Base Erosion and Profit Shifting in Indonesia

Abstract

The ownership, location and internalisation (OLI) framework introduced by Dunning (1977) explains why multinational enterprises (MNEs) establish subsidiaries overseas. According to the OLI framework, MNEs have advantages over companies that operate at the domestic level, including more power, such as patent, trademark and international reputation (ownership), more flexibility to choose locations for better access to customers and lower tariffs (location) and, most importantly, broader opportunities to set up intra-firm prices and processes (internalisation). While there have been strong indications that Indonesian affiliates of foreign MNEs have been using the internalisation aspects of the OLI framework, such as profit shifting, to avoid Indonesian corporate income tax (CIT), there are no peer-reviewed studies on the existence of profit shifting by MNEs in Indonesia.

When an MNE shifts profit out of a host country, it simultaneously reduces both the taxable income and the accounting profit reported in the host country. Therefore, in this thesis, profit is represented by two measurements: taxable income and accounting profit before tax.

Using confidential tax return data for the period 2009–2015, this thesis investigates the issue of profit shifting in Indonesia by conducting three related studies, which are outlined below.

Study 1 investigates whether foreign-owned Indonesian companies (FOICs) shift profits out of Indonesia by examining the effect of the difference in statutory corporate tax rates (STR) between the source country of investment and Indonesia on the profit reported by FOICs in Indonesia. The regression results show that the lower the tax rate of the parent country relative to Indonesia, the lower the profit reported by FOICs, providing empirical evidence consistent with the profit shifting occurring in Indonesia.

Study 2 further investigates whether FOICs shift profits out of Indonesia by following an approach introduced by Hines and Rice (1994) based on the Cobb–Douglas production function with some modifications. The regression results show that a tax rate that is one percentage point lower in the parent country reduces the accounting profit and taxable income reported by FOICs in their Indonesian tax returns by 2.56% and 2.89%, respectively. These findings are consistent with the findings of Study 1 and provide further evidence of profit shifting from Indonesia to low-tax countries.

Study 3 attempts to provide more direct evidence of the existence of cross-border profit shifting in Indonesia by investigating whether FOICs use the two most commonly used channels to shift profits: intra-group transfer pricing and debt financing. This is done by matching FOICs with comparable domestic-owned Indonesian companies (DOICs) and comparing the paired sample in terms of (1) earnings before interest and taxes scaled by sales (to detect profit shifting using transfer pricing), and (2) long-term debt to related parties scaled by assets (to detect profit shifting using intra-group debt financing). The results suggest that while FOICs use both channels to shift profits, transfer pricing plays a more significant role than debt financing.

This thesis contributes to the literature by providing empirical evidence of profit shifting by MNEs to erode the CIT base of Indonesia.