VAT Debate on Non-Deductible Interest over Thin Capitalization: Should recharacterization of interest on thin cap as dividend be also considered for VAT purposes?

The thin capitalization rules have long remained one of the most debated areas of Turkish corporate income tax legislation. In recent years, however, the discussion has expanded beyond corporate income tax and the VAT treatment of interest arising from thin capitalization has become a significant area of controversy.

The key question is straightforward: can a payment that is deemed to be a dividend for corporate income tax purposes still be regarded as consideration for a financing service for VAT purposes?

Legislative Framework

Pursuant to Article 12 of the Corporate Income Tax Code ("CIT Code"), loans obtained by corporations from their shareholders or related parties and used in the business are regarded as thin capital to the extent that the outstanding balance exceeds three times the company's opening equity at any time during the relevant accounting period.

Under Article 12/7 of the CIT Code, except for foreign exchange differences, interest and similar payments calculated on thin capital are deemed to constitute distributed dividends (or, in the case of non-resident entities, amounts transferred to the head office) as of the last day of the relevant accounting period, both from the perspective of the borrower and the lender.

Furthermore, pursuant to Article 11/1-b of the CIT Code, interest, foreign exchange losses and similar expenses relating to thin capital are non-deductible for corporate income tax purposes.

From a VAT perspective, however, the analysis is based on a different legal framework. Under Article 1 of the VAT Code, supplies of goods and services performed in Türkiye within the scope of commercial, industrial, agricultural or professional activities are subject to VAT. In addition, Article 4 of the VAT Code defines a service as any transaction other than the supply of goods or transactions deemed to constitute supplies.

Accordingly, the central issue is whether the characterization of interest on thin capital as a deemed dividend under the CIT Code should also produce the same legal consequence for VAT purposes.

Article 30/d of the VAT Code and Recent Legislative Amendments

The treatment of interest and foreign exchange differences arising from thin capitalization should be evaluated not only in light of the Corporate Income Tax Code but also within the framework of Article 30/d of the VAT Code.

As is well known, significant amendments were introduced to Article 30/d through Law No. 6728 and subsequently Law No. 7104. These amendments revised the rules governing the deductibility of input VAT incurred on expenses that are non-deductible for income or corporate income tax purposes.

However, the legislator expressly excluded interest and foreign exchange differences arising from thin capitalization from the scope of these amendments.

Despite this legislative change, the Turkish Revenue Administration maintains that the amendments should not be interpreted as meaning that interest and foreign exchange differences arising from thin capitalization fall outside the scope of VAT.

According to the Administration, financing provided to a related party retains its economic nature as a financing service. Accordingly, VAT should continue to be calculated on interest and foreign exchange differences arising from thin capitalization.

Furthermore, the Administration argues that such VAT is not deductible pursuant to Article 30/d of the VAT Code It consistently maintains that the fact that the VAT has either been declared under the reverse-charge mechanism or has been charged by the counterparty and remitted to the Treasury does not create any entitlement to deduct the related input VAT.

The Turkish Revenue Administration's Position

The Turkish Revenue Administration has maintained a consistent approach for many years.

According to the Administration, lending between related parties constitutes the provision of a financing service, and therefore interest arising from such financing should be subject to VAT.

Under this approach, the subsequent reclassification of the loan as thin capital and the treatment of the related interest as a deemed dividend for income or corporate income tax purposes do not alter the nature of the transaction for VAT purposes.

In other words, the Administration considers the transaction to remain a financing service in economic substance, and accordingly regards the related interest as consideration subject to VAT.

Importantly, this approach has remained unchanged even after the amendments made to Article 30/d of the VAT Code.

The Turkish Revenue Administration continues to maintain that:

VAT should be calculated on interest and foreign exchange differences arising from thin capitalization

such VAT is not deductible; and

neither declaration of VAT under the reverse-charge mechanism nor payment of VAT by the counterparty gives rise to any right of deduction

What Does the Council of State Say?

The judicial approach has not been consistent.

Recent case law demonstrates that different chambers of the Council of State have adopted conflicting positions. During the 2023–2024 period, the Third Chamber of the Council of State ruled that interest arising from thin capitalization is subject to VAT, whereas the Ninth Chamber concluded that such interest falls outside the scope of VAT.

On the other hand, in its decisions dated 15 February 2023 (E.2021/499, K.2023/94 and E.2021/263, K.2023/95), the Council of State Tax Chambers Board ("VDDK") held that amounts calculated on thin capital are deemed to constitute dividends as of the end of the accounting period and that dividends do not constitute supplies of goods or services within the meaning of Article 1 of the VAT Code. Accordingly, the VAT assessments were held to be unlawful.

Similarly, the VDDK's decision dated 27 March 2024 (E.2024/207, K.2024/253) also supports the conclusion that interest arising from thin capitalization should not be subject to VAT.

Conversely, certain decisions of the Third Chamber of the Council of State dated 4 April 2023, as well as its decision dated 5 December 2024 (E.2024/5391, K.2024/6480), concluded that such interest remains subject to VAT.

Accordingly, although the VDDK's decisions provide significant support for taxpayers, it cannot yet be said that the controversy has been fully resolved.

The Core of the Debate

The debate extends well beyond the question of whether interest on thin capital is subject to VAT.

The real issue concerns how the same transaction should be legally characterized under different tax laws.

The Turkish Revenue Administration focuses on the economic substance of the transaction and considers it to constitute a financing service.

By contrast, the VDDK emphasizes that once a payment is expressly deemed to be a dividend under the Corporate Income Tax Code, it can no longer be regarded as a supply of goods or services for VAT purposes.
Accordingly, the discussion ultimately revolves around a fundamental question of tax law

Should a legal recharacterization made under one tax law automatically produce consequences under another tax law?

What Does This Mean for Companies in Practice?

The current legal landscape represents a significant tax risk area for companies engaged in intra-group financing arrangements.

Although the VDDK's decisions provide strong legal support for taxpayers, the Turkish Revenue Administration continues to maintain that VAT should be calculated, while conflicting decisions among the chambers of the Council of State remain.

Accordingly, companies involved in financing arrangements that may give rise to thin capitalization should carefully evaluate:

• Their debt-to-equity structure
• Related-party financing arrangements
• Applicable interest rates and contractual terms
• Whether VAT has been properly accounted for; and
• Potential input VAT deduction risks

Furthermore, even where VAT is considered applicable, a separate issue arises as to whether the borrowing company may recover the related input VAT.

The Turkish Revenue Administration maintains that VAT incurred on interest, foreign exchange losses and similar expenses that are non-deductible due to thin capitalization cannot be deducted pursuant to Article 30/d of the VAT Code.

BeOne Commentary

Although the taxpayer-favourable decisions of the Council of State Tax Chambers Board constitute an important legal basis, the Turkish Revenue Administration has not changed its position on this issue.

In particular, even after the amendments introduced to Article 30/d of the VAT Code through Law No. 6728 and Law No. 7104, the Administration has consistently maintained that:

• VAT should be calculated on interest and foreign exchange differences arising from thin capitalization
• The VAT so calculated is not deductible; and
• Neither payment of such VAT by the borrower under the reverse-charge mechanism nor payment by the counterparty creates any right to deduct input VAT

In our view, when the recent legislative amendments are considered together with the unchanged administrative approach, the VAT treatment of interest and foreign exchange differences arising from thin capitalization now presents a greater tax audit and litigation risk than in previous years.

On the other hand, the characterization of a payment as a deemed dividend for corporate income tax purposes does not necessarily lead to the same legal consequence for VAT purposes. Given the distinct legal framework governing VAT and the principles relating to the taxable event, the VAT implications should always be assessed independently. Indeed, this divergence in legal characterization lies at the heart of the current controversy.

Accordingly, we suggest that intra-group financing structures be reviewed not only from a corporate income tax perspective but also by taking into account their VAT implications, input VAT restrictions and potential tax controversy risks.

Conclusion

The debate regarding the VAT treatment of interest arising from thin capitalization forms part of a broader discussion concerning how the same transaction should be interpreted under different tax laws.

The fundamental question therefore remains:

To what extent is it compatible with the fundamental principles of the VAT system and the concept of the taxable event to continue treating a payment that is statutorily deemed to be a dividend for corporate income tax purposes as consideration for a financing service for VAT purposes?

Although recent judicial decisions provide significant support for taxpayers, the Turkish Revenue Administration's position and the divergent case law of the Council of State indicate that this issue is likely to remain a subject of tax audits and judicial proceedings in the foreseeable future.