How to Avoid Double Taxation in Turkey: Leverage DTAAs & Foreign Tax Credits

I. Introduction

With the increasing integration of the global economy, the presence of Turkish businesses in international markets is steadily strengthening. While this situation creates significant opportunities through foreign trade, service provision, and investment activities, it also brings forth complex tax issues such as the inherent risk of double taxation in Turkey for international operations.

Income generated from activities in another country may typically be subject to taxation in the country where it was earned (the “source country”). Simultaneously, as a Turkish company, its global income is generally subject to corporate tax in Turkey (its “residence country”). This situation can lead to the same income being taxed twice, significantly impacting profitability and competitiveness.

To address this, Turkey has concluded Double Taxation Avoidance Agreements (DTAAs) with over 90 countries. These agreements are specifically designed to prevent or reduce double taxation in international trade and to foster competition. DTAAs are bilateral agreements signed between two countries that establish clear rules for how different types of income will be taxed internationally, aiming to make the tax burdens arising from cross-border trade more predictable and fair for individuals and companies involved.

II. How Double Taxation Avoidance Agreements Function: Principles for Tax Relief

Double Taxation Avoidance Agreements are concluded to prevent income from being taxed twice and to establish the fundamental principles to be applied between the contracting states in this regard. The primary function of these agreements is to create a clear framework for how income is treated across international borders.

One of the core principles of DTAAs is the allocation of taxing rights. These agreements determine which of the two contracting states – the country where the income originates (“source country”) or the country where the business is a tax resident (in this case, Turkey, the “residence country”) – has the primary right to tax specific types of income. In some instances, both countries may retain a right to tax; however, the DTAA then clearly specifies the method for eliminating double taxation.

To achieve this elimination, DTAAs generally employ one or a combination of two main methods:

Credit Method: In this common approach, the tax paid in the source country on a particular income is allowed to be credited against the tax liability arising from the same income in the residence country (Turkey). For example, if a Turkish company pays tax on certain income in a foreign country, it can reduce its Turkish corporate tax attributable to this income by the amount of tax already paid abroad. This ensures that the total tax paid does not exceed the higher of the two countries’ tax rates on that income.
Exemption Method: According to this method, certain types of income earned in the source country may be entirely exempt from taxation in the residence country (Turkey). This means that once the income has been taxed in the source country in accordance with the DTAA’s provisions, it will not be taxed again in Turkey.

In addition to preventing double taxation, DTAAs also serve to promote a fair environment in international taxation. They include provisions aimed at preventing tax evasion by facilitating information exchange between tax authorities. Furthermore, DTAAs ensure the principle of non-discrimination, meaning that a Turkish business operating in a foreign country should not be subjected to higher or more burdensome taxation than a local business in that foreign country under similar circumstances.

III. Key Provisions of DTAAs

To effectively utilize DTAAs, businesses must understand their core provisions, which define how various income streams are taxed internationally. These agreements standardize critical concepts that affect a company’s tax obligations by providing a common framework.

3.1. Tax Residency: Definition and Importance

Tax residency is one of the fundamental issues clarified by DTAAs. The agreements lay down clear rules for determining in which country a company is considered a tax resident. The rules regarding which country a company is considered a tax resident are specifically regulated in each DTAA, and their correct analysis is of great importance. This is because this concept holds vital importance for companies with international operations, as it determines which country’s tax laws (and DTAA benefits) will primarily apply to their worldwide income. For companies, residency is generally determined by factors such as the place of effective management.

3.2. Permanent Establishment (PE): The Threshold for Taxation Abroad

Another critical concept is Permanent Establishment (PE). DTAAs define in detail what constitutes a permanent establishment in a foreign country. Generally, a permanent establishment refers to a fixed place of business through which the business of an enterprise is wholly or partly carried on. This definition may include elements such as a branch, an office, a factory, or even a construction site lasting beyond a certain period. The importance of a permanent establishment lies in the fact that if a business is deemed to have a permanent establishment in a foreign country, the profits attributable to this establishment may become taxable in that foreign country.

3.3. Withholding Taxes in Double Taxation Avoidance Agreements

DTAAs also specifically address withholding taxes on various types of international income. In foreign countries without a DTAA, domestic tax regulations might apply withholding tax rates that could be high. However, DTAAs generally set lower, agreed-upon withholding tax rates for common income categories such as:

Dividends: Payments made by a company to its shareholders. DTAAs generally reduce the withholding tax rate applied by the source country on these payments.
Interest: Income derived from loans or debt claims. DTAAs usually limit the withholding tax that the source country can levy on interest payments.
Royalties: Payments for the use of intellectual property, such as patents, copyrights, trademarks, or industrial processes. DTAAs generally specify reduced withholding tax rates for royalties.
Professional or Technical Services: While not always subject to withholding tax, DTAAs may regulate the conditions under which income from these services can be taxed in the source country, often linked to the existence of a permanent establishment or specific time thresholds.

IV. How to Benefit from Double Taxation Avoidance Agreements

For businesses to fully capitalize on the advantages offered by Double Taxation Avoidance Agreements, it is essential to first correctly identify the source of their income, and subsequently determine whether these incomes are subject to a special regulation in the relevant DTAA. In this regard, adopting a proactive approach in matters falling within the scope of DTAAs will be a more appropriate strategy for tax optimization.

4.1. Confirmation of Tax Residency

The primary step in benefiting from DTAA advantages is the determination of tax residency. This is because DTAAs are applicable only to residents of one or both of the contracting states. Therefore, for a Turkish company, documenting its tax residency in Turkey will be the first step to take. This is generally achieved by obtaining a Tax Residency Certificate (TRC) from the Turkish tax authorities. This document can be used as proof of residency for DTAA purposes in the relevant foreign country.

4.2. Following Source Country Requirements

When income is earned in a foreign country, it may generally be subject to that country’s domestic tax legislation and withholding taxes. To benefit from reduced DTAA rates or exemptions, businesses need to understand and follow the source country’s requirements. This situation typically requires the submission of the Turkish Tax Residency Certificate along with other special forms or declarations to the payer in the foreign country before the payment is made. This enables the payer to directly apply the lower withholding tax rate specified in the DTAA, instead of the higher domestic rate.

4.3. Claiming Foreign Tax Credit in Turkey

If withholding tax has been applied in the source country, or if income is taxable in both countries under DTAA provisions, businesses can generally claim a credit for the tax paid in the foreign country in accordance with DTAA provisions. This claim involves correctly declaring the gross foreign income in the Turkish corporate income tax return, and subsequently deducting the tax paid abroad from the Turkish tax liability related to this income. For the relevant credit operation, supporting documents such as evidence of income and the official document of tax paid in the foreign country (e.g., Withholding Tax Certificate or equivalent) must be submitted.

V. Conclusion

Double Taxation Avoidance Agreements serve as strategic tools for businesses operating internationally. The existence of these agreements plays a critical role in fostering cross-border trade and investments by providing a clear and predictable tax environment.

For tax optimization in international business and transactions, a proactive process in line with DTAA provisions is required. Businesses need to actively determine how these agreements apply to their international income streams and operations, and accordingly take the right steps to optimize their tax burden. This is possible by making accurate determinations regarding the conditions for establishing tax residency, the implications of a permanent establishment, and various mechanisms for eliminating double taxation, such as credit and exemption methods.

Further details regarding tax structuring and optimization for Turkish entities can be found here.