Internal Comparables and External Comparables in the Application of the Arm's Length Principle

Executive Summary (Key Points)

• Comparability Analysis aims to validate affiliated transactions by seeking a fair market price, in accordance with PMK-172/2023.
• Internal Comparables (Primary Priority) are sourced from independent transactions conducted by the Taxpayer (WP) itself or its affiliates. Advantage: Highest level of comparability (functions, risks, assets) because they originate from within the same entity.
• External Comparables (Secondary Priority) are sourced from transactions between third parties (pure independent transactions), Market Data, or Commercial Databases. Challenge: Requires extensive adjustments (accounting, functions, risks, market conditions) to achieve acceptable comparability.
• PMK-172/2023, Article 8 Paragraph (5)-(9), explicitly mandates the hierarchy that Internal Comparables must be explored and used before switching to External Comparables.

The application of the Arm's Length Principle is a cornerstone in transfer pricing regulation to ensure that transactions influenced by a special relationship reflect fair market conditions. The key methodology in applying this principle is Comparability Analysis, which requires the identification and evaluation of independent transaction data. This article analyzes the two main sources of comparable data—Internal and External—as well as the hierarchy of their reliability in accordance with the latest regulatory framework, specifically as mandated by the Minister of Finance Regulation Number 172 of 2023.

Comparability Analysis is an essential phase in transfer pricing documentation, aiming to determine the acceptable price or margin for an affiliated transaction. This concept is based on the premise that the most reliable transaction data is the data that possesses the highest degree of comparability with the transaction being tested. The reliability of comparable data heavily depends on its source, which is generally categorized into internal comparables and external comparables. The Indonesian regulatory framework, as stipulated in the Minister of Finance Regulation Number 172 of 2023 (PMK-172/2023), explicitly establishes the priority for the use of these data sources.

A. Internal Comparables

Internal Comparables are defined as data derived from independent transactions conducted by the tested Taxpayer (WP), or its affiliated entities, with fully independent third parties. This source is prioritized because it possesses the inherently highest potential for functional comparability.

Internal data is considered the most reliable comparable because the critical factors in the comparability analysis—such as market conditions, product/service characteristics, functions, assets, and risks—tend to have minimal variation between the affiliated transaction being tested and the internal independent transaction.

Internal Comparables are identified through transactions carried out between the Tested Party and Independent Parties. The price or margin data from these independent transactions is then used as an arm's length benchmark to validate similar transactions conducted by the Tested Party with its Affiliated Party.

B. External Comparables

When Internal Comparables are unavailable, insufficient, or fail to meet reliability criteria, the analysis shifts to External Comparables. This source consists of transaction data or financial information derived entirely from outside the consolidated entity of the Taxpayer.

External Comparables are based on the market price or financial performance of pure independent transactions, meaning transactions between an Independent Party (Seller) and an Independent Party (Buyer), which constitutes third-party data.

This data is obtained through publicly available Market Data or through subscriptions to Commercial Databases. The main challenge in using external comparables is ensuring adequate adjustments. Differences in functions, assets, risks, and geographical/economic conditions between the comparable companies and the Taxpayer require extensive adjustments to achieve an accurate level of comparability.

Hierarchy of Comparable Usage and Regulatory Basis

Transfer pricing regulations in Indonesia strictly govern the priority hierarchy for the use of data sources. According to Article 8 Paragraph (5) through Paragraph (9) of PMK-172/2023:

• Primary Priority: The use of Internal Comparables must be explored and documented first.
• Secondary Priority: If Internal Comparables cannot be used or are deemed less reliable, the analysis then switches to External Comparables.

This principle reflects international best practice, which recognizes that internal comparability generally provides stronger and less distortion-prone evidence of the arm's length result.

Conclusion

Comparability Analysis is the methodological foundation of transfer pricing. The success of this analysis relies heavily on the correct selection of the comparable source. By prioritizing Internal Comparables—which offer the highest degree of comparability—and shifting to External Comparables—with careful adjustments—Taxpayers can uphold compliance with the Arm's Length Principle as mandated by the national legal framework, specifically the Minister of Finance Regulation Number 172 of 2023.

References

Minister of Finance Regulation Number 172 of 2023 concerning the Application of the Arm's Length Principle in Transactions Influenced by a Special Relationship (Peraturan Menteri Keuangan Nomor 172 Tahun 2023 tentang Penerapan Prinsip Kewajaran dan Kelaziman Usaha Dalam Transaksi yang Dipengaruhi Hubungan Istimewa).