Recent macroeconomic developments in Indonesia, and most notably, the number of recent increases in the benchmark rate by Bank Indonesia (the most recent of which has increased the benchmark rate to seven per cent.), has led to various market commentators and participants pointing to the international bond markets as the most likely source of capital for Indonesian corporates seeking to raise capital. In the context of the benchmark rate increases leading to a potentially higher cost of funds for Indonesian issuers (who traditionally seek to access debt capital in the Rupiah-loan or bond market), the international bond markets are increasingly being viewed as a potential source of cheaper, possible longer tenure and more stable capital.
As in most emerging markets jurisdictions, the imposition of withholding taxes are a primary structural consideration for any issuer seeking to access international bond markets, and for managers marketing such an offering. For Indonesia, Indonesian tax laws and regulations impose a withholding tax at a rate of 20 per cent., to be withheld on the payment of any interest to an offshore tax resident (i.e. bond investors) by an Indonesian taxpayer (the Indonesian-incorporated issuer, in a typical plain-vanilla eurobond issue structure) unless this rate is reduced under the application of an applicable tax treaty, such as with Singapore (10 per cent.) or the Netherlands (0 per cent.). Whilst the terms and conditions of bonds will invariably include a traditional tax gross-up provision obligating the issuer to pay such additional amounts as will result in the holder of the bonds receiving such amount as would have been received had no such withholding been applied, the imposition of a 20 per cent. withholding tax adds a significant layer of transaction and finance cost for the issuer. In addition, in circumstances where Indonesian credits are sufficiently comfortable in adopting a structure designed to lower this cost (and such as to proceed with a bond offering), the risk of the gross-up being triggered could result in significant stress being placed on the underlying credit’s cash flows, and in larger bond offerings, could conceivably trigger material adverse change clauses in other financing arrangements.
This briefing seeks to revisit some of the bond issuance structures which have been adopted by Indonesian issuers to achieve tax savings post the Director General of Tax Regulation 61/PJ/2009 and 62/PJ/2009 (the “Indonesian Double Tax Regulations”) which clarified, among other things, that in order for the recipient of income to benefit from a double taxation treaty (such as with Singapore or the Netherlands, as referred to above), such recipient needs to be the beneficial owner of such income and essentially be an operating entity in its own right which was not incorporated solely for the purposes of minimising Indonesian tax liability. One would have thought that following the implementation of these regulations and particularly in light of the litigation that ensued in Indonesia in respect of the Indah Kiat International Finance Company B.V. and APP International Finance Company B.V. bond offerings (which highlighted the risk of using an SPV issue structure to minimise tax), Indonesian issuers will no longer use an offshore SPV bond issue structure to minimise tax, but that is not what has happened in the market following the promulgation of those regulations. We are still seeing issuers adopt the typical (albeit modified) SPV bond issue structure to maximise tax efficiencies. Whilst some of these issues have done so for historic reasons rather than to maximise tax efficiencies, gaining access to double tax treaty benefits remains the primary driver of these bond structures.
1. The Indonesian Double Tax Regulations in more detail
In summary, a double tax treaty with Indonesia may result in withholding tax being reduced to a rate lower than 20 per cent. on the payment of any interest to a tax resident of the treaty country which is the “beneficial owner"1 of the payment. If such tax resident is able to comply with the requirements of the Indonesian Double Tax Regulations, it must provide to the Indonesian taxpayer the duly prescribed DGT 1 form, endorsed by the tax authorities of such treaty country, which sets out that:
- the tax resident, in corporate form (the “tax resident company”), is not incorporated or established in Indonesia;
- that the structure or transactions entered into by the tax resident company are not purely for the purpose of accessing treaty benefits (i.e.: the reduction in withholding tax from 20 per cent.) under the relevant double tax treaty with Indonesia;
- the tax resident company has its own management and sufficient authority to make decisions;
- the tax resident company has sufficient qualified employees;
- the tax resident company is actively engaged in a business or trade;
- the income derived from Indonesia is subject to taxation in the tax resident company’s jurisdiction of residence (on the Indonesian sourced income); and
- not more than 50 per cent. of the total income earned by the tax resident company is used to settle its obligations to other parties in the form of interest, royalties or other types of compensation (excluding dividends and ordinary operating expenses).
If the tax authorities of the treaty country to which the tax resident is subject cannot provide an endorsement, then the tax resident has to obtain a certificate of domicile or tax residence issued by the tax authorities, which is to be submitted to the Indonesian tax payer.2
2. Structuring Considerations, Risks and Mitigants
Offshore SPV Structures
On the basis of the withholding tax regime applicable to Indonesian issuers, as set out above, eurobond offerings by Indonesian corporates have typically adopted the structure represented diagrammatically below in order to benefit from the 10 per cent. rate of withholding tax (in the case of the use of Singapore SPVs) or the zero per cent. rate of withholding tax (in the case of the use of Dutch SPVs):
Click here to view digram.
Whilst the jurisdiction of incorporation of the offshore SPVs, and therefore also the rate of withholding tax, differs, the structures are effectively identical, and are as follows:
- The underlying credit, namely the Indonesian company or “borrower” (“IndoCo”) establishes an offshore SPV as a wholly-owned subsidiary which will be the issuer of bonds to international investors (“Offshore Issuer SPV”).
- Similarly, the Offshore Issuer SPV itself establishes an offshore SPV as its wholly-owned subsidiary, incorporated in the same jurisdiction (for tax neutrality purposes) (the “Offshore Intermediate SPV”).
- The Offshore Issuer SPV issues the bonds to international investors, and utilises the net proceeds from that issue to fund the Offshore Intermediate SPV, usually in the form of a combination of shareholders’ loans and a subscription for equity securities of the Offshore Intermediate SPV. This mix of funding (from the parent Offshore Issuer SPV to the Offshore Intermediate SPV) is designed in such a manner as to ensure compliance with the requirement of the Indonesian Double Tax Regulations that not more than 50 per cent. of the total income earned by the company is used to settle its obligations to other parties in the form of interest, royalties or other types of compensation (excluding dividends and ordinary operating expenses).
- In turn, the Offshore Intermediate SPV then enters into an intercompany loan agreement with IndoCo, where the combination of subscription moneys and shareholders loans are effectively then passed through to the Indonesian onshore IndoCo. It is in this step of the structure that the treaty benefits are accessed.
- The repayment terms of the intercompany loan between IndoCo and the Offshore Intermediate SPV are then commercially (and not identically, for reasons that will become apparent in the course of this briefing) matched over the tenure of the bonds and the loan to the commercial terms of the bonds (in relation to redemption and coupon payments), with the Offshore Intermediate SPV repaying the shareholder loans or making equity distributions (in the form of dividends) to the Offshore Issuer SPV, in order to place it in sufficient funds for the purposes of ultimately meeting its principal and interest repayment obligations under the bonds.
- In order to provide the bonds with a measure of credit enhancement, and give investors in the bonds direct recourse to IndoCo in the event of the Offshore SPVs failing to meet their obligations under the various intercompany transactions (for example, where the Offshore Intermediate SPV, under independent management, does not declare or pay a dividend to the Offshore SPV), IndoCo will guarantee the obligations of the Offshore Issuer SPV under the bonds.3
The principal commercial difference between the structures is, of course, the treatment of the withholding tax. This remains at zero per cent. where a Dutch SPV is used, and 10 per cent. where a Singapore SPV is used. Where withholding tax is payable, liability is ultimately born by IndoCo, which will gross-up payments of interest under its intercompany loan with the Offshore Intermediate SPV.
By reference to the requirements of the Indonesian Double Tax Regulations set out above, it is essential to ensure that the Offshore Intermediate SPV:
- acts as an active group financing company, with independent management (formally meeting in its jurisdiction of incorporation) and its own employees;
- is subject to tax in its own jurisdiction of incorporation (i.e. Singapore or the Netherlands) on the income received from Indonesia (i.e. the payments received under the intercompany loan from IndoCo); and
- that 50 per cent. or more of such income is not used to satisfy its obligations to other parties in the form of interest or other rewards (which we understand to exclude operating expenses and dividends). Accordingly, the mix of shareholder loans and equity injections from the Offshore Issuer SPV needs to be carefully composed in order to remain in compliance with this requirement.
3. Structural Risks
A principal structural risk with the approach outlined above is that the Indonesian tax authorities find or direct that the parties to the offshore SPV structure are not compliant with the double tax treaty or the requirements of the Indonesian Double Tax Regulations, in which case, withholding tax will apply at the usual rate of 20 per cent. In addition, any payments made by IndoCo under the guarantee will, regardless of the views of, or action taken by, Indonesian tax authorities, be subject to withholding tax at the rate of 20 per cent. This could happen, for instance, where Indonesian tax authorities find that the Offshore Intermediate SPV’s status as an “active group financing company” is not sufficient to meet the requirements of having an active operation or business.
A related, and potentially graver risk, is that of the validity of the bond issue as a whole being challenged in the Indonesian courts on the grounds of the transaction not being compliant with Indonesian tax regulations. If such challenge is successful, it could result in the bond issue and related transaction being declared unlawful, and thus unenforceable, in Indonesia. The risk of such challenges is particularly relevant in the context of a default scenario, and can not only cause considerable difficulties for international investors seeking to recover outstanding amounts, but also lead to additional (and in some cases, considerable) sanctions being imposed on bondholders and other counterparties to the bond transaction documents, such as the trustees and lead managers.
Regrettably, there is an established history of such structural risks manifesting in Indonesia. The various decisions of the Indonesian lower courts and Supreme Court in relation to the invalidation of US$500 million of bonds issued by Indah Kiat International Finance Company B.V. and US$550 million of bonds issued by its sister company, APP International Finance Company B.V. are well-documented, and are frequently cited, both in commentary on Indonesian civil law in the context of cross-border financing transactions as well as in extensive risk factor disclosure in offering documents, as a prime example of the structural risks faced by issuers and investors in Indonesian eurobonds. Our firm advised the lead managers in relation to the challenges brought to these bond structures.
The challenges made to the Indah Kiat and APP bond structures (and the outcome of these disputes) highlight risks that remain relevant considerations for counterparties to a bond offering by Indonesian corporate issuers. These include the following:
- as Indonesia is a civil law jurisdiction where the legal concept of stare decisis (i.e. the legally binding nature of precedent judgments of superior courts) does not apply, an element of uncertainty will always remain in relation to the manner in which Indonesian courts will treat structures aimed at maximizing tax efficiencies and benefits in bond structures. Indeed, this uncertainty is both illustrated and exacerbated by the fact that the Indonesian Supreme Court has issued conflicting decisions at final instance (Civil Review) in two separate cases relating to the Indah Kiat bond issue. As such, investors (and other counterparties to Indonesian bond offerings, principally lead managers and trustees) should be fully cognisant of the risk of claims being made against them by issuers, which could, as seen in the Indah Kiat and APP cases, exceed the proceeds of an issue;
- as a general rule, foreign court judgments are not enforceable in Indonesia. A case to which a foreign judgment relates will need to be re-litigated afresh in Indonesia and, whilst the foreign judgment may serve as prima facie evidence, any findings of a foreign court of fact or law are rebuttable before the Indonesian courts. Accordingly, the general consensus is that standard euromarket tax gross-up provisions in bond documents (or, indeed, most other contractual protections) would not necessarily be of assistance if the bond documentation is deemed to be invalid as a matter of Indonesian law. In such case, it will not be possible to enforce such a gross-up (assuming that the issuer does not exercise the tax call) even if judgment is granted in favour of bondholders in the jurisdiction of the governing law of the bond documentation (such as the United Kingdom or New York);
- moreover, whilst the approach in recent Indonesian corporate bond offerings has been to include detailed disclosure of the structural risks inherent in the approaches described above, this will theoretically only serve to mitigate the risks of liability of managers and issuers in claims by investors for material omissions or misstatements in an offering circular;
- as to the merit of potential challenges to the SPV structure on the grounds of non-compliance with Indonesian tax regulations or double tax treaties, whilst the view of transaction counterparties on recent offerings is that an “active group financing company” is “actively engaged in a business or trade” for the purposes of the Indonesian Double Tax Treaty Regulations, there remains an argument to be made that the SPVs are being put in place purely for the purpose of accessing treaty benefits. To the extent such SPVs are held not to be “actively engaged in a business or trade”, there remains a risk, at the very least, of the withholding tax rate increasing to 20 per cent, and, in the worst-case scenario, of the bond issue being declared unlawful altogether; and
- the choice of jurisdiction of incorporation (i.e. typically between the Netherlands and Singapore) also has its own risks, which are examined below.
4. Choice of SPV Incorporation and the Meaning of “Beneficial Owner”
In designing the structure of a corporate bond offering by reference to treaty benefits and the rate of withholding tax applicable, Indonesian issuers and their advisers will, from a purely economic perspective, undoubtedly prefer to establish the Offshore Issuer SPV and Offshore Intermediate SPV in the Netherlands (where the withholding tax rate is zero per cent.) as opposed to Singapore (where the withholding tax rate is 10 per cent.). Whilst there are recent examples of each jurisdiction being adopted for an Indonesian corporate bond offering, caution should be exercised in adopting the more aggressive structure using a Dutch SPV to reduce withholding tax to zero per cent.
This risk was perhaps best-illustrated in the case of Indofood International Finance Ltd v JP Morgan Chase Bank NA, London Branch4 where the English Court of Appeal held that a Dutch SPV in an Indonesian corporate bond offering structure not dissimilar to that described above was not the beneficial owner of the income derived under the intercompany loan, as it was, under the terms of the transaction documents, bound to pay on to the principal paying agent (on behalf of the issuer) what it received from the guarantor / borrower, and as such, did not have full privilege to benefit from the income, but was instead, an administrator of the income.
In arriving at its decision, the English court gave the term “beneficial ownership” an “international fiscal meaning”, and in doing so, placed substantial reliance on the Indonesian Director General of Taxation, whose view was that “the concept of beneficial ownership is incompatible with that of the formal owner who does not have ‘the full privilege to directly benefit from the income.’”
The International Tax Law Reports’ Editor’s Note to this case made the point that “one has to remember that the ultimate decision rests upon the facts of the case”, and “(i)f in any situation one was going to advise that there was a substantial risk that the beneficial ownership test was not satisfied, this would have to be such a case.” In drawing these conclusions, the editor cited the structure as being “an egregious example of payment through a conduit”, and pointed to the following facts:
- the principal amount loaned and borrowed, and the interest rate payable, under the intercompany loan component of the structure was identical;
- the terms of the intercompany loan and other transaction documents required that the payment of interest was to be paid one day after receipt; and
- perhaps most egregiously of all, the Dutch SPV (and the rights and obligations created under the intercompany loan) was, in managing the cash flows in the structure, completely ignored, with payments being made directly to the paying agent, and eventually, the trustee for the bondholders.
In addition, the court also held that the place of effective management was the place where the key commercial decisions necessary for the conduct of the Dutch SPV’s business were, in substance, made. As the trust deed clearly provided that such decisions were to be made by the Indonesian parent, it was likely that Indonesian tax authorities would find that the Dutch SPV was resident in Indonesia, and not the Netherlands.
Accordingly, as the Dutch SPV was held not be the beneficial owner of the payments under the loan, the rate of withholding tax on the Indofood bonds issued under that structure reverted to 20 per cent, as opposed to the zero per cent initially anticipated by the issuer (and notably, not the 10 per cent. withholding tax rate applicable under the previous treaty).
The lessons to be learnt, and applied to future Indonesian corporate bond structures, from the court’s decision in Indofood and the manifold circumstances surrounding it, are as follows:
- even in the context of recent successful corporate bond transactions structured to comply with the Indonesian Double Tax Treaty Regulations, there is still a significant measure of uncertainty in relation to the manner in which such structures will be treated by the Indonesian courts and tax authorities in future;
- meticulous attention needs to be paid to both the letter, and so far as discernible, the spirit, of the Indonesian Double Tax Treaty Regulations in the concept and design of an Indonesian corporate bond offering structure at the outset of the transaction execution process, with particular emphasis placed on ensuring that the SPVs are independently managed, staffed by their own employees and that the cash flow management systems that are put in place are appropriately structured so that the SPV qualifies as the “beneficial owner” of payments under a loan. In designing the offshore cash flows, this should be considered side-by-side with the requirement that not more than 50 per cent. of the SPV’s income is used to satisfy an obligation to another party in the form of interest;
- market-standard transaction documentation, such as trust deeds and agency agreements, need to be carefully prepared in order to ensure that they not only achieve the mechanical objectives of the transaction, but also that their terms preserve the structural integrity of the cash flows between the underlying credit and the offshore SPV entities; and
- for as long as the bonds remain outstanding, the ultimate parent and each offshore SPV need to diligently ensure that all payments of principal and interest are made in accordance with the strict requirements of the transaction documents, and that the essential terms of the cash flows in the structure are observed.
These issues and considerations are not unique to SPVs incorporated in the Netherlands. The requirements of the Indonesian Double Tax Treaty Regulations apply equally to SPVs established in Singapore (or other countries with which Indonesia has concluded a double tax treaty), as do the structural risks identified above, regardless of the fact that the treaty benefits result in a reduction of the withholding tax rate to 10 per cent., as opposed to zero per cent. in the case of the Netherlands. However, there are practical considerations that Indonesian corporate issuers and their banking advisers should be aware of, namely:
- it is more likely that Indonesian fiscal policy considerations would lead to the Indonesian tax authorities taking a more favourable view on the application of the regulations to SPVs incorporated in a jurisdiction where some withholding tax is applied and paid. As we understand the current position, there have been no adverse directives issued by Indonesian tax authorities in jurisdictions, such as Singapore, where a rate of 10 per cent. has been applied. That being said, the risk of such directives being issued in respect of these jurisdictions cannot be excluded altogether, particularly in cases where a designated “active group financing company” is not truly “actively engaged in a business or trade”; and
- it is not clear that the legislative intent of the Indonesian authorities was to allow for a zero per cent. withholding tax haven to corporate bond issuers. A number of circulars (which do not have the power of law or regulation) issued by the Indonesian tax authorities have made it clear that the Indonesia-Netherlands double tax treaty remains subject to the agreement and formulation of implementing measures which may leave the structures utilising offshore Dutch SPVs open to specific challenge.
Accordingly, whilst adopting a structure where Dutch SPVs are used will, in the absence of a challenge by Indonesian tax authorities (or a challenge of the wider transaction structure in the Indonesian courts), result in significant tax savings and efficiencies for issuers compared to jurisdictions such as Singapore (a significant difference of 10 per cent.), if the risks identified above manifest, Indonesian corporate issuers will face not only the significant execution costs (both in terms of time and financial expense) of implementing a fairly complex and multi-jurisdictional structure, but also a substantial increase in their financing costs by virtue of having to gross-up interest payments, through their structure, to the ultimate bondholders. From a marketing viewpoint, whilst investors will theoretically be unaffected by virtue of having the benefit of tax gross-up provisions in the bond conditions (and probably also enjoy the added benefit of a guarantee from the ultimate Indonesia parent), any such action by Indonesian tax authorities will leave the underlying Indonesian company, as the ultimate credit, in the uncomfortable position of not only having to gross-up any payments under the intercompany loan to take into account the additional amounts ultimately payable to bondholders, but will have also gone to considerable expense in establishing the offshore SPV structure set out above.
Apart from the adverse operational financial consequences that such a significant cost increase would entail, there would also be additional transactional risk in that, in an unfortunate set of circumstances, such a significant increase in the cost of funds could conceivably result in a material adverse change under various financing arrangements. Further, and as the international bond markets and investors become more educated on the regulatory- and structural-specific risks in Indonesia, there is a strong likelihood that offshore SPV structures could also lead to investors “pricing-in” significant additional risk in the bond offering itself.