S. 161Chapter 17 Turkey: Leasing of Aircraft - Characterization of Leasing Payments as Royalties

Billur Yalti

17.1. Introduction

Turkey has 80 double tax conventions (DTCs) in force. Turkey's tax treaties generally follow the provisions of the OECD Model Tax Convention on Income and on Capital 2010 (hereinafter OECD Model). Deviations concern in particular withholding taxes, professional income and capital gains. Although there is a significant treaty network, the jurisprudence on these treaties is considerably rare. One of the exceptional cases that concerns the characterization of income as "royalties" will be explained and analysed in this report. The decision, which was given by the Supreme Administrative Court (SAC), is related to the definition of industrial, commercial and scientific equipment (ICSE) provided in article 12 of the DTCs.

17.2. Facts of the case

The SAC gave its decision on 10 April 2013. In K.2013/1281, a Turkish resident airlines company (providing passenger air transportation services) leased aircrafts from US resident financial leasing companies. Although the content of the contracts between the parties was not clear from the decision, these contracts were characterized as ordinary rental agreements S. 162in the decision. The Turkish resident company asserted that the aircraft leasing payments made to the non-resident companies were business profits in character and as a result of article 7 of the tax treaty concluded with the United States, Turkey had no right to apply domestic withholding taxes applicable on leasing payments since there was no permanent establishment (PE) located in Turkey.

The tax administration, however, characterized the payments made for aircraft leasing as royalties, on which the US tax treaty in article 12 provides Turkey limited taxing rights. Thus, the legal issue was whether the payments made for aircraft leasing would be treated as royalties or business income under the applicable DTC. Upon the lower court's decision that upheld the tax authorities' decision, the taxpayer appealed to the SAC.

17.3. Applicable law

17.3.1. Domestic law

Under the Turkish Corporate Income Tax Law (CITL), a non-resident corporate body is subject to corporate income tax on its business profits if it has a PE or a permanent representative in Turkey and if it receives corporate income through the PE or representative (article 3(3)(a) of the CITL). For the definition of business income, the CITL refers to the Individual Income Tax Law (ITL), in which business income is defined as "all income from any sort of commercial or industrial activity" (article 37 of the ITL). Business profits of a non-resident company are subject to 20% corporate income tax on the basis of an annual return (article 32 of the CITL).

Payments to non-resident companies for the use of immovable property or of movable property or rights are taxable in Turkey if the immovable property is located in Turkey and the movable property or the rights are used in Turkey or accounted for in Turkey (i.e. the payment is made in Turkey or, if made abroad, is recorded in the accounts of the Turkish payer in Turkey) (article 3(3)(ç) of the CITL and article 7 of the ITL). The CITL stipulates only "income of non-resident companies from letting of immovable and movable property and rights" to be taxable and, for the definition of such income, it refers to the ITL (article 3(4) of the CITL). "Income from immovable property", which is regulated under article 70 of S. 163the ITL, includes not only income from the leasing of real property as such but also income derived from copyrights (royalties), ships or an interest therein, vehicles and machinery, estates in mortmain and the leasing of rights such as patents, trademarks, films, etc., and know-how. Specifically, income derived from the letting of "motor-driven transport and traction vehicles and all types of motor vehicles, machinery and installation" (article 70(8) of the ITL) is treated as income from immovable property and such payments made to non-residents are subject to a final withholding tax at a rate of 20%, or 1% in case of financial leasing payments (article 30 of the CITL).

17.3.2. Treaty law

In the case at hand, articles 7, 8, and 12 of the Turkey-United States DTC are relevant. With regard to article 7, the business profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in the other contracting state through a PE situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other state but only so much of them as attributable to that PE. Article 8 of the US DTC regulates the income from shipping and air transportation activities. According to the first indent of that article, profits of an enterprise of a contracting state from the operation of ships or aircraft in international traffic shall be taxable only in that state. However, the second indent provides that profits from the operation of ships or aircraft in international traffic include profits derived from the rental of ships or aircraft if such rental profits are incidental to other profits described in paragraph 1. Furthermore, article 12 of the US DTC on royalties stipulates:

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17.4. The courts' decisions

17.4.1. The lower tax court's decision

The decision of the lower Antalya Tax Court, which rejected the taxpayer's arguments and upheld the tax authorities' decision, is not so clear from the text of the judgment; the SAC decision only includes a summary of it. However, it is understood that the lower court has discussed the applicability of article 7 or 8 and did not refer to article 12 on royalties. Interestingly, the lower court stipulated that,

[s]ince the "shipping and air transportation" has been regulated separately from "business profits" and the only profits covered by Article 8 of the treaty were the profits derived from the aircraft rental activities carried incidental to the operation of aircrafts, the legal issue in the case has to be solved under the provisions of international transportation, and there were no controversy on the permanent character of the rental activities evaluated in the case, to that end the aircraft rental activities are not covered by the tax treaty as a result of which the tax authorities' decision is compatible with the law.

There is no further information about the decision of the lower court. If it is understood correctly from the summarized information, the lower tax court's approach was based on the scope of article 8 of the US treaty, which covers income derived from air transportation operational activities and incidental income derived from aircraft rental activity carried on in addition to the main operating activity by such air transport companies. The court correctly determined that the income considered in this case was not covered by article 8; however, it is not clear why the court did not come to the conclusion that such permanent and continuous aircraft leasing activities were covered by article 7 and not taxable in Turkey thereof due to the nonexistence of a PE.

S. 16517.4.2. The SAC's decision

The SAC gave its decision in favour of the tax authorities, basing its judgment on the following arguments:

In the decision, the SAC first evaluated the applicability of article 8 and came to the conclusion that that article was not applicable in the case. Its reasoning was as follows:

According to the provisions on "shipping and air transport" of the tax treaties, the incidental income derived by an enterprise of a contracting state from the leasing of aircraft or ships are taxable only together with the income derived from the operation of ships or aircraft in international traffic of that enterprise; thus the income derived from financial leasing of aircrafts by the non-resident companies in this case do not have the character of international transportation income.

The SAC then continued to discuss the applicability of article 7 in the case. On this issue, the SAC stated:

Under Article 7 of the tax treaties which regulates business profits, it is stipulated that where profits include items of income which are dealt with separately in other articles of the treaty, then the provisions of those articles shall not be affected by the provisions of this article. Thus, for the determination of the tax situation of the income, the treaty article which covers the income should be considered.

Lastly, the SAC came to the conclusion that article 12 on royalties was applicable in the case on grounds provided in a prior tax audit report that directly referred to the OECD documents. The SAC characterized the aircraft leasing income as royalties since the aircraft was commercial equipment in character. The reasoning of the SAC was as follows:

The prior tax audit report (24.10.2008, CIV-01/16-16), which was issued in relation to the plaintiff and included in our Chambers case file numbered E.2010/7227, clearly revealed that "the Turkish tax treaties were based on the OECD Model Convention, and the Commentaries of the OECD Model Convention, which were signed by not only the OECD member countries but also by non-member countries attending the negotiations under observer country status, were considered as the main source of interpretation having priority during the interpretation of Turkish tax treaties. While income from the leasing S. 166of industrial, commercial and scientific equipment had been characterized as royalties under the Commentaries of Article 12 of the OECD Model Convention, due to an amendment made in 1992 the income from the rental of such equipment were then treated as business income; however, Turkey submitted a reservation to Article 7 declaring that it reserved the right to tax at source the income from the leasing of industrial, commercial and scientific equipment; and during the 1995 amendments made on the Commentaries Turkey transferred its reservation to Article 12. By way of this reservation to the Model Convention, Turkey has declared that it reserved the right to tax as a source country the income from the leasing of industrial, commercial and scientific equipment which has been covered since then by the article on business profits of the Model Convention. Most of the Turkish bilateral treaties included the provisions compatible with the reservation and Article 12 of those treaties on royalties contained a provision regarding income from the leasing of such equipment. The term "industrial, commercial and scientific equipment" also covered aircraft, and the OECD Report dated 13.9.1983, which was issued in relation with the amendment of Article 12, referred advanced technological equipment in paragraph 5 and stipulated that the producers or customers of such products often preferred to lease rather than to sell or buy such products. Thus, the aircrafts leased by the plaintiff company under financial leasing contracts were commercial equipment being an advanced technology product and the leasing payment for such equipment should be treated under Article 12 of the treaty". When the arguments and findings in that audit report are considered, the Court comes to the conclusion that the income of non-resident companies derived from aircraft leasing are taxable in Turkey under Article 12 of the treaty.

17.5. Comments on the Court's decision

The decision of the SAC is significant for Turkish tax treaty practice in two aspects. Firstly, the decision represents an important change in the jurisprudence of the SAC established on the issue so far. Secondly, as far as the SAC decisions disclosed to the public are concerned, the SAC referred for the first time to the OECD Model Commentaries and the relevant OECD reports.

Although the payments made for the use of, or the right to use, industrial, commercial or scientific equipment (ICSE) has been removed from the text of the royalty definition in article 12(3) of the OECD Model, Turkey, along with the reservation it has submitted to the Model, still includes the S. 167income received from ICSE in article 12 of its tax treaties. The question whether the income from aircraft leasing is covered by the definition of the ICSE was always a controversial issue in Turkish tax practice. As far as the author of this report knows from the publicly disclosed decisions, the SAC has historically characterised the income from aircraft leasing as business profits; however, in those decisions the SAC did not provide any explanations and reasoning as a result of which it was not so clear why the aircrafts were not previously characterized as ICSE and why the income from such leasing transactions were not treated as royalties. The subsequent lower tax court decisions also followed the SAC characterization as business profits, although their decisions also lacked of reasoning. The mentioned decisions did not provide any discussion on the concept of ICSE and the royalty article thereof. As a general assumption derived from those decisions, it might be asserted that in case of non-resident financial leasing companies, the leasing income were characterized as business profits due to the fact that the main activity of the company was aircraft leasing, which was in nature a commercial activity and carried on regularly. In such cases, the courts did not even refer to article 8 since the scope of that article was limited to the companies dealing mainly with international transportation operations and deriving incidental rental income. The above jurisprudence of the courts was strongly criticized in the tax literature; tax practitioners asserted that the interpretation of the courts was wrong and that the payments for renting aircrafts, helicopters, machines, etc. should have been characterized as royalties and taxed in Turkey albeit at limited rates. The authors of this S. 168opinion referred to Vogel's interpretation characterizing aircrafts as ICSE and further emphasized that the 1983 OECD Report has stipulated trucks and ships as technical equipment.,

Interestingly, in case K.2013/1281, which represents a significant change in the jurisprudence, the SAC directly and explicitly mentioned the OECD Model Commentaries and the 1983 OECD Report for the first time in Turkish tax treaty jurisprudence. However, the SAC did not make any evaluations on the treaty interpretation rules of the Vienna Convention on Law of Treaties (VCLT), which governs the treaty law and provides international customary rules to which countries must abide even though they are not a party. Thus, the SAC's approach to articles 31 and 32 of the VCLT, and whether it has based its decision on the OECD Model Commentaries and OECD Report by considering them an interpretative source of "ordinary meaning" of the treaty term of ICSE within the framework of article 31 of the VCLT, or of "special meaning" of the term in the sense of article 31(4), or of supplementary source of interpretation within the scope of article 32 of the VCLT, is not explained in the decision. In this regard, the author of this report finds the decision poor in the legal sense but important since the SAC has explicitly referred and based its reasoning on an external international tax source for the first time. In the decision, the SAC completely agrees with the tax audit report, which referred to the OECD Commentary as "the main source of interpretation having priority". Nevertheless, the author of this report wonders if the SAC would continue to refer to the Commentary as a basic source of interpretation in its subsequent decisions or whether such a position was case specific.

S. 169At this point, the author of this report wants to trace the answer of the question whether the legal result would be different if the SAC would not initially take into account the OECD Commentaries and the Report, and instead refer to article 3(2) of the DTC. The term "equipment" (Turkish equivalent term, teçhizat) is used in the definition of royalties in article 12(3) but not defined in the US DTC. However, for the terms used in the DTC but not defined therein, a special interpretation rule exists in article 3(2). Accordingly, article 3(2) stipulates the following provision:

As regards the application of this Agreement by a Contracting State any term not defined therein shall, unless the context otherwise requires, or the competent authorities agree to a common meaning pursuant to the provisions of Article 25 (Mutual agreement procedure), have the meaning which it has under the laws of that State concerning the taxes to which the Agreement applies.

This renvoi clause points to the domestic law of the country applying the treaty under a dynamic approach to determine the meaning of an undefined term, provided the meaning derived is compatible with the context of the DTC. The domestic law referred to covers not only the tax laws but also any relevant provision found in the legal order, unless it produces contradictory results to the tax legislation. Furthermore, in order to ascertain the meaning of a DTC term, a similar or comparable, but not equal, national term is sufficient.

According to the dictionary meaning of "equipment"/"teçhizat" , it is defined in the Turkish official dictionary as "war appliances other than weapons, accoutrements". Apparently, this definition does not provide any rational basis in the legal sense. When one moves to the tax legislation, it can be determined that although the term has been reproduced in several articles of the ITL, it has not been defined separately and not used to define or cover an aircraft or other transportation vehicles. As an illustration, the term "equipment" refers to "clothing distributed to the personnel as a fixed asset" in article 27 of the ITL; article 70(5) of the ITL stipulates "materials and equipment necessary for the use of the industrial rights"; article 89 of the ITL uses the expression of "the supply of any kind of vehicles and equipment"; and temporary article 48 refers to "machinery, equipment and fixed assets". Thus, the term has not been clearly defined in the ITL and does not necessarily predicate an aircraft; instead, the ITL uses the expression "motorized transport vehicles" in article 70, which regulates income from S. 170immovable capital. In the Tax Procedure Law (TPL), the provisions on valuation of assets do not reproduce the term "equipment", whereas they treat "ships and other vehicles" as immovable property (article 269(3) of the TPL). In the Value Added Tax Law (VATL), however, article 13(d) provides that the supply of machinery and equipment to taxable persons having an investment incentive document is exempt from VAT. General Announcement 69 on VATA defines the term "equipment" as fixed assets subject to depreciation and explicitly clarifies that transportation vehicles are not covered by the term "equipment". Thus, the domestic meaning of the term "equipment" does not include aircrafts. According to the author of this report, if the SAC applied article 3(2) of the DTC and referred to the national meaning of the term "equipment", the legal result would be different.