CHAPTER 2

THEORETICAL FOUNDATION

2.1 Overview of Tax

2.1.1 Definition of tax

It is the matter of fact that tax is the biggest income for almost all countries,

having said that, tax authoritys responsibility becomes even harder. Every approach

should be done to reach the target. No matter the target is realistic or not, peoples

awareness to pay taxes need to be improved with regard to the self assessment system.

Higher government attention is needed to resolve tax issues.

Definitions of taxes have been defined by many of expertise, but having some

basic and purposes:

a. Prof. Dr. P. J .A Adriani:

Tax is the citizens installment for government, (enforceable) payable by

the tax payers according to the rules with not getting direct counter- achievement,

which can be directly appointed, and which the function is to pay common cost

related to countrys duty in running the government. (Boediono, 2000: 8,

translated independently by the Author of this Thesis)

b. Sommerfeld Ray M., Anderson Hershel M., & Brock Horace R

Tax is a transfer of resources from the private sector to the government

sector, not the result of violations of the law, but must be carried out under

conditions previously defined, with no immediate reward and proportional to the

government to carry out its tasks to run the government. (Sommerfeld, at all,

1983, translated independently by the Author of this Thesis)

From these various definitions of taxes, it can be inferred that the characteristics inherent

in the tax definition, is as follows:

1. Tax is collected under the imposable Law and its implementing

regulations;

2. Tax payment can not be shown by the existence of counter-individual

achievements by the government;

3. Tax is collected by both state central government and local government;

4. Tax is state income to cover expenditures, where the surplus is used to

finance public investment.

2.1.2 Function of Tax

There are four taxes functions:

1. Budgeter function

Budgeter function is a public sector function to collect the tax

money as much as possible in accordance with applied regulations that

would in time be used to finance state expenditures.

2. Regulerend Function

Regulerend function is a function that the tax will be used as a tool

to achieve certain goals, which were located outside the financial sector.

3. Democratic function

Democratic function is a function, which is an embodiment or a

form of mutual assistance system, including government activities and

development for societys welfare.

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4. Distribution function

Distribution function is a function emphasizing on the element of

equality and justice in society. This can be seen, for example, from higher

rate in progressive tax system for community who have large incomes and

vice versa.

2.1.3 Tax Collection Conditions

Few Conditions should be considered during tax collection process:

1. Justice Terms (collection of taxes must be fair)

That is to be in accordance with the legal objectives, namely achieving

justice, legislation and fair implementation tax collection. Fair in terms that

laws and regulations is to impose a general and equitable tax, adapted to

citizens respective abilities while, fair in its implementation is by

accommodating the rights for taxpayers to file objections, delays in payments

and to appeal to the Tax Advisory Council.

2. Juridical Terms

In Indonesia, the tax regulation is provided in the 1945 Constitution

Article 23 Paragraph 2. This law guarantees to express justice, both for the

Country and its citizens.

3. Economic Terms

Collection of taxes should not interfere the production and trading

activities to avoid the economic downturn.

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4. Financial Terms

Accordance budgetary function, the cost of tax collection should be

pressed, lower than the results of the collection.

5. Tax collection should be simple

Simple collection system will facilitate and encourage the community in

meeting tax obligations. The new taxation law has met this requirement.

2.1.4 Theories that Support Tax Collections

2.1.4.1 Adam Smith Theory

Adam Smith put forward a theory in the tax collection, which are:

1. Equality

Which means that taxes must be fair and equitable, which is charged to

private persons in proportion to his ability to pay such taxes, and in

accordance with benefits received. Taxing can be considered fair if all

taxpayers contribute an amount to be used for government spending

proportional to his/her ability and with the benefits received from the

government.

2. Certainty

Tax regulation should be clear at the same understanding by taxpayer and

the authority, otherwise it can be abused by both. Adam Smith puts four

certainties that would be able to ensure justice in the establishment of the

desired tax collection:

a. Certainty if the tax subject

b. Certainty of the tax object

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c. Certainty of the tax rate

d. Certainty of the tax procedures

3. Convenience

Deadline of tax payout should be determined with regards to the

convenience time of the tax payers.

4. Economy

Economic principles should be applied on the following subjects:

Cost of tax collection should be efficient

Tax should not prevent the payers to continue their business

activity

Tax should be able to provide greater society benefits instead of

burdening the society. (Smith, 1981: 350)

2.1.4.2 Hector S De Leon Theory

Hector S De Leon has a theory on three main principals of taxation system, which

are:

1. The principle of adequacy of revenues

Source of tax revenue as a whole should be adequate as a source of the

state budget. It can be seen from the current state income, that revenues from

the tax sector are very adequate to be the source of the state budget.

2. The principle of justice

The tax burden should be proportional to the ability of the taxpayer to pay

taxes. Fairness in taxation is divided into horizontal and vertical equality. A

tax collection system is considered fair if the tax responsibility for every
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taxpayer is equal for every same level of income and burden, regardless of the

income sources and type. In the horizontal and vertical condition, an income

tax should be in accordance with the principle of justice for every added

economic capability without differentiating the source and type of income.

3. Feasibility Principle Administration

All the tax rules should be administered with a good, easy, and effective

way. Complete information and accountability is the key to an effective and

efficient tax administration and efficient. Foundations for the implementation

of good tax administration consist of 4 things:

1. First, the clarity and simplicity of the provisions of the Law allows for the

administration to provide clarity for taxpayers.

2. Second, simplicity is good in juridical formulation, which can provide

better process of understanding.

3. Third, the existence of a realistic tax reform should consider the ease of

achieving efficiency and tax administration effectiveness.

4. Fourth, an effective tax administration and efficiency should be

formulated with regards to the arrangement, collection, processing, and

utilization of information about the tax subject and object of taxation.

(Hector, 1993: 10-11)

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2.4.1.3 Glenn P Jenkins Theory

Glen P Jenkins has a theory about nine principals of taxation.

1. Benefits Principle

Goods and services provided by government are public goods, which can

be utilized by the community as a whole.

2. Paying Ability Principle

In determining the tax rate, government should consider the ability of the

taxpayer.

3. Efficiency Principle

The tax rate must be imposed to create efficiency. Based on these

efficiency principles, the imposition of tax on goods and services will raise the

prices of goods and services by adding a certain percentage of the price; any

price increase creates the distortion on the selling price to consumers and

production costs. Market distortion caused by the tax would be a loss in

creating economic efficiency; high tax rates create economic inefficiencies. So

the government may consider the level in imposing the tax as efficient as

possible in order not to create market distortions.

4. Principles of Growth of Economics

Taxation system should be able to affect economic growth in one country,

and a good tax system should also give impulsion to create new jobs.

5. Revenue Adequacy Principles

Tax must be appropriate and adequate as a source of funds to finance

government spending. Hence the acquisition tax must be greater than the costs

incurred.
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6. Stability Principle

A stable tax laws and rates will be an attraction for the private sector to

invest. Tariff changes and unstable tax laws that are will cause difficulty in

long-term planning for the private sector. The existence of an unstable tax

structure and system create business risk and burdens, which eventually

became the elements of economic inefficiency.

7. Simplicity Principle

A good tax system should be simple and understandable by the public. The

simplicity to comply should be applied in the tax administration, which will

help taxpayer to comply better.

8. Low Cost Principles

Tax collection and administration cost should not burden tax payers.

9. Neutrality Principle

A good tax system should eliminate the distortion in public consumption

and production behavior and new foreign tax policy should encourage current

investment and attract new foreign investors to invest in the country. (Jenkins,

1997:2-5)

2.2 Overview of Income Tax

National development is a continual activity to develop people welfare, both

material and spiritual. National development needs financial support. By fact, tax is the

major domestic financial source.

Tax plays important role in national development. In short, tax is a lifetime

sponsor of a State. There are various types of taxes imposed by State to the citizens who
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are registered as taxpayers. One of them is the income tax (Pajak Penghasilan PPh).

Income tax Law as stipulated in the Income Tax Act 1984, set the tax on income

(earnings and profits) obtained by either individuals or corporate.

2.2.1 Subject of Income tax

Income tax is imposed to tax subject related to their income within the fiscal year.

According to the Income Tax Act 2000 Article 2, paragraph (2), tax subject is defined

into two groups; local tax subject and foreign tax subject. Income Tax Act 1984 Article 2

paragraph (3) defined the local tax subject as follows:

1. Individuals

Individual is a tax subject, could be resident or non resident.

2. Inheritance

An undivided inheritance is a tax subject to represent the heirs due to

inheritance is not yet divided.

3. Entity

Entity is a group of people and/or capital which is a unity conducting or not

conducting business that includes a limited liability company, commanditair

venootschap (CV), other companies, state or local owned enterprises with any

name or form, firms, partnerships, associations, pension funds, partnerships,

associations, foundations, mass organizations, social political organization, or

any similar organizations, institutions, permanent establishment, and other

forms of entity. (Income Tax Act, 2000: Article 2 paragraph 3)

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Income Tax Act 2000 Article 2, paragraph (4) defined foreign tax subject as follows:

1. Individual who is not residing in Indonesia or stays in Indonesia no more than 183

(one hundred and eighty three) days within 12 (twelve) months period, and

entities that are not established and not domiciled in Indonesia, which carries on

business or conduct activities through a permanent establishment in Indonesia.

2. Individual who is not residing in Indonesia or stays in Indonesia no more than 183

(one hundred and eighty three) days within 12 (twelve) months period, and

entities that are not established nor domiciled in Indonesia who can recieve or

derives income from Indonesia not from doing business or conduct activities

through a permanent establishment in Indonesia. (Income Tax Act, 2000: Article

2, paragraph 4)

2.2.2 Object of Income Tax

Refer to 2000 Income Tax Act Article 4 paragraph (1), tax object is income, and

income could be defined as every additional economic capability received or acquired by

taxpayers, derives from Indonesia or outside Indonesia, which can be used for

consumption or measuring tax payer asset at any names and forms. (Income Tax Act,

2000: Article 4 paragraph 1)

2.2.3 Income Tax Payment

Taxpayers could settle or pay their outstanding income tax by filling out Surat

Setoran Pajak (SSP) at the following time:

1. During the Fiscal Year

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The settlement of the Income Tax can be done monthly or other period

determined by the Minister of Finance. (Income Tax Act, 2000: article 20,

paragraph (1))

2. Post Fiscal Year

Refer to the Income Tax Act 2000 section 28, 28A, and 29, settlement of taxes

post fiscal year is allowed only if the amount of income tax payable for the

defined fiscal year is bigger than the amount of tax credits for the related fiscal

year. This must be settled no later than the 25th of the third month after end of the

fiscal year, before submission of SPT. (Income Tax Act, 2000: section 28, 28A,

and 29)

3. When Surat Ketetapan Pajak (SKP) and or Surat Tagihan Pajak (STP) is formally

received.

Settlement of tax is due when SKP and or STP issued by Directorate General

of Tax and received by taxpayer. Therefore, the taxpayer must immediately

submit the SPT to the related Kantor Pelayanan Pajak (KPP) and pay the

outstanding tax payable.

2.2.4 Corporate Income Tax Return

Income Tax Act 2000 in Article 1 paragraph (10) stated that the Corporate Tax

Return (Surat Pemberitahuan SPT) is a letter used by taxpayers to report tax collection

and or tax payment, the tax object and / or not the tax object and / or asset and liabilities,

as stated on the Tax Law.

Annual SPT of Income Tax is a tool for taxpayers to self assessed the amount of

tax payable, by way of:

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1. To report and take responsibility of the tax payable calculation

2. To report self assessment of tax payment on the specified fiscal year or part of

fiscal year.

3. To report withholding or collection of tax done by the other parties during

specified fiscal year.

(Income Tax Act, 2000: Article 1 paragraph 10)

2.2.5 Tariff of Corporate Income Tax

Act of 2000 Income Tax basically adopt progressive rates. The meaning of

progressive is the higher the income the higher the percentage of tax rates. Progressive

tariff is in line with the tax function to achieve the equality distribution of people income

.Tax rate was set in Law number 17 of Year 2000 Article 17 paragraph (1) and applies to

the specific taxable income of domestic permanent establishments. The rates are as

follows:

Table 2.1: Indonesia Corporate income tax rates 2008

Source: http://www.pajak.go.id
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In comparison, below is the Singapore Corporate Income Tax for the same fiscal year:

Table 2.2: Singapore Corporate Income tax rates 2008

Source: www.iras.gov.sg

It is the matter of fact that Singapore tax rates are much lower than Indonesia.

2.3 Concept of Income and Expense by Indonesian Tax Regulation

2.3.1 Concept of Income

The concept of income in the commercial accounting is different from tax point of

view. This happens because taxation is related to vertical and horizontal justice, and used

as an instrument in economic and social policy, Not in the case of commercial

accounting.

2.3.1.1 Definition of Income

Income Tax Act year 2000 Article 4 states that income is: "any increase in

economic capability received or accrued by a Taxpayer, originating from Indonesia as

well as from offshore, in whatever name or form, that can be used to consume or to

increase the wealth of the Taxpayer ". (Income Tax Act, 2000: Article 4, translated by

Danny Darussalam)

Meanwhile, the Indonesian Accountant Association (Ikatan Akuntan Indonesia

IAI) defines income as: "Economic benefits during an accounting period in the form of

income or assets increase or decrease in liabilities that result in an increase in equity

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that are not derived from the contribution of capital investment". (SAK 2002; PSAK; 23

Paragraph 26, translated independently by the author if this thesis). Earnings may include

income or profit. Income is derived from the implementation of regular activities and

known differently as sales, service income, interest, royalties, dividends, and rent.

2.3.1.2 Loss Compensation

Referring to Gunadi (2004), gross income is the sum (consolidation or

aggregation) of all the elements (categories) of income (additional economic capability)

that received or acquired by company in a fiscal year if there is one element of negative

amount (loss), the numbers can be calculated (set off) by other elements in the same year.

Referring to tax laws in 2000 regarding Income Tax in Article 6 paragraph (1) part (d), it

is stipulated that negative amount can be loss suffered from sales and transfer of goods

and/or possessed rights and used in the company (business asset) of the right to acquire,

collect, and preserve income. Thus the loss of the transfer of non-business assets (private

property) and or non-operating asset (property that has not been used) can not be

calculated with the other elements of income (positive). If in one fiscal year from the sum

of all elements was obtained loss of income, Referring to Income Tax Act 1984 Article 6

paragraph (2), the loss can be counted against profits for the next five years

(respectively). In accordance with the provisions of article 31A, the body that invest in

economic sectors that have high priority in the national scale, especially those

encouraging exports, and which operate in certain areas (remote) can be compensated for

losses to a maximum period of ten years. (Gunadi, 2004)

Because of the limitation loss compensation time (five years) for tax objective, the

amount of cumulative retained earnings available for dividends will not be the same with
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the amount of profit after tax in commercial accounting. This is acceptable because of

loss compensation in commercial accounting will be unlimited while in tax calculation

will only be five years.

2.3.2 Concept of Cost

Referring to Income Tax Act 2000 in Article 6 paragraph (1) in general,

deductible expenses, is any cost fees that meet the requirements for obtaining, collecting,

and maintaining the income. In accordance with the explanation of this article, the

(direct) relationship between the costs or expenses and income determines whether costs

can be deducted from income.

2.3.2.1 Definition of Cost

Suandy (2003) states "Cost is all deduction against income. In connection with

accounting period the use of expenditures can be divided into capital expenditure (the

expenditure that provides benefits more than one accounting period and recorded in the

assets), and revenue expenditure (the benefits only for one accounting period concerned

that is recorded as an expense)". (Suandy, 2003)

Cost is usually divided into three groups:

1. Costs associated with income within period

2. Costs associated with a particular period which is not associated with income

3. Costs which can not be associated with any period for practical reasons.
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2.4 Overview of transfer pricing

2.4.1 Definition and concept of transfer pricing

Transfer pricing is an issue that is very relevant to business activities and also

taxation. The majority of multinational firms see that transfer pricing is the most

important issues in the international taxation. (Hamaekers, 2001: 30) Transfer pricing is a

part of business and taxation activities in order to discover whether the prices applied in

transactions between companies that have a special relationship, is based on the principle

of fair market prices or arm's length price principle or not. Besides that, transfer pricing

can also be applied in the transactions between an organizational unit to another

organizational unit within a company or between head office and branch offices, or

between one branch office with other offices that are still in the same company. (Larking,

2005: 442). For economic purposes, transfer pricing is defined as determination of the

price of goods or services by an organizational unit of a company to other organizational

units within the same group. (Horngren, at all, 1996). While Lyons defines transfer

pricing as the price charged by a company for goods, services, intangible asset to the

company that has a special relationship. (Lyons, 1996: 312)

The definition of transfer pricing as describe above is a neutral definition.

However, the term transfer pricing is often connoted as something that is not good, that is

the transfer of taxable income from a company owned by multinational company to

countries that have lower tax rates (tax haven) in order to reduce the total tax burden from

business group these multinational company. (Haemakers, 2004: 3). In connection with

abuse of transfer pricing, Lyons defines it as an inappropriate allocation of income and

expenses which intended to reduce taxable income. (Lyons, 1996: 313). While the other

writer, Eden, using the terminology of transfer pricing manipulation to express the abuse
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of transfer pricing. The terms of transfer pricing manipulation is defined as activities to

increase or lower the cost of the bill to minimize the amount of tax payable. (Eden, 2001).

Thus, the manipulation of transfer pricing can be done by increasing or decreasing

the selling cost through transfer pricing mechanisms to reduce tax payments, and thus, the

manipulation of transfer pricing may occurs by setting the transfer price to "too big or too

small" in order to minimize the amount of tax payable.

2.4.2 OECD Transfer pricing guidelines

Organization for Economic Cooperation and Development (hereinafter referred to

OECD) is an organization of economic cooperation between developed countries which

was established in 1960. At this moment, OECD has 30 countries as its members. The

field of taxation in the OECD is handled by the Committee on Fiscal Affairs (CFA).

Related to transfer pricing, CFA, through its subgroup of working party no. 6, published

OECD Transfer Pricing Guidelines (hereinafter referred to as the OECD Guidelines) as a

guide for multinational enterprises and tax authorities in matters of transfer pricing.

OECD Guidelines which available now is the development and consolidation of the

OECD Transfer Pricing and Multinational Enterprise in 1979 and 1984, and most of

Indonesia law related to transfer pricing is referring to this OECD Guidelines.

OECD Guidelines provides guidance for tax authorities and the multinational

companies in dealing with transfer pricing issues. OECD Guidelines is made with the

intention to assist the tax authorities and multinational companies in dealing with transfer

pricing issues, assist the tax authorities (not only to member countries but also countries

that are not members OECD) as well as multinational companies in providing guidance

on how to solve transfer pricing dispute that beneficial for both parties, and between the
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tax authorities with multinational companies. (OECD Guidelines, paragraph 15). In other

words, the purpose of OEDC Guidelines is to share the revenue earned by multinational

companies fairly (true taxable income) to countries where these multinationals operate.

To avoid the multinational companies for not transfer its tax revenues through

transfer pricing mechanisms in inappropriate ways, it is important for a country to have

the authority to perform the calculation again, or make corrections (primary adjustment)

for the prices that set by the parties which have special relationships if the transaction

price does not represent the taxable income is in each country:

Related to the transfer pricing regulations in each country, basically those

countries can be classified as follows:

1. Few countries apply the regulations transfer pricing, transfer pricing regulations

only apply to particular transactions.

2. Some countries follow the transfer pricing regulations which contained in the

OECD Guidelines.

3. Many countries do not yet have specific regulations for the transfer pricing in the

domestic law, but they refer to the rules of anti-tax evasion (tax anti avoidance

rule). (Rohatgi, 2002: 420)

2.4.3 Related Parties

Tax authorities are empowered to make corrections (primary adjustment) for

transactions which not reflect the fair market price by parties that have a special

relationship. (Rotondaro, 2000, page 2). In other words, a country is allowed to conduct a

primary adjustment, as long as these transactions are not in accordance with the principle
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of fair market value (arm-length principle) and the transactions is conducted by parties

which have a special relationship.

Therefore, the definition of special relationship is very important in the context of

transfer pricing. Discrepancy definition of what is meant by the parties who have a

special relationship between countries with other countries will lead to double taxation.

(Rotondaro, 2000). Therefore, the definition of related parties or related parties is an

important factor in the transfer pricing context. (Rotondaro, 2000, page 9).

Article 9 OECD Model, sets about special relations or related parties in the

context of transfer pricing. Special relationship under Article 9 paragraph (1) OECD

Model, in principle can be explained by the following situations: (Hamaekers, 2008).

1. Company A in country A "participates either directly or indirectly in the

management, control, or ownership of capital" of company B in country B.

2. The same side (can be formed as an individual or company) "participates either

directly or indirectly in the management, control or ownership" of the state A in

company A and company B in country B.

Related to the definition of special relationship, whether article 9, paragraph (1) OECD

Model or the OECD Guidelines does not provide clear definitions of what is meant by

"management control either directly or indirectly, and control over the company through

share ownership." (IFA, 2003). According to David Grecian, in a congress held by the

International Fiscal Association (IFA), control is included has the authority to make

decisions related to financial and operating policies of an enterprise, and has a leverage to

determine the price set . The meaning of participate in a management is involved in

making decisions on a company's operations. The management which stated before is

the level of director or manager level, while the definition of participation is the
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ownership of shares in a company. (Grecian, 2003). As for how much percentage of share

ownership that can be expressed will cause a special relationship between countries with

other countries is very varied.

Based on article 9, paragraph (1) OECD Model, tax authorities may make

adjustments if they already meet the requirements; the price does not reflect the fair

market price, and the parties to a transaction are parties that have a special relationship.

Thus, although the prices charged is not reflecting the fair market price, the tax

authorities of a country should not make a correction if the transaction is conducted by

parties who have no special relationship.

Related parties is also described in the Statement of Financial Accounting

Standards (Pernyataan Standar Akuntansi Keuangan PSAK). The parties considered

have a special relationship is when one party has the ability to control other parties or

have a significant influence over other parties in decision-making financial and

operational. Transactions between the parties having a special relationship are a transfer

resources or obligations between the parties having a special relationship, without

regardless of whether a price calculated. Control is the direct ownership through its

subsidiaries with more than half the voting rights of a company, or a substantial interest

in the voice and power to direct the financial policies. (IAI, PSAK no7, 1994)
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2.4.3.1 Income Tax Act Article 18

The special relationship matter is also discussed in the Indonesia Income Tax Act

Article 18:

(1) The Minister of Finance is authorized to issue a regulation on debt equity

ratio for the purposes of computing tax payable in accordance with this

law. (Indonesia Income Tax Act Article 18: 2000, translated by Danny

Darussalam)

This law gives power to the minister of finance to prescribe the companys liability to

equity ratio which will be valid for tax purposes. If the debt to equity ratio is higher than

the arm lengths debt to equity ratio, the company may not in the good condition

economically.

(2) The Minister of Finance is authorized to determine as when dividends

acquired by a resident Taxpayer on participation in an offshore company

other than public companies, provided that one of the following condition

is met:

a. the Taxpayer owns at least 50% of the voting stock of the company; or

b. the Taxpayer together with other resident Taxpayers own at least 50%

of the voting stock of the corporation. (Indonesia Income Tax Law

Article 18: 2000, translated by Danny Darussalam)

In these economic enhancement and international trade days, taxpayers may invest in the

foreign company. This law was made to minimize the tax avoidance by giving those

powers to the minister of finance.

(3) Director General of Taxes is authorized to reallocate income and

deductions between related parties and to characterize debt as equity for

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the purposes of the computation of taxable income to assure that the

transaction are those which would have been made between independent

parties.

(3a) Director General of Taxes is authorized to conclude an agreement with a

Taxpayer and with tax authority from other countries on transfer pricing

method between related Taxpayers referred to in paragraph (4) which

may cover a certain period and to evaluate it as well as to renegotiate

after the agreement is expired. (Indonesia Income Tax Act Article 18:

1984, translated by Danny Darussalam)

When the special relationship exists, there may be possibilities that the income is

understated or overstated, for that reason, the director general of taxes those power to

prevent the tax avoidance due to the existence of special relationship.

(4) The term related Taxpayers referred to in paragraphs (3), (3a), and (4) of

Article 8, paragraph (1) (f) of Article 9, and paragraph (1) of Article 10

means:

a. a Taxpayer who owns directly or indirectly at least 25% of equity

of the other Taxpayers or a relationship between Taxpayers

through ownership of at least 25% of equity of two or more

Taxpayers, as well as relationship between two or more Taxpayers

concerned;

b. a Taxpayer who controls other Taxpayers; or two or more

Taxpayers are directly or indirectly under the same control;

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c. a family relationship either through blood or through marriage

within one degree of direct or indirect lineage. (Indonesia Income

Tax Act Article 18: 1984, translated by Danny Darussalam)

The special relationship between two parties may exist because of an ownership and

participation in technology or management, and also by blood or marriage. A special

relationship because of an ownership occurs if the ownership is at least 25% or more of

equity. A special relationship because of participation in technology or management

occurs if the two entities are controlled by the same person, or the relationship between

the two entities is controlled by the same person. The relationship by blood within one

degree of direct lineage vertically means children of parents, while horizontally mean

relatives. The relationship by marriage within one degree of direct lineage vertically

means parents in law or step children, while horizontally means relatives in law.

2.4.3.2 Value Added Tax Act article 2

The special relationship matter is also discussed in the Indonesia Value Added

Tax Law article 2:

(1) If the Sales Price or Consideration is influenced by special relationship,

the Sales Price or Consideration shall be calculated on the basis of a fair

market price at the time of a supply of Taxable Goods or the rendering of

Taxable Services. (Indonesia Value Added Tax Act Article 2: 2000,

translated by Danny Darussalam)

The Director General of Taxes has given power to adjust sale price to a fair market price

applying in the market to prevent the influence of special relationship which may has

possibility to set the price below the market price.

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(2) A special relationship is deemed to exist:

a) where a Firm owns direct or indirect participation of 25% (twenty-

five percent) or more in another firm; likewise, between two or

more firms where there is direct or indirect participation of 25%

(twenty-five percent) in each of those firms by another firm; or

b) A Firm has control over another firm, or two or more firms are

under the same control, whether directly or indirectly; or

c) There exists a family relationship either through blood-line or

through marriage within one degree of direct or in direct lineage.

(Indonesia Value Added Tax Act Article 2: 2000, translated by

Danny Darussalam)

The special relationship exists when there is an ownership of 25% or more, either direct

or indirectly. It also applies when an entity has control over other similar entities.

2.4.3.3 Indonesia Singapore Tax Treaty Article 9

The special relationship matter is also discussed in the Indonesia Singapore Tax

Treaty article 9 about associated enterprises, where:

(a) An enterprise of a Contracting State participates directly or indirectly in

the management, control or capital of an enterprise of the other Contracting

State; or

(b) The same persons participate directly or indirectly in the management,

control or capital of an enterprise of a Contracting State and an enterprise of

the other Contracting State;

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and in either case conditions are made or imposed between the two enterprises in their

commercial or financial relations which differ from those which would be made between

independent enterprises, any profits which would, but for those conditions, have acquired

to one of the enterprises, but, by reason of those conditions, have not so acquired, may be

included in the profits of that enterprise and taxed accordingly. Any profit made by the

related parties company will be acquired to on of the enterprises.

(Indonesia Singapore Tax Treaty Article 9: 1990)

2.4.4 Arm-length term principal and methods

The principle of fair market value (arm's length principle) is a criteria for

determining the value of transactions between the parties that have a special relationship.

According to the arm's length principle, the transaction between the parties having a

special relationship should refer to the fair market price, which determined based on the

price if the transaction carried out by the parties which have no special relationship.

Theoretically, the arm's length principle is based on the same transaction and in

the same conditions by the parties who have no special relationship. However, the

transaction and the same conditions as those in practice rarely or never happened.

Therefore, in the application, the determination of arm's length principle is based on

comparable transactions and in conditions that can be compared when there is no

transaction actually the same. (Feinschreiber, 2004, page 41).

If the arm's length principle is not applied in the transactions which are conducted

by the parties who have a special relationship, then the tax authorities may make the

correction (primary adjustment) to reflect the real fair market price. There are several

methods that can be used to determine a fair market price. The purpose of these methods
 32

is to verify whether a set price in the related parties transactions have been done

consistently in accordance with the arm's length principle. In general there are three

methods of arm's length principle:

1. Traditional methods:

a. Comparable Uncontrolled Price (CUP)

b. Cost Plus

c. Resale Price

2. Transactional Profit methods:

a. Profit Split

b. Transactional Net Margin

3. Other methods:

a. Formulary Apportionment

b. Global Profit Split

OECD Guidelines does not allow any other method as the method of determining the

price of transfer pricing transactions, since this method does not reflect the principle of

fair market price. According to the OECD Guidelines, the traditional methods are

preferred to be applied in comparison with other methods. However, it is very difficult to

get a comparative market price in these traditional methods. Therefore, if methods other

than traditional methods will be used, then the question is in what conditions these other

methods can be used. (OECD Guidelines, paragraph 2.49).

 33

Associated with the application of the method arm's length principle, the OECD

Guidelines states that:

1. There is no correct method to be used in each situation.

2. Taxpayers are not required to determine the fair market price through various

methods of approach that already existed

3. Traditional methods of CUP, Resale Price, and Cost Plus are more preferable than

the Transactional Profit methods.

This will be presented the following explanation of each method of arm's length

principle:

1. Comparable Uncontrolled Price (CUP)

In traditional methods, an important element in determining the fair price

of transfer pricing is the availability of comparative data. Thus, if there are

comparative data available, the use of CUP is very appropriate. In the CUP

method, fair market price analysis is done by comparing the prices applied by the

parties having a special relationship and the parties who have no special

relationship. (OECD Guidelines, para. 2.6). CUP method is widely used in oil

mining company, iron ore, wheat, and other types of goods in the commodity

markets. This method is also applied to buffer industrial goods but can not be

applied to the automotive industry companies that make products that are not

spare parts sold to independent companies. (Arnold and Mc Intyre, page 63). If

the comparison data are not available, then the CUP method can not be used to

determine a fair market price. (Hinneken, 2006, page 11). Thus if the CUP

method can not be used, taxpayers can use other traditional methods. The main

difference between CUP method and the Resale Price or Cost Plus method is the
 34

thing that is compared in CUP method is the price of goods or services, while

Cost Plus in the resale price method or the method of comparison is the level of

margin (percentage) certain profit that is expected in return from corporate

functions performed, assets used, and the risk incurred. (Bernstein, 1999).

2. Cost Plus Method

Based on the cost plus method, fair market price is determined by adding the

gross profit margin to the cost of goods sold. This method is applied to the

following conditions:

a. Goods that are bought and sold by parties who have a special relationship

are semi-finished goods;

b. The contract of sale of long-term;

c. Services;

d. Agreement on the joint facility. (OECD Guidelines, para 7.31).

OECD Guidelines also gives the types of activities that can implemented by these

methods such as cost plus contract manufacturing, research charging, and

charging administrative costs. (OECD Guidelines, para 7.40 7.42). Problems

that needs more attention in the application of this method is how to determines

the gross profit percentage to be added to the cost of goods sold and determine the

cost elements that make up the cost of production.

3. Resale Price Method

In this method, the determination of a fair market price is based on products

that purchased from affiliated companies and then resold to an independent

company. Then, determination the fair market price on the basis of this method is

calculated by subtracting the resale price by a certain gross profit margin; which
 35

those gross profit margins are derived from gross profit margins from the similar

companies that conduct transactions with related parties that have no special

relationship. Resale Price method is well suited for application in a company

engaged in the marketing field. (OECD Guidelines, para 2.14.)

4. Transactional Profit Methods

Transactional Profit Methods is used when there is no comparative data or not

enough data. If we compare transactional profit methods with the cost plus and

resale price method, there are similarities in the use of margin. However, the

cost plus method and the resale price method is using comparable of gross

margin, while the transactional profit methods, the comparison is the "net

margin" Transactional Profit Methods is divided into two, the profit split and

transactional net margin method.

a. Profit split method is used when there is no comparable data. In the

approach to this method, profits from transactions between the parties

having a special relationship can be determined by analyzing the function

of doing business.

b. Transactional Net Margin Method is used to test the fairness of the net

profit on the transaction between the parties having a special relationship.

The approach is comparing net income with the cost of production, sales

or assets used to produce the net profit. After getting the net margin, then

the net margin is compared with net margins of similar companies that

conduct transactions that can be compared with those who have no special

relationship.
 36

2.4.5 Tax Avoidance and Tax Haven Countries

Tax revenue is often become the mainstay for the developing countries, including

Indonesia. However, tax revenues from this sector often experience erosion due to tax

evasion activities, either through avoidance or evasion. Theoretically, these two are

different because usually avoidance is still in the corridors of law. If the taxpayer violates

the anti-avoidance rules, the violation did not belong to the criminal action and sanctions

in the form of fines. The influence of tax avoidance on tax revenue itself large is

considered to be moderately big.

There are several scenarios frequently used to avoid tax, such as by manipulating

the transfer price. Transfer price is basically the price that is attached to provide value to

a product that is exchanged between companies that still belong in one field of group. By

manipulating the transfer price, multinational companies can arrange a way so that the

income for subsidiary company in its group located in the country that has the lowest tax

rates can be as high as possible. The profit of manipulating the transfer price is become

bigger if the difference between the source and residence country is bigger. The situation

may be different if between the two countries is inserted tax haven, which usually does

not impose any tax or, if there is any, very low tax rates. If it's so, then the rate difference

between the source and residence country can be no longer relevant because the taxpayer

would shift most of his income to the tax haven.

Although the problem was not only faced by developing countries, but the result

will be more severe to the developing countries. This is because developed countries have

a legal device that is more complete, such as various anti-deferral rules. Besides the tax

authorities also have sufficient ability to detect such techniques. On the other hand,

developing countries often do not have adequate regulations. Even if the rules are there,
 37

they usually do not have enough tax authorities that are able to detect and counter transfer

pricing. In addition, the data needed to determine the arm's length price is difficult to

obtain, even if there are transfer pricing cases that had been identified, the solution often

takes a long time. The small number of tax treaty network can also be influential because

it means the facility for data exchange become more limited, especially if there is a tax

haven countries involved.

To fix this, developing countries can unilaterally implement training to improve

the tax authorities. They also can make the rules of anti-avoidance for further

strengthening the legal basis. Multilaterally, the OECD has called on its members to carry

out coordinated efforts which include thin capitalization, rejected the charges paid to the

parties that came from a tax haven, as well as limit and cancel the tax treaty with

countries involved in harmful tax practices. (Danny and Darussalam, 2008, page 59-61)

2.4.5.1 Abuse of Transfer Pricing through Tax Haven Countries

International tax evasion is often carried out with various schemes. The scheme is

often done with transfer pricing, treaty shopping, thin capitalization and controlled

foreign corporation. The fourth scheme is mostly done by involving countries that

classified as a tax heaven or often known as the tax haven countries, or a tax paradise

called in France, or called Tax Oasis in Germany. (Orlov, 2004, page 96). The

researchers in the field of international taxation in general, tax haven countries divided

into four groups as follows:

1. Classical tax haven, which states that no income taxes at all or apply income tax

rates low.

2. Tax Haven, which the tax exemption applies to income from abroad (no tax on

foreign source of income).

 38

3. Special Tax Regime, which states that provide special tax facilities for certain

areas in the country.

4. Tax Treaty Haven, which the states that have a very good network and apply a

low tax rates for withholding tax on passive income. In general, these countries

will be used as an intermediary for the state rate reduction to get facilities

provided by a tax treaty.

Thus, it can be said that the definition of tax haven countries is countries that deliberately

giving tax facilities to other state taxpayers to income taxpayers other countries and

transferred to their country (tax haven) to be taxed less or not subject to tax at all. In other

words, the presence of tax haven countries will encourage other countries taxpayer to

make tax evasion or avoidance in the country where the taxpayer is running the actual

business activities. Thus, the existence of tax haven countries is certainly a big issue for

other countries because it would threaten their tax revenue. It will be even worse if other

countries are very weak provisions of the anti tax-avoidance. (Danny and Darussalam,

2008, page 63-64)

2.4.5.2 Definition of Tax Haven Countries

OECD states that tax haven countries can not be precisely defined because it is a

tax haven country is very relative, depending on the conditions of each country in

defining it. According to the OECD, a country could be called a tax haven by other

countries if the country is called to give an incentive in the economic activity in a

particular region in the country. Therefore, a country would be classified as a tax haven

country or not by other countries depending on the definition of tax haven countries that

provided by other countries are. (OECD, 1987, page 23). While the International Tax
 39

Glossary, tax haven countries defined as countries that impose a tax with low rates or not

impose any tax at all, and so maintain the confidentiality of tax information from

taxpayers who are domiciled in the country. (Larking, 2005, page 403)

2.4.5.3 Indonesia Tax Regulation Related to Transfer Pricing

There are several tax provisions related to the Indonesia tax haven countries,

KMK-650/KMK.04/1994 makes the list of countries categorized as a tax haven countries.

As these countries are as follows:

Table 2.3: Tax Haven Countries based on Taxation Regulation 1994

Source: Attachment from KMK-650/KMK.04/1994

2.5 Indonesia Tax Prevention and Investigation Process of Transfer Pricing

One way to suppress the rise of transfer pricing practice is to conduct an audit on

transfer pricing by multinational companies. The value of the transfer of goods and

services between companies within a group is expected to be in accordance with the

principle of arm's length, so that income shifting does not occur between countries and

will create a fair tax climate.

In order to prevent tax evasion, among others through the pricing is not

reasonable, in the tax legislation Indonesia, has found the provisions which essentially
 40

authorized the officers to make corrections to transactions that are not fair to others who

have a special relationship.

2.5.1 Tax Regulation Number: KEP-01/PJ.7/1993

Decision of the Director General of Taxation Number: KEP-01/PJ.7/1993 on Tax

Examination Guidelines against Taxpayers who have related party to prevent tax payment

reduction through transfer pricing practices:

2.5.1.1 Learning the Taxpayer Files

This stage is done by studying the notaries document and amendments. It must

be investigated from the shareholders structure whether there is a related party as referred

to in Article 18 paragraph (4) no income tax. 10 of 1994 and the Law no.11 of the value

added tax Article 2 paragraph (1). The goal is to find a general picture that the taxpayer,

as follows:

a. About the business and corporate characteristics

b. Regarding the ownership structure, whether there is the possibility of related party

between the shareholders and the audited taxpayers.

c. Learning the organizational structure of related companies. As much as possible

showing the organizational chart describing the companies that having a special

relationship and economic relationship with the audited taxpayers included the

illustration and location of activities.

d. Studying the nature and type of taxpayers business. Described the taxpayer

business activities from the order issued until the completion of orders, whether

regarding the purchase or sale.

 41

e. Study the possibility of over or under invoicing. Purchases or sales or import or

export by taxpayers who have related party with suppliers and customers are

mainly located in Tax Haven Countries, should be studied the possibility of over

and under invoicing.

f. Studying the previous audit report. It to find out anything referred to paragraph b,

c, and d above that can be used as clues in the audit to be conducted. (KEP-

01/PJ.7/1993)

2.5.1.2 Analyzing Corporate Tax Return and Financial Statements.

The purpose of this analysis is to detect irregularities of sale or the purchase price

between the related parties to be able to do it; the common ratio analysis will be used.

The methods which used in determining the arm-length principle are as follows:

1. Comparable market price method or Comparable Uncontrolled Price (CUP)

2. Resale Price Method

3. Cost plus Method

(Departemen Keuangan Republik Indonesia Direktorat Jendral Pajak, 1993)

2.5.2 Tax Regulation Number SE-04/P.J7/1993

Tax regulation Number SE-04/P.J7/1993 was made especially for transfer pricing,

it is a basic guidelines to handle transfer pricing cases in Indonesia. In this

guideline, the it is stated about the areas where the unfairness transaction usually

happen:

1. Selling Prices

2. Purchase Prices,
 42

3. Administration and Overhead cost allocation,

4. Interest on Shareholder Loan,

5. Payment of commission, license, franchise, rent, royalty, fee on

management service, and other fees,

6. Purchase company assets by a shareholder or other party which has special

relationship with lower price than market price,

7. Selling to a party in other state through third parties which have no (less)

business substance (dummy company, letter box company, re-invoicing

center).

SE-04/P.J7/1993 example number 2 explains about the unfairness in purchasing

goods, which a party purchases goods with higher or lower prices than the market

price. The difference between companys and market price is categorized as

disguised dividend. Disguised dividend is a distribution of income which using

other forms, so it does not look like dividends, then the company will not forced

to pay the 20% tax on dividend distribution. The regulation about tax on dividend

is stated on the Income Tax Act, article 26 point (1).

The following income, in whatever name and form, paid or payable by a

government institution, a resident taxable entity, a person who organizes

activities, a permanent establishment or a representative of a non-resident

company to a non-resident Taxpayer other than a permanent

establishment in Indonesia, shall be subject to withholding tax of 20%

(twenty percent) of the gross income:

a. dividends;
 43

b. interest, including premiums, discounts, swap premiums and

compensation in accordance with a loan guarantee;

c. royalties, rent, and other income connected with the use of

property;

d. compensation for services employment and activities;

e. gifts and rewards;

f. pensions and other periodic payments. (Income Tax Act 2000,

article 26 point (1))

2.5.3 General Guidelines Act for Taxation no 28 year 2007

General Guidelines Act provides standards in taxation inspection process.

Surat Ketetapan Pajak (SKP) is described in this guidelines.

Tax Determination Letter (Surat Ketetapan Pajak) is a determination

letter which covers Tax Determination Letter Underpayment (Surat

Ketetapan Pajak Kurang Bayar), Tax Determination Letter Additional

Underpayment (Surat Ketetapan Pajak Kurang Bayar Tambahan), Tax

Determination Letter Overpayment (Surat Ketetapan Pajak Lebih Bayar),

or Tax Determination Leter Nil (Surat Ketetapan Pajak Nihil).

(General Guidelines Act for Taxation no 28 year 2007, article 1, point

(15), translated independently by the author of this thesis)

SKP is released after the inspection process is conducted. SKP will be sent to

taxpayer which the tax payer should obey the SKP. If tax payer doesnt obey the

SKP, it will be categorized as criminal taxation and later the case will be

forwarded to the Law Authority.

 44

i. In the transfer pricing practice which related to purchase activity, company often

purchase goods from its related party with higher price than other supplier, and

leads to the lower margin for the company and lower income tax for government

(tax loss for government). Usually the type of SKP that will be released after the

inspection is the Tax Determination Letter Underpayment (SKP Kurang Bayar).

When Tax Determination Letter Underpayment (SKP Kurang Bayar) is released,

reffering to the General Guidelines Act for Taxation no 28 year 2007 article 13

point (2), tax payer should pay the administration sanction of 2% each month for

maximum of 24 months;

Underpayment of tax in the Tax Determination Letter Underpayment

(SKP Kurang Bayar) which is reffered in the point (1) letter a and letter e,

plus administrative saction of 2% (two percent) each month for maximum

24 months (twenty-four months), counted as when the tax becomes due or

in the end of fiscal period, part of fiscal period, or fiscal period until the

issuance Tax Determination Letter Underpayment (SKP Kurang Bayar)

(General Guidelines Act for Taxation no 28 year 2007 article 13 point (2),

translated independently by the author of this thesis)

2.6 Foreign Investment

2.6.1 Economic Integration Theory

Regional economic integration, that is the goal of countries in a region, is

considered to be an important policy because:

1. The member States will gain a mutual benefit by joining in one community

2. Increase bargaining position in international trade

 45

3. Reduce tariff

4. Increase price transparency and transnational competitiveness

Before reaching an integrated economy, a region must conclude a roadmap of integration

as a sign of establishing the process of transnational economic and political cooperation

starting from the grassroots to the highest level of integration. This roadmap of

integration could form a political integration, while usage of a single currency has a very

close correlation with political and economical integration.

A classic theory concerning the establishment of single currency was brought

forward by Mundell, which was called Optimum Currency Area (OCA). OCA is defined

as a geographical area where State parties are united to gain profit by using a single

currency system. Requiring factors for countries to be able to use a currency collectively

are:

1. Economical diversification degrees

2. The presence of symmetric shock among member States

3. Price and wages flexibility

4. Economical transparency and measurement

5. Similarities in inflation rates

6. Financial development degrees

7. Political and fiscal integrity

Among requirements that have been stated above, economical transparency measurement

refers to many aspects, including trades and investments. Economical transparency

regarding the flow of capital shows a countrys efforts in achieving economic integration.

Conveniences on the flow of capital into the real sectors in the form of foreign direct
 46

investments can be an indicator to see the economical transparency in a country to make

an integrated economy happen.

2.6.2 Definition of Investment

Term investment comes from the Latin: "investire" (wear). The experts have

different views about the theoretical concepts of investing. Fitzgeral defines investment

as:

"Activities that related with withdrawal of business funding sources used to make

capital goods in the present, and the capital goods will be produced flow of new

products in the future" (Murdifin Basalamah Haming and Salom, 2003: 4)

In this definition, investments constructed as an activity for:

a. Withdrawal of funding sources used for the purchase of capital goods

b. Capital goods would be produced a new product

Another definition of the proposed investment Kamaruddin Ahmad:

"Put the money or funds with the hope to obtain additional or specific advantages

of money funds (Kamaruddin Ahmad, 1996: 3)

In Encyclopedia of Indonesia, the investment is defined as:

"Investment money or capital in the production process (with the purchase of

buildings, machinery, material reserves, cash administration and development).

Thus the enlarged capital reserves so far things no capital goods should be

replaced" (Encyclopedia of Indonesia, tt: 1470)

Above definitions can be refined into the following:

 47

"Investment is the investment made by investors, both foreign and domestic

investors in various business fields open to investment, in order obtain the

benefits" (Salim and Budi Sutrisno, 2007: 33)

2.7 Cost of Good Sold

2.7.1 Definition of Cost of Good Sold

There are several definitions to about cost of good sold:

a. According to Lie Dharma Putra,

Basically Cost of Sales is any cost incurred in order to make a

product to be ready for sale. Or with another sentence, Cost of sales is

the cost involved in the manufacturing process or that can be directly

connected to the process of carrying merchandise ready for sale. (Lie

Dharma Putra, 2008 http://putra-finance-accounting-

taxation.blogspot.com/)

2. According to by John W. Day, MBA:

The definition of Cost of Goods Sold is the cost of goods that have

been removed from inventory and delivered to customers (sold) during

an accounting period. (John W. Day, MBA, 2008: 1)

3. According to the Indonesian Accounting Association (IAI):

Cost of goods sold is the amount of expenditure and the burden that

is permitted, directly or indirectly to produce goods or services in the

state and the place where goods can be used or sold. (IAI, 1979:40).

4. According to Prof.Dr.H.J.Van der Schroeff:

 48

Price point is a quantitative description of the sacrifice (the aim) is to

be done by the manufacturer in exchange of goods or services offered

on the market. (Schroeff, 1976:11)

5. According to the book of Accounting Principle 7th edition:

The cost of good sold is the total cost of merchandise sold during the

period. This expense is directly related to the revenue recognized from

the sale of the goods. (Weygandt, Kieso, at all, 2005:183)

2.7.2 Function of Cost of Good Sold

According to Schroeff, function cost of goods is as follows:

1. As a basis for determining the selling price

By knowing the basic price of a product, then the seller will determine the

selling price.

2. As a basis for determining the amount of profits

In addition to other purposes, reasonable profit is the main objective of each

company, the company must know the cost of goods, and thus the company

should sell its products over the base price for a profit.

3. As a basis for monitoring the efficiency of the company

By knowing the cost price calculation of a product, it is unknown how the

workings of management, efficiency or not.

4. As a tool to assist management in making decisions

The policy is taken very influential leader on the course of business activities,

for it requires the data and information on matters pertaining to the production

process.
 49

5. As a basis to prepare financial statements

Number of inventories of raw materials (materials), products in process,

product ready for sale, wage labor was and still should be paid, the loan is not

paid off, will be the data in the preparation of corporate financial statements.

(Schroeff, 1976:12)

In general, any store or company in conducting its business operations will face problems

in determining the base price. Basic pricing is very important, both for trading

companies, service companies and industrial companies. Selling price of a product can

not be set before the known amount of cost. Selling price is the price determined a store

or company for goods or services they sell and the purchase price is the price to be paid

to obtain a good or service (D. Hartanto, 1981:80).

2.8 Indonesia Tax Treaty with Singapore

Tax treaty is the bilateral agreement in taxation area.

According to the Vienna Convention on the Law of Treaties 1969,

(a) treaty means an international agreement concluded between States

in written form and governed by international law, whether embodied in a single

instrument or in two or more related instruments and whatever its particular

designation; (Vienna Convention on the Law of Treaties 1969, Article 2, point 1

(a))

The governments of Indonesia and Singapore have agreed to build tax treaty to prevent

tax avoidance and double taxation in these two countries. The articles related to the main

topics are article 6 about income from immovable property, article 7 about business

profit, and article 8 about shipping and air transport.

 50

2.8.1 Article 6

Article 6 is about Income from Immovable Property:

1. Income derived by a resident of a Contracting State from immovable

property situated in the other Contracting State may be taxed in that other

State.

2. For the purposes of this Agreement, the term "immovable property" shall be

defined in accordance with the laws of the Contracting State in which the

property in question is situated. The term shall in any case include property

accessory to immovable property, livestock and equipment used in agriculture

and forestry, rights to which the provisions of general law respecting landed

property apply, usufruct of immovable property and rights to variable or fixed

payments as consideration for the working of, or the right to work, mineral

deposits, oil or gas wells, quarries and other places or extraction of natural

resources including timber or other forest produce. Ships, boats and aircraft

shall not be regarded as immovable property.

3. The provisions of paragraph 1 shall also apply to income derived from the

direct use, letting, or use in any other form of immovable property.

4. The provisions of paragraphs 1 and 3 shall also apply to the income from

immovable property of an enterprise and to income from immovable property

used for the performance of professional services. (Indonesia Singapore

Tax Treaty Article 6: 1990)

Income that came from the immovable property of one company from one country may

be taxed only in that country. The term "immovable property" referred to livestock and
 51

equipment used in agriculture and forestry and also the rights which associated with it.

Ships, boats and aircraft are not categorized as the immovable properties.

2.8.2 Article 7

Article 7 is about Business Profits:

1. The profits of an enterprise of a Contracting State shall be taxable only

in that State unless the enterprise carries on business in the other

Contracting State through a permanent establishment situated therein. If

the enterprise carries on business as aforesaid, the profits of the

enterprise may be taxed in the other State but only so much of them as is

attributable to that permanent establishment. (Indonesia Singapore Tax

Treaty Article 7: 1990)

Income of a company from one country may only be taxed in that country unless that

company has other business in other contracting country with permanent establishment, if

that so, income of that company in a country may be taxed in other country but just the

income that came from the other company with the permanent establishment.

2. Where an enterprise of a Contracting State carries on business in the

other Contracting State through a permanent establishment situated

therein, there shall in each Contracting State be attributed to that

permanent establishment the profits which it might be expected to make if

it were a distinct and separate enterprise engaged in the same or similar

activities under the same or similar conditions and dealing wholly

independently with the enterprise of which it is a permanent

establishment. (Indonesia Singapore Tax Treaty Article 7: 1990)

 52

If a company in one country has business in other country with permanent establishment,

the income that calculated by each country is income that each country received as if

those company run the business separately and freely as separate legal entity.

3. In determining the profits of a permanent establishment, there shall be

allowed as deductions expenses including executive and general

administrative expenses, which would be deductible if the permanent

establishment were an independent enterprise, insofar as they are

reasonably allocable to the permanent establishment, whether incurred in

the State in which the permanent establishment is situated or elsewhere.

(Indonesia Singapore Tax Treaty Article 7: 1990)

In calculating the profit of an entity, the expense that related to executive, general, and

administrative can be deducted, as long those expense are fair allocated.

4. If the information available to the competent authority is inadequate to

determine the profits to be attributed to the permanent establishment of an

enterprise, nothing in this Article shall affect the application of any law of

that State relating to the determination of the tax liability of a person by

the exercise of a discretion or the making of an estimate by the competent

authority, provided that the law shall be applied, so far as the information

available to the competent authority permits, in accordance with the

principle of this Article. (Indonesia Singapore Tax Treaty Article 7:

1990)

If the information that provided by the authority is not enough to calculate the profits of

an entity, this article will not affect the application of any law of a country.
 53

5. For the purposes of the preceding paragraphs, the profits to be

attributed to the permanent establishment shall be determined by the same

method year by year unless there is good and sufficient reason to the

contrary. (Indonesia Singapore Tax Treaty Article 7: 1990)

The business profits have to be determined in the same manners year to year.

6. Where profits include items of income which are dealt with separately in

other Articles of this Agreement, then the provisions of those Articles shall

not be affected by the provisions of this Article.

7. No profits shall be attributed to a permanent establishment by reason of

the mere purchase by that permanent establishment of goods or

merchandise for the enterprise. (Indonesia Singapore Tax Treaty

Article 7: 1990)

Profits from good purchases from an entity for the enterprise are not categorized to a

permanent establishment.