Making Better Indonesia’s Thin Capitalization Rules (Lesson Learn from China)

Thin capitalization rules are an effective instrument used by the tax authorities in many countries to prevent tax avoidance attempts through base erosion. These rules must be applied while maintaining adherence to the substance over form and the arm’s length principles. In Indonesia’s case, a stricter thin capitalization rule enables the country to overcome issues of taxation involving multinational corporations as well as issues of base erosion and profit shifting (BEPS). However, in comparison to other countries, the debt-to-equity ratio (DER) applied in Indonesia as part of the country’s thin capitalization rule is considered lax. With a tax policy that is non-disincentive to business activities as well as lessons learnt from the regulations prevailing in China in mind, a number of suggestions for a more effective thin capitalization rule in Indonesia are offered, including DER review, application of the arm’s length principle as an alternative, revision of the definition and scope of debt, and regulations improvement by providing clarity on the time basis of interest financing, treatment of the penalty imposed on late debt payment, treatment of interest income not considered as an expense to the borrower, and treatment of interest expense that cannot be carried forward to the subsequent period.