The Cash Capital Deduction mechanism, integrated into our tax system with the aim of strengthening the capital structures of corporations, encouraging businesses to finance themselves with equity rather than debt, and thereby enhancing financial resilience on a macroeconomic scale, has gained a legal basis through the addition of subparagraph (ı) to paragraph 1 of Article 10 of the Corporate Income Tax Law No. 5520 (“CITL”). Under this provision, corporations may deduct a certain portion of the amount calculated based on the commercial loan interest rates announced by the Central Bank of the Republic of Turkey (“CBRT”) from their corporate income tax base, with respect to the amounts of capital they have increased in cash and registered with the Commercial Registry.
However, the legislature did not establish this right to a deduction as an absolute freedom; rather, it granted the executive branch the authority to impose certain restrictions to ensure that capital is genuinely directed toward production, employment, and the commercial cycle. Pursuant to Council of Ministers Decision No. 2015/7910, issued under this authority, the deduction rate has been set at 0% (zero) for corporations whose total income for the relevant fiscal period consists of 25% or more of passive income.
In practice, the fundamental issue that frequently pits the tax authority against taxpayers and leads to legal disputes is precisely whether foreign exchange gains arising from companies’ commercial activities fall within the scope of passive income—to which the legislature has applied a 0% deduction rate—or not.
The Distinction Between Passive Income and Active Business Income in Tax Law
When evaluating whether income is eligible for a deduction based on cash capital increases or the cash portion of paid-in capital in newly established capital companies, it is necessary to first examine the wording and purpose of Article 10, Paragraph 1, Subparagraph (ı) of the CITL to determine whether the income constitutes active profit or passive income. The legislature has defined the types of income that restrict the right to a deduction as follows:
“…passive-natured income such as interest, profit shares, rent, license fees, and income from the sale of securities that are not within the scope of the corporation’s principal activity…”
As is clearly evident from this definition in the text of the law, the foundational and essential element for classifying income as passive in tax law is that the income does not fall within the scope of the entity’s principal activity.
In tax law doctrine, passive income is defined as income earned by a company as a result of investing its idle capital solely in financial markets, without conducting active commercial operations, expending actual labor, or assuming commercial risk. The primary reason the legislature explicitly lists interest, dividends, and partnership profits in the text of the law is precisely this rentier nature.
The Legal Nature of Exchange Rate Differences Arising from Commercial Receivables and Liabilities
Due to the dynamics of commercial life, companies in any sector may hold receivables denominated in foreign currency, incur liabilities, or make commercial advance payments based on commercial agreements within the scope of their core activities.
Pursuant to Article 280 of the Tax Procedure Code No. 213 (“VUK”), it is a legal requirement that these foreign currency-denominated assets and liabilities be mandatorily revalued at the end of interim tax and accounting periods using either market rates or CBRT exchange rates. As a result of this mandatory revaluation, exchange rate gains arising on balance sheets are generally classified as passive income in administrative practice—based on a broad interpretation of the word “such as” in the Corporate Income Tax Law—and taxpayers’ statutory deduction rights are not applied based on a 0% rate.
However, the exchange rate difference arising from mandatory revaluation during the performance of a commercial transaction within the scope of the business’s principal activity stems not from the speculative investment of idle funds, but directly from the active commercial operation itself. For this reason, the exchange rate difference arising from the taxpayer’s principal commercial activity is not an independent interest income but an inseparable and organic derivative of the primary commercial profit.
Assessment in Light of the Principle of Legality of Taxation and Judicial Precedents
The principle of the legality of taxation, which forms the constitutional foundation of tax law, requires that deductions, exemptions, and exclusions related to tax liability be regulated by law, and that their boundaries be clearly defined. In practice, when administrative authorities expand the scope of the law to the taxpayer’s disadvantage through interpretation—based on the use of the phrase “such as”—despite the absence of an explicit reference to exchange rate differences in the statutory text, this undermines the principle of legal certainty.
When the administration acts as a legislator and establishes new rules, this is considered a violation of the right to property and the principle of legality in the case law of the Constitutional Court (“AYM”). Indeed, in a decision defining the limits of the administration’s regulatory authority, the AYM established the following fundamental principle:
“In cases where it is not possible to regulate every matter in its entirety and in full detail by law, the administration may be granted the authority to issue regulatory acts, provided that the framework is defined and such acts remain within those limits. However, regulations issued by the executive branch should not be aimed at determining the fundamental elements of taxation… It is contrary to the principle of legality for the administration to determine the scope of exemptions in tax laws for which no minimum or maximum limits are specified through its own actions.” (Constitutional Court Decision No. 2016/3675 dated November 3, 2020)
In addition to this constitutional protection, the aspect of the issue relating to the distinction between passive income and active income has also been tied to a clear criterion in the decisions of the Council of the Tax Litigation Chambers of the Council of State; it has been ruled that when determining whether an income is passive or active, one must look not only at the name of the transaction but also at its underlying commercial nature. Indeed, pursuant to the Decision of Tax Law Divisions Assembly of the Council of State dated February 15, 2023, No. 2021/222 E., 2023/96 K.;
“The resolution of the dispute depends on determining whether a revenue is of a passive or active nature; in this assessment, it is mandatory to consider not the form of the transaction, but the nature of the activity and the connection between the revenue and the business’s primary activity.”
It has been established in case law that exchange rate gains arising from valuations conducted as a result of legal obligations—based on commercial contracts or commercial advances within the scope of a business’s primary activities—cannot be legally or practically classified as non-operating passive income solely based on their accounting designation.
Indeed, the Council of State’s established case law on similar matters also supports this view, and in all decisions evaluating foreign exchange gains, it has been ruled that such gains must be recognized as an element of the business from which they are derived and subject to the same rules:
In the relevant section of the Council of State’s Fourth Chamber’s decision No. E.2002/2218 and K.2002/2974:
“Article 19 of the Tax Procedure Code stipulates that a tax claim arises upon the occurrence of the event or the completion of the legal situation to which tax laws attach the tax; and Article 42 of the Income Tax Code further provides that, it is established as a rule that in construction and repair projects spanning more than one calendar year, profit or loss shall be definitively determined in the year the project is completed, with the entire amount treated as income for that year and reported on the tax return for that year; and since, pursuant to the aforementioned provisions, the tax liability for construction and repair projects spanning multiple years arises in the year the project is completed, the interest income and exchange rate differences earned by the liable entity—which were held in repo accounts, foreign currency deposit accounts and by purchasing government bonds; and since the interest income and exchange rate differences derived therefrom were not obtained through a separate organizational structure outside the construction project, and since these revenues will affect the profit or loss upon completion of the project, they cannot be classified as income derived from another source…”
In the relevant section of the Council of State Fourth Chamber’s decision No. 2012/2357 E. and 2015/982 K.;
“…since the interest and repo income generated from the investment of payments earned by the plaintiff company in connection with its multi-year construction project in banks will affect profit or loss upon completion of the project, such income must be treated as a component of the construction project’s revenue, linked to the construction account, and included in the tax return as of the project’s completion date, and thus subject to taxation…”
These consistent judicial precedents clearly demonstrate that: exchange rate differences arising from income earned or commercial advances made within the scope of commercial activities are part of the main activity, unless they are derived from a separate commercial organization. If the business’s primary activity is active trade, the exchange rate difference—which is a monetary extension of that trade—is also of an active nature and should not be subject to the limitations under Article 10 of the Corporate Income Tax Law.
Conclusion
The purpose of the restriction on passive income related to the cash capital deduction under the Corporate Income Tax Law is to limit structures that focus entirely on generating rentier income in financial markets, rather than active commercial enterprises that provide production, investment, and employment.
Exchange rate gains arising from the valuation—as required by law—of amounts collected or held by companies in connection with contracts related to their core business activities, commercial receivables and payables, or foreign currency advance transactions cannot legally be classified as passive interest income. The authorities’ practice of treating this item—which is not explicitly listed in the text of the provision—as passive income solely through analogy and expansive interpretation, thereby eliminating the right to a deduction, constitutes a violation of both the constitutional principle of the legality of taxation and established judicial precedents.
Therefore, it is of great importance for companies whose financial statements contain a high proportion of commercial exchange rate gains to carefully analyze the structure of their commercial operations and the causal link between such income and their principal business activities when claiming the cash capital deduction, and to take steps to protect their legal rights by invoking the right to file a reservation of rights when necessary, in order to address any potential tax assessments they may face.
Frequently Asked Questions (FAQ)
What is the Cash Capital Deduction under the Corporate Income Tax Law?
It is a legal right that allows capital companies to deduct a certain portion of an amount—calculated based on the commercial credit interest rates announced by CBRT over the capital amounts they have increased in cash and registered with the trade registry—from their corporate tax base.
What does Passive Income mean in Tax Law?
Passive income refers to rentier-type income generated outside the scope of the institution’s principal activity, without conducting an active commercial organization, expending labor, or undertaking commercial risk. (e.g., interest, dividend, rent, license fee, income from the sale of securities).
What is the effect of an institution generating passive income on the cash capital deduction?
Pursuant to the Council of Ministers Decision No. 2015/7910, the cash capital deduction rate is applied as 0% (zero) for institutions whose 25% or more of their total income in the relevant accounting period consists of passive income, and these companies cannot benefit from the deduction right.
Are foreign exchange gains arising from commercial receivables and payables considered passive income?
Foreign exchange gains arising from the mandatory valuation during the performance of a commercial relationship within the scope of the enterprise’s principal activity are not independent investment returns, but rather derivatives of the core commercial income, as they arise directly from the active commercial operation itself, and therefore should not be considered passive income.
What is the Council of State’s legal criterion in distinguishing between passive income and active earning?
According to the established jurisprudence of the Board of Tax Law Divisions Assembly of the Council of State; in determining whether an income is of a passive or active nature, it is mandatory to examine not only the name or form of the transaction but also the nature of the activity and the direct connection between the generated income and the principal activity of the enterprise.
