Disguised profit distribution through transfer pricing is one of the tax security methods regulated under Article 13 of Corporate Tax Law No. 5520 (“CTL”). Pursuant to this article, if corporations purchase or sell goods or services with related parties at prices determined contrary to the arm’s length principle, the profit is deemed to have been distributed implicitly through transfer pricing in whole or in part. In the event that the disguised profit distribution is determined through transfer pricing, many consequences such as refusal of deduction, correction, and dividend assessment occur for taxpayers.
In addition, if the transaction subject to disguised profit distribution through transfer pricing is also subject to value added tax (“VAT”), the VAT aspect of transfer pricing should be examined. The controversial issue in the relationship between disguised profit distribution through transfer pricing and VAT is whether the VAT calculated for the disguised profit distributed can be deducted or not. In this article, the relationship between disguised profit distribution and VAT is examined in the light of current law amendments, the dominant view in practice, and the decisions of the Council of State.
Disguised Profit Distribution Through Transfer Pricing Pursuant to the CTL
In accordance with Article 13 of CTL, in case corporations engage in purchase or sales of goods or services with related parties at prices determined contrary to the arm’s length principle, it is stipulated that the income will be deemed to have been distributed in a disguised manner through TP. The purchase or sale of goods or services means purchase, sale, manufacturing and construction, leasing and renting transactions, borrowing and lending, and all kinds of transactions which imply wage, salary, premium and other.
In this context, in the event that corporations sell goods or services to related parties at a value below a valid price in accordance with the arm’s length principle, or purchase goods or services from related parties with a value above the arm’s length principle, the difference between the actual price and the arm’s length price represents the profit distributed through transfer pricing. In other words, disguised profit distribution through transfer pricing is possible if the income is either less than it should be or if the expense is more than it should be.
The purpose of transfer pricing is to prevent the treasury loss. Also, in case the price applied in the purchase and sale of goods and services between institutions and real persons is different from the price applied in transactions with unrelated parties, the use of this difference in bad faith is prevented by transfer pricing.
Besides, if it is determined that there is a disguised profit distribution through transfer pricing, this situation has some consequences for the taxpayers: (i) refusal of the deduction, (ii) determining the distributed earnings as dividends and (iii) correction.
Pursuant to Article 11/1 (c) of the CTL, in cases where goods or services are sold and purchased by related parties at prices in contrary to the arm’s length principle, the difference between the price actually applied and the precedent value, the amount of disguised earnings distributed through transfer pricing, are not taken into account as a discount in the determination of corporate income.
The Situation of Disguised Profit Distribution Through Transfer Pricing Under Value Added Tax Law No. 3065
In accordance with Article 1/1 of Value Added Tax Law No. 3065 (“VATL”), commercial, industrial, agricultural and professional deliveries and services made in Turkey are subject to VAT. In this context, if the purchase and sale of goods between related parties falls under Article 1 of the VATL, the purchase and sale of goods is also subject to VAT.
However, considering the new rules created when the CTL entered into force, some discussions have arisen regarding VAT in cases where the transfer pricing regulations have to be put into practice, since the necessary explanations are not made in the VATL.
Namely, as stated in the section above, the deduction of the disguised profit distributed through transfer pricing is not allowed in the determination of corporate income under Article 11/1 (c). On the other hand, in the old version of Article 30 of the VATL, there was a clause which stated that VAT paid “due to expenses whose deductions are not accepted in the determination of income according to Income and Corporate Tax laws.” Under this version of the law, since the disguised profit distribution was an expense that was not accepted by law, the deduction of the VAT paid was not accepted. For this reason, many problems occurred in practice.
The legislature, which was not indifferent to this problem, made changes in related communiqués and the VATL in successive years. The relevant changes are as follows:
The Communiqué (Serial No: 6) on the Amendment to the Communiqué on Value Added Tax General Application
This Communiqué has eliminated the need to make any adjustments in the deduction accounts regarding the taxes that are paid excessively or improperly due to the deductions in the import base of taxpayers who have the right to deduction (including the cases where it is determined that disguised profits are distributed through transfer pricing).
The Law Making Amendments on Certain Laws Aiming to Improve the Investment Environment Law No. 6728 (“Law No.6728”)
Law No. 6728 states that the VAT deduction prohibition regarding expenses will not be applied to disguised profit distributed through transfer pricing, VAT paid on imports related to the differences against the corporations, and VAT paid by responsible in accordance with Article 41/1 (5) of Income Tax Law No.193.
VAT deduction pertaining to VAT paid in import or paid as a tax responsible relating to disguised income distributed through transfer pricing and also VAT deduction declared and paid on time by taxpayers who deliver goods or perform services in domestic transactions has been accepted. As a result, the deduction of VAT, which is an unaccepted expense and calculated over the disguised income, has been accepted.
Although these amendments have resolved the VAT deduction problem, the effective date of the last revision, 06.04.2018, is very crucial. In this context, the aforementioned confusion continues in terms of tax inspections before 06.08.2018 and disputes at the litigation stage.
Views on the Deduction of VAT on Disguised Earnings
Through the latest regulations, it has been clarified that VAT corresponding to the disguised income distributed through transfer pricing can be deducted. However, it is not clear that the VAT corresponding to the distributed earnings can be deducted in the period before the legal changes
The prevailing opinion in the doctrine and practice is that the deduction of VAT corresponding to the said income should be accepted in the period before the legal changes. The main supports of this approach are as follows:
- In accordance with Article 11/1 (c) of CTL, the amount above the arm’s length price of the transaction between related parties is not accepted as a deduction from the corporate income. Therefore, the regulation in question only concerns financial profit. In this context, the amounts corresponding to the disguised income cannot be evaluated within the scope of Article 30/d of VATL.
- In Article 30/d of VATL, entitled “Non-Deductible Value Added Tax,” it is stipulated that the VAT paid due to expenses that are not accepted as a deduction in determining the income according to the Income and Corporate Tax Laws cannot be deducted. The main purpose of the provision of this article is to prevent the deduction of expenses that are not related to a business or the corporations. In this context, the expenses incurred for obtaining and maintaining commercial income can be deducted. As a matter of fact, transactions that result in disguised income distribution are within the scope of commercial activity. A contrary interpretation contradicts the basic principle of VAT. This principle says that the taxes incurred by taxpayers in context of work-related expenses should not born by taxpayers.
- VAT must be processed as a chain. In cases where goods or services are purchased from the related party at a higher price than their counterparts, the transaction subject to disguised gain is “calculated VAT” for one party and “discount VAT” for the other party. In this context, not allowing VAT deduction on one side in accordance with Article 30/d of VATL interferes with the functioning of the VAT chain and disrupts the chain system.
- Disguised profit distribution through transfer pricing is one of the tax security methods regulated by the CTL and must remain within the scope of the CTL. Therefore, since the disguised profit distribution through transfer pricing is regulated in the CTL and is an event that concerns this law, the price agreed by the parties should be taken as a basis in other transactions for taxation. This view was clearly emphasized in the decision of the 4th Chamber of the Council of State with the following justification:
“Evaluating the above-mentioned legislation provisions together with the information and documents in the case file; the resolution of the dispute seems to depend on the determination of the existence of the disguised profit distribution with the transfer pricing method. However, essentially, the resolution of the dispute depends on the comparison of the provisions of the Value Added Tax Law which regulates the expenses that are not accepted as deductible and the Corporate Tax Law.
In this case, with the last amendment made in article 30/1-d, which regulates the expenses that are not accepted as deduction of the Law No. 3065, it is not necessary to deduct the value added taxes paid due to the goods/services obtained from abroad regarding the earnings disguised through transfer pricing, from the discount accounts…”
On the other hand, opposing view argues that the wording of the old VATL is quite clear and in this context, the VAT deduction corresponding to the disguised profits cannot be accepted. Pursuant to this opinion, the inability to deduct VAT related to the disguised profit is not the result of the transaction not arising from commercial activity; it is a result of the imperative provision of Article 30/d of VATL.
Disguised profit distribution through transfer pricing is one of our tax security methods regulated in Article 13 of the CTL. One consequence of this practice for taxpayers is that the income distributed implicitly through transfer pricing is not allowed to be deducted in the determination of corporate income. Although the rejection of the discount is clear in terms of the CTL, the situation in terms of VAT has been quite controversial. In order to resolve these discussions, regulations have been made under the framework of the VATL since 2016. Although these regulations remove the uncertainty on the subject, the situation is still controversial in terms of the period before the new regulations entered into force.
Although there are opinions that do not accept the VAT deduction regarding the pre-regulation period, especially considering the will of the legislature regarding the new regulations, the better view is that disguised profit distribution through transfer pricing does not have any consequences in terms of VAT, and that the deduction of VAT declared and paid within this scope should also be accepted.
(Authored by Özge Kısacık and first published by Erdem & Erdem on November 2021)
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