SUMMARY

A forward contract, which is a capital market instrument, is defined as a type of contract that requires one party to purchase the financial asset subject to the contract at a certain future date at the price determined in the contract and the other party to sell the financial asset subject to the contract. Thus, it is aimed to hedge the risk of being affected by exchange rate changes. In this article, Value Added Tax ("VAT") aspect forward contracts will be examined in the light of the advance rulings of tax authority.

Keywords: Forward, Forward Contracts, Currency Risk, Value Added Tax, Banking and Insurance Transactions Tax.

INTRODUCTION

A forward contract is defined as a contract that gives the holder the right and obligation to buy/sell any commodity or security at a future date and at a specified price. The future date is referred to as the date on which the transaction will be executed, and the specified price is the forward contract's price on the maturity date of the transaction. By definition, forward contracts are future trade agreements between two parties rather than securities.1 Further, they are not traded on a centralized exchange and are considered over-the-counter ("OTC") derivative instruments. OTC derivatives (rather than being traded on exchanges as financial products) are realized between financial institutions and their customers. They are based on commodity and foreign exchange prices, interest rates and stock market indices, and whose amount, maturity and other technical conditions are tailored to their needs.2

In forward contracts, one party is the ultimate seller and sells the foreign currency, commodity, or security at a pre-agreed, specified price. The other party is the ultimate buyer, who sells the foreign currency, commodity or security and makes the payment at the pre-agreed specified price.3

The section titled "6.1.1.1. Forward transactions" of the General Communiqué on Corporate Tax Serial No. 1 also defines a forward contract as a type of contract that requires one party to purchase the financial asset subject to the contract at a specified future date at a specified price determined in the contract and the other party to sell the financial asset subject to the contract.

International markets are affected by various political and geographical factors that cause fluctuations in the sale and purchase rates of valuable commodities such as foreign exchange, gold, oil, and mineral products. The main purpose of forward contracts is to reduce and eliminate such financial risks.

In this context, in our article, we will first provide definitions regarding forward transactions. Then, we will make evaluations based on the Turkish Tax Authority's advance rulings on the subject.

  1. QUALIFICATION AND VAT ASPECT OF FORWARD TRANSACTIONS

In order to assess the taxation of forward transactions, first the qualification of these transactions must be examined.

Forward is a transaction used in risk management for risk transfer and profit. The importance of forward in risk management is to bring regularity to firms' cash flows by reducing future uncertainties and risk.

Forward transactions differ from other derivative instruments such as options, futures, and swaps in terms of structure, functioning and liability. In respect of accounting, forward transactions bring mutual rights and obligations to the parties, just like debits and credits. Therefore, a forward transaction cannot be withdrawn or revoked unilaterally. The parties to the contract are under duty until the contractual obligations are fulfilled. Cancellation of the contract is also possible upon the agreement of the parties.

The legal nature of the forward transactions varies, depending on the subject and type of tax. While evaluating the forward transactions in terms of Value Added Tax ("VAT"), the determination of whether they shall be qualified as "service" or not generally becomes an indispensable factor for tax treatment.

Forward contracts can result in different ways. The parties may fulfill their obligations by cash settlement or physical delivery. Feasance of the contracts between parties in different countries limits the possibility of physical delivery. Hence, the parties generally conclude the contract by cash settlement. Since physical delivery method means the delivery of the foreign currency, money or commodity agreed upon in the forward contract to the buyer on the maturity date, it is not a common method in foreign exchange Forward. In foreign exchange Forward, the difference between the exchange rate on the maturity date and the exchange rate determined at the time of the forward contract may result in favor of the buyer or the seller. Contracts executed in this way are defined as forward contracts fulfilled by 'cash settlement method' in the doctrine.

  1. Evaluation of Whether Forward Transaction is a "Service" in respect of VAT

Article 4 of the Value Added Tax Law No. 3065 ("VAT Law"), titled "service", defines service as transactions other than delivery, deemed delivery and import of goods.4

Although VAT Law provides a very broad definition and lists many transactions in an open-ended manner through sampling, in our opinion, it is not possible to consider forward transactions within the scope of the "service" definition. First of all, in forward transactions, it is not certain which party will be favored at the time the contract is concluded, and the price of the performance to be obtained by the parties in whose favor the contract is concluded becomes certain only on the maturity date. The profit or loss that will arise in forward transactions arises as a result of the supply and demand conditions in the futures market, regardless of the contract or any other transaction. This makes it difficult to consider a transaction with these characteristics as a "service" within the meaning of the VAT Law.

In this context, when it is accepted that forward transactions are NOT the equivalent of any service, they should not be subject to VAT.

  1. Evaluation of Whether Forward Transaction is a "Delivery" in respect of VAT

It is controversial whether the forward transaction is within the scope of VAT. As a matter of fact, based on the reasoning below, we are of the opinion that the provisions of the VAT Law regarding "delivery" should also be taken into consideration in the evaluations made within this scope.

Forward transactions are defined as transactions between banks and their customers or brokers without a centralized marketplace. The parties are in constant communication with the tools provided by information technologies, and the terms of the contract are fulfilled by crediting or debiting the relevant bank accounts at the payment stage. Today, although the delivery of money and foreign currency is not "physically delivered", it is realized as wire transfer through the bank in accordance with the nature of financial transactions.

Unlike other derivatives, forward transactions do not require daily settlements at the clearing house. In these contracts, accounting entries are made twice subsequently. The first entry is conducted at the contract phase and the other is when the obligation of the contract is fulfilled at maturity. In forward contracts, profit or loss is realized at the due date. Therefore, forward transaction will result in one party's loss and other's profit.

As a result of the forward transaction maturity, money is delivered to the party in whose favor the profit is calculated. In VAT Law, Article 17/ para 4/sub para (g), regulates that foreign currency and money delivery transactions are exempted from VAT. Consequently, if we accept the forward transaction as a delivery, VAT shall not be applicable.

  1. ADVANCE RULINGS OF THE TAX AUTHORITY ON THE TAXATION OF FORWARD TRANSACTIONS

It can be said that the distinction mentioned in the previous section of our article has been adopted by the Administration and that there are different practices in terms of taxation between contracts with physical delivery and contracts fulfilled by cash settlement.

  • Advance ruling of the Istanbul Tax Office, Taxpayer Services Value Added Tax Group Directorate dated 22.07.2019 and numbered 39044742-KDV.1-590857 on "VAT application in the conclusion of the Commodity Forward Contract with cash settlement" explains that:

    "...In the event that banks intermediate futures contracts such as forwards and swaps, banks are required to calculate BITT on the money they receive in favor due to the said intermediation transaction. However, the amounts received by the Company are not subject to BITT since the Company is not a BITT taxpayer due to the aforementioned contracts and does not require BITT liability due to these transactions.

    ...As a result of the transactions carried out in accordance with the framework agreement between the group companies, the difference between the market price and the future price determined in the agreement arises from a service. Therefore, VAT should be calculated over this difference.

    On the other hand, if the commodity contract is concluded with a cash settlement, the VAT to be calculated over the money received in favor of the Company due to the contract will be declared as a taxpayer with VAT declaration No.1. In case of a price difference in favor of the company resident abroad, the VAT to be calculated by the Company over the price difference must be declared and paid as Tax Responsible with the VAT declaration No.2, and it is natural that the VAT paid will be deducted in the VAT declaration No.1."

According to this advance ruling; the Company, which is not liable for BITT, will not be subject to BITT on the amount arising from the Forward contract resulting in cash settlement. However, the Company will be required to calculate VAT for the contracts concluded in favor and declare and pay VAT as responsible for the contracts concluded in favor of the foreign resident company.

  • In line with the advance ruling above Advance ruling of the Large Taxpayers Tax Office Presidency Taxpayer Services Group Directorate dated 27.05.2014 and numbered 64597866-125[6-2014]-81 on "Corporate Tax and VAT application of the profit or loss arising from the forward transaction" explains that:

    "...The difference between the forward contract rate and the contract rate will be determined as profit or loss at due date and included in the corporate income. In addition, in case of a loss, no corporate tax will be deducted on this amount owed to the foreign company.

    On the other hand, it will be necessary to consider the provisions of the Thin Capital and Disguised Profit Distribution through Transfer Pricing in Articles 12 and 13 of the Corporate Tax Law No. 5520 in forward transactions with the group company abroad

    ...The difference between the current exchange rate at the end of each contract period between "the group companies" and "the exchange rate determined in the contract" arises from the service provided by the company that benefits from the difference. Therefore, VAT should be calculated over this difference.

    In the event where the company in Turkey benefits from the currency rate differential at the conclusion of the deal, VAT will be calculated on the invoice issued by the company and declared as a taxpayer in VAT declaration No.1. In the event of an exchange rate difference in favor of the company abroad, the company that resides in Turkey will declare and pay the VAT calculated over the exchange rate difference with VAT declaration number 2 as Tax Responsible."

In this assessment, it is emphasized that the party in whose favor the exchange rate difference occurs in forward contracts concluded by cash settlement should qualify this situation as a "service" in the sense of VAT Law and should declare VAT as a taxpayer.

It should be noted that view of the Tax Authority qualifies "forward" transactions as service, on the contrary of our opinions on the matter.

  • The advance ruling dated 20.06.2019 and numbered 64597866-130[1]-11822 of the Taxpayer Services Group Directorate of the Large Taxpayers Tax Office on "Tax obligations in the forward transaction made on behalf of the group company" indicates that:

    "...As a result of the forward transaction made by your company with the bank on behalf of the group company, which is your subsidiary, the amount of the contract and all kinds of profit / loss and the transfer of all costs of the transaction to the group company will not be subject to value added tax. The price received by your company in accordance with the precedent regarding the provisions of Article 13 of the Corporate Tax Law due to the intermediation of the transaction in question will be subject to VAT at the general rate, as it will constitute the service provided by your company."

In this respect, it was stated that the profit arising from the Forward transactions made with the bank on behalf of the group company only as an intermediary activity will not be subject to VAT, but VAT will be applied on the price received in accordance with the precedent for the provision of this service.

CONCLUSION

Forward transactions are highly preferred in international markets due to exchange rate and price fluctuations. However, it is observed that there is a distinction in practice as to whether the transaction is concluded with a cash settlement or not. At this juncture, it should be noted that forward contracts ought not to be subject to VAT, as a forward does not constitute a delivery or a service. Since there is no precedent on the topic, VAT taxation of the forward contracts is controversial between taxpayers and tax office. The implementation of a specific regulation exempting forward contracts from VAT would clarify this issue.

Footnotes

1. Ebiçlioğlu F.K., Kahraman A., Forward İşlemleri İşleyişi ve Vergisel Boyutu, TÜRMOB Yayınları

2. (Ersan, 1998: 165)

3. Murat BAKIRTAŞ, "Forward Sözleşmelerinin Hukuksal Niteliği ve Türk Vergi Sistemindeki Yeri", Vergi Raporu, Mayıs 2012, s.152

4. "Services are transactions other than delivery, conditions deemed as delivery and importation of goods. These transactions may take place in such forms as making, processing, creating, manufacturing, repairing, cleaning, cleaning, preserving, preparing, evaluating, renting, undertaking not to do something.

In case the return of a service is a delivery of goods or another service, each of these are separate transactions and are taxed separately according to the provisions of service or delivery."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.