An Assessment of Free Trade Zones from a Transfer Pricing Perspective(*)

1. Introduction

The term “free trade zone” (FTZ) refers to one or more special areas of a country in which certain normal trade barriers (e.g. tariffs and quotas) are eliminated and bureaucratic requirements are minimized in hopes of attracting new business and foreign investment. FTZs can be defined as labour-intensive manufacturing centres that involve the import of raw materials or components, and the export of factory products. As commonly accepted, FTZs are geographic locations in which legal provisions on tariffs, taxation, price, quality and standards are not applied, although these zones remain within the political boundaries of concerned country.

The aims of FTZs include:

promoting the industrialization process of goods and services for external markets;
increasing investment and production for export;
fulfilling the demand of any industry for input in an inexpensive and appropriate manner;
securing foreign direct investment and developing high technology; and
benefiting from outside financing and trade opportunities.

FTZs in Turkey have been established with these aims and, similar to the description above, an FTZ is a specially designed production site which aims at increasing export-oriented investment and production in Turkey, accelerating the entry of foreign capital and technology into Turkey, enhancing the productivity and economies of scale and increasing the utilization of external financial sources and trade opportunities. Consequently, 21 FTZs have been started in various geographic regions in Turkey since 1985.

Trading volume in FTZs grew at the rate of 3.1% and, according to the annual statistics of the Deputy Secretary of Foreign Trade their annual trade volume amounted to USD 24.6 billion in 2007. In the same year, 96% of total trading volume in FTZs consisted of industrial products, while sales from FTZs into Turkey consisted of raw materials and investment products. The shares of the machinery industry and textile industry in total trading volume are 23% and 17.7%, respectively. There are 799 production companies operating in FTZs in addition to 631 foreign enterprises which manufacture in many different areas. The most significant trading partners of FTZs are located in EU Member States, and 30% of total trading volume involves these countries.

Although an FTZ is within the boundaries of Turkey, it is treated as if it were a territory abroad. National regulations relating to foreign trade, financial matters and economic matters are partially applicable to FTZs. Generally, all types of activities may be performed in Turkish FTZs, including manufacturing, storing, packing, general trading, banking and insurance. While investors are free to construct their own premises, FTZs also have available office spaces, workshops and warehouses on a rental basis with attractive terms. All fields of activities open to the Turkish private sector are also open to joint ventures of foreign companies.

Tenants may begin operating as soon as they receive their operating licences from the regulator of the relevant FTZ. Investing companies, on the other hand, must obtain a construction licence to implement any construction projects. Once they complete the construction, a determination is made as to whether the construction complies with the terms of the construction licence. Upon approval of the buildings, investing companies may begin operating. Depending on whether ownership or leasing is concerned, a 15 to 20-year licence may be granted for production companies.

With regard to service companies, a company that will use a completed office may be granted a 10-year licence, whereas an investing company that will build its own office may be granted a 20-year licence. Another feature of FTZs in Turkey is that FTZ earnings and revenue may be freely transferred to any country, including Turkey, without any prior approval, and are not subject to any type of tax, duty or fee.

FTZs are operated in accordance with Free Trade Zones Law 3218 of 1985 (“the FTZ Law”). In Turkey, determination of the location and borders of FTZs is authorized by the Council of Ministers. Several years ago, Turkish FTZs were on the OECD blacklist. However, after the enactment of new regulations, they were removed from this list by the OECD. In 2006, Art. 6 of the FTZ Law (Exemptions and Incentives) was amended as follows:

An FTZ is treated as if it were outside the customs area. In such an area, the provisions of legislation on tariffs and foreign exchange are not effective. Independently from Turkish Tax Procedure Code 213, the Ministry of Finance is authorized to issue regulations on the books and records that must be retained by taxpayers. Founders, the organization which provides infrastructure, operators, and the institution or agency which operates the zone, may utilize non-tax incentives which are established by the Council of Ministers for the period of investment and/or production.

The reason for the new regulations was that Turkish FTZs were tax-free zones, and income generated through activities in those zones was thus exempt from all types of taxes, including personal income tax, corporate income tax and VAT. This created a competitive disadvantage for taxpayers operating outside the FTZs, and considerable tax evasion arose from practices within FTZs.

Bearing this in mind, a full analysis of FTZs and their features is beyond the scope of this article. Rather, this article will consider FTZs in Turkey from a tax and transfer pricing perspective. The focus will be on practice, and some simplified examples will be presented to explain significant details of current transfer pricing rules applicable in FTZs.

2. Taxation in Free Trade Zones

Operations in FTZs qualify for investment incentives, but not export incentives. The tax advantages of operating in FTZs include:

no VAT is due;
no corporate income tax is imposed on the manufacturing income of production companies; and
no customs duties are levied on goods imported from abroad into the zone.

The earnings of taxpayers that obtained an operating licence prior to 6 February 2004 are exempt from corporate income tax until the expiry date of that licence. In the meantime, manufacturing firms that have obtained a manufacturing license are exempt from corporate income tax with regard to earnings from the sale of their manufactured goods until the end of the financial year in which Turkey obtains full membership in the European Union. Manufacturing firms that obtained an operating licence after 6 February 2004 are eligible to benefit from a corporate income tax exemption. This exemption does not apply to withholding tax payments or profit distributions from FTZs that are subject to withholding tax under the Personal Income Tax Law.

By the same token, an income tax exemption with regard to salaries for services carried out in FTZs is applicable until 31 December 2008 for firms that obtained an operating licence before 6 February 2004. Accordingly, their employees’ salaries for their services carried out in FTZs will not be taxable until 31 December 2008. However, if the expiry date of the company’s FTZ operating licence is before 31 December 2008, the expiry date of the operating licence will be taken into consideration when determining the expiry date of the income tax exemption with regard to salaries. One should bear in mind that FTZ operators that obtained their operating licence after 6 February 2004 or renewed their licence after this date will not be able to benefit from an income tax exemption for their employees’ salaries, even if they are operating in the manufacturing sector.

3. Transfer Pricing Rules Applied to Free Trade Zones

Since the amendment of Art. 6 of the FTZ Law (Exemptions and Incentives), all individuals and entities operating in FTZs must register at the relevant tax office for their tax liability under general tax rules. This is because of the new rule that changes the provision which used to prevent the application of tax laws in FTZs. However, some exceptions still remain, as mentioned above.

Furthermore, the provision regarding “hidden profit”, which was found in Corporate Income Tax Law 5422, was replaced under the heading of “hidden distribution of profit by means of transfer pricing” in Art. 13 of the new Corporate Income Tax Law 5520, taking into account international developments and OECD guidance. In parallel with the transfer pricing rules introduced into the Turkish tax system by the new Corporate Income Tax Law, a related provision has been added to Art. 41 of Personal Income Tax Law 193.

In preparing these legal provisions, the main principles laid down in the OECD Guidelines were taken into account. Transfer pricing rules applicable to FTZs in Turkey are considered below, namely Art. 13 of the new Corporate Income Tax Law, the Cabinet Decision on the Hidden Distribution of Profit by means of Transfer Pricing and the Communiqué on the Hidden Distribution of Profit by means of Transfer Pricing.

3.1. Transfer pricing provisions under the Corporate Income Tax Law

The Turkish transfer pricing system is based on the arm’s length principle. For tax law purposes, the arm’s length principle implies that transfer prices applied in the purchase or sale of goods or services between related parties should be in accordance with prices that would have been agreed between unrelated parties. Under Art. 13 of the Corporate Income Tax Law, if the prices agreed in the purchase or sale of goods or services between companies, including all corporate and personal income taxpayers in FTZs, and their related parties are not consistent with the arm’s length principle, the profit therefrom is fully or partially classified as a hidden distribution of profit by means of transfer pricing. Buying, selling, manufacturing and construction operations; leasing and renting transactions; borrowing and lending money; bonus payments; monthly salaries and other similar payments will be considered as “purchase or sale of goods or services” in all cases.

For purposes of Art. 13 of the Corporate Income Tax Law, related parties of companies established in FTZs include:

the company’s own shareholders;
individuals and entities associated with those shareholders; and
individuals and entities, the company attached to or under the control of the company directly or indirectly in the management, supervision or capital.

A shareholder’s spouse, along with any relatives of a shareholder or the spouse (including lineage up to the third degree by blood or marriage) is also regarded as a related party.

Cross-border transactions will also be regarded as related-party transactions if carried out with parties in foreign jurisdictions or territories that are listed by the Council of Ministers as offering harmful tax regimes (based on whether taxation of profit in the foreign jurisdiction is at the same level and scope as Turkish taxation).

For example, assume that Company X is established to fabricate Product Y in the Antalya FTZ in Turkey. Company X’s parent, Company Z, is located in Bermuda, which is generally regarded as a tax haven. Company X pays a royalty of 25% of its annual total profit to Company Z. Company X has total sales in 2007 of USD 5,000. Under these circumstances, Company X will pay USD 1,250 to Company Z as a royalty payment and also will make this payment subject to a 30% withholding tax as a tax agent.

Another subject arranged under Art. 13 of the Corporate Income Tax Law is transfer pricing methods. Companies in FTZs must determine arm’s length transfer prices to be applied in related-party transactions by using the most appropriate method, taking into account the true nature of the relevant transaction. These methods, which are specified in Art. 13 of the Corporate Income Tax Law, are the comparable uncontrolled price (CUP) method, the cost-plus method and the resale price method.

The CUP method is defined as determination of the arm’s length price by comparing the company’s transfer price to the (market) price applied in comparable purchases or sales of goods or services between unrelated parties. Assume that Company A, established in the Istanbul FTZ, produces Product X, a machine for the steel industry, and sells it to a related party, Company B, which is located in Germany. Company A has no transactions with unrelated parties. Also, Company C, established in the Istanbul-AHL FTZ, produces the same machines and sells them to an unrelated party, Company D, in Germany.

In this case, there is no internal comparable for Product X from the perspective of Company A. However, the same machines as produced by Company A are also sold by Company C, which is established in another FTZ, to companies in same country. At the same time, there is no significant difference among the products manufactured by Company A and Company C. Transactions between unrelated parties (i.e. Company C established in another FTZ and Company D in Germany) may be accepted as comparables, and the CUP method in this case would be the best method for pricing the related-party transactions.

Under Turkish Corporate Income Tax Law, the cost-plus method is defined as determination of the arm’s length price by applying an appropriate gross profit markup to costs incurred in supplying goods or services. As an example, assume that Company X, established in the EGE FTZ, produces automobile tires, and sells them only to a related party, Company Y, located in the Netherlands. As such, there are no internal comparables for the relevant product.

Companies A, B and C, established in other FTZs, produce similar tires and sell them to unrelated parties both abroad and in Turkey. The average gross profit markup for Companies A, B and C is 10%. In this example it is assumed that automobile tire industries in both Turkey and the Netherlands are identical, and that transactions of Companies A, B and C with unrelated parties in the Netherlands are regarded as external comparable for the gross profit markup. The cost to Company X per tire is computed as USD 100. Under these circumstances, the transfer price for each automobile tire is USD 110 (100 x 1.10), which is determined by adding a 10% gross profit markup.

The law defines the resale price method as determination of the arm’s length price by subtracting an appropriate gross profit margin from the resale price applied when the goods or services in question are resold to unrelated individuals or entities. Assume that Company X, located in Italy, sells cars to a related party, Company Y, in an FTZ in Turkey. Company Y is the exclusive distributor of Company X in Turkey. The market price of the cars is USD 50,000. The average profit margin of other distributors that import similar cars is 10% of the resale price. This average profit margin does not include the cost of advertising or guarantee services that are carried out by the distributor.

It is determined that the cost for advertising and guarantee services of distributor Company Y in the FTZ is USD 2,000. After the average profit margin and cost for advertising and guarantee service are deducted from the resale price of the distributor, the transfer price is computed as follows:

[50,000 / (1 + 0.10)] — 2,000 = USD 43,455

When none of the above-mentioned methods is conclusive in determining the arm’s length price, certain other method may be applied by the taxpayer if it is the most appropriate based on the true nature of the transactions, namely profit-based methods such as the profit split method, the transactional net margin method or the comparable profit method.

Lastly, Art. 13 of the Corporate Income Tax Law mentions that partially or fully unwarranted distribution of profit by means of transfer pricing will be regarded as a dividend distribution from an FTZ entity, or as an amount transferred back to the head office from a branch/permanent establishment in an FTZ as at the end of fiscal period in which the specified requirements are met. Taxes assessed on both parties involved in such a disguised profit distribution will be adjusted accordingly. In order to make these adjustments, the original tax assessment on the FTZ entity that made the disguised profit distribution must have been finalized and the taxes already collected.

3.2. Cabinet Decision on the Hidden Distribution of Profit by means of Transfer Pricing

Under Art. 13 of Corporate Tax Code, the Council of Ministers has the authority to determine guidelines with regard to transfer pricing in the form of administrative regulations. In this regard, the Council of Ministers issued the Cabinet Decision on the Hidden Distribution of Profit by means of Transfer Pricing on 12 December 2007 in the Official Gazette. This Cabinet Decision sets forth guidelines with regard to transfer pricing.

These guidelines contain explanations and definitions of transfer pricing, related parties, the arm’s length principle, controlled transactions, uncontrolled transactions, internal and external comparables, comparability analysis, functional analysis, traditional transactional methods (CUP method, cost-plus method and resale price method), transactional profit methods (profit split method and transactional net margin method), advance pricing agreements (APAs), secondary adjustment for transactions and documentation. The rules contained in these guidelines are also applicable to companies located in FTZs.

3.3. Communiqué on the Hidden Distribution of Profit by means of Transfer Pricing

The Communiqué on the Hidden Distribution of Profit by means of Transfer Pricing was prepared in order to ensure that transfer pricing principles are better understood by taxpayers and that uniform application is achieved. Within this framework, if corporate entities in FTZs purchase or sell goods or services to related parties at a price not in line with the arm’s length principle, the resulting profit will be deemed to be a “hidden profit” fully or partially distributed by means of transfer pricing. Purchases, sales, manufacturing and construction transactions; renting and leasing transactions; borrowing and lending; transactions involving premiums; salaries; and similar payments carried out or paid between parties related to corporate entities in FTZs will all be regarded as the purchase or sale of goods or services in every situation and condition.

The definitions and examples given in the OECD Guidelines are also taken into consideration by the Communiqué. In this regard, key transfer pricing issues, such as the definition of related party, the arm’s length principle, comparability analysis, the arm’s length range, transfer pricing methods, documentation, APAs and secondary adjustments, are explained in detail, and these provisions also apply to the transactions of corporate entities established in FTZs

In formulating the definition of related party, the definition under Art. 9 of the OECD Model Tax Convention is taken into account. Moreover, from the perspective of both personal income taxpayers and corporate income taxpayers, all transactions with persons located in countries or territories that are deemed by the Council of Ministers to have a harmful tax regime will be regarded as transactions made with related parties. Such countries are characterized based on (1) whether the tax system of the country in which the profit is earned provides the same level of taxation as that under the Turkish tax system and (2) whether or not the country allows exchange of information with Turkey.

In defining the arm’s length principle and comparability analysis for Turkish purposes, the OECD Guidelines are used as a starting point. In addition, the Communiqué states that internal comparables must be used first in determining an arm’s length price, only if such price does not exist or is not reliable, may external comparable be used. In addition, where it is not possible to determine a single arm’s length price, the use of an arm’s length range may also be accepted by the tax authorities.

Also in defining transfer pricing methods for Turkish purposes, the OECD Guidelines were used. In this regard, the Communiqué states that traditional transaction-based methods (CUP method, cost-plus method and resale price method), as well as other methods (profit split method and transactional net margin method) may be used. In addition, where the arm’s length price cannot be calculated by applying these methods, the taxpayer may resort to other methods as determined by the taxpayer, in line with the true nature of the transaction.

4. Transfer Pricing Rules in Free Trade Zones

4.1. General

All full and limited liability individuals and corporate entities in Turkey are subject to the transfer pricing rules. The purchase or sale of goods or services made externally or internally with related parties fall within the scope of application. Except some documentation differences, there is no distinction between cross-border transactions and domestic transactions in the application of transfer pricing rules, and no special provision or exception applies for small or medium-sized enterprises, nor for companies located in FTZs.

From 6 February 2004, under the rules applicable to FTZs, companies established in FTZs that have an operating licence, as well as other taxpayers that open a branch in an FTZ and operate in other locations in Turkey, are subject to corporate and personal income tax on the income earned in FTZs, without any limitations. All such individuals and entities in FTZs must maintain books and comply with their other legal obligations on a balance sheet basis under the Tax Procedure Code. This explanation indicates that (except with regard to exclusions such as VAT, corporate income tax on manufacturing income of production companies and customs duties on goods imported from abroad into an FTZ) individual income taxpayers and corporate income taxpayers operating in FTZs have the same tax obligations as parties not doing business in an FTZ.

Although customs and foreign exchange legislation deem these zones to be outside Turkish borders, FTZs are considered to fall within the scope of Turkish tax legislation. Thus, FTZs and the operations of companies in FTZs currently have no special exemptions, as compared to other taxpayers, in the application of transfer pricing rules in Turkey. Save for certain exceptions, transfer pricing provisions under tax law will be applied to all transactions between parties in FTZs and companies outside FTZs, and between Turkish headquarters and branches in FTZs as related parties.

In the case of partially or fully unwarranted distribution of profit by means of transfer pricing, transactions between related parties in an FTZ or branches and entities outside of these zones will be regarded as giving rise to (1) a dividend distribution from an entity or (2) an amount transferred back to the head office from a branch or permanent establishment as at the end of fiscal period. Taxes assessed for both parties involved in a disguised profit distribution will be adjusted accordingly. In order to make such adjustments, the original tax assessment on behalf of the entity that distributes the disguised profit must have been finalized and the taxes already collected.

Consequently, a deemed dividend distribution from an entity or a deemed transfer of an amount back to the head office from a branch or permanent establishment, is assessed as net income and carried out gross income to find out the the amount which is subject to withholding tax and the amount determined in this regard is taxed by depending on the legal situation of recipient of the deemed transfer under Personal or Corporate Income Tax Law. In other words, all individuals and entities are regarded as fully fledged taxpayers in such a case.

Assume that Company A, located in Turkey, sells Product X to Branch B, operating in the Mersin FTZ, for consideration of USD 70,000, but the arm’s length price of Product X is USD 120,000. The legal consequences are as follows. The amount of the deemed dividend distribution of USD 50,000 is regarded as a disallowed expenditure for Company A and is added to its profit for the period by being assessed for additional payment of corporate income tax. This is because USD 50,000 is effectively transferred by Company A to Branch B in the Mersin FTZ.

On the other hand, Branch B has purchased Product X, for consideration of USD 70,000, although the arm’s length price is USD 120,000. A hidden distribution of profit by means of transfer pricing from Company A to Branch B, which is a full-liability taxpayer or resident company under Art. 5 of the Corporate Income Tax Law, is evaluated as a participation exemption and an adjustment is made to the corporate tax return of Branch B.

Meanwhile, if Branch B‘s field of activity is exempt from tax, Branch B is considered to be a non-resident company, and the dividend distribution from Company A to Branch B is assessed as net income and carried out gross income as explained previously. In this case, Branch B is regarded as a non-resident company, and under Art. 30 of the Corporate Income Tax Law, the gross income amount is subject to withholding tax at the rate of 15%, calculated as follows:

Gross income amount:

USD 50,000 ´ 100

———————– = USD 58,824

100 — 15

Dividend withholding tax:

USD 58,824 ´ 15% = USD 8,824

In case of B, to which hidden profit was transferred, is not a branch, but a non-resident taxable person, the amount of hidden profit allocated by Company A is assessed in the same way and the amount calculated as such is, this time, subject to withholding tax at the rate of 15% as for a legal recipient of a dividend under Art. 94 of the Personal Income Tax Law.

4.2. Transactions between headquarters and its branch or permanent establishment in a free trade zone

When one considers the issue in the context of related parties, companies having a branch or permanent establishment in an FTZ, as well as their transactions with each other, fall within the scope of the transfer pricing rules. In addition, individuals and entities operating in FTZs are subject to separate tax registration at the relevant tax office because of legal obligations, causing the branch or permanent establishment involved to have a separate legal personality. Thereby, the branch or permanent establishment is to be regarded as a partnership or associated company for both tax and transfer pricing purposes.

In view of the circumstances, in a transaction between a headquarters and a branch or permanent establishment (including the provision of goods or services, financial services, leasing and compensation), if the arm’s length principle is not taken into account in determining the consideration, it could be said that there is a hidden profit distribution between the related parties. Therefore, the arm’s length principle must be seriously taken into account in transactions between a headquarters and a branch or permanent establishment.

4.3. Applicable transfer pricing rules where there is a tax exemption in a free trade zone

First, taxpayers that obtained an operating licence prior to 6 February 2004 do not fall within the scope of application of the transfer pricing rules, as they are exempted from corporate income tax until the expiry date of their operating licence. After that date, such a taxpayer will have an obligation under the transfer pricing rules.

For example, Company X obtained an operating licence for textile goods in an FTZ on 6 May 2003, and the expiry date of the operating licence is 31 April 2010. Company X normally must apply transfer pricing rules to its transactions with related parties. However, it holds an exemption with regard to the earnings from textile goods until 31 April 2010, and there is no need for Company X to apply transfer pricing rules, even though it engages in transactions with related parties.

Furthermore, manufacturing firms that have obtained a manufacturing licence are not subject to any transfer pricing rules until the end of the financial year in which Turkey obtains full membership in the European Union. Also, manufacturing firms that also have obtained an operating licence after 6 February 2004 are eligible to benefit from corporate income tax exemption, which also entails an exemption from transfer pricing obligations. Transfer pricing rules are not applied because the earnings of such companies from FTZ activities related to the sale of their manufactured goods are exempt from corporate income tax.

The legal basis for this comment is that any income from activities subject to exemption and/or exception in an FTZ may not be asserted to fall within the scope of tax laws. Therefore, these types of transactions between related parties are not seen as appropriate for application of transfer pricing rules. It is not possible to claim that there is a hidden distribution of profit among related parties that are parties to a transaction from an FTZ to another territory in Turkey or abroad, or from the outside an FTZ into an FTZ, because, regardless of the agreed transfer price, there would be no tax avoidance by reason of the tax exemption of those earnings.

5. Documentation and Disclosure Obligations for Companies Located in Free Trade Zones

5.1. General

For purposes of Turkish transfer pricing legislation, company records, charts and other documentation relating to determination of the arm’s length price must be retained within the company as documentary evidence. Consequently, documentation must be maintained for all calculations and circumstances that are related to the method selected and the application of that method.

There is no standard form in which transfer pricing documentation must to be recorded. The company may keep documentation containing evidence in any form it chooses. In addition, there are no special provisions regarding the time period for which transfer pricing records must be retained under the Corporate Tax Code. For general tax purposes, documentation must be retained for a period of five years from the end of the chargeable period to which that documentation relates. On this account, one can say that a company in FTZ must keep its documents for related party transactions for a period of five years from the end of the chargeable period.

When an enquiry has been opened into a return, however the tax authorities may request from a company any documents or other particulars relating to a potential tax liability. If necessary, the tax authorities may issue a written notice requiring the provision of the information within a specified time, but not less than 15 days.

5.2. Level of documentation

For transactions with related parties, all entities operating in FTZs must prepare documentation that may be used as a basis for assessing the transfer prices, in order to determine whether prices and terms of intercompany transactions are at arm’s length. The Cabinet Decision and Communiqué on the Hidden Distribution of Profit by means of Transfer Pricing set forth documentation requirements, namely:

summary information, including a description of the activities, the form of the organization (e.g. headquarters or branch), shareholders, form of capital, economic sector, economic background, legal background of the taxpayer and a description of the related parties (e.g. tax identification number, address and telephone numbers) and information about ownership relations between these parties;
all information related to the functions, risks and assets used;
the price list for the year in which the transaction occurred;
the cost of production for the year in which the transaction occurred;
information about the volume of controlled and uncontrolled transactions in the fiscal period, including transaction dates and invoices, bank slips and similar documents;
copies of agreements between related parties for the fiscal period of transaction;
summaries of financial statements of related parties;
the intercompany pricing policy applied to transactions between related parties;
a statement regarding whether the related parties use different accounting standards and methods, as well as the information related to these standards and methods;
information related to intangible property ownership and payments for intangible rights;
information and documents (internal and/or external comparables, comparability analysis) related to the selection and application of the transfer pricing method used;
detailed information related to the calculation of and assumptions in determining the arm’s length price or profit margin;
if an arm’s length range is determined, the method used in determining that range; and
other documents that are required to determine the arm’s length price.

The tax authorities may request additional information and documentation from a taxpayer when it is considered necessary. If the related information and documents are written in a foreign language, a Turkish translation of such information and documents must be presented to tax authorities.

5.3. Tax return disclosures

Taxpayers in FTZs (except individual taxpayers) that engage in the purchase or sale of goods or services with related parties must prepare and submit their tax returns electronically by enclosing “The Form on Transfer Pricing, Controlled Foreign Companies and Thin Capitalization” by 25 April after the close of the tax year. Also, for transactions with related parties, all entities operating in FTZs must prepare an annual transfer pricing report providing information on related parties, transfer pricing analysis and details of transactions.

Besides during the period in which an APA is applicable, the tax authorities will oversee, by means of a review of the annual report, whether the taxpayer has followed the conditions of the APA and whether the specified conditions are still applicable. If a company in an FTZ has entered into an APA with the tax authorities, an annual report on the APA must be submitted, together with the corporate income tax return each year during which the APA is valid, by 25 April (the last day for filing the corporate tax return). However, a company that has entered into an APA and has submitted an annual APA report for the entire period of the APA has no obligation to submit separately an annual transfer pricing report.

6. Advance Pricing Agreements for Companies Located in Free Trade Zones

For tax purposes, the transfer prices applied in the purchase or sale of goods or services between related parties, as well as methods to be used to compute such prices, may be specified in an agreement with the Ministry of Finance. The method determined by this means will be valid for a maximum of three years, provided that the terms and conditions specified in the APA remain applicable.

Taxpayers have the opportunity to enter into an APA with the tax authorities in order to allow taxpayers to plan their transfer pricing in a predictable manner, without being subject to risk of challenge or penalties. As such, possible disputes are prevented that might otherwise be settled in judicial proceedings. In this context, the transfer pricing method(s) to be determined by the tax authorities and taxpayers will be definite within the framework of the time and the conditions laid down in the APA. However, the term of such an APA may not be longer than three years.

The APA process consists of application, preliminary evaluation and analysis stages. At the end of these stages, the tax authorities may accept or reject the taxpayer’s application. Where an APA is agreed with the taxpayer, the renewal or revision of an existing agreement is possible. In addition, there are situations that may necessitate the cancellation of an existing APA. The information and documents are required in the period of an APA is applied, and an annual report during the term of the APA must be prepared.

Currently, only corporate taxpayers may apply for APAs. In this context, from 1 January 2008 taxpayers registered with the Large Taxpayers’ Tax Office in Istanbul (from 1 January 2009 for all corporate taxpayers) without any exceptions or limits may request an APA from the tax authorities, formally known as the Revenue Administration, with regard to their cross-border transactions with non-resident entities or related parties to determine the transfer pricing method to be applied.

Naturally, taxpayers registered with the Large Taxpayers’ Tax Office in Istanbul and operating in FTZs could enter into an APA from the start of 2008. However, although personal income taxpayers in FTZs fall within the scope of transfer pricing rules, they may not request an APA for either internal or cross-border transactions.

In addition, from 1 January 2009, it is possible to request an APA with regard to transfer pricing for transactions among corporate taxpayers operating in FTZs in Turkey and other corporate taxpayers outside of FTZs, as if domestic transactions were cross-border transactions. This means that there is no obstacle for companies operating in FTZs to enter into an APA with regard to internal and cross-border transactions with related parties. This opportunity has only been given to companies in FTZs even though corporate taxpayers outside FTZs cannot legally request an APA for their domestic transactions.

7. Transfer Pricing Penalties

There are no separate penalties for transfer pricing under Turkish Corporate Income Tax Law; the general rules regarding incorrect returns apply. However, business owners and corporate entities engaged in the purchase or sale of goods or services for consideration other than the arm’s length price, entirely or partly, with related parties are subject to penalties under the Tax Procedure Code. Also, taxpayers that must submit documentation to the tax authorities, but fail to comply with these obligations, are subject to the same penalties under the Tax Procedure Code. All these conditions on transfer pricing penalties are effective for transaction accomplished in FTZs.

8. Conclusion

Art. 6 of the FTZ Law was amended in 2004. Thus, an FTZ is treated as if it was outside the customs area, and in these areas the legal provisions on tariffs and foreign exchange are not applicable. However, with this amendment, Turkish tax law became effective in FTZs, and tax exemptions for resident and non-resident taxpayers were terminated.

Put another way, as a result of the new rules, exemptions in FTZs have been mostly eliminated but exception system is limitedly applied in particular areas in FTZs. For this reason, transfer pricing rules are effective for transactions between related parties, one of which is in an FTZ; or transactions from a headquarters to a branch or permanent establishment; and transactions from a branch or permanent establishment to headquarters, and related parties must fulfil their obligations just as other taxpayers outside FTZs.

Currently, corporate and personal income taxes are applied to all earnings from activities in FTZs and entities, branches, permanent establishments and individuals located in FTZs are treated as ordinary taxpayers. Taxpayers no longer have an exemption from legal obligations with regard to transfer pricing and transactions between related parties except several situations as stated above.

Nevertheless, FTZs in Turkey still retain their attractiveness (especially for foreign investors), as there continues to be a hybrid system in terms of taxation and attracting interest from many investors around the world. This is because goods purchased in Turkey by companies located in an FTZ are exempt from VAT; companies based in an FTZ may keep their products in a designated duty-free storage area for an indefinite period of time; and they may export the products in lots at any time (at the time of export, a customs duty for the lots is paid). Also, energy, water and telephone utilities supplied within a zone are all exempt from special consumption tax and VAT.

Most importantly, production companies in an FTZ are still exempt from both corporate and income taxes, and goods imported from abroad are exempt from customs duties. In addition, there are no restrictions on the age or model of machinery to be imported from abroad, and these items are exempt from both VAT and customs duty.

In terms of transfer pricing, the application of provisions on the hidden distribution of profit by means of transfer pricing as included in Art. 13 of Corporate Tax Law 5520, is regulated by the decision of the Cabinet, and all individual residents, non-resident taxable individuals and corporations fall within the scope of application of this rule. This rule is aimed at causing individuals and corporations that enter into transactions with related parties regarding the sale or purchase of goods or services, to declare their income fully and correctly, as well as to prevent erosion of the tax base by means of transfer pricing.

To put in a nutshell, unfair competition for taxpayers operating outside FTZs, along with considerable tax evasion from practices within FTZs, have triggered a new process, and the tax regime in FTZs has been notably amended. One of these revisions is that transfer pricing rules now also apply in FTZs. In future, FTZs will play a key role, not as tax havens, but in production and direct investment for both Turkish and foreign investors.

(*) This article was published by IBFD.