This article will examine the Supreme Court’s interpretations of the term “Beneficial Owner” in the context of the applicability of Tax Treaties, based on Supreme Court Decree No. 2932/B/PK/Pjk/2020 dated 14 August 2020 (“SP Decree”) on the application of tax treaty of double Dutch BV structure.
Executive Summary
Article 11, paragraph (1) of the Indonesia–Netherlands Tax Treaty (“Treaty”) stipulates that “interest arising in one of the Contracting States and paid to a resident of the other Contracting State may be taxed in that other State.” The case of TAXPAYER v. the Directorate General of Taxes (“TAX AUTHORITY”) revolves around the improper utilization of such Treaty benefits. Through the SP Decree, it is evident that the Supreme Court adheres to the principle of substance over form in its decision by asserting that possessing a certificate of residence does not solely imply that it is the beneficial owner and can avail of the benefits under the Treaty.
Background of the Case
The case revolves around the issuance of an Underpayment Assessment Letter (Surat Ketetapan Pajak Kurang Bayar – “SKPKB”) by the TAX AUTHORITY, which imposes Article 26 Income Tax on TAXPAYER. The TAX AUTHORITY considers TAXPAYER as the beneficial owner of the interest paid to A B.V (Netherlands), thereby rendering A B.V (Netherlands) ineligible to avail of the Treaty benefit. Disagree with this SKPKB, TAXPAYER files an appeal to the tax court. In accordance with Tax Court Decree No. PUT-003939.13/2018/PP/M.XXB dated 30 July 2019, the tax court rendered a decision in favor of TAXPAYER, effectively revoking the imposition of Article 26 Income Tax by TAX AUTHORITY.
Consequently, the TAX AUTHORITY initiated a cassation appeal against the court of appeal’s decision, leading to the issuance of the SP Decree.
For brief information on the shareholding structure of TAXPAYER and A B.V (Netherlands), TAXPAYER, an Indonesian company, holds 100% of the shares in B B.V. (Netherlands), which in turn holds 100% of the shares in A B.V (Netherlands). TAXPAYER pays interest on a loan to A B.V. Economically, TAXPAYER is the actual owner of the capital, and the party that ultimately enjoys the interest income through dividend distributions.
Relevant Regulations
The Treaty allows interest arising in Indonesia or Netherlands and paid to a resident of the other state to be taxed in that other state. However, there are limitations to such facility as stated under Article 11 paragraph (2) and paragraph (4) of Treaty states that:
(2) However, such interest may also be taxed in the State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other State, the tax so charged shall not exceed 10 per cent of the gross amount of the interest.
(4) Notwithstanding the provision of paragraph 2, interest arising in one of the two States shall be taxable only in the other State if the beneficial owner of the interest is a resident of the other State and if the interest is paid on a loan made for a period of more than 2 years or is paid in connection with the sale on credit of any industrial, commercial or scientific equipment.
As the above Treaty emphasizes that tax should be paid in the jurisdiction of the party that constitutes the beneficial owner. Accordingly, it is necessary to assess the beneficial owner of the interest income.
The definition of beneficial owner is further regulated under Article 4 paragraphs (1) of Director General of Taxes Regulation No. PER-62/PJ/2009 on the Prevention of Abuse of Double Taxation Avoidance Agreements, as amended by Director General of Taxes Regulation No. PER-25/PJ/2010 (“Rule 2009”) as the recipient of such income who does not (a) act as an agent, (b) act as a nominee, or (c) is not a conduit company.
Additionally, under Article 4 paragraph (2)(g) of the Rule 2009, for companies receiving or deriving income under a tax treaty where beneficial ownership is regulated, the beneficial ownership requirements must be satisfied to avoid being considered as misusing the treaty are as follows:
- the establishment of the company or the structuring of the transaction scheme is not solely intended to obtain benefits under the Double Taxation Avoidance Agreement;
- business activities are managed by its own management with sufficient authority to conduct transactions;
- the company has employees;
- the company carries on active business activities;
- income sourced from Indonesia is subject to tax in the recipient’s country of residence;
- the company does not use more than 50% (fifty percent) of its total income to fulfill obligations to other parties in the form of, inter alia, interest, royalties, or other payments.
Supreme Court’s Decree
The Supreme Court set aside the Tax Court’s decision and re-examined the case. Having regard to the applicable laws and treaty provisions, the Supreme Court concluded that the available evidence sufficiently established that TAXPAYER qualifies as the beneficial owner of the interest. The Supreme Court considered that the certificate of residence should serve merely to evidence that the recipient of the interest income is registered as a foreign tax resident of a treaty partner jurisdiction and does not constitute proof of beneficial ownership.
On that basis, it held that the issuance of the Underpayment Tax Assessment Letter for Article 26 Income Tax fell within the TAX AUTHORITY’s legal authority, was conducted in a measured manner, and complied with the General Principles of Good Governance. The TAX AUTHORITY’s corrections were therefore upheld as being in accordance with the relevant statutory provisions, including Article 26 of the Income Tax Law and Article 11 paragraphs (2) and (4) Treaty.
Accordingly, the Supreme Court determined that the remaining tax payable consists of the Article 26 Income Tax on the interest paid by TAXPAYER, together with the applicable administrative sanctions.
Key Takeaways
One of the fundamental objectives underlying the Double Taxation Avoidance Agreement is not only to eliminate double taxation but also to prevent tax avoidance. In this context, the Court emphasized that transactions seeking to benefit from treaty provisions must be carefully assessed and prioritize the principle of factual substance to prevent misuse, applying a dual analysis that examines both the economic substance and the legal form of the transaction. In the case of discrepancies between these two aspects, the Court reaffirmed the application of the substance over form principle, under which the economic substance of a transaction prevails over its formal legal structure.
Such implementation is evident in the Supreme Court’s Decree, while the formal structure of the transaction placed A B.V. as the legal recipient of the interest income and that as per the certificate of residence such interest may be taxed in the Netherlands. The Court evaluated from a substance over form standpoint, examining the ownership structure and determining that TAXPAYER ultimately enjoyed the benefit of the interest income and was the ultimate beneficial owner. Such certificate of resident is merely a formal requirement and in itself not sufficient to establish entitlement to treaty benefits.
Conclusion
The decision of the TAX AUTHORITY and the Supreme Court signals possible scrutiny of parties engaging in treaty shopping. It indicates that formal structures alone are insufficient to secure treaty benefits, as tax treatment will be determined based on economic substance and the identity of the ultimate beneficial owner rather than merely the legal form of the transaction. Any divergence between legal form and economic substance may expose taxpayers to recharacterization risks, denial of treaty benefits, and consequent tax underpayments, including administrative sanctions.
For further information, please contact:
MetaLAW, Legal & Tax Consultant, Jakarta, Indonesia
general@metalaw.id
