Royalty taxation and transfer pricing risks in Indonesia | Practical points to avoid denial in tax audits

In Indonesian royalty transactions, royalties paid to overseas parent companies and affiliated companies may be subject to tax audits. In particular, when royalties are paid overseas in the name of trademarks, brands, patents, manufacturing know-how, technical manuals, software, etc., confirmation is required from the perspective of withholding tax, VAT, corporate tax, and transfer pricing taxation.

Just having a contract for royalties is not enough. A tax audit confirms whether the intellectual property is actually being used, whether the use of the intellectual property is generating economic benefits for the Indonesian corporation, and whether the fee rate is reasonable compared to third-party transactions.

In this article, we will explain the basics of royalty taxation in Indonesia, points that are likely to be rejected in a tax audit, and matters that should be organized in transfer pricing documents.

What is royalty trading in Indonesia?

Royalties are compensation paid for the use of intellectual property. Typical intellectual properties include trademarks, brand names, logos, patents, manufacturing know-how, technical manuals, copyrights, and software.

A typical example is a transaction in which an Indonesian subsidiary uses the manufacturing know-how and brands owned by the Japanese head office, and is compensated for this by paying a certain percentage of sales as royalties.

In this way, royalties are transactions that tend to occur between parent companies and subsidiaries. Therefore, the tax authorities will check from the perspective of whether the profits of the Indonesian corporation have been transferred overseas.

Difference between loyalty and service

In practice, intra-group services are often confused with loyalty.

Royalties are compensation for the continued use of intellectual property. Services, on the other hand, are compensation for the services actually provided.

[Table 1: Difference between royalties and services]

Particularly in the manufacturing industry, royalty contracts often include technical support, engineer dispatch, quality audits, factory audits, troubleshooting, etc. However, if the actual situation is limited to maintenance and training, the tax office may point out that ``this is not royalty, but service.''

Main tax risks related to royalties

Royalties are transactions that are likely to have a large impact if rejected, as they span multiple tax categories.

[Table 2: Main tax issues regarding royalties]

The seminar materials indicate that royalty payments are subject to withholding tax, that the applicability of tax treaties is an issue depending on the status of DGT acquisition, and that the handling of VAT should also be confirmed.

Please note that tax rates and declaration methods may change depending on system revisions and transaction details, so it is necessary to check the latest laws and practices when actually filing a tax return.

Cases that are likely to be denied in a tax audit

Royalties are likely to be denied in the following cases:

・There is a contract, but there are no manufacturing manuals or technical documents.
・There is no record of the engineer's business trip report or instruction content.
・The contents of the work report are mainly about maintenance and training.
・There are no documents showing that research and development is being conducted at the head office.
・The value of patents and technology is already declining.
・Unable to explain the basis of royalty rates

A contract alone may be considered insufficient as a document to explain the reality of royalties. For manufacturing know-how, it is important to prepare manufacturing manuals, work standards, quality control guidelines, technical support reports, R&D expense details, etc. For brand usage fees, examples include trademark registration certificates, materials showing brand recognition, and comparison materials with other companies in the same industry.

Points to check regarding transfer pricing taxation

Royalty transactions are also subject to transfer pricing taxation. There are four main points to check:

・Is the rate reasonable compared to third-party transactions?
・Is the payee involved in the development and maintenance of intellectual property?
・Is there not only a contract but also the actual situation?
・Is there a risk that excessive payments will be treated as deemed dividends?

The appropriateness of royalty rates may be verified by comparison with similar contracts. For example, if your company's rate is 5% and the rate range for similar contracts between third parties is 2% to 7%, it will be easier to provide certain explanations. However, we will also check the industry type, target intellectual property, region, contract terms, scope of usage rights, etc.

Furthermore, it is not enough for the payee to simply be the holder of the contract. It is necessary to explain which legal entities are actually involved in the development, enhancement, maintenance, protection, and utilization of intellectual property through functional and risk analysis.

Practical checkpoints to avoid rejection

In order to ensure that your royalty agreement is not rejected in a tax audit, it is important to check the following points:

・Clarify the distinction between royalties and services
- Specify the content, scope of use, and fee rate of the intellectual property in the contract.
・Storing manufacturing manuals, technical support reports, and research and development materials
・Compare the appropriateness of rates with third-party transactions
・Make the master file and local file consistent
・If there is a rate difference with a subsidiary in another country, be able to explain the reason.
・Check the handling of DGT, withholding tax, and VAT in advance

What is particularly important is not to ask whether there is a contract, but to be able to explain what was actually provided and what benefits it brought to the Indonesian corporation.

summary

Royalty transactions in Indonesia are high-risk transactions involving corporate tax, withholding tax, VAT, and transfer pricing taxation.

The main reason why royalties are denied is not just the lack of a written contract. Problems include a lack of documentation explaining the actual situation, unclear basis for rates, and lack of consistency with transfer pricing documents.

Companies that have entered into royalty agreements, make payments to foreign affiliates, or include royalty transactions in their transfer pricing documents are advised to check the integrity of their contracts, supporting documents, and transfer pricing documents before being subject to a tax audit.

Keystone Consulting Group provides practical support for Japanese companies regarding royalty taxation and tax audits in Indonesia.

Related services:Indonesia tax audit/transfer pricing support