Substantive Approach to Tax Treaty

International taxation has increasingly shifted toward stronger anti-abuse standards. Global practice,  shaped by the Base Erosion and Profit Shifting (BEPS) initiative led by the Organisation for Economic Co-operation and Development, now places heightened emphasis on addressing treaty shopping and other forms of treaty misuse. Against this backdrop, Indonesia issued Minister of Finance Regulation No. 112 of 2025 on Procedures for the Application of Tax Treaties (PMK 112/2025).

The regulation implements Article 50 paragraph (2) of Government Regulation No. 55 of 2022 (PP 55/2022) and forms part of Indonesia’s broader effort to align its tax treaty practice with internationally accepted anti-abuse principles, while safeguarding its tax basein cross-border transactions.

In practice, the application of tax treaty benefits has long been treated primarily as an administrative exercise, where relief was generally presumed to apply once a valid Certificate of Domicile (CoD) or Form DGT was submitted. PMK 112/2025 shifts this approach by introducing the Principal Purpose Test (PPT) as a central determinant of treaty entitlement, supplementing administrative documentation and beneficial ownership assessments with a substantive review of the transaction intent.

Strengthening the Review Process

The PPT provides a legal basis for denying treaty benefits where one of the principal purposes of a transaction or arrangement is to obtain treaty benefits. Treaty relief may, therefore, be denied even where administrative requirements have been satisfied, if the transaction structure indicates that the arrangement was designed primarily to obtain treaty advantages. This approach reflects the minimum standard under OECD BEPS Action 6, which seeks to ensure that tax treaties are not used in ways inconsistent with their object and purpose.

Within this framework, the PPT operates as part of a broader substantive review intended to prevent treaty abuse. Its application complements other anti-abuse mechanisms, including beneficial owner requirements, shareholding thresholds, limitations on  capital gains on immovable property, rules addressing the avoidance of permanent establishment (PE) status, and limitation on benefits (LOB) provisions where applicable.

The PPT assumes particular relevance in cases where other treaty-based anti-abuse provisions cannot be directly applied or where complex arrangements are designed to secure treaty benefits indirectly. In this respect, the PPT functions as a residual safeguard, reinforcing the principle that treaty relief must be grounded in genuine commercial substance rather than formal compliance alone.

Anti-Fragmentation and Aggregation Rules for Permanent Establishments

PMK 112/2025 also reaffirms the application of an anti-fragmentation approach in determining the existence of a permanent establishment. Business activities that are divided into separate operations which individually appear preparatory or auxiliary in nature are no longer assessed on a standalone basis.

Where such activities, in substance, form part of a coherent business operation that goes beyond preparatory or auxiliary functions, the existence of a permanent establishment may be recognized. This approach is consistent with post-BEPS developments under OECD BEPS Action 7, including the aggregation of time periods for construction, installation, or similar projects carried out by closely related parties.

Overall, PMK 112/2025 establishes a more structured and substance oriented approach to the application of tax treaties in Indonesia. Treaty benefits are no longer viewed as an automatic consequence of holding a CoD or Form DGT, but as relief that must be supported by arrangements aligned with the purpose and intent of the relevant tax treaty.

For taxpayers engaged in cross-border transactions, a clear understanding of these rules is essential not only for accessing treaty benefits, but also to ensure that transaction structures remain defensible under heightened scrutiny. As Indonesia continues to align its treaty practice with global anti-abuse standards, the emphasis on substance over form signals a maturing tax administration that prioritizes integrity, consistency, and fairness in international taxation. (Shintya)