Government Moves on Tax Front to Encourage Greater Equity Contribution to Company Capital
The Minister of Finance recently issued Regulation No. 169/PMK. 010/2015 (the “Regulation”) on the ratio of debt to equity in a company’s capital (debt-to-equity ratio /“DER”) for tax calculation purposes. This is significant as Law No. 7/1983 on Income Tax, as lastly amended by Law No. 36/2008, provides that interest expenses are deductible in the calculation of a company’s tax liabilities.
The Regulation, which enters into effect in fiscal year 2016, sets the DER at 4 : 1, meaning that interest expenses arising on borrowings incurred to provide company capital will no longer be deductible for tax purposes where such borrowings exceed 80 percent of the company’s capital.
The Regulation is mainly aimed at the taxation implications that arise in connection with the proportion of a company’s capital sourced using two different methods, i.e., equity versus debt. When a large proportion of a company’s capital is provided by borrowings, the company is said to be “thinly capitalized.” This may have undesirable consequences from both the perspective of creditors and the revenue authorities (Directorate General of Taxes). For the former, there will be less shareholder capital available to repay the company’s debts in the event of insolvency, while for the later, excessive deductions of interest expenses are clearly undesirable.
Thus, as stated by the Ministry of Finance, the Regulation is intended to encourage shareholders to provide a greater contribution to company equity and discourage excessive reliance on borrowing.
The Regulation defines “debt” as interest-bearing short- and long-term borrowings and trade-related debts, while “equity” is defined as both equity and interest-free loans from parties with special relationships.
A number of exemptions are provided, including in the case of banks, consumer finance, insurance and reinsurance firms, oil and gas and mining firms with particular types of contractual relationships with the state, companies that are subject to final tax, and companies involved in infrastructural development.
A similar ruling was first introduced by virtue of Minister of Finance Regulation No. 1002/KMK.04/1984 (but at a tighter ratio of 3 : 1). However, the requirement was put on indefinite hold the following year by Minister of Finance Regulation No. 254/KMK.01/1985. Thus, there have been no DER limits since 8 October 1984 on the amount of interest expenses that may be set off against a company’s taxable income, even in the case of loans from shareholders or affiliates.
While DER rules on company capital are quite common in civil law jurisdictions, questions have nevertheless been raised about the precise timing of the Regulation as it has the clear potential to increase the financial burden facing companies at a time when the national economy is experiencing turbulence and the rupiah continues to weaken. It has also been commented that the new policy appears to run contrary to the spirit of the government’s recently announced deregulation package.
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