Transfer Pricing on Hard-to-Value Intangibles: The Disparity Between OECD Guidelines, the UN Manual, and Indonesia’s Income Tax Law

By Muhammad Fandy Zainuddin, employee of the Directorate General of Taxes

Transfer pricing practices have been dramatically increasing, both in quantity and complexity. Policymakers have to keep their eyes wide open on the ever-changing dynamic of tax avoidance methods in order to level the playing field and prevent tax revenue loss. Therefore, a comprehensive and adaptive tax policy and regulation should sit at the top of the list that the government should bear in mind whenever such cases arise. In the case of the Government of Indonesia, the formulation of domestic tax law regarding transactions on hard-to-value intangibles (HTVI) could be another major breakthrough that the country needs to restore confidence in the system and ensure that profits are taxed where value is created.

While the guidance and technical regulations about the tax treatment of intangibles have been adamant and ubiquitous, little is known about the treatment of hard-to-value intangibles, as can be seen from the lack of technical guidance and rules stated regarding the subject in the United Nations Transfer Pricing Manual and Indonesia’s Income Tax Law. The term itself was first defined in the United Nations Practical Manual on Transfer Pricing for Developing Countries (2021) and then followed by the Organization for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines (2022) with exactly the same definition. The OECD Transfer Pricing Guidelines state in Chapter VI: Intangibles, paragraph 6.189, that:

"HTVI covers intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises, (i) no reliable comparables exist, and (ii) at the time the transaction was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer."

It further elaborates on characteristics of transactions involving the transfer or use of HTVI that have never been specifically addressed elsewhere, especially in the UN Transfer Pricing Manual and Indonesia’s Income Tax Law, as follows:

1. "The intangible is only partially developed at the time of the transfer.
2. The intangible is not expected to be exploited commercially until several years after the transaction.
3. The intangible does not itself fall within the definition of HTVI in paragraph 6.189 but is integral to the development or enhancement of other intangibles that fall within that definition of HTVI.
4. The intangible is expected to be exploited in a manner that is novel at the time of the transfer, and the absence of a track record of development or exploitation of similar intangibles makes projections highly uncertain.
5. The intangible, meeting the definition of HTVI under paragraph 6.189, has been transferred to an associated enterprise for a lump sum payment.
6. The intangible is either used in connection with or developed under a Cost Contribution Arrangement (CCA) or similar arrangements."

According to Indonesia’s Transfer Pricing Country Profile, which was published by the OECD in December 2021, Indonesia has not yet provided any transfer pricing rules or special measures that are related to intangibles, let alone relevant to HTVI. Comparatively, the UN Transfer Pricing Manual has issued guidance on tax treatment related to intangibles with the use of ex-ante and ex-post analysis, though there is still no guidance on HTVI matters. Simply put, ex-ante analysis is an analysis to determine the expected outcomes at the time the transaction is undertaken, while ex-post analysis refers to the actual outcomes.

The OECD Transfer Pricing Guidelines have clearly illustrated how HTVI transactions can be approached by tax authorities. The use of ex-ante analysis and post-analysis is fundamental, with a few exceptions to be aware of. The use of ex-post analysis is exempt if:

i) The taxpayer provides:

1. Details of the ex ante projections used at the time of the transfer to determine the pricing arrangements, including how risks were accounted for in calculations to determine the price (e.g., probability weighted), the appropriateness of its consideration of reasonably foreseeable events and other risks, and the probability of occurrence; and,
2. Reliable evidence that any significant difference between the financial projections and actual outcomes is due to:

• a) unforeseeable developments or events occurring after the determination of the price that could not have been anticipated by the associated enterprises at the time of the transaction; or
• b) the playing out of the probability of the occurrence of foreseeable outcomes and that these probabilities were not significantly overestimated or underestimated at the time of the transaction;

ii) The transfer of the HTVI is covered by a bilateral or multilateral advance pricing arrangement in effect for the period in question between the jurisdictions of the transferee and the transferor.

iii) Any significant difference between the financial projections and actual outcomes mentioned in i)2 above does not have the effect of reducing or increasing the compensation for the HTVI by more than 20% of the compensation determined at the time of the transaction.

iv) A commercialization period of five years has passed following the year in which the HTVI first generated unrelated party revenues for the transferee and in which any significant difference between the financial projections and actual outcomes mentioned in i)2 above was not greater than 20% of the projections for that period.

The first exemption means that, even though the ex-post evidence about financial outcomes provides relevant information for tax authorities to consider the appropriateness of the ex-ante pricing arrangements, in the event that the taxpayer can satisfactorily demonstrate what was predictable at the time of the transaction and reflected in the pricing assumptions and that the developments leading to the difference between projections and outcomes arose from unpredictable events, tax authorities will not be entitled to make adjustments to the ex-ante pricing arrangements based on ex-post outcomes. For instance, if the evidence of financial outcomes indicates that sales of products exploiting the transferred intangible reached 2,000 a year but the ex-ante pricing arrangements were based on projections that considered sales reaching a maximum of only 200 a year, then the tax authorities should consider the reasons for sales reaching such higher volumes. If the higher volumes were caused by, say, a natural disaster or some other unexpected event that was either impossible to predict at the time of the transaction or had a very low chance of happening, then the ex-ante pricing should be recognized as being at arm's length, unless there is evidence other than the ex-post financial outcomes that shows that price setting was not at arm's length.

The OECD Guidelines further illustrate the tax treatment of HTVI by providing clarifying examples of the application of the HTVI approach in different scenarios. The guidance initiated by the OECD is now adopted by 40 countries around the world, leading to a more just and adaptive taxation system that resonates with the tax treatment of common intangibles set out in the UN Manual. Meanwhile, Indonesia is pretty much in a gray area where no specific measures are applied to the said transaction, which was confirmed by the OECD’s latest assessment of Indonesia’s transfer pricing profile. It poses risks to our taxation system, such as revenue loss through the Base Erosion and Profit Shifting (BEPS) scheme, inconsistency and uncertainty in law enforcement, and double taxation.

So, the writer argues that to close the gap between Indonesia's current situation and international best practices, the government should come up with specific rules for how to tax HTVI transactions. This would improve consistency and certainty, prevent economic double-taxation, and possibly increase revenue by stopping BEPS schemes that use HTVI. The proposed transfer pricing rules might reflect those of the OECD, given that the majority of developing countries have adopted the method, including our neighboring countries such as Malaysia and Singapore.

*)This article is the author's personal opinion and does not reflect the view of the institution where the author works.