Recent Judicial Decisions on Interest Payments within the Scope of Thin Capitalization
Introduction
While tax systems introduce general regulations to prevent the abuse of laws, special regulations are introduced as tax security institutions within the scope of tax laws for situations where general regulations do not fulfill the expected function in practice. One of these tax security mechanisms is the thin capitalization regulated under Article 12 of the Corporate Tax Law No. 5520 ("CTL"). The tax systems of countries generally encourage the financing of companies through equity and aim for shareholders to provide financing to companies by contributing capital rather than lending large amounts of money. One of the reasons for this aim is that the interest paid by shareholders in return for lending money to companies is deducted from the corporate tax base of the company, resulting in tax loss. In this article, the issue of thin capitalization as a tax security mechanism introduced to prevent such tax loss is analyzed in terms of corporate tax and value-added tax ("VAT") within the scope of the most recent and important decisions of the Council of State Plenary Session of the Tax Law Chambers ("Council of State PSTLC") regarding interest payments.
Thin Capitalization in General
Under Article 12/1 of CTL, the portion of the loans obtained directly or indirectly from the shareholders or persons related to the shareholders and used in the enterprise, which exceeds three times the shareholders' equity of the corporation at any time during the accounting period, is considered as thin capitalization for the relevant accounting period. There are three basic conditions for the emergence of thin capitalization:
- The first is that the corporation has borrowed from real and legal persons with certain relationships.
- Second, borrowings exceeded three times the corporation’s equity at any time during the accounting period.
- Finally, there is a relationship between the institution and the natural and legal persons from whom the debt is borrowed, within certain ratios.
Accordingly, the term "person related to a shareholder" means (i) in which the shareholder is, directly or indirectly, a shareholder of at least 10%, or (ii) in which the shareholder holds at least 10% of the voting or dividend rights, or (iii) a natural person or entity that directly or indirectly holds at least 10% of the capital, voting or dividend shares of the shareholder or such entity related to the shareholder.
Under Article 12/7 of the CTL, two important consequences are regulated for companies that fall within the scope of thin capitalization:
- For Income and Corporate Tax Laws, interest and similar payments or calculated amounts, excluding foreign exchange differences, shall be considered as dividends distributed as of the last day of the accounting period in which the conditions for thin capitalization are met for both the borrower and the lender, or as amounts transferred to the head office for limited taxpayers.
- Previous taxation transactions shall be corrected accordingly before the taxpayers who are parties to the correction to be made before the fully liable taxpayer institutions, including the exchange differences related to the thin capitalization. However, for this correction to be made, the taxes levied on behalf of the corporation using thin capital must be finalized and paid..
Under Article 11/1-b of the CTL, another result on the subject is regulated and accordingly, interest, exchange differences and similar expenses paid or calculated over the thin capitalization will be included in the tax base as unallowable expenses.
Under Article 5/1-a of the CTL, gains derived by corporations from participation in the capital of another fully liable taxpayer corporation are exempt from corporate tax.
Section 12 of the Corporate Tax General Communiqué Serial No. 1 ("Communiqué") includes the details of the thin capitalization correction. In the Communiqué, it is stated that when the correction is made by the lender, the portion of the interest income corresponding to the thin capitalization will be taken into account as dividend income and will be exempt from tax as an exemption from participation gains in the presence of conditions.
As it is understood from both the legal regulation and the Communiqué, interest payments corresponding to the thin capitalization are exempt from participation income in the determination of the related period's corporate income, if the conditions are met for the lender.
Recent Council of State PSTLC Decision on Interest Paid within the Scope of Thin Capitalization in Terms of Corporate Tax
One of the issues that may be subject to criticism by the tax administration is that the interest calculated on the debt accepted as thin capitalization is considered a non-allowable expense and if corporate tax is not paid on all or part of this expense, it is claimed that no correction can be made because "the condition that the taxes are finalized and paid" is not met. According to this interpretation, it is not possible for the company that obtains the interest income related to the debt to consider the interest amount as a dividend within the scope of the participation income exemption.
However, within the scope of the recent decision of the Council of State PSTLC numbered E. 2022/93 K. 2024/102 and dated 06.03.2024, it is decided that the tax administration’s penalized assessment made under the tax inspection report issued because the "condition that the taxes are finalized and paid" is not met for the correction within the scope of thin capitalization is now lawful. The significant evaluations made within the scope of the decision are as follows:
- Previous taxation transactions should be corrected by considering the interest paid to the related company by the institution using the debt within the scope of thin capitalization as a non-allowable expense, and the interest income obtained by the lending institution as a "dividend".
- Article 12/7 of the KVK states that to correct the "previous taxation transactions", the "assessed" taxes must be finalized and paid. What should be understood here is that, after the close of the accounting period, in other words, after the corporate tax return has been filed and the corporate tax has been accrued, the tax that has been assessed based on the declaration, either ex officio or on an ex officio basis, must have been finalized and paid in terms of the correction request to be made by the corporation using thin capitalization. Therefore, the requirement of finalization and payment will not be in question for the corrections made within the period before the taxation and assessment process has been realized.
- In this case, the necessary correction transactions can also be made before the lending company if the borrowing company does not pay corporate tax because it has incurred a loss although it has been taken into account as a non-allowable expense in the accounting period, or the event that a lower amount of tax is paid than the tax amount corresponding to the correction amount.
- Therefore, the interest income related to the debt should be considered as dividend and evaluated within the scope of the participation income exemption.
Although there are many other judicial decisions on the subject, the recent decision of the Council of State PSTLC is highly significant for taxpayers with its important evaluations regarding the tax administration's narrow and unlawful interpretation of the Article 12/7 of the KVK.
Recent Council of State PSTLC Decision on Interest Paid within the Scope of Thin Capitalization in Terms of Value Added Tax
Whether the interest income derived from the thin capitalization and accepted as dividends is subject to VAT or not is another controversial issue regarding the thin capitalization.
As it is known, under Article 1 of the Value Added Tax Law No. 3065 ("VAT Law"), deliveries and services made in Türkiye within the framework of commercial, industrial, agricultural, and self-employment activities are subject to VAT.
According to the approach of the tax administration, the providing debt within the scope of thin capitalization is a financing service and the interest paid for the financing service is subject to VAT.
However, since these payments in the form of dividends are considered as dividend distribution in accordance with the wording of the law and dividend distribution is not subject to VAT, interest payments related to the debt within the scope of thin capitalization are not subject to VAT. Within the scope of the recent decisions of the Council of State PSTLC numbered E. 2021/499, K. 2023/94 and dated 15.02.2023 and E.2021/263, K.2023/95 and dated 15.02.2023, the decision of the tax courts which found the VAT accrual on interest payments within the scope of thin capitalization in accordance with the law, have been abolished. And, the plaintiff's appeal requests were accepted based on that the amounts calculated over the thin capitalization are accepted as dividends, that dividends are not included in the matters that are subject to the VAT listed in Article 1 of the Value Added Tax Law, and that there is no compliance with the law in the accrued tax subject to the lawsuit.
Conclusion
Interest payments made about the debt given within the scope of thin capitalization are one of the issues that the tax administration tends to criticize both in terms of corporate tax and VAT. However, the very recent decisions of the Council of State PSTLC on the subject contain significant explanations in favor of taxpayers regarding these criticisms. As a matter of fact, within the scope of these decisions it has been ruled that (i) in terms of corporate tax, if no corporate tax is paid because there is a loss in the case of thin capitalization, or if a lower amount of tax is paid than the tax amount corresponding to the correction amount, the necessary correction transactions can be made before the lending company and the interest income related to the debt should be considered as dividend and should be evaluated within the scope of the participation income exemption; (ii) in terms of VAT, the payment transaction in question will not be subject to VAT since the interest payments made are like dividends and dividend distribution cannot be characterized as a type of delivery or service listed in the VAT Law. These decisions constitute a significant case law in terms of thin capitalization.
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