Welcoming the Hybrid Territorial Tax System in Indonesia

For a country, the application of an effective international tax system is a “must” in winning the global tax competition. In particular, if the country’s main goal is to advance its economy through development in the field of cross-border investments. Therefore, unsurprisingly, numerous countries are attempting to establish a tax system that corresponds to state conditions while being competitive in attracting investments (Li Liu, 2018).

In practice, every country has the sovereignty to design and apply its own international tax system. However, in concept, the international tax system is designed based on two basic taxation principles, namely the domicile principle and the source principle.

A tax system designed based on the domicile principle is known as the worldwide tax system, i.e. a system that imposes taxes on all income received by resident taxpayers, either domestically- or foreign-sourced. A country that adopts the worldwide tax system also imposes taxes on income received by non-resident taxpayers sourced from that country (Razin and Slemrod, 1990).

On the other hand, a tax system based on the source principle is referred to as the territorial tax system. A country with a territorial tax system only imposes taxes on income sourced from the country. In other words, income sourced from outside the country is not taxed (Rohatgi, 2005).

Although the worldwide tax system is often deemed an international tax system applied by many countries, today’s trend shows otherwise. Many countries have abandoned the worldwide tax system and switched to the territorial tax system (Matherson, 2013). 

As an illustration, in 2000, 17 out of 34 OECD countries adopted the worldwide tax system. In 2018, only 6 OECD countries adopted the worldwide tax system.

We should also observe what the United States (US) has undertaken. At that time, through the ratification of a new law called the Tax Cuts and Jobs Act (TCJA) on 22 December 2017, one of the highlighted points was the claim of the change in the US tax system from the worldwide system to the territorial system, even though only certain types of foreign-sourced income sourced were not taxed.

These certain types of income are exempt from the tax on foreign-sourced dividends received by US resident taxpayers. In other words, the US territorial tax system does not apply to all types of foreign-sourced income. However, it is limited to certain types of income. In concept, this system is known as the hybrid territorial tax system. 

The switch undertaken by the US from the worldwide tax system to the territorial tax system is not the first. The UK and Japan had already “migrated” from the worldwide system to the territorial system. Similar to the US, the territorial tax system applied by the UK and Japan is not a pure territorial tax system as stated in the concept. Both countries adhere to the hybrid territorial tax system.

This is because the UK only excludes the imposition of taxes on payments of foreign-sourced dividends as well as profits generated by company branches overseas. On the other hand, Japan’s territorial tax system only applies to foreign-sourced income in the form of dividends.

Inevitably, the trend of the shift from the worldwide tax system to the territorial tax system by countries evokes one major question, namely the main reasons for the shift. Mullins in his article entitled “Moving to Territoriality? Implications for the United States and the Rest of the World” reveals the reasons for a country’s shift from the worldwide system to the territorial system.

First, the territorial tax system is considered capable of reducing the complexity of the application of the worldwide tax system. Second, increasing the economic competitiveness of a country in seizing international market share. This was the case in the UK which at that time was competing with other EU countries (Ireland, Benelux and Switzerland).

Third, preventing lock-out capital. For example, in the US and Japan. Fourth, eliminating loopholes from the application of the worldwide tax system on foreign-sourced income.

The choice of the international tax system is crucial for any country. Moreover, amidst the increasingly intense interstate tax competition and massive cross-border tax avoidance practices. As such, what about Indonesia?

Indonesia’s Perspective

The “migration” trend by countries from the worldwide to the territorial tax system will also be felt by Indonesia if the Omnibus Draft Law on Taxation is validly promulgated. Through the planned enactment of Article 4 paragraph (1) subparagraph ‘b’ and subparagraph ‘c’ of this Draft Law, Indonesia will move towards an impure territorial tax system.

The application of this territorial tax system is characterised by the exclusion of several types of foreign-sourced income received by resident taxpayers from taxation insofar as the income is invested in Indonesia within a certain period. Details and provisions of these exclusions can be seen in the following table.

Table 1 Types of Foreign-Sourced Income Excluded from the Imposition of Taxes in Indonesia

Table 1 above shows that the territorial tax system formulated in the Omnibus Draft Law on Taxation is not a pure territorial tax system, but a hybrid territorial tax system as applied in the US, UK and Japan. This is because the exclusion from taxation in the Draft Law does not apply to all foreign-sourced income. However, it only applies to dividends, income after tax of PEs as well as income from overseas businesses not through PEs.

Indonesia’s plan to “welcome” the hybrid territorial system is integral to the goal of the Omnibus Draft Law on Taxation, which is to increase domestic investment funding by repatriating the income of Indonesian resident taxpayers that has been “parked” overseas. This income will be locked for a certain period so as not to leave Indonesia. That’s the desired outcome.