Turkey

Yusuf Penezoglu
Ernst & Young
Turkey

Yusuf Penezoglu of Ernst & Young examines the taxation environment created in Turkey with recently rendered Council of State and tax court decisions regarding several disputes between the tax authorities and multinational companies resident in Turkey in relation to the loss replenishment fund, investment allowance and disguised profit distribution through transfer pricing and VAT.

Loss replenishment cases

A number of disputes arose between the tax authorities and local subsidiaries of international companies in relation to the loss compensation fund. The disputes based on the grounds that the amounts sent to the local subsidiaries as loss compensation fund and capital advance were in fact a compensation paid in return for the services rendered to the international company for promotion, implementation, placement and the increase of the value of the international company brands and accordingly the loss compensation fund and capital advance amounts should be subject to corporate tax as well as VAT.

Companies have filed law suits against the tax inspection reports and because of the first instance tax court examination, some of the cases have been concluded in favour of the taxpayer, whereas some of them are concluded either in favour or partially in favour of the tax authority.

These decisions can be summarised as follows:

The courts tended to examine the procedural requirements. If the procedures mentioned in Article 324 of the Turkish Commercial Code (TCC) were not met, the funds were characterised as income and taxed accordingly.
With this approach, tax courts checked for conformity between the date and amount of the fund reflected in the corporate documents (for example Shareholders' Decision) and the actual date and amount of the transfer of the fund. If the amount did not match, the funds were not viewed as loss compensation and were to be included in the corporate tax base as service income.
In those decisions in which the funds received were accepted as loss compensation, VAT issues were concluded similarly to corporate tax issues: in the taxpayer's favour.
In some cases the tax courts ruled in favour of the tax office on the grounds that the procedural requirement for the loss replenishment fund has not been satisfied to the effect that loss compensation fund has been sent without taking any shareholder board's decision in relation.

Decision of the Council of State

The Turkish Council of State ruled against the taxpayer in the corporate tax cases since the company incurred losses for more than 10 years and to bear such losses with the aid of money transfers from abroad to avoid bankruptcy is not in line with sound economic and commercial practice.

As the company was the sole seller of the products of its shareholder company in Turkey, the Council of State determined that the purpose of the company was to sell the products of the parent company in the Turkish market. Accordingly, the parent company profited from the sales of its products. As such, it was not contrary to law to include the funds in the corporate income of the Turkish company.

Comparing the decisions of the tax court and the Council of States, evidently, the Council of State is more focused on the long term (12 years) loss situation of the Turkish subsidiary, while the tax court's primary interest is in the procedural requirements such as the shareholder board's decision for loss compensation funds.

The files related to VAT are being examined at the Council of State; however the Council of State has not rendered any decisions for these cases yet.

Investment allowance exemption

Under the Turkish legal system, the concept of investment allowance exemption is defined as an incentive mechanism excluding investments from income and corporate taxes. Article 19 of the Income Tax Law (ITL), defining the investment allowance exemption, is abolished through the Law numbered 5479 (the Law) and consequently the application of investment allowance is terminated as of January 1 2006.

However Article 3 of the Law inserted a new article to ITL (Provisional Article 69 of ITL) which limits tax payers' right to use investment exemption amounts in terms of a definite time period. In the referred article, it is held that tax payers may deduct their investment allowance exemption amounts from their incomes earned only during the years of 2006, 2007 and 2008. In case there is an amount not deducted from the referred years' income, tax payers may not reduce the remaining amount from their incomes gained after the year of 2008.

Nevertheless, the said regulation limiting the deduction of investment allowance exemption in terms of a definite time period is cancelled by the Constitutional Court's decision, which appeared in the Official Gazette dated January 8 2010. Consequently, time limitation related to the investment allowance exemption was annulled.

Firms confronting with this limitation declared their corporate tax returns with reservation. A number of lawsuits have been filed for the cancellation of assessment made without taking into account the reservation based on the claims.

At the tax court level, most of the cases have been concluded in favour of the taxpayer on the grounds that provisions of the Code restricting the investment allowance right have been annulled by the Constitutional Court Decision and therefore, the tax payer shall benefit from the investment allowance without time limitation, for example for the year of 2009.

However the tax office has recourse to the appeal against the tax court decisions and the files are being examined at the Council of State whose decision is eagerly expected..

After the cancellation decision of the Constitutional Court, Article 5 of the Code numbered 6009 deleted time limitation regarding the investment allowance exemption whereas it created a quantity restriction. Because of the amendment made by the referred law, the amount subject to deduction in terms of investment allowance exemption may not exceed 25% of the relevant year's income. So the aforementioned regulation deleted the time limitation in accordance with the Constitutional Court Decision, however this time, it created a quantity limitation. Following this amount restriction, several litigations have been initiated by the taxpayers. Cases in relation to this amount restriction are still on trial.

Disguised profit distribution

Upon a sectoral tax inspection conducted in 2008 in Turkey against almost every multinational innovator – generic pharmaceutical companies resident in Turkey, a number of disputes arose between the tax authorities and pharmaceutical companies in relation to the alleged disguised profit distribution through transfer pricing.

The tax authority, without disclosing the name of the other pharmaceutical companies and the name of the comparables to the tax payers, alleged that the compared active substances are identical or essentially similar based on the information received from the CAS registration system. Almost all of the pharmaceutical companies in Turkey have filed law suits against the tax inspection reports and tax assessments with penalties.

In one of the tax court cases filed by one of the most important pharmaceutical companies, the Council of State recently reversed the decision of the Court of First Instance and stated that there can be differences in the purchase prices – as the characteristics of the active substances such as physical conditions and production technique may vary – which would lead to the result that the companies and the active substances referred by the tax authority are not comparables. Furthermore, the Council of State referred in its decision that the comparables should have been determined in detail covering all the relevant circumstances. It should be highlighted that because of the decision of the Council of State, the price of the active substance can vary to the effect that active substances are provided from different suppliers and production techniques and physical conditions could lead to price differences between active substances even if they are numbered identically under the CAS registration system.

The Council of State decision has not been finalised yet; however this new policy is important because the Council of State decision would have the favourable effect on the pending cases regarding the same matter in dispute. Especially, the Council of State decision has created a new environment for the other tax disputes which are still pending before either the first instance tax courts or the Council of State.

VAT of the annihilated goods

One of the most important specialties of the Turkish VAT system is the reduction mechanism. General principle of tax reduction is regulated under Article 29 of the VAT Law. Accordingly, tax payers can reduce the VAT paid for the deliveries and services provided to them (purchase of goods and services) from VAT paid for the deliveries and services they provide to other parties (sale of goods and services).

On the other hand, Article 30 of the VAT Law regulates the conditions in which the VAT cannot be deducted. Based on paragraph c of the referred article, VAT of the lost goods, except the ones that are damaged as a result of earthquake, flood or the ones where Ministry of Finance announced act of providence because of fire, cannot be reduced.

With the VAT General Communiqué No.113, circulated in the Official Gazette dated December 5 and No 27423, a completely contrary regulation to the established practice has been introduced. Under this regulation, VAT burdened over the goods that are annihilated since their utilisation period expired and they become unusable with respect to the decision of the Valuation Commission cannot be subject to deduction.

Upon this new but adverse regulation, tax payers have removed the previously reduced VAT from deductable VAT line and added to the additional VAT line in their VAT (correction) returns and submit them with reservation. Nevertheless, since the tax administration made the assessment without taking the reservations into consideration, tax litigations have been initiated for the refund of the excessive paid VAT and annulment of the tax assessments made without considering the reservations.

Some of the first instance tax courts have rendered decisions in favour of the tax authority, whereas, in a tax court case filed by one of the most important pharmaceutical companies, the court has decided in favour of tax payer.

The unfavourable decisions of the first instance court, in general, based on the following reasons,

Dispute is about whether the goods, whose utilisation period expired or which become unusable and are annihilated before official/tax assessment committees, can be regarded as lost good.
The term "lost" is defined as vanished, gone, disappeared, faded away in the dictionary.
Accordingly, whatever the reason is, the goods, annihilated before the official committees, are vanished and these goods should be regarded as "lost" goods.
The previous adverse applications of the tax administration have no legal effect on the qualification of the goods in dispute.
In the litigation initiated for the annulment of part "E" of the VAT General Communiqué No. 113 titled "The transaction to be made for the burdened VAT of the goods whose utilisation period expired or which become unusable", 4th Chamber of Council of State has rejected the request of stay of execution

On the other hand, in one of the litigation initiated by one the most important pharmaceutical company, one of the Istanbul tax courts has accepted the case on the grounds that the existence of a lost good according to the one defined in Article 30/c of the VAT Law is out of question because of the following reasons;

The annihilation process cannot be accepted as being made with self-control,
This process is a result of ordinary course of business,
The lost goods stipulated in the Law are the ones related to natural reasons besides from business operations,
It is undisputable that the annihilations are made in line with tax administration's decision and within its knowledge,

As can be seen from the above mentioned tax court decisions, there is no consistency between the Istanbul Tax Courts decisions regarding the deductibility of the VAT burdened for the annihilated goods and that these goods can be categorised as lost goods as per Article 30/c of the VAT Law.

The aforementioned cases have been in the stage of the appeal; therefore, since the decision of the Council of State will be awaited, final evaluation in relation to the said decision shall be made after the reasoning of the Council of State.

No certainty

When the decisions rendered for the cases are evaluated, the common characteristic of the cases are seem to be that; either there is no consistency between the decisions of the first instance tax court or the cases are still pending in the stage of the Council of State.

It is miserable that although most of the litigations have been initiated in the years of 2009, the referred decisions have not been finalised yet.

This situation unfortunately seems to create an unclear environment for the multinational companies who have done business and will make in the future in Turkey. However, it is expected that this indefinite situation will last with the respective decisions of the Council of State in the near future.

In this regard, as the Council of State will review the court file in accordance with the properties of the case, we may expect that the different decisions based on the property of the case will be rendered. The decisions mentioned above shall be considered as an example for the related cases; however, every case shall be examined in detail by taking into consideration of the matter of dispute in each case.

Therefore, at this time, it is still a matter of question how the Council of State will render its decision on different cases.

Yusuf Penezoglu (yusuf.penezoglu@tr.ey.com) is a partner in the tax controversy practice of Ernst & Young in Turkey