Choosing and Applying the Right Transfer Pricing Method

In the international tax landscape, the heart of affiliated transaction compliance lies in the selection of the right transfer pricing method. Errors in choosing a method not only risk significant fiscal corrections but can also trigger prolonged disputes with tax authorities.

In Indonesia, the Directorate General of Taxes (DGT) through Regulation of the Minister of Finance Number 172 of 2023 (PMK 172/2023) has established standard standards regarding recognized methods for testing transaction fairness. This article will dissect these methods in detail, when to use them, and their selection hierarchy according to The Most Appropriate Method principle.

The Most Appropriate Method

Before getting into the technicalities of methods, it is important to understand that Taxpayers are not free to choose a method arbitrarily. Indonesia adheres to the "The Most Appropriate Method" principle. This means the selected method must be the one that provides the most reliable measure of an arm's length result.

Although there is no rigid hierarchy, regulations in Indonesia provide a preference (priority). If the CUP Method and another method have equal reliability, then CUP must be prioritized. Similarly, transaction-based methods (CUP, RPM, Cost Plus) are prioritized over profit-based methods (TNMM, Profit Split) if their reliability is equal.

Traditional Transaction Methods (Traditional Transaction Methods)

These methods are considered the most direct because they compare the price or gross margin of the transaction specifically.

1. Comparable Uncontrolled Price (CUP Method)

Comparable Uncontrolled Price (CUP) is a method that compares the price of goods or services in an affiliated transaction directly with the price of goods or services in an independent transaction.

• When to Use: Commodity product transactions (coal, CPO, oil) or goods/services that are highly identical.
• Pros: The most direct method with the strongest proof.
• Cons: Very sensitive to product or transaction time differences.
• Application in Indonesia: PMK 172/2023 emphasizes the use of commodity exchange quoted prices as comparables.

2. Resale Price Method (RPM)

This method is used by deducting the resale price of goods (to an independent party) by a fair gross margin.

• When to Use: Distributors or resellers that do not provide significant value-added.
• Focus of Analysis: Gross margin of comparable independent distributors.
• Pros: More tolerant of product differences compared to CUP.

3. Cost Plus Method (CPM)

This method determines the fair price by adding a fair gross profit mark-up to the production cost basis incurred by the provider of goods/services.

• When to Use: Contract manufacturers (contract manufacturer), toll manufacturers, or routine services.
• Focus of Analysis: Gross mark-up of independent manufacturers.
• Challenge: Ensuring consistency of cost classification (COGS vs operating expenses).

Transactional Profit Methods (Transactional Profit Methods)

These methods compare net operating profit, not price or gross margin, used when gross margin data is unreliable.

1. Transactional Net Margin Method (TNMM)

TNMM compares the net operating profit ratio (net profit margin) against a specific basis (sales, costs, or assets).

• When to Use: The method most frequently used due to its flexibility.
• Pros: Most tolerant of product and function differences.
• Profit Indicators (PLI): Operating Margin (distributors), Full Cost Mark-up (manufacturers), ROA (capital intensive).

2. Profit Split Method (PSM)

This method divides the combined profit (or loss) based on the relative contributions of the parties, as if they were partners in an independent partnership.

• When to Use:
  • Both parties possess unique and valuable contributions (strong technology/brand).
  • Business activities are highly integrated.
  • Both parties share significant business risks together.
• Approach: Contribution Analysis (directly dividing total profit) and Residual Analysis (giving routine profit first, then dividing the remainder).

Other Methods (Valuation)

PMK 172/2023 recognizes "Other Methods" if the five methods above cannot be applied reliably, specifically for unique transactions.

Asset Valuation and Business Valuation Methods (Valuation)

• When to Use: Transfer of intangible assets (patents, brands), business restructuring, or transfer of shares without an active market.
• Common Technique: Using future cash flow projections (Discounted Cash Flow / DCF) according to applicable valuation standards.

Choosing a transfer pricing method is not just about choosing which is most profitable tax-wise, but which most accurately describes the economic reality of the transaction (substance). The key to the success of this analysis is strong documentation (TP Doc) that explains logically why a certain method was selected and why other methods were rejected, based on the hierarchy and criteria regulated in law.

References

1. Ministry of Finance of the Republic of Indonesia. (2023). Regulation of the Minister of Finance of the Republic of Indonesia Number 172 of 2023 concerning the Application of the Principle of Fairness and Business Prevalence in Transactions Influenced by a Special Relationship.
2. OECD. (2022). OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022. OECD Publishing, Paris.
3. Republic of Indonesia. (1983). Law Number 7 of 1983 concerning Income Tax as last amended by the Law on Harmonization of Tax Regulations.