A lawsuit in Indonesia is a warning to banks not to lend into questionable structures that reduce withholding taxes on interest payments.

An Indonesian paper company borrowed $480 million in 1994. Morgan Stanley underwrote the notes and sold them to international investors. However, rather than borrow directly, the paper company set up a subsidiary in Holland to issue the notes and relend the money to the Indonesian parent company. Borrowing this way produced two benefits. First, it reduced an Indonesian withholding tax on interest payments from 20% to 10%. The rate is only 10% under a tax treaty between Indonesia and Holland. It also ensured that the lenders would not have to pay capital gains taxes if they sold the notes at a profit.

Nine years later in 2003, the Indonesian paper company filed suit in the Indonesian courts to have the debt declared void. It argued, among other things, that the transaction was an illegal tax evasion intended to circumvent the 20% Indonesian withholding tax. It also argued that use of a trustee in connection with the security arrangements for the loan violated Indonesian laws on loan collateral since the concept of a trust is unknown in Indonesia.

The Supreme Court recently confirmed the transaction was illegal. The case is Indah Kiat Pulp & Paper Tbk v. U.S. Bank National Association et al.

The paper company may have shed its obligation to repay the loan, but the Indonesian tax authorities could come after it for the back withholding taxes that were evaded. It could also have income in the amount of the canceled debt.

A British court declared that a similar treaty-shopping effort involving an Indonesian borrower and a loan run through Mauritius did not work in March 2006 in a case called Indofood International Finance Ltd. v. JPMorgan Chase Bank, N.A., London Branch. The difference is the British court found the transaction did not qualify for treaty benefits without declaring the underlying loan void.

Keith Martin