Reclassification of Excessive Royalties as Disguised Dividends: A Normative Analysis of Secondary Adjustment in Indonesian Tax Law and OECD Standards

Abstract

Transfer pricing practices in related-party transactions often involve royalty or service payments that deviate from the arm’s length principle, leading to tax base erosion. In Indonesia, Article 18(3) of the Income Tax Law authorizes the tax authority to reallocate profits and to treat the excess portion of such transactions as hidden dividends. This paper aims to analyze the concept of reclassification of excessive royalties into disguised dividends through the framework of primary and secondary adjustments. Using a normative juridical approach, the study examines statutory provisions in the Indonesian Income Tax Law, implementing regulations such as PER-22/PJ/2013, and international guidelines including the OECD Transfer Pricing Guidelines (2017) and OECD Model Convention Commentary on Article 10. The results show that primary adjustments on royalties—when deemed excessive—necessitate secondary adjustments in the form of constructive dividends to align profit allocation with the arm’s length principle. This constructive dividend concept is consistent with international practice where excess profits are recharacterized as disguised dividends, equity contributions, or loans. The findings further demonstrate that Indonesian law explicitly recognizes disguised dividends under Article 4(1) of the Income Tax Law, thereby reinforcing the legitimacy of secondary adjustments as a safeguard against profit shifting. In conclusion, reclassifying excessive royalty payments as hidden dividends not only ensures fairness in taxation but also harmonizes domestic practice with international standards while preventing tax avoidance.