Mitigating Tax Risk on Interest from Affiliate Loans

Loan interest payments may look simple: a company receives funds, records a liability, and pays interest under an agreement. In transactions between affiliated parties, however, interest expense is not automatically safe for tax purposes.

The Directorate General of Taxes may assess whether the financing is truly debt, whether the interest rate is arm’s length, whether the debt-to-equity ratio remains acceptable, and whether the borrowed funds give economic benefit to the borrower. If the answers are weak, the interest may be corrected, disallowed as a fiscal expense, or even treated as a disguised dividend.

This article summarizes risk mitigation for loan interest payments, with a practical focus on what companies should prepare.

Why Is Interest on Affiliate Loans Risky?

Loans from affiliated parties often arise within business groups: a parent company funds a subsidiary, a shareholder lends to a limited liability company, or one group company finances another operating entity.

From a business perspective, this structure can make sense. The problem is that, from a tax perspective, affiliated-party transactions always carry risk because the parties are not fully independent. Interest rates, tenor, collateral, repayment schedules, and even the decision to classify funding as debt or equity may be influenced by group interests.

For that reason, the main principle is not merely “there is a loan agreement.” The company must be able to prove that the transaction:

has economic substance as a loan;
is needed by the borrower;
is used to obtain, collect, and maintain income;
provides economic benefit;
carries an arm’s length interest rate and commercially reasonable terms; and
does not breach the applicable limitation on borrowing costs.

The Regulatory Map to Understand

Several main references are connected to each other.

First, Minister of Finance Regulation No. 172 of 2023 (PMK 172/2023) regulates the application of the Arm’s Length and Ordinary Business Principle, or Prinsip Kewajaran dan Kelaziman Usaha (PKKU), for transactions influenced by special relationships. Under this regulation, financial transactions related to loans are among the specific transactions that require preliminary steps before entering into a transfer pricing arm’s length analysis.

Second, Article 18 paragraph (3) of the Income Tax Law gives the DGT authority to redetermine income and deductions, including recharacterizing debt as equity, for taxpayers with special relationships when transactions are not consistent with arm’s length and ordinary business principles.

Third, PMK 169/PMK.010/2015 regulates the ratio between debt and equity for income tax calculation purposes. In general practice, the commonly cited limit is a maximum Debt to Equity Ratio (DER) of 4:1, with exceptions for certain sectors.

Fourth, Government Regulation No. 55 of 2022 (PP 55/2022) strengthens the anti-tax avoidance framework, including debt-to-equity recharacterization, limitation of borrowing costs, and treatment of non-arm’s-length affiliated-party transaction differences as dividends.

In other words, loan interest risk does not sit in only one article of law. It sits at the intersection of transfer pricing, thin capitalization, expense substantiation, and anti-tax avoidance rules.

Step 1: Prove the Loan Really Exists

The first document usually requested is the loan agreement. But the agreement alone is not enough.

In the PKKU context, a company must prove that the loan is consistent with its substance and actual circumstances. A loan that looks formal on paper may still be challenged if its behavior is closer to an equity contribution.

Several indicators should be prepared:

the creditor and debtor recognize the loan legally and economically;
there is a clear maturity date;
there is an obligation to repay the principal;
there is a repayment schedule for principal and interest;
the borrower has the capacity to obtain and repay the loan like an independent debtor;
the agreement is made under the applicable legal requirements;
there are legal consequences if the borrower defaults; and
the creditor has collection rights comparable to those of an independent creditor.

If the loan has no maturity date, is never repaid, has no default consequences, and the creditor never attempts to collect, its fiscal position becomes fragile. The tax authority may view it as equity funding labelled as debt.

Step 2: Prove Business Need and Economic Benefit

PMK 172/2023 places benefit substantiation as an important part of the preliminary stage. For loans, the practical question is: why does the company need to borrow, and what benefit does it obtain from the funds?

Economic benefit may include:

increased sales;
reduced costs;
protection of the commercial position;
fulfilment of business activity needs;
financing of inventory, projects, expansion, or working capital; or
other activities that support efforts to obtain, collect, and maintain income.

For example, a loan to buy production machinery is easier to explain if there are investment plan documents, purchase orders, vendor payments, asset records, and production capacity projections. By contrast, a loan whose funds are immediately circulated back to another affiliate without a clear business reason will be harder to defend.

The principle is simple: do not only prove that money came in. Prove that the money was used for real business activity.

Step 3: Test DER and Thin Capitalization Risk

After the substance of the loan is proven, the company still needs to review its financing structure. This is where thin capitalization becomes relevant.

Thin capitalization is a condition where a company is funded too heavily by debt compared with equity. In a tax context, this structure is risky because debt interest can reduce taxable profit, while dividends from equity are not treated as expenses.

PMK 169/PMK.010/2015 regulates the debt-to-equity limitation for certain corporate taxpayers. If the debt-to-equity ratio exceeds the permitted limit, part of the borrowing costs may be at risk of being non-deductible for fiscal purposes.

In an internal review, the finance team should calculate:

average debt balance;
average equity balance;
whether the entity falls within an exempted sector;
interest, provision fees, discounts, and other borrowing costs recorded; and
the fiscal correction impact if part of the borrowing costs cannot be deducted.

DER is not merely a financial statement ratio. It becomes an initial filter for assessing whether interest expense remains within a defensible range.

Step 4: Prove the Interest Rate Is Arm’s Length

A loan that truly exists and satisfies DER requirements still needs an arm’s length interest test. In independent transactions, interest rates are usually influenced by many factors: currency, tenor, credit risk, collateral, the borrower’s financial position, and market conditions when the loan is granted.

Therefore, the company should prepare a benchmarking analysis. The approach may include:

comparing the interest rate with loans from banks or independent financial institutions;
comparing it with comparable debt instruments;
assessing the borrower’s credit risk profile;
reviewing the loan currency and tenor;
evaluating whether collateral or guarantees exist;
ensuring the repayment schedule is consistent with market practice; and
documenting the reason for selecting the transfer pricing method.

If the interest is too high, a possible correction is an adjustment to an arm’s length interest rate. The difference may be disallowed as an expense and, in certain circumstances, treated as a profit distribution to the affiliated party.

Risks If the Evidence Is Weak

Failure to substantiate an affiliate loan can create several consequences at once.

First, interest expense may become non-deductible in calculating taxable income. This directly increases fiscal profit and corporate income tax.

Second, debt may be redetermined as equity. This risk arises when the loan characteristics resemble capital participation, for example where there is no realistic repayment schedule or no collection action.

Third, the non-arm’s-length difference may be treated as a dividend. PP 55/2022 confirms that the difference in a special relationship transaction that is inconsistent with PKKU may be treated as an indirect profit distribution.

Fourth, the risk may expand into withholding tax, administrative sanctions, transfer pricing documentation, and tax audit disputes. For cross-border loans, the issue may also intersect with Article 26 income tax and tax treaty application.

Mitigation Checklist Before Paying Interest

Before a company pays or accrues interest on an affiliate loan, use the following checklist:

Make sure there is a loan agreement stating the amount, tenor, interest, maturity date, repayment schedule, collection rights, and default consequences.
Match fund disbursement with bank accounts, accounting journals, and use of funds.
Prepare evidence of loan need, such as cash flow projections, business plans, investment plans, or working capital documents.
Document the economic benefit received by the borrower.
Calculate DER and identify whether the entity is exempt or not.
Benchmark the interest rate based on the loan characteristics.
Ensure interest payments are actually made according to schedule, or that there is a commercial reason if restructuring occurs.
Review withholding tax obligations on interest, especially for offshore payments.
Keep transfer pricing documentation if the transaction meets the documentation threshold.
Perform periodic reviews because market conditions, credit risk, and loan balances may change from year to year.

This checklist is best completed before the end of the tax year. If the review is only done after a tax audit begins, the room for correction is usually much narrower.

When Is a Tax Review Needed?

A company should conduct a tax review if it has any of the following conditions:

the loan comes from a shareholder or group company;
interest is significant relative to profit;
the company has DER close to or above the 4:1 limit;
the loan does not have a disciplined repayment schedule;
there is restructuring from debt to equity or vice versa;
the loan is denominated in a foreign currency;
interest is paid to an offshore party; or
the company is preparing its annual corporate income tax return and transfer pricing documentation.

For service companies, manufacturers, property businesses, or business groups that actively use internal financing, this review can become part of annual tax planning and compliance documentation. If your business operates in the professional services sector, our professional services tax page can be a starting point for mapping affiliated-party transaction risk and fiscal expense risk.

Conclusion

Mitigating risk on loan interest payments is not enough by merely preparing a loan agreement. A company needs to prove loan substance, business need, economic benefit, a healthy DER, and an arm’s length interest rate.

In affiliated-party transactions, documentation is the main shield. The tidier the evidence prepared from the beginning, the stronger the company’s position when facing clarification, SP2DK, or a tax audit.

Need a review of shareholder loans or affiliated financing transactions? Arunika Consulting can help perform a tax health check, calculate DER, assess interest arm’s lengthness, and prepare supporting documentation before risk becomes a dispute. Contact us for an initial consultation.

Main references: PMK 172 Tahun 2023, PMK 169/PMK.010/2015, PP 55 Tahun 2022, and Article 18 paragraph (3) of the Income Tax Law.

This article is educational and prepared based on presentation material titled “Mitigasi Risiko atas Pembayaran Bunga Pinjaman” and official regulatory references. For specific tax decisions, consult a certified tax consultant.