Legal liabilities: Ins and outs of Turkish tax law

RESIDENCE: Residents are fully liable under the Turkish tax system: that is, they pay taxes based on their worldwide income. Non-residents have limited liability and are subject to tax on their business earnings derived in Turkey.

Corporations have full liability to Turkish taxation if their legal headquarters or business centres are in Turkey. Business centre is defined as a place where business transactions are concentrated or carried out. All companies established in Turkey with foreign capital have full liability. If a foreign company – with corporate status abroad and legal and business headquarters outside of Turkey – is operating in the country without having a legal entity incorporated here, it is usually regarded as having limited liability under the Corporation Tax Law.

Under Turkish tax legislation, for the income of a non-resident company to be deemed to be taxable, the company must have a place of business or a permanent representative in Turkey and the earnings must have been realised either at this place of business or through this representative.

CORPORATION TAX: The corporate tax rate in Turkey is 20%. The dividend withholding tax rate is now 15% on distributions of profit to non-resident shareholders and sums repatriated by a branch to its head office. Thus the total tax burden is 32% (20% + 0.8*15%), though double-tax treaties can reduce the withholding tax rate. Dividends distributed by a Turkish entity to another resident entity remain exempt from dividend withholding tax. Tax losses may be carried forward for five years but may not be carried back. If a company incurs such losses that its share capital becomes impaired or that it becomes insolvent (technical bankruptcy), the shareholders should “repair the equity” in accordance with Article 324 of the Turkish Commercial Code.

Losses of one company cannot be used to offset profits in another company: all companies are taxed separately even when they form part of a group.

Dividends received from foreign participations are exempt from corporate income tax in Turkey if certain conditions are satisfied.

Corporation tax returns must be filed within four months from the end of a company’s accounting period (normally the calendar year – exceptions require Ministry of Finance approval). Advance corporation tax is payable quarterly during the year, with a final instalment in the month of filing.

CAPITAL GAINS: In general, capital gains form part of a company’s taxable income and are subject to 20% corporate income tax just like any other income.

A corporate income tax exemption is granted for 75% of capital gains derived from the sale of participations and immovable property that have been held for at least two years, provided that certain conditions are satisfied.

Capital gains derived from the sale of foreign participations that have been held for at least two years by an international holding company resident in Turkey are exempt from corporate income tax. However, to qualify, certain conditions must be met.

Controlled foreign companies’ rules are applicable where a Turkish resident company controls, directly or indirectly, at least 50% of the share capital, dividends or voting power of a foreign entity and certain specified conditions are met. In that case, the Turkish company’s share of the foreign profits will be taxable in Turkey regardless of whether or not they are remitted to Turkey.

TRANSFER PRICING: Turkey’s transfer pricing rules are in line with OECD guidelines. The transfer pricing rules apply when transactions between related parties (either resident or non-resident) are not at arm’s length prices. In such cases, the profits arising from the transaction will be deemed to be “constructive dividends” subject to both corporate income tax and dividend withholding tax.

The rules provide for both traditional and profit-based transfer pricing methods listed in the OECD transfer pricing guidelines. Taxpayers are required to maintain documentation to support the transfer prices determined and used.

Corporate taxpayers have the right to apply for an advance pricing agreement (APA). Applications for unilateral (i.e., with the Turkish tax authority only) as well as bilateral and multilateral APAs are allowed.

The thin capitalisation rules are triggered where loans from shareholders or related parties exceed a debt-to-equity ratio of 3:1 at any time in an accounting period. Loans from related party banks or financial institutions will not trigger the rules unless the ratio exceeds 6:1. Where the debt-to-equity ratio is exceeded, interest and any relevant related expenses will be deemed to be “hidden profit distributions” or a “remittance of profits”. Such expenses will be non-deductible and subject to dividend withholding tax at the rate of 15%. Under certain conditions, borrowings from related parties may not trigger thin capitalisation provisions.

Costs incurred by headquarters located abroad may be allocated to Turkish branches and deducted through distribution keys in accordance with the arm’s length principle, provided the costs incurred abroad relate directly to the commercial activities of the Turkish branch. Branches of foreign companies are considered to have limited tax liability based on their income derived in Turkey.

Non-resident limited-liability taxpayers’ income (other than business income) is subject to withholding tax, ranging from 0% to 20%. Income such as royalties, consulting income and technical fees is subject to withholding tax at 20%.

DOUBLE-TAX TREATIES: Turkey has double-tax treaties with 76 countries, including the US, most European nations and many Middle Eastern and East Asian countries. Under Turkey’s treaties, income derived from foreign countries is generally excluded from consideration in Turkish tax computations, or tax paid in treaty countries is deductible from tax assessments in Turkey. However, the details of the treaties should be consulted. Among the benefits offered by the tax treaties are reduced rates of Turkish withholding taxes on dividends and royalties.

In the case of countries that do not have a tax treaty with Turkey, taxpayers that have full tax liability in Turkey are also taxed on their worldwide income. However, they are allowed to deduct taxes paid abroad up to the applicable Turkish rate from their Turkish tax liabilities.

TAX PAYMENTS: Delays in paying taxes are subject to a monthly delay charge at the rate of 1.4% ( effective from October 19, 2010). This rate can be amended by the tax authorities at any time.

If a taxpayer fails to file a return, the tax authorities may impose an ex-officio assessment. In case of fraudulent transactions there may be imprisonment penalties from 18 months to five years in addition to the monetary tax penalties.

Advance corporation tax payments must be made based on 20% of quarterly profits, as shown in the corporate taxpayer’s quarterly income statements. Direct inspections for tax purposes are carried out by government tax inspectors under the supervision of the Ministry of Finance. Controls are strict and tax inspectors from the Ministry of Finance make spot checks of tax returns.

Certain transactions and documentation require certification by YMM financial accountants. There is an optional service available from YMM financial accountants called tax certification, in which the accountant reviews a company’s tax compliance during the year and writes an opinion to the tax authorities after the year-end about the compliance. Although optional, tax certification is widely used among businesses because the tax authorities have indicated that they are unlikely to conduct direct inspections at companies which have obtained such reports. There is also the benefit that expert advice is then available to the company’s own accountants during the year.

INDIVIDUAL INCOME TAX: In general, individuals residing in Turkey are liable for personal income tax on all of their worldwide income. However, individuals who do not reside in Turkey but receive part of their income from Turkey are liable for income tax only on their income derived in Turkey. The former are known as full-liability taxpayers, and the latter as limited-liability taxpayers.

Expatriates who reside in Turkey for more than six months in one calendar year are generally considered as full-liability taxpayers. Foreigners who are in Turkey for a fixed period on a temporary mission are not regarded as settled or residing in Turkey, even if they stay for more than six months. To determine the Turkish tax liability of an expatriate, the provisions of double-tax treaties with the individual’s home country should also be considered.

Regardless of their nationality, most Turkish residents, unless covered by exemption, are subject to personal income tax. The emoluments of employees of liaison offices are exempt from income tax subject to certain conditions. Income tax is levied on the following types of personal income:

• Business profits;

• Agricultural profits;

• Salaries and wages;

• Income from professional services (such as services rendered by lawyers, tax consultants and engineers etc.);

• Income from immovable property (mainly rental income);

• Income derived from securities (interests, dividends); and

• Other income (capital gains and non-recurring income). All income arising from an individual’s employment is subject to personal income tax. As a rule, all benefits received from employment (in cash or in kind) are taxable, but there are some exceptions: for example, equipment that the employer owns but assigns to the employee’s use. Reimbursed business expenses are also allowable expenses, as well as additional insurance premiums for sickness and life policies.

Income tax rates for personal income are progressive. The tax bands are raised each year, normally approximately in line with inflation. The tax year for individuals is the calendar year. Generally, individuals must file their income tax return by March 25 of the following year and pay any taxes owed in two instalments in March and July.

Individuals earning commercial and/or professional service income are required to make advance income tax payments based on 15% of quarterly profits shown in their quarterly income statements.

Tax is withheld at source from a wide range of payments, including employment income. Generally, employees and a number of other individuals are not required to submit annual individual income tax returns if the tax withheld at source constitutes the final tax burden of that individual.

VAT: VAT is levied on goods delivered and services rendered in Turkey, as well as on all imported goods and services. Exports are exempt from VAT, as are certain specified goods and services.

Taxpayers deduct the VAT that they have paid to other suppliers (input VAT) from the VAT that have they collected on their own sales (output VAT). Thus, the ultimate consumer is the one who finally bears the VAT burden, not the provider.

OTHER TAXES: Special consumption tax is an indirect tax applied on the producers or importers of various products such as natural gas and petroleum products, vehicles, tobacco products and luxury goods. The special consumption tax rate on a car above 2000 cc is now 130%, in addition to VAT at 18%, so that the showroom sticker price now approaches three times the pre-tax price of the vehicle.

Stamp duties are levied on a wide range of transaction documents, including all contracts which specify a monetary amount. The rates vary from 0.165% to 0.825% depending on the type of the paper. It is also payable on payrolls at a rate of 0.66% of wages paid to a company’s workforce.

A banking and insurance transaction tax (BITT) is levied on all transactions carried out by banks and insurance companies. The general rate is 5% of the income received by a bank or insurance company as a result of a transaction subject to BITT. But reduced rates are applicable for certain transactions (e.g. deposits among banks, foreign exchange sales, etc.).

SOCIAL SECURITY PREMIUMS: Social security premiums (as a percentage of employee’s gross earnings) are payable by both employers and employees. The normal rates for office employees in the private sector are 19.5% of gross salary as the employer’s contribution and 14% as the employee’s contribution. Employers may benefit from 5% premium incentive (19.5%-5%), which is covered by the Treasury if certain conditions are met. Rates for employees employed in specific sectors, including mining and oil and gas exploration, may vary depending on the risk category of the work involved in the job.

Maximum and minimum bases for calculation of monthly social security premiums are TL5762.40 (€2449) and TL886.50 (€377), respectively, for the first half of the year 2012. Foreigners making social security contributions in their home countries do not have to pay the Turkish social security premiums if there is a reciprocal agreement between the expatriate’s home country and Turkey.

Unemployment insurance premiums must be paid to the Social Security Organisation together with an employee’s social security premiums. The rates of unemployment insurance are 2% of gross salary for the employer and 1% for the employee.

THE UNRECORDED ECONOMY: The unrecorded economy remains a major problem for Turkey. The share of unrecorded activity in Turkey’s overall economy (estimated to be around 30-40%) is high when compared to OECD countries.

An OECD study found that the unrecorded element in Turkey varies widely between sectors, from a full 91% of total activity in the agricultural sector down to 20% in financial services and 14% in mining. Further, the authors identified three main reasons for the unrecorded activity. The first is demographic and developmental factors, with much unrecorded employment being in very small enterprises.

The second reason is policy factors. Turkey has the highest tax burden on employment of any OECD country: 35.9% on labour costs in 2011, compared to an OECD average of 24.8%. The figure in the US is 16.3% and 15.5% in Mexico. The third reason consists of cultural factors: in economies with low unrecorded elements, tax evasion tends to be considered unacceptable by most of the population.

It is clear that the government has been working on to reduce the size of the unrecorded economy and bring tax revenues more in line with total economic activity. One key solution is the encouragement of recorded activity through the lowering of taxes and social security contributions on employment, allowing regional variations in minimum wages and more flexibility in employment regulations. The state can also encourage those areas of the economy where the unrecorded problem is smallest.

The strengthening and expansion of inspection teams and increases in penalties for unrecorded activity is also important as a deterrent, while generating public disapproval of tax evasion, ideally through better transparency and services, is the ideal solution. This is a long-term objective given that improved services often depend on investment.

INVESTOR CONFIDENCE: Our impression is that there is a wide range of compliance, from total compliance in some companies to serious levels of evasion in others. While compliance does appear to be strongly correlated with size of the firm (the smaller the business, the more likely it is to have unrecorded transactions) and also varies by sector, it also clearly depends on the outlook and ethics of the individual owners and managers involved.

Few companies maintain two sets of books. To do so would increase the risk of detection, might require the cooperation of the whole accounting department (raising the risk of whistle-blowing), and would involve significant time and costs. Instead, one set of books will be maintained but the owner/managers and a close circle of others will be aware of the amount of adjustments needed to reach “real” figures, based on a separate spreadsheet or other “back-of-the-envelope” type records.

Very few businesses would record expense invoices which are fake (so-called “nylon invoices”) or would issue invoices for wholly fictitious transactions. Such activities are considered fraud and carry very high penalties which discourage this activity.

What is more likely is that actual sales, purchases or wage payments have occurred without any accounting record being made: no invoice, no cash movement record, no payroll entry.

An investor considering coming into a business is quite likely to be informed about any unrecorded transactions, because the “real” figures are likely to present a more attractive picture of profitability. Note that this is not always the case: sometimes losses are concealed rather than profits, because of a company’s intention to mislead lending banks rather than the tax authorities.

Vendors sometimes do not seem to appreciate that investors, especially foreign investors, will not find this risk acceptable. Vendors may have got used to their way of running a company, whereas investors focus on the risk of tax penalties which, in the worst case, could ruin the company.

Representations and warranties can only go some way to mitigating this risk. Moreover, the investor never really knows whether the “real” figures presented are indeed real: there is no way of verifying them, and there is always a risk of unrecorded expenses or liabilities not disclosed to the investor. Any potential investor is very likely to insist that no further unrecorded transactions take place in the firm.

Note that there is also an important efficiency penalty in companies with unrecorded transactions: the statutory accounts do not present the real picture so any management accounts based on them would be similarly misleading. In practice there may be a complete absence of management accounts, making it more difficult for the firm’s line management to do their jobs effectively.

INDICATORS OF UNRELIABLE ACCOUNTS: Investors are encouraged to be aware of the following signs of potential unrecorded activity. Large balances due to or from shareholders in the balance sheet can be a sign of trouble. Sometimes shareholders really are injecting cash to their business to meet its working capital needs. But other times, large balances with shareholders (especially if they show frequent movement) actually arise because the firm is earning unrecorded cash and the accountants could not find any other way to show it coming into the business, other than via from the shareholders as a loan. Similarly, if money has been paid out on an expense which cannot be recorded (i.e. there is no invoice for it), it may be shown as a loan to shareholders. This type of problem builds up over time until the recorded balances start to look very odd.

Large petty cash balances shown in the records are also likely to be unreal. The reality is that money was actually paid out for expenses with no invoice, but no accounting record could be made.

Paying the legal minimum wage may be the reality for unskilled jobs, but it may also conceal the fact that a proportion of employees’ total salary is being paid in cash, with no payroll record, using the cash earned from unrecorded sales. The total problem is thus evaded VAT on the sales, evaded corporation tax on the profit, and evaded income tax and social security contributions on the undeclared wages.

A surprisingly high figure for stock (inventories) might conceal the fact that goods have been sold without an invoice and, therefore, without any record. Conversely, a low stock figure might conceal the fact that incoming goods (especially any “free” stock received as premiums) have not been recorded, but have been sold in recorded transactions.

Tangible fixed asset figures might not be reliable. Sometimes the purchase price of land or buildings is actually higher than the recorded amount, because the company was trying to save on the title transfer tax (which used to be a total burden of almost 10% of the value) or VAT by declaring a lower value.

However, the main reason why tangible fixed asset values are of little use in statutory financial statements is just the cumulative effects of inflation and changes in market values of land and buildings. Depreciation rates may also be out of line with actual useful lives, even though acceptable under tax law.

THE TAX AMNESTY: The government introduced a one-off tax amnesty (Law 6111) which allowed taxpayers to escape from the penalties they might otherwise have suffered on past irregularities in exchange for a moderate extra tax payment. Applications were made under the tax amnesty law between February and May 2011. Many companies made such applications, which were encouraged by tax offices. This arrangement provided the government with a one-off source of revenue. It also facilitated merger and acquisition transactions because it removed or mitigated the past tax risks in many companies for sale. The taxes covered by the amnesty were as follows:

• Income tax;

• Corporate tax;

• VAT; and

• Income withholding tax (i.e. on salary payments, rental payments, independent professional service fee payments and the payments associated with multi-year construction works). A separate application was required in respect of each tax, and companies were free to elect to benefit from the amnesty in respect of some of the above taxes but not others. Where an application was made, the tax base for the relevant years was accepted to be increased by a percentage and therefore extra taxes (at 15% or 20%) became payable on that increased tax base. These extra taxes could be paid in instalments. The applications could be made for any or all of the years 2006, 2007, 2008 and 2009. Once the application was made, the Ministry of Finance would never investigate the years covered.

In addition, the law included provisions allowing taxpayers to make one-off corrections to certain balance sheet accounts which had become misstated through previous tax evasion. These accounts were inventories (both upward or downward adjustment were allowed), cash balances and balances due from shareholders. A moderate tax payment was due in respect of such adjustments (for example, 3% on the write-off of fictitious cash balances).