Prohibition On Hidden Income Shifting
Prohibition on hidden income shifting is one of the most important issues that is broadly regulated under Capital Markets Law No. 6362 (“CML”). In conjunction with CML Article 21, which has a broader context than Article 15 of the abrogated Capital Markets Law No. 2499, another significant step has been taken regarding one of the most primary aims of the Capital Markets Board (“CMB” or “Board”), a public regulatory authority, which is to provide protection on the rights of shareholders of public companies.
By virtue of the managerial abuses of joint stock companies that are subject to the capital markets legislation, the prevention of, particularly, the potential damages of the shareholders/minority shareholders, apart from the persons or group which hold the control of the company, in other words, the account owners who are capital market investors, is the primary purpose of the CML, and one of the preeminent duties and authorities of the CMB[1].
The hidden income shifting problem has been regulated in the tax legislation in a more broad, but tax-oriented concept, at first, due to the fact that it triggers tax losses. On the other hand, the CML regulates this issue more distinctively, and within a narrower context, with regard to investing shareholders[2]. The components of the hidden income shifting prohibition are determined in the first paragraph of CML Article 21, entitled, “Prohibition of the Hidden Income Shifting.”
The first paragraph of CML Article 21 states that “It is prohibited to the shift income of public companies and collective investment schemes, and their subsidiaries and affiliates, to real persons or legal entities with whom they have a direct or indirect relationship in terms of management, audit, or share capital, through reducing their profits or their assets, or preventing the increase of their profits or their assets, by virtue of performing transactions, such as forming contracts or commercial practices comprising different prices, fees, costs or conditions, or via producing a trading volume that is in violation to market practices (the arm’s length principle[3]), according to prudence and honesty principles of commercial life.”
A remarkable point in this provision is that its scope of application with respect to applicable persons is widened, in comparison to abrogated Article 15. In this Article, along with public companies’ collective investment schemes, their subsidiaries and affiliates have been included in the scope of the Article. The opposite party of the transaction is regulated as the real or legal entity, with whom the persons as listed under four categories in the Article are either in a direct, or an indirect, relationship in terms of management, audit or share capital.
The Article, as a rule, specifically prohibits hidden income shifting. The first paragraph of the Article sets forth that such shifting can be executed through four different methods. These are; (i) the reduction of profits (ii) the reduction of assets and (iii) the prevention of the increase of profit or (iv) the prevention of the increase of assets.
The Article also sets forth that prohibited income shifting may be performed through forming contracts or commercial practices comprising different prices, fees, costs or conditions that are in violation of market practices, the arm’s length principle, or prudence and honesty principles of commercial life, or through concluding transactions, such as producing transaction volumes.
The meaning of the word “transaction” as defined in CML Article 21 is accepted in the doctrine to include the avoidance of a typical or atypical agreement, such as service, attorney, work, sale/purchase or shareholders agreement, or avoidance of a behavior. Accordingly, it is concluded that income may also be shifted through the non-entrance into tenders that are in favor of the concerned persons, quotation of high prices, or the transfer of certain businesses to certain persons[4].
The second paragraph of CML Article 21 states that the hidden income shifting prohibition can also be passively violated. The second paragraph of CML Article 21 sets forth that “ In the cases where public companies and collective investment schemes, along with their subsidiaries and affiliates, do not perform the activities expected from them as prudent and honest merchants in accordance with their articles of association or their internal rules, or if they do not perform activities in order to conserve or increase their profits or assets in accordance with market practices, providing the increase of the profits or assets of real persons and legal entities with whom they are related shall also be deemed as hidden income shifting transactions.”
The second paragraph of CML Article 21 prohibits the reduction of assets, along with the reduction of the profits of the company through transactions concluded by the company through a certain method and, accordingly, foresees a broader approach than Article 15 of the abrogated law.
When the first two paragraphs of the Article are jointly evaluated, it is clear that the active operations stipulated in the first paragraph as (i) the reduction of profits (ii) the reduction of assets and (iii) the prevention of the increase of profits or (iv) the prevention of the increase of assets, are prohibited, along with the passive operations as stipulated in the second paragraph of the Article, as (i) the non-performance of the activities that are expected to be performed in order to protect or increase the profit, and (ii) the non-performance of the activities that are expected to be performed in order to protect or increase the assets.
In this context, the new regulation not only aims to prohibit the reduction or prevention of increase the profits or assets through active behavior. Additionally, damaging the company through passive behaviors shall also be assessed within the scope of the hidden income shifting prohibition.
In accordance with CML Article 21, it is not necessary for the source shifting to be performed by the public company in person, and/or directly. The hidden income shifting may be performed via public company’s subsidiary and/or affiliate, in person, or through its subsidiary and/or affiliate. Accordingly, along with direct income shifting, damages may occur within a public company, by virtue of the transactions conducted within the scope of the group relation[5].
Together with the protection of the incomes of publicly held joint stock companies, another impact of the aforementioned regulation is that it introduces a provision parallel to the protection of the assets principle, which is also regulated under the Turkish Commercial Code (“TCC”). Through this provision on the prohibition of the hidden income shifting, the assets of the public company are protected, and the opportunity for the minority shareholders to obtain efficient and necessary amount of dividend is enabled. Additionally, it should be noted that the hidden transactions that result in the reduction of company’s profits or assets, in other words, those transactions that cause damage, are generally considered as collusive transactions[6].
The third paragraph of CML Article 21 imposes documentation and safekeeping obligations, and sets forth that “The public companies and collective investment schemes are obliged to certify that the related party transactions have been performed in accordance with arm’s length principles, market practices, prudence and honesty principles of commercial life, and to preserve the documents and information so certifying for at least eight years. The Board shall determine the principles and procedures to be followed where a violation of the principles set forth under paragraph 1 occurs.”
In the third paragraph of the said Article, the public companies and collective investment schemes shall be obliged to provide certification that the related party transactions have been performed under the conditions that are in conformity with the arm’s length principle, market practices and prudence and honesty principles of commercial life, and are obliged to keep the documents and information so certifying this for at least eight years.
The fourth and last paragraph of CML Article 21 regulates the sanction that shall be applied where hidden income shifting occurs. In accordance with this paragraph, the public companies, collective investment schemes, together with their subsidiaries and affiliates, shall request from the parties to which an income transfer has been made, to return the transferred amount and its legal interest to the company or collective investment scheme whose assets or profits have been reduced, within the timeframe determined by the Board, where the income transfer has been detected by the Board. Moreover, the parties that have received an income transfer are obliged to return the transferred amount with its legal interest within the period determined by the CMB. Additionally, civil, penal and administrative sanctions may be applied in accordance with Articles 94 and 110 regarding the violation of the prohibition of hidden income shifting.
Within this context, the public company may request the repayment of the transferred amount, with interest, and disclose the audit results to the public, where income shifting is detected by the CMB. Sanctions, such as filing a restitution lawsuit, requesting compensation for the breach, filing lawsuits regarding annulment-nullity-invalidity, revocation of signatory authority, and/or dismissal may be applied with regards to the said transaction. “Abuse of Confidence” and “Administrative Fines” may be applied with regard to criminal liability.
In conclusion, as far as hidden income shifting is concerned, company assets will be negatively affected, and the subsequent decision of the investor will be negative as a consequence of the low profits. Additionally, the value of the securities will also be low. Therefore, the shares should be exchanged more frequently, and generally, the circulation should be in a manner that would result in the shares being transferred to major shareholders. Within this context, as per the regulation of Article 21 of the CML, the protection of the public company and, accordingly, the investing shareholders, and the prevention of company sources to be transferred to the related persons that have a controlling power, is intended. By virtue of this provision, the intervention to the source transfers/hidden income shifting transactions, directly, or indirectly executed, and whose execution is procured through the board of directors by those persons with the controlling power over the company, will reduce or prevent the increase of the company profits or assets[7].
[1] Arslan Kaya İÜHFM C. LXXI, S. 2, p. 193-204, 2013.
[2] Arslan Kaya İÜHFM C. LXXI, S. 2, p. 193-204, 2013.
[3] Please see Corporate Tax Law Article 13.
[4] Ünal Tekinalp, Sermaye Piyasası Hukukunun Esasları, İstanbul 1982, p. 77.
[5] Arslan Kaya İÜHFM C. LXXI, S. 2, p. 193-204, 2013.
[6] Akbulak/Akbulak, Sermaye Piyasası Araçları p. 386-387.
[7] Arslan Kaya İÜHFM C. LXXI, S. 2, p. 193-204, 2013.
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