Developments in the Transfer Pricing Landscape

1. Introduction

Turkey introduced its first transfer pricing rules in 2007, and the Turkish transfer pricing system was adopted from OECD guidance and based on the arm’s length principle. In the first year of implementation, the Turkish Cabinet determined the transfer pricing procedures based on the authority granted by the Corporate Income Tax Law (CITL) through two decrees. In the same year, the tax authorities also released two communiqués on the hidden distribution of profit by means of transfer pricing.

These communiqués contain explanations and definitions of the arm’s length principle, related parties, controlled transactions, uncontrolled transactions, internal and external comparables, comparability analysis, functional analysis, traditional transactional methods, transactional profit methods, advance pricing agreements (APAs), secondary adjustments for related-party transactions, intra-group services and documentation.

Furthermore, in 2008, transfer pricing rules under article 13 of the CITL were partly amended, such that no transfer pricing adjustment will be imposed in cases where there is no loss of tax revenue to the national treasury as regards domestic transactions.

Although the tax authorities released a circular on the transfer pricing form that is attached electronically to the annual corporate tax return and issued Guidelines on Advance Pricing Agreements with the aim of assisting corporate taxpayers that envisage filing an APA request, in 10 years no significant changes have been experienced from the perspective of transfer pricing rules in Turkey.

Although this has been a fact in Turkey, tax practices have dramatically changed in the last 10 years. OECD and G20 countries initiated the Base Erosion and Profit Shifting (BEPS) Project which brings significant amendments to international tax rules. Thus, the OECD Action Plan on BEPS (BEPS Action Plan) has been a focal point of governments and taxpayers, and has impacted the approaches of tax authorities all over the world. It is obvious that the BEPS Action Plan has already had a significant impact on domestic tax laws of various countries.

As can be appreciated by many, every country will reflect a different impact from the BEPS Action Plan in its tax laws, and some BEPS actions will not be relevant for all countries, especially developing countries. As Turkey is both an OECD and a G20 county, it has been directly involved in the OECD BEPS work and committed to implement outcomes of the BEPS Project in its domestic law. Accordingly, Turkey has drafted BEPS-related regulations. For instance, Turkey is expected to conclude and introduce legislation on the OECD’s three-tiered transfer pricing documentation approach (Action 13).

The Draft Tax Procedure Code also includes provisions on the digital economy (Action 1), treaty shopping (Action 6), transfer pricing penalties (Action 13) and mutual agreement procedures (Action 14). In addition, Turkey is also expected to sign the multilateral instrument (Action 15) which will automatically introduce international standards to Turkish tax treaties.

In connection with the BEPS Action Plan, Turkey took its first step and is fully associated with the transfer pricing landscape. As a result, Law 6728 on the Improvement of the Investment Environment introduced many amendments to the CITL. These include amendments to article 13 which sets forth transfer pricing rules. These amendments concern:

the scope of the definition of related party;
transactional profit methods;
the introduction of a roll-back mechanism for APAs;
the introduction of reduced transfer pricing penalties for taxpayers that fulfil their documentation obligations completely and on time; and
additional authorization to the Cabinet related to transfer pricing procedures.

With the amendments, transfer pricing rules set out in article 13 of the CITL have been expanded and revised. In general, it seems that some uncertainties regarding transfer pricing practices have been removed thanks to these amendments. However, the appearance of new questions in some cases has also been the subject of discussion.

When positive aspects and uncertainties of the new amendment are taken into consideration, the author believes that the changes will directly affect corporate income taxpayers and transfer pricing practices in Turkey. Accordingly, this article addresses the amendments to transfer pricing practices in Turkey and evaluates their impact on corporate income taxpayers.

2. Definition of Related Party for Corporate Income Taxpayers

Article 13 of the CITL defines related parties to include the following:

the company’s own shareholders;
individuals and corporates associated with the shareholders;
individuals and corporates under the control of the company, directly or indirectly, in the management, supervision or capital;
individuals and corporates attached to the company, directly or indirectly, in the management, supervision or capital; and
a shareholder’s spouse and any relatives, including lineage within the third degree relationship by blood or marriage.

In addition, cross-border transactions will be regarded as related-party transactions if performed with parties in foreign jurisdictions or regions that are designated by the Council of Ministers as providing harmful tax regimes. This determination is based on whether taxation of profit in the foreign jurisdiction is at the same level and capacity as Turkish taxation.

Among the amendments, it is stated that at least an interest of 10% in capital, voting or dividend rights is required in order to be considered within the scope of a disguised profit distribution by means of transfer pricing in cases where the relationship is formed, directly or indirectly, through the shareholding.

Under the new regulations, in cases where there is a direct or indirect voting right or dividend right of at least 10% without a relationship through shareholding, the parties are also deemed to be related parties. The 10% threshold is taken into consideration collectively for related parties.

Prior to the amendment, there was no percentage directly or indirectly specified for characterization as a related party in terms of shareholding. Thus, for instance, if a company holds only a single share in another company, it was considered to be a related party. This surely caused serious problems in practice. Taking this into account, the legislature has set a threshold of 10% in association with the relationship through shareholding, as is applied in some other countries. Accordingly, in cases where the relationship occurs directly or indirectly through shareholding, the 10% threshold applies in terms of capital, voting or dividend rights. In this context, for example, if a person holds a 10% or greater share of another company, it will be considered as a related party of that company.

The amendment also stipulates that parties will be considered to be related parties even if there is a direct or indirect right to vote or receive dividends of at least 10% without a capital relationship. For example, if a company is not a shareholder of another company, but has at least a 10% voting right in that company’s management, the two companies will be regarded as related parties.

It is also important to determine whether there is an indirect 10% capital, voting or dividend right from the perspective of shareholding. For example, if Company A holds 50% of the shares of Company B and Company B also holds 20% of Company C, will Company A and Company C be considered as related parties? It is clear that these two companies will be regarded as related parties, namely because Company A indirectly holds 10% (50% x 20%) of the shares of Company C.

On the other hand, assume that Company A owns 30% of Company B’s shares, and Company B holds only 6% of the shares of Company C. In such case, Company A indirectly owns 1.8% (30% x 6%) of Company C, and Company A and Company C will not be regarded as related parties because the share ratio is below the legal threshold of 10% even if the participation of Company A and Company B in Company C is considered in the aggregate (1.8% + 6%= 7.8%).

This change in the definition of the related party is also closely connected to the documentation obligations of corporate taxpayers. Accordingly, transactions with related parties that fall below the required legal threshold of 10% capital, voting or dividend rights will not be evaluated within the scope of documentation requirement.

In this context, transactions with parties having an capital, voting or dividend right directly or indirectly not exceeding 10%, will not be included in the annual transfer pricing report, nor in the transfer pricing form that is to be submitted along with the corporate tax return. Some taxpayers may be positively affected in terms of documentation obligations. However, this will be limited, as the 10% threshold will be considered collectively for related parties. For that reason, the majority of related party transactions will continue to be included in transfer pricing documentation.

Although transfer pricing legislation is silent in this regard, the author believes that the 10% threshold as an independent criterion will likely be considered in benchmarking studies as comparable companies are searched in commercial databases. If this is the case, benchmarking studies might be negatively affected by this threshold of 10%. Thus, the application of the 10% independence criterion will result in the identification of a smaller number of comparable companies in the final set of a benchmarking study.

Nevertheless, the introduction of the 10% threshold is clearly a positive step for the corporate income taxpayers, as the practical problems arising from the direct or indirect capital, voting or dividend rights are now eliminated. This amendment will decrease the documentation obligation and transfer pricing risks of corporate taxpayers, although they might be limited in certain cases.

3. Transactional Profit Methods

Article 13 of the CITL did not previously regulate transactional profit methods, but covered only so-called “traditional transaction methods”, namely the comparable uncontrolled price method, cost-plus method and resale price method. However, transactional profit methods consisting of the transactional net margin method and profit split method were included in Cabinet Decree 2007/12888 and General Communiqué 1 on Disguised Profit Distribution by means of Transfer Pricing. This meant that the tax authorities recognized these methods in practice, even though the CITL did not regulate them.

In the author’s experience, transactional profit methods, especially the transactional net margin method, have been heavily used by Turkish taxpayers due to difficulties in the application of traditional transaction methods due to, for example, a lack of comparables. With the new amendment, these two methods are also included in article 13 of the CITL. As stated in the preamble of the Amending Law, the purpose of including the transactional net margin method and profit split method in article 13 of the CITL is to ensure that the underlying law is aligned with the amendments to the OECD Transfer Pricing Guidelines (2010) (OECD Guidelines).

Before the amendment, traditional transaction methods prevailed over transactional profit methods, and this was openly stated in General Communiqué 1. In view of the new amendment, the hierarchy among the traditional methods and transactional methods has been removed. Thus, it is reflected in the CITL that the most appropriate method based on the nature of the transaction will be applied for controlled transactions. However, based on the author’s understanding, the traditional transaction methods will continue to prevail over transactional profit methods where traditional transaction methods and transactional profit methods are equally applicable, as stated in the OECD Guidelines.

The most significant impact of these changes on companies will be seen in the challenges that are raised in transfer pricing examinations by tax auditors. In some cases, tax auditors applied traditional transaction methods without providing any publicly available comparables, including secret comparables, and their main claim was that the taxpayer, as indicated by the transfer pricing regulations in place, should have used a traditional transaction method, as such methods prevail over transactional profit methods. Accordingly, such challenges raised by tax auditors because of the use of transactional profit methods instead of traditional transaction methods, will be reduced as a consequence of this revision.

The author believes that another outcome of this amendment on related-party transactions of companies is that transactional profit methods will be used more often than in the past, as some taxpayers deliberately did not select transactional profit methods in an effort to reduce the risk of potential challenges by the tax authorities. However, transactional profit methods should not be directly selected as the best method for particular related-party transactions unless traditional transaction methods are rejected based on appropriate reasons; for example, comparability conditions are not met under such methods. Therefore, it is advisable that taxpayers initially review whether traditional transaction methods are equally applicable with transactional profit methods. If not, the transactional profit methods may be selected as the most appropriate method for the related-party transaction in question.

4. Roll-Back Mechanism for Advance Pricing Agreements

Advance Pricing Agreements (APAs) became possible in Turkey with the CITL that came into force on 1 January 2007. Article 13 of the CITL stipulates that the methods to be used to compute transfer prices may be determined upon agreement with the Turkish tax authorities; a method determined by these means will be valid for a maximum of three years, provided that the terms and conditions set forth in the APA do not change.

Although it was possible to sign an APA for future fiscal years, article 13 did not legally allow the tax authorities to cover previous periods under an APA on a retrospective basis. Nevertheless, in some APA cases the tax authorities requested that the taxpayer submit a correction declaration for the adjustment of previous years. This generally required an upward adjustment by the APA applicant and resulted in the payment of additional taxes.

Applicants generally opted to adjust their previous tax declarations so that negotiations would not be interrupted and an APA could be secured to cover future years.

Thus, the previous rules prevented corporate taxpayers from enforcing APAs for past periods, and from the perspective of the tax authorities there was no legal basis to retroactively sign an APA. Also, it has been observed that this situation caused some problems, especially in terms of implementation of APAs, and it was understood that the desired result in certain cases could not be completely obtained from the agreement. In order to eliminate the difficulties in this regard, article 13 was amended to introduce new provisions such that it is now possible to apply an APA to previous tax years.

However, under the new provisions, the following conditions must be met for the application of the method determined under an APA to past periods;

the past tax years are within the statute of limitations; and
the repentance and correction provisions of the Tax Procedure Code are applicable to the case.

The first of these two conditions indicates that APAs may be retroactively applied to the prior five years, which is the statute of limitations in Turkey. Furthermore, an APA may be agreed upon for three years going forward under the CITL provisions. Accordingly, an APA may cover a total of eight years, with a retrospective application period of five years. As a result of the amendment, the Cabinet is also authorized to extend the three-year period to five years, and if the Cabinet exercises this authority, the period of an APA would be up to 10 years (five prior years and five future years). Regarding the second condition, in order to benefit from the repentance and correction provisions of the Tax Procedure Code, there may not be a complaint about the related taxpayer, and a tax examination may not have been initiated by the tax authorities.

However, any taxes paid by the taxpayer will not be refunded if the agreed transfer pricing method under the APA is applied to past taxation periods and this results in a reduced taxation for the applicant company. For example, where a company has a profit margin of 8% on the total cost (full cost mark-up) as a contract manufacturer in the previous period, if the profitability rate is set at 5% by an APA, the prior tax paid will not be refunded to the taxpayer due to the excess profitability of 3%, even if the APA is applied retroactively. However, in the opposite situation, if a company has a profit margin of 5% on the total cost as a contract manufacturer in prior periods, if the profitability rate were determined as 8% by an APA, would the related taxpayer be requested to remit the unpaid tax due to the 3% lower profitability in the case of retrospective application of the agreement?

Based on the author’s experience with earlier APAs, the answer to this question is that there will be a request that the taxpayer submit a retroactive correction statement. The new rule also confirms this situation, as it refers to repentance and correction provisions of the Tax Procedure Code. Therefore, it would be beneficial for APA applicants to make a detailed analysis of the impact of an APA application for prior years before requesting a retrospective APA, as such a request might result in an additional tax burden for the APA applicant.

To the best of the author’s knowledge, the tax authorities have, to date, signed 10 unilateral APAs and one bilateral APA since the introduction of the APA programme in 2008. Furthermore, more than 10 APA applications are now pending, including two bilateral APAs. It is the author’s belief that the number of APA applications will gradually increase due to the BEPS implementations in future years. Thus, introduction of the roll-back mechanism for APAs will be supportive of the APA programme in Turkey and will attract more APA requests as compared with the previous period.

5. Introduction of Reduced Transfer Pricing Penalty

Under Turkish law, there are no special penalties applicable only to transfer pricing cases. However, personal income taxpayers and corporate income taxpayers that have purchased from, or sold goods or services to related parties at a price not in line with the arm’s length principle, either entirely or partly, are subject to the penalty for loss of tax set out in the Tax Procedure Code.

Also, those taxpayers that do not submit documents to the tax authorities in compliance with these obligations, are further subject to additional penalties under the Tax Procedure Code. However, the amount of such additional penalties applicable to non-compliance with the documentation requirement is currently low.

The new amendment introduces a 50% reduction in tax penalty charges for taxpayers that fulfil transfer pricing documentation obligations completely and on time. Thus, the criticisms raised by taxpayers and the business community in Turkey since the first introduction of documentation obligations in 2007 have been taken into consideration, and a distinction has been made between taxpayers that fulfil their duties completely and on time, and taxpayers that never fulfil their obligations or fail entirely. In this way, taxpayers that fulfil their transfer pricing documentation obligations completely and on time are subject to tax penalties at a reduced rate of 50%, even if they are faced with a tax loss penalty.

In the author’s opinion, taking a step in this direction will have a positive impact on companies and motivate them to comply with their transfer pricing documentation obligations. For this reason, taxpayers that fulfil their transfer pricing documentation obligations completely and on time are entitled to benefit from reduced tax penalties even if their transfer prices are not at arm’s length, which results in the distribution of disguised profit by means of transfer pricing.

The introduction of such provisions in the CITL indicates that transfer pricing documentation has become even more important. Therefore, it is beneficial for companies to complete their transfer pricing documentation obligations as soon as possible for all past years within the statute of limitations. On the other hand, the new provisions under article 13 of the CITL do not specify what is meant by “full and timely fulfilment of statutory transfer pricing documentation obligations”. The author anticipates that details in this regard will be provided through either the new Cabinet Decree or the Communiqué on Transfer Pricing.

Although it is presently not entirely clear, the author’s experience indicates that transfer pricing documentation such as an annual transfer pricing report (local file) which does not include a detailed analysis of related party transactions and comparables studies, does not meet the transfer pricing documentation requirements, and such documentation is not likely to be regarded as fully compliant with the law. Therefore, documentation with detailed analysis and benchmarking studies has become even more critical following the latest amendments.

In addition, Turkey released draft transfer pricing documentation rules in line with BEPS Action 13, bringing into effect the OECD’s three-tiered documentation approach. It is expected that these changes will be finalized in 2017. New documentation obligations might be applicable as from 2017. Thus, it is author’s recommendation that taxpayers consider upcoming changes to their documentation obligations as well.

6. Additional Authorization to Turkish Cabinet Related to Transfer Pricing Procedures

Article 13 of the CITL authorized the Cabinet to determine transfer pricing procedures. The Cabinet used this authorization in 2007 and 2008, and specified those procedures. As new regulations also brought new provisions in article 13 of the CITL, the following additional authorizations have been granted to the Cabinet under the amending law:

decreasing, collectively or individually, of the 10% condition to 1%, or increasing to 25% for capital, voting or dividend rights in order to be regarded as a related party in the case of real persons, corporates or direct or indirect ownership or acquisition of shares;
increasing the duration of APAs up to five years;
imposing transfer pricing documentation obligations and the obligation to include information on the activities of related parties abroad within the scope of documentation requirements in accordance with international agreements; and
determining the principles and procedures for the international exchange of information with other countries within the framework of international agreements.

Among the authorizations granted to the Cabinet, the most remarkable one is related to transfer pricing documentation obligations and exchange of information. In this context, it is understood that with the amendments to the law, the legal basis for the OECD’s three-tiered documentation (including country-by-county reporting) has been established.

This indicates that the expected Cabinet Decree will also amend the existing Decrees and will introduce three-tiered documentation into Turkish transfer pricing law. Furthermore, the Cabinet Decree will specify the procedure for the exchange of country-by-county reports with other countries. With the stated Decree, Turkey will be able fulfil its commitment to the tree-tiered documentation system (master file, local file and country-by-country report) adopted by Action 13 within the scope of the OECD BEPS Project.

As mentioned, the tax authorities also released a draft General Communiqué 3 on Transfer Pricing on 16 March 2016. The author believes that the final version of the General Communiqué will provide more details on the new transfer pricing documentation obligations and exchange of country-by-country reports. The author also predicts, based on amendments, that the Cabinet Decision and General Communiqué on Transfer Pricing will be published in 2017 and will introduce new transfer pricing documentation obligations in accordance with the OECD’s tree-tiered documentation system.

7. Conclusion

Ten years’ implementation of transfer pricing rules in Turkey required modification of the existing rules. In fact, changes in Turkish transfer pricing rules reflect the developments and needs in the transfer pricing landscape of Turkey. The amendments of the scope of the definition of related party and transfer pricing methods were introduced to resolve the issues observed in practice. The introduction of the roll-back mechanism for APAs was implemented in order to advance current practices, whereas reduced transfer pricing penalties are offered to motivate taxpayers to comply with transfer pricing documentation obligations.

Some of the amendments to article 13 of the CITL, which governs transfer pricing rules, are directly associated with the BEPS Action Plan. Actually, these changes are a first step in the adoption of the BEPS Action Plan into Turkish domestic tax law. Within this framework, in relation to amendments, there is a draft regulation introducing the OECD’s three-tiered documentation approach, i.e. the master file, local file and country-by-country report.

Under the draft legislation, a Turkish corporate taxpayer that is part of a multinational enterprise group and has both assets and net sales revenue amounting to at least TRY 250 million must prepare a master file by the end of the second month following the submission of the corporate tax declaration.

Local file requirements are also revised as follows by the draft legislation:

Transfer Pricing Annual Report: large taxpayers conducting domestic and cross-border related-party transactions, as well as other taxpayers carrying out cross-border related-party transactions, must prepare an annual transfer pricing report by the due date for the corporate tax return. This requirement is already in place and no substantial changes are expected;
Annual Transfer Pricing Form – Annex 2: all corporate income taxpayers with intercompany transactions exceeding TRY 30,000 must electronically submit their Annual Transfer Pricing Form by the due date for the corporate tax return. This form is already in place; there is only an amendment of the transaction threshold (which is currently nil); and
Transaction Based Transfer Pricing Form – Annex 4: corporate income taxpayers with assets and net sales revenue amounting to at least TRY 100 million must prepare a new transfer pricing form which requires quite detailed information, and must submit it electronically by the last day of the second month following submission of the corporate income tax return.

In addition, an ultimate parent company resident in Turkey must file a country-by-country report if its consolidated group revenue amounts to at least TRY 2.037 million (equivalent to EUR 750 million as at January 2015). It is highly anticipated that the draft legislation will be enacted in 2017 and will be applicable as from 1 January 2017.

On the other hand, the Draft Tax Procedure Code introduces transfer pricing specific penalties, under which a TRY 50,000 (approximately EUR 12,750) tax penalty that will be applicable if no documentation is available, no documentation is submitted or documentation does not meet legal requirements. This TRY 50,000 tax penalty will be also applicable if transfer pricing forms (including the country-by-country report) are not electronically submitted or if they contain misleading information.

Ultimately, it is significant that some of the uncertainties regarding transfer pricing implementation have been removed by amendments. Furthermore, these changes will directly affect corporate income taxpayers and transfer pricing practices in Turkey. They also form a basis for the introduction of BEPS-related rules in the near future. In light of these developments, the author believes that amendments to transfer pricing rules will generally bring about positive outcomes from a taxpayer perspective.

(*) This article was published by IBFD.