Controversial Issues and Recent Judicial Decisions on the Cash Capital Increase Interest Deduction

1. Introduction

Article 10(1)(ı) of Corporate Tax Law No. 5520 (“CTL”) sets out the interest deduction incentive for cash capital increases, providing a significant tax advantage to encourage corporations to strengthen their equity structures. Under this provision, which entered into force on 1 July 2015, corporations, excluding those operating in the finance, banking and insurance sectors and state economic enterprises, may deduct from their corporate tax base 50% of the amount calculated by reference to the weighted annual average interest rate applied by banks to Türkiye lira commercial loans, as announced by the Central Bank of the Republic of Türkiye for the relevant fiscal year. For capital increases carried out as of 26 October 2021, the portion funded by cash brought in from abroad is subject to an enhanced rate of 75%.

Having been in force for over a decade, this corporate tax deduction has given rise to numerous disputes between the tax authority and taxpayers on a variety of issues, and these disputes have been brought before the courts. The disagreements between the tax authority and taxpayers generally center on: capital increases made from the “331 Due to Shareholders” account and the “529 Other Share Capital Reserves” account; whether share premium amounts may be included in the deduction base; the purpose for which the increased capital is used; and whether a capital reduction carried out for balance sheet clean-up purposes pursuant to Article 376 of Turkish Commercial Code No. 6102 (“TCC”) constitutes a bar to the deduction. This article examines these contested issues in light of the arguments advanced by taxpayers and the tax authority, as well as recent judicial precedents.

1. Use of Payables to Shareholders in Capital Increases

Capital increases affected by transferring the company’s debt to its shareholders into equity are a commonly preferred method in practice. In such a transaction, the company adds to its capital the cash amount recorded in its balance sheet under “331 Due to Shareholders.” From an accounting perspective, the economic outcome is not materially different from an ordinary cash capital increase: in both cases the company’s equity is strengthened, and the improvement in financial structure that the legislature sought to incentivize is actually achieved.

Notwithstanding this, the tax authority characterizes such an increase as an intra-balance sheet offset between accounts, and on the ground that no new cash inflow is generated for the company, takes the position that the interest deduction is unavailable. Taxpayers, however, contend that this transaction amounts to a shareholder forgoing the repayment of a debt owed by the company and converting that amount into equity, rather than a mere netting of accounting entries. Indeed, in capital increases affected in this manner, the company’s liability is directly reduced and its equity is strengthened.

In the disputes brought before the courts by taxpayers, the chambers of the Council had previously ruled in favor of taxpayers. However, the Council of State Plenary Session of the Tax Law Chambers has since held that the interest deduction is not available for capital increases made from the payables to shareholders account.

The courts’ position changes, however, where instead of capitalizing the payables directly, a fresh cash injection is first made to affect the capital increase and the debt to the shareholder is thereafter repaid separately. The Council of State Third Chamber has ruled that where a company first carries out a cash capital increase and subsequently repays its debt to its shareholder, there is no impediment to the company claiming the interest deduction. In that decision, the capital increase and the debt repayment were characterized as two independent and separate transactions.

This approach, however, gives rise to an inconsistency in practice. The economic outcome is identical in both cases: the company is relieved of its debt to the shareholder and the company’s equity is strengthened. The courts’ treatment of two economically equivalent transactions differently based solely on the order in which they are carried out does no more than compel taxpayers to adopt a formalistic arrangement. Effecting the capital increase first and then repaying the debt, rather than capitalizing the debt directly, is simply a different form of the same underlying economic transaction. Given that the legislative purpose of the provision is to strengthen companies’ financial structures, there are views to the effect that both forms of capital increase, each serving that same purpose, should fall within the scope of the interest deduction.

1. The Time Restriction on the Capitalization of Capital Reserves

Amounts deposited by shareholders into the company’s bank account in advance, for the purpose of a future capital increase, are characterized as capital advances and recorded in the balance sheet under “529 Other Share Capital Reserves.” Under the section of Corporate Tax General Communiqué Serial No. 1 headed “10.6.3.1.1. Status of Capital Advances,” the tax authority requires, as a condition for these amounts to qualify for the interest deduction, that the resolution to increase capital be registered with the trade registry by the end of the fiscal year in which the capital advance was deposited into the bank account.

This restriction produces unequal and inequitable results in practice. For example, a company that deposits a capital advance into its bank account in January and registers the capital increase in December may benefit from the deduction, whereas a company that deposits the advance in December but registers the increase in January, i.e., at the beginning of the following fiscal year, is denied that benefit. Yet both companies have in substance carried out the same transaction, making the distinction an arbitrary one.

There is no condition under the CTL requiring that a capital advance be capitalized within the same fiscal year. This restriction was introduced solely by way of a Communiqué and narrows the scope of the legislative incentive in a manner that exceeds and runs contrary to its purpose. Given the heavy workload at trade registry directorates, the inability to complete registration within the same fiscal year, particularly near the year-end, is a matter entirely beyond the taxpayer’s control.

Indeed, the Council of State Ninth Chamber has ruled in favor of taxpayers on this issue, holding that a right conferred by statute cannot be restricted by a Communiqué in a manner not contemplated by that statute. However, in a 2022 decision, the Council of State Fourth Chamber held that capital advances remitted to a company by a shareholder in 2014 and 2015 for the purpose of capitalization, which were actually capitalized in 2016, could not benefit from the deduction.

1. Whether Share Premiums May Be Included in the Deduction Base

A share premium arises where a company issues shares at a price above their nominal value during a capital increase. Its primary purpose is to prevent the dilution of capital. In order to protect the value of existing shareholders’ interests, shares issued to new shareholders or in certain capital increases must be issued at their actual value, and the excess over nominal value is recorded as a share premium under “520 Share Issue Premiums,” a separate equity item in the balance sheet.

In substance, a share premium may be regarded as a capital element that brings fresh cash into the company from outside; it is not an income or profit item but directly strengthens the company’s equity structure, which is precisely the legislative aim.

The tax authority, however, takes the view that share premiums cannot be included in the interest deduction base, on the grounds that they are not the amount registered as a capital increase and are recorded as a separate equity item in the balance sheet.

Although conflicting decisions have been issued over the years on this long-disputed question, the Council of State Third Chamber recently rendered a decision in favor of the taxpayer overturning the lower court’s ruling. In that decision, it was stated that a share premium does not constitute income but rather has the nature of a legal reserve, and, emphasizing that it is a capital element not subject to taxation, the Chamber concluded that such amounts may be included in the interest deduction base. The court of appeal, however, declined to follow this reversal decision of the Council of State Third Chamber and adhered to its earlier ruling. Accordingly, the final word on this matter rests with the Council of State Plenary Session of the Tax Law Chambers.

1. The Restriction Based on the Nature of Activities

Council of Ministers Decree No. 2015/7910 provides that companies whose income consists of 25% or more of passive-type revenues, such as interest, dividends, rent, license fees and proceeds from the sale of securities, derived otherwise than through commercial, agricultural or professional activities conducted with capital, organization and personnel commensurate with the company’s business, may not benefit from this corporate tax deduction.

This restriction, however, produces inequitable results for certain sectors in practice. Companies operating shopping centers, whose core business activity is real estate investment and the generation of rental income, are denied this deduction because the overwhelming majority of their revenues consists of rental income. Yet for these companies, rental income is not passive in nature but rather flows directly from their primary business activity. Imposing a blanket restriction of this kind, rather than conducting a case-by-case examination for each company, produces inequitable outcomes for certain taxpayers and causes genuine loss of rights.

Accordingly, the Council of State Third Chamber, in a recent decision rendered in favor of the taxpayer, held that the relevant Council of Ministers Decree was intended for taxpayers earning income outside their stated activities, and that the rental income earned by the claimant company, one of whose stated objects in its articles of association was to earn rental income, should be characterized not as passive income but as commercial profit, entitling the company to benefit from the deduction.

1. Capital Reduction in the Context of Technical Insolvency

Article 10(1)(ı) of the CTL provides that where a capital reduction is carried out following a capital increase, the reduced amount shall not be considered in the deduction calculation. The legislative purpose behind this restriction is evidently to prevent companies from making a cash capital increase to benefit from the interest deduction and subsequently returning that amount to shareholders through a capital reduction.

However, companies may carry out a simultaneous capital reduction and increase under Article 376 of the TCC, which governs the remedy of technical insolvency. A capital reduction carried out for this purpose is in substance a balance sheet clean-up exercise: accumulated losses are offset against capital so as to bring the balance sheet into alignment with the company’s actual financial position, and the subsequent cash capital increase effectively strengthens the company’s financial structure. No cash is paid out to shareholders in this process; the reduction is purely an intra-balance sheet adjustment.

Taxpayers accordingly argue that a capital reduction carried out in the context of technical insolvency should not be placed in the same category as the situation the legislature sought to prevent, namely, the repayment of increased capital to shareholders. The core argument is that this type of capital reduction, which is entirely notional in character and amounts to no more than reclassifying accumulated losses out of the capital line so as to present a more effective and accurate balance sheet, should not adversely affect the corporate tax deduction. However, the Council of State Third Chamber currently rules against taxpayers on this issue, concluding that the amount of a capital reduction carried out in this manner must be excluded from the corporate tax deduction calculation.

1. The Five Fiscal Year Limitation and the Vested Rights Debate

It will be recalled that when the cash capital increase interest deduction was introduced in 2015, there was no temporal restriction. Provided no capital reduction was made, companies could benefit from the deduction indefinitely, on a fiscal year-by-fiscal year basis. This changed with Law No. 7417, which entered into force on 5 July 2022, limiting the period during which the deduction may be claimed to a total of five fiscal years, including the fiscal year in which the capital increase resolution is registered.

A transitional arrangement was also introduced by Provisional Article 15(13) of the CTL, inserted by the same Law, for companies that had affected a capital increase or been newly incorporated before 5 July 2022. Under this arrangement, those taxpayers may continue to benefit from the deduction for five fiscal years including the 2022 fiscal year, meaning that for such companies, the 2026 fiscal year will be the last year in which the deduction may be claimed.

A significant number of companies that carried out capital increases prior to 5 July 2022 did so in the expectation of an open-ended incentive and structured their financial planning accordingly. Whether the five-year limitation introduced retrospectively has infringed the vested rights of those taxpayers and the extent to which it is compatible with the rule of law principle enshrined in Article 2 of the Constitution of the Republic of Türkiye remains an important and unanswered question.

The matter has not yet been crystallized into active litigation. It is, however, anticipated that in the corporate tax returns for the 2027 fiscal year, taxpayers will assert that they remain entitled to continue claiming the deduction indefinitely, and that those claims will be brought before the courts.

1. Conclusion

The cash capital increase interest deduction has been part of Türkiye’s tax law for over a decade. The disputes that have arisen in practice under this corporate tax deduction, introduced with the fundamental aim of strengthening companies’ equity structures, demonstrate that the normative framework has yet to achieve sufficient clarity.

Given that judicial precedents have not yet settled into a consistent line and that the tax authority takes a decidedly narrow view of this deduction, taxpayers would be well advised, on each of the disputed issues examined above, to file their corporate tax returns under reservation and bring the matter before the courts, so as to avoid also being exposed to tax penalties.

Att. Ahmet Hakan Mirza