Understanding the Principal Purpose Test, Rules on Anti-Abuse of Tax Treaty in PMK 112/2025
Through Minister of Finance Regulation Number 112 of 2025 (PMK 112/2025), the Indonesian government has introduced provisions on anti-tax treaty (P3B) abuse, one of which is the application of the Principal Purpose Test (PPT).
Under the PPT, tax treaty benefits will not be granted if “one of the main purposes” of a transaction is merely to secure the benefits of a tax treaty.
Under these rules, taxpayers should be cautious about claiming the tax treaty benefits, as meeting formal requirements alone will not suffice. They must also prove that the treaty is not being abused.
In addition to the PPT, several other forms of tax treaty abuse are also regulated in PMK 112/2025, including:
- Determination of the beneficial owner of income
- Minimum shareholding percentage and holding period to apply lower tax withholding or collection tax rates on dividends
- Holding period and compliance with the immovable property percentage threshold relative to total assets for determining taxing rights on gains from the transfer of shares or interests in an entity
- Prevention of avoidance of permanent establishment status
- Limitation on benefits (LOB) provisions.
However, this article focuses only on the PPT, covering its application to tax treaties affected or not affected by the Multilateral Instrument (MLI), interpretative challenges, and mitigation measures that taxpayers should prepare.
PPT Application
The PPT may be applied if at least one of the following conditions is met. First, when the Directorate General of Taxes (DGT) is unable to apply other tax treaty anti-abuse provisions. Second, there are indications that treaty benefits were obtained through transactions designed purposely to access those benefits.
To help understand the PPT, PMK 112/2025 provides illustrative examples.
Company A (resident in Country X) intends to invest in Indonesia (PT Indo). Country X does not have a tax treaty with Indonesia, meaning high withholding tax rates.
Company A then decides to establish a shell company (SPV) in Country Y, which has a favorable tax treaty with Indonesia (low dividend withholding tax rates). The SPV in Country Y has no employees, no adequate physical office, and immediately passes dividends received from PT Indo on to Company A in Country X.
Although on paper, the SPV in Country Y is the legal shareholder of PT Indo, the tax authority takes a different view. According to the DGT, the principal purpose of establishing the SPV was solely to access benefits of the Indonesia–Country Y tax treaty, without any strong commercial rationale.
As a result, tax treaty benefits are denied, and PT Indo is required to withhold tax from dividend at the normal rate of 20%, as if the SPV did not exist.
PPT as a Minimum Standard and Safety Net
Under the Base Erosion and Profit Shifting (BEPS) Action 6 project, the PPT is determined as a minimum standard. This means that the jurisdictions that have signed and ratified the MLI must adopt the PPT in their covered tax agreements.
Because of its status as a minimum standard, the PPT plays a crucial role as a safety net when there are mismatches in the adoption of more specific anti-avoidance provisions under the MLI.
Addressing Mismatches in Specific Anti-Avoidance Rules (SAAR)
In practice, Indonesia and its tax treaty partners often adopt different options under the MLI for specific anti-avoidance rules. For example, Indonesia may adopt a 365-day holding period requirement to qualify for lower withholding tax rates on dividends, while the tax treaty partner may not. As a result, the specific 365-day holding-period provision becomes inapplicable.
In such cases, the PPT serves as a safety net. Even if the 365-day holding period rule is not automatically applicable, the DGT may still deny the dividend rates using the PPT if it is proven that shares were acquired shortly before dividend distribution solely to avoid taxes. In this way, the PPT closes the loophole created by the specific rules.
Application to Non-MLI Tax Treaty Partners
For tax treaty partners that are not parties to the MLI, the minimum standard does not automatically apply to their tax treaties. However, PMK 112/2025 allows the DGT to apply the PPT domestically.
Indonesia adopts the principle that every agreement must be applied in good faith. Accordingly, even where the tax treaty does not explicitly contain a PPT clause from the MLI, the DGT may still rely on domestic principles (substance over for) to deny tax treaty benefits for transactions that lack economic substance.
Legal Certainty Challenges: Managing Regulation Subjectivity
The shift from rigid, rule-based provisions to principle-based rules such as the PPT brings its own practical challenges. The core issue lies in the complexity in aligning views on what constitutes an arm’s length “business purpose”.
- Broad room for interpretation: The phrase “reasonable to conclude” in the PPT creates significant discretion in interpreting facts. Business decisions that taxpayers view as driven by genuine commercial efficiency may still be perceived as dominantly tax-driven from a regulatory perspective.
- The importance of consistent standards: A challenge going forward is establishing consistent standards. Without detailed technical guidance, differing interpretations may lead to unnecessary disputes between taxpayers and tax auditors over the boundary between legitimate tax planning and aggressive tax avoidance. This requires both parties to focus on a strong substantive analysis.
What Should Taxpayers Do?
In this new era of transparency and PPT enforcement, taxpayers can no longer be passive. The following strategic steps should be taken.
Review existing structures
Taxpayers should assess their current cross-border transaction structures. Is there any entity with minimal economic substance, such as those with only a PO Box address or no employees in a tax treaty partner country? If so, it will present high risk.
Strengthen business-purpose documentation
Taxpayers should not rely solely on contracts and invoices. They should also retain evidence of business decision-making processes, such as:
Minutes of the board of directors or shareholders’ general meetings discussing the commercial rationale for transactions or expansion.
Email correspondence relating to negotiations
Feasibility studies demonstrating that investment locations were chosen based on market, logistics, or workforce considerations, not solely tax benefits.
Enhance economic substance
Ensure overseas entities have factual beneficial ownership, including decision-making authority over funds, assumption of risks, and assets and employees aligning with their business functions.
Prepare a “defense file”
Before any tax audit, taxpayers should prepare a structured argument explaining why transactions were carried out in a particular manner, highlighting non-tax commercial benefits obtained the company, such as access to financing, asset protection, or regional expansion.
