, Farrar & Mawani (2008) pointed that by modification of asset apportionment application, thin comprehensive capitalization regime allows government to recognize the balance between tax revenue need and government's objectives on foreign direct investment policy. Based on this approach, both of intra group debt and the external debt of a multinational group is treated equally on non-deductible rule.
Moreover, Edgan, Farrar & Mawani explained that specification of a leverage ratio defines the outer limit on the sourcing of interest expense associated with either form of debt. For multinational groups that exceed the specified safe-harbor ratio, interest expense can still be sourced on a tax-deductible basis to the extent that the leverage ratio of a particular member of the group, on an unconsolidated basis, does not exceed the worldwide consolidated ratio or a modest multiple of that ratio. The application of asset apportionment is thereby limited to this legislative exception.
Farrar & Mawani (2008) described that thin capitalization rules can be commonly categorized as objective or subjective. First, Objective rules (debt to equity ratio limitation rule) use a quantitative measure, such as a debt-equity ratio, to limit interest deductions. Second, subjective rules (interest stripping rule) are qualitative and require a firm to limit its interest deductions if the amount of interest is unreasonable according to facts and circumstances.
In addition, Kaserer (2007) stated that some European Union member states implemented corporate tax rules restricting the deductible of interest payments. Moreover, he said that the most important - although unwarranted - argument in favor of an interest stripping rule is that government has to prevent the erosion of their domestic tax base. Allegedly, this has become even more important as increasing tax competition forces government to reduce their statutory corporate tax rates. Interestingly, corporate tax revenues have been increasing slightly over the last 30 years for the majority of OECD countries, although statutory tax rates have decreased considerably over this period.
The 1987 OECD Report (2000) identifies eight specific tax policy aspect arising from the use of loan financing rather than equity financing. It does acknowledge, however, that thin capitalization may be a result of decisions made for purely commercial or economic reasons rather than obtain tax advantages. To implement thin capitalization rule, OECD Report has identified two principal alternative approaches, these are fixed ratio approach and rm's-length principle. Under first approach, if the borrower's exceeds a certain proportion of its equity capital, the interest on the loan or interest on the excess of loan over the approved proportion automatically disallowed or treated as dividend. On the other hand, countries adopting the second version look at arm's-length position and consider the size of loan that would have been made under arm's-length conditions. Interest on the excess of the actual loan over what is regarded an arm's-length loan would normally be disallowed and might possibly be treated as dividend. The debt to equity ratio would be one factor to be taken into account in using either of this approach, but it would not necessarily be deciding factor.
In fact, Indonesian Tax Authorities has adopted these two approach of thin capitalization rules. Fixed ratio approach has reflected on article 18 par (1) Income Tax Law and the other approach has addressed in article 18 par (3) Income Tax Law. The research investigates the implementation of this Indonesian thin capitalization rules.
7. Methodology and Scope of Limitation
In order to gain the research objectives, this study conducted in two focuses. First, to identify thin capitalization rules implementation by ITA and multinational's companies in Indonesia, and lastly to determine arm's-length DER for multinational's companies.
The first study focus exercised by qualitative research. Therefore, the research is a case study research by conducting literature study on thin capitalization rules. It compares among thin capitalization rules in several countries, including Indonesia, and its implementation in Indonesia. This research use descriptive analysis to describe the results of research.
The second study is focused on testing and determining arm's-length DER for multinational's companies. This study use quantitative method using IBM SPSS software where the object of research are multinational's companies that listed and registered on the Indonesian Stock Exchange (IDX). Inter-quartile method used to determine arm's-length DER whereas The method is adopted from OECD Gudelines. In this method, data to be measured using median as the statistical tool to determine the representative result of a sample set. The inter-quartile range is also used to determine the range of acceptable arm's-length DER. An inter-quartile range is advantageous because, by excluding outlying or extreme data point, which may be unrepresentative, the range frequently provides a good indication of representative values. To ensure the sample was normally distributed, the research use the Kolmogorov-Smirnov testing.
This study limited for last five years of financial statements. For the purpose of testing and determination of the arm's length DER, the samples are limited to:
a. the companies do not booked a loss in the current year;
b. the companies do not have a negative equity position;
c. the companies are affiliated with other company that operate out of Indonesia.
Moreover, the sample companies are limited in terms of the following:
a. all debt account except for trade payables;
b. debt position by year-end balance; and
c. equity is limited to the amount paid up capital at year-end positions, including retained earnings.
8. Structure of Research Report
Chapter 1 explains overview of the research. These explanations include background of research and implementation of existing thin-capitalization rules in Indonesia. Chapter 2 pertains to literature review wherein literature gap is identified. This chapter explores capital structure theory; tax aspect on both debt financing and equity financing; controlled transaction and affiliated party; thin capitalization definition and rules also its regimes in selected countries, including Indonesia. More specifically, this chapter discuss two approach of thin capitalization rules compare to Indonesian thin capitalization rules. Next, Chapter Three consists of theoretical framework and research design. It covers, inter-alia, research problem definition, research objective, significant of research, research questions, research methodology and scope of limitation. The most important part, research analysis, findings and discussion provided in Chapter 4. In this chapter, researcher discuss implementation of thin capitalization rules in Indonesia and compare it to selected countries and OECD model is analyze using qualitative method; next step is presentation of the analysis result on debt to equity ratio of selected sample companies that listed in Indonesian Stock Exchange (IDX) using two of OECD's approaches and its interpretation using quantitative method by IBM SPSS software. Lastly, conclusion, recommendations, limitations and need for future research provided in Chapter 5.
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Research Proposal ï¿½Thin Capitalization - Maman Surahman