The Turkish Corporate Income Tax Act No. 5422 dated 10 June 1949 is planned to be wholly revised. The Draft Corporate Income Tax Act (DTCA) prepared by the Tax Council to the Ministry of Finance was submitted to the Council of Ministers and released to public on 30 January 2006. After the Parliamentary procedure is completed, it is expected that the new provisions will be applied from 1 January 2006.

One of the basic features of the DCTA is that it introduces new anti-avoidance measures on transfer pricing and controlled foreign companies (CFC). Currently, Turkish tax laws do not contain such special provisions. In addition, the DCTA amends the existing thin capitalization rules clarifying the debt-to-equity ratio and other conditions.

Transfer pricing

The DCTA introduces transfer pricing rules for transactions between resident or non-resident companies (corporations and limited liability companies) and related persons. The rules will also be applied to other corporate taxpayers, such as cooperatives, and commercial and industrial enterprises owned and operated by public authorities, associations and trusts.

(a) Scope. Under the DCTA, in cases where a sale or service transaction between a company and a related person is effected under prices determined contrary to the arm's length principle, the transaction is fully or partially considered to be a hidden profit distribution via transfer pricing (Art. 13/1 DCTA). The following transactions are considered to be a sale or service transaction (Art. 13/2 DTCA):

-		sale or purchase of goods;
-		production or construction transactions
-		service contracts;
-		leasing;
-		loan transactions; and
-		salary payments

Hidden profit distributions via transfer pricing are non-deductible when calculating the taxable income (Art. 11/1(c) DCTA). Such hidden profit distributions are considered to be constructive dividends derived at the end of the taxable period in which the above conditions are met. For non-residents, such hidden profit distributions are deemed as profits remitted to the head office. In such cases, adjustments are made for previous taxes of both parties (Art. 13/9 DCTA). Thus, hidden profit distributions are not tax deductible for the distributing company and in addition, in principle are subject to income withholding tax.

(b) Related persons. The following persons are considered to be "related" (Art. 13/3 DCTA):

-		shareholders;
-		an individual or a legal entity related to a shareholder or the distributing company (e.g. a relative or a partnership relation); or
-		an individual or a legal entity which is directly or indirectly connected to or controlled by the distributing company.

Under the DTCA, sales to low-tax jurisdictions are also regulated. Accordingly, in cases where the transaction is effected with persons from countries or areas listed and issued by the Council of Ministers, the transaction is deemed to be realized between related persons. The relevant country or area will be determined based upon a comparison between the "tax capacities" of Turkey and that other country, considering whether the latter's tax capacity is similar to Turkey's (Art. 13/4 DCTA).

(c) Methodologies. Under the arm's length principle, the price used in a sale or service transaction effected between related persons is the price that would be used for similar transactions between unrelated persons (Art. 13/5 DCTA). In determining the transfer price that will be used in a transaction with related persons, companies may use one of the following methods that may best suit the nature of the transaction (Art. 13/6 DCTA):

-		comparable uncontrolled price method: arm's length sale price is determined by comparing the market price that would be charged for comparable sale or service transactions between unrelated individuals or legal entities;
-		cost price method: arm's length price is determined by adding an appropriate gross profit to the costs incurred for the goods or services; or
-		resale price method: arm's length price is determined by reducing an appropriate gross profit from the price that would be charged during the resale of goods or services to unrelated individuals or legal entities.

In cases where the arm's length price cannot be determined by the above methods, companies may use other methods that are appropriate to the nature of the transaction. The taxpayers are obliged to keep as evidence the documents, tables and charts prepared for the calculation of the transfer prices (Art. 13/7 DCTA).

For transactions between related companies, advance pricing agreements with the Ministry of Finance are possible. In such cases, agreed pricing method is fixed for maximum of 3 years (Art. 13/8 DCTA).

The Council of Ministers is authorized to determine the procedural rules for transfer pricing (Art. 13/10 DCTA).

Thin capitalization

Under the DCTA, items deemed paid or calculated on the basis of hidden equity capital are non-deductible (Art. 11 DCTA). Hidden equity capital refers to loans which (Art. 12/1 DCTA):

-		are taken directly or indirectly from shareholders or persons related to the shareholders; and
-		are used in the business; and
-		exceed, at any time in a tax period, two times of the borrowing company's equity (i.e. maximum debt-to-equity ratio is 2 to 1 for financing by related persons).

In cases where a shareholder or a person related to the shareholder is a bank or a similar credit institution (except credit companies providing loans only to related companies), 50% of the loans are taken into account for the debt/equity comparison (Art. 12/2 DCTA). For companies whose shares are registered with the Istanbul Stock Exchange, hidden equity capital rules apply to loans received from the shareholders that acquired the shares through the Exchange, provided that their capital share is at least 10% (Art. 12/4 DCTA).

 For the calculation of debt/equity ratios, loans from shareholders and persons related to the shareholders are aggregated (Art. 12/5 DCTA).

"Persons related to shareholders" are:

-		companies of which the shareholder directly or indirectly owns at least 10% of its capital or voting rights; or
-		individuals or legal entities which directly or indirectly own at least 10% of the capital or voting rights of the shareholder, or of the companies mentioned above (Art. 12/3 DCTA).

The following loans are not considered to be a hidden equity capital (Art. 12/6 DCTA):

-		loans from third parties under a guarantee in kind which is provided by a shareholder or persons related to the shareholder; and
-		loans from the subsidiaries, shareholders or persons related to the shareholders, provided that the loan is obtained from banks and financial institutions or capital markets and transferred under same conditions.

interest and other items paid, or exchange rate differences realized on loans from shareholders and persons related to shareholders, in excess of the 2 to 1 debt-to-equity ratio are treated as dividends for tax purposes. For non-residents, such hidden profit distributions are deemed as profits remitted to the head office. In such cases, adjustments are made for previous taxes of both parties (Art. 12/7 DCTA). Thus, the interest is not tax deductible for the borrowing company; in principle, the interest is subject to income withholding tax applied to dividends.

Controlled foreign companies

Under the DCTA, controlled foreign company (CFC) provisions apply to foreign subsidiaries of resident companies in low-tax jurisdictions. CFC rules also cover the foreign subsidiaries of other resident corporate taxpayers such as cooperatives, and commercial and industrial enterprises owned and operated by public authorities, associations and trusts.

A "controlled foreign company" is a foreign subsidiary of a resident company which owns directly or indirectly 50% of the share capital, profit or voting rights of the subsidiary. For the determination of the control ratio, the maximum ratio in a tax period is considered. CFC profits, whether distributed or not, are taxable in Turkey, provided that the following conditions are met (Art. 7 DCTA):

-		at least 25% of the CFC's gross profit must be passive income, such as interest, dividend, rent, licence fee or capital gains;
-		taxes applied to the CFC's profits must be similar to corporate income or individual income taxes;
-		tax burden on the CFC's commercial balance sheet profits must be below 10%; and
-		the total turnover of the CFC in a tax period must be over the amount in foreign exchange equivalent to YTRL 100,000.

According to the explanatory note to the DCTA, the determination of a low-tax jurisdiction is based on the tax burden criteria. This criteria is chosen as the basis for comparability because it is based on the final taxes paid after all kinds of deductions, refunds or credits. In computing the tax burden, the total sum of accrued taxes is apportioned by the total sum of distributable after-tax profits plus accrued taxes (Art. 5 and Art. 7/3 DCTA). Legal or optional reserves must be included in distributable profits. Real expenses which are considered as non-deductible under the rules of the relevant jurisdiction, but which are in fact realized, may be considered as a deductible item in determining the distributable profits.

CFC profits corresponding to the participation ratio of the resident company are included in the corporate income tax base, and taxed accordingly in Turkey (Art. 7/4 DCTA). In cases where the relevant profits are subsequently distributed by the foreign subsidiary, only the portion of the dividends that were not previously taxed as CFC profits are taxable (Art. 7/5 DCTA). Taxes paid by the CFC may be credited against the corporate income tax calculated in Turkey on CFC profits (Art. 33/2 DCTA). The credit may not exceed the Turkish corporate income tax calculated on the foreign-source income (ordinary credit) (Art. 33/4 DCTA).

Foreign capital gains to be exempt from corporate income tax

The draft Corporate Income Tax Act, which was released to the public on 30 January 2006, introduces a corporate income tax exemption for foreign capital gains derived by resident corporations (ASs) from the disposal of participation shares in non-resident companies similar to the Turkish AS or limited liability company (Ltd S) under certain conditions. The exemption is expected to be applied from 1 January 2006.

To qualify for the exemption, the following conditions must be met:

-		the resident AS must have owned at least 10% of the share capital in the non-resident companies continuously for at least 2 years; and
-		the participation in the non-resident companies must constitute at least 75% of the assets (excluding cash) of the AS continuously for at least 1 year.

Losses incurred from the disposal of the above participation shares are not deductible from other (non-exempt) profits of the AS.

Conditions for exemption for foreign dividends and PE profits to be amended

Dividends from foreign subsidiaries

The draft Corporate Income Tax Act, which was released to the public on 30 January 2006, amends the corporate income tax exemption for qualifying foreign-source dividends derived by resident companies. For the exemption to apply, the following new conditions must be met:

-		the non-resident company paying the dividends must correspond to a Turkish corporation (AS) or limited liability company (Ltd S);
-		the resident company (AS or Ltd S) must have owned at least 10% (previously, 25%) of the share capital in the foreign company continuously for at least 1 year (previously, 2 years);
-		the profits out of which the dividends are distributed must have been subject to a corporate income tax or a similar tax in the source country;
-		the effective tax burden applied in the foreign country must be at least 15% (previously, 20%); and
-		the dividends must be transferred to Turkey by the filing date of the corporate income tax return for the relevant taxable period

In cases where the profits of the foreign company arise from financing services, including financial leasing or insurance or security investments, the effective tax burden in the foreign country must be at least 20%. Previously, profits from financial leasing or security investments did not qualify for the exemption, and the tax burden criteria for insurance or financial transactions was 30%.

In computing the tax burden, the total sum of accrued taxes is apportioned by the total sum of distributable after-tax profits plus accrued taxes. Legal or optional reserves must be included in distributable profits. Genuine expenses that have been non-deductible in the source country may be considered as a deductible item in determining the distributable profits.

Profits from permanent establishments

Under the draft Act, qualifying profits from PEs and representatives of Turkish companies in foreign countries are also exempt from corporate income tax. For the exemption to be applied:

-		the profits earned in the source country must have been subject to a corporate income tax or a similar tax in that country;
-		the effective tax burden in the source country must be at least 15% (previously, 20%); for business income from insurance or financial transactions, including financial leasing, and security investments, 20%; and
-		the profits must be transferred to Turkey by the filing date of the corporate income tax return for the relevant taxable period.