In brief
With the release of the inflation figures for November by the Turkish Statistical Institute on 3 December 2021, the subject of inflation adjustment again arose on the agendas of businesses. Our bulletin discusses the “when” and “how” of inflation adjustment.
In detail
Repeated article 298 of the Tax Procedural Law prescribes when an inflation adjustment for tax purposes must be applied. According to this article, as amended in 2004, if:
i. the increase of the domestic PPI in the last three years (including the current year) is more than 100%, and
ii. the increase in the domestic PPI in the current year is more than 10%,
then financial statements must be restated for inflation.
Restatements are made by applying a general price index. Monetary items on the balance sheet (such as cash, banks accounts, receivables, payables) that are already stated in the measuring unit on the balance sheet date are not restated. All other items on the balance sheet are restated based on the change in the general price index between the date those items were acquired and the balance sheet date.
Net gain or loss from the restatement is included in taxable income and disclosed separately on the income statement. No adjustment is made on income statement except incorporating this restatement difference.
The last time the inflation adjustment was applied was in 2004. Since then, corporate taxpayers have not been required to apply it as the conditions for inflation adjustment set out in the Tax Procedural Law did not exist.
Where do we stand now?
According to the PPI figures announced for November 2021, it seems that both the conditions are highly likely to be met for 2021 (final assessment must wait for the December 2021 PPI, which is to be announced by 3 January 2022).
Unless the above stated conditions in the Tax Procedural Law are amended with a new law (e.g., an amendment in the Tax Procedural Law), or the December 2021 PPI is declared to be negative 1.5 percent (which under normal conditions seems unlikely), it appears that inflation adjustment is on the way for 2021 year-end.
Based on the current law (Tax Procedural Law rep. art. 298(7)), when the conditions causing inflation adjustment (as explained above) arise following a calendar year or years for which inflation adjustment has not been applied, the inflation adjustment must be applied starting from the last time it was applied. Accordingly, since the last time inflation adjustment was applied was in 2004, corporate taxpayers would need to restate the value of the non-monetary items on their balance sheets by considering the PPI changes from 2004 to 2021.
Inflation adjustment – the authority granted to Ministry of Finance
Based on the current law (Tax Procedural Law rep. art. 298(8)), the Ministry of Finance has been granted broad authority with regard to principles and procedures, such as:
- allowing the use of aggregated methods in inflation adjustment to determine the items for which the aggregated method can be applied, based on total assets, the turnover of the taxpayers or the type or professional groups of taxpayers;
- determining what kind of financial statements will be subject to inflation adjustment and whether or not they will be corrected in advance tax periods, based on the total assets or turnover of the taxpayers or the type or professional groups of taxpayers;
- allowing taxpayers to make adjustments by considering foreign exchange, gold and similar values by region, industry, business group, business type and non-monetary item and to use indices/values determined on daily basis;
- determining monetary and non-monetary assets on the balance sheet, etc.
As things currently stand it is not certain how the Ministry might use such authority.
If the conditions in the Tax Procedural Law are met, corporate taxpayers are obliged to prepare their advance tax declarations as per the inflation adjustment principles. Therefore, if inflation accounting is required in 2021, the advance tax return for the fourth quarter of 2021 will need to be declared in accordance with the inflation accounting principles by 17 February 2022, leaving taxpayers with a very short time period for preparations.
Inflation adjustment – calculation principles
Inflation adjustment is defined as the calculation of non-monetary items in terms of the changes in purchasing power at the date of the financial statement by multiplying the amounts to be considered in the inflation adjustment with the correction indices.
Typical examples of non-monetary assets to be considered within the scope of inflation adjustment are shares, prepaid expenses, deposits and guarantees given, advance payments, inventories and fixed assets. The revaluation of these items in terms of inflation adjustment typically triggers taxable income for taxpayers.
Deposits and guarantees received, advances received, paid-in capital, profit reserves (legal reserves, statutory reserves, special funds) are the major examples of non-monetary liabilities. The inflation adjustment of these items raises deductible expense for taxpayers.
Accumulated depreciation amounts corresponding to each balance sheet asset are also subject to revaluation by considering the indices applied for those assets. After inflation adjustment, the depreciation expense is calculated on the restated value of the related fixed asset.
Inflation adjustments are recorded in the difference accounts of the related assets and in the inflation adjustment account. The restated amounts are considered as the beginning values of the following period, regardless of whether the inflation adjustment is made in the following period.
In the application of the inflation adjustment, the following dates are used for determining the applicable correction indices:
a) for securities and fixed assets valued at purchase price, the purchase date;
b) for the elements included in the cost of raw materials and materials, commercial goods, semi-finished and finished goods; the elements that constitute cost in construction and repair work extending to multiple years; assets subject to special depletion and the elements constituting these assets; payments for construction and repair work; tangible assets and the elements constituting these assets; rights and goodwill payments and prepaid expenses, the date of entry in the legal books;
c) for non-monetary deposits and guarantees and advances, paid-in capital, share premiums, share cancellation profits, the collection date;
d) for non-monetary deposits, guarantees and advances, the payment date;
e) for assets that are capital in kind, the date of the transfer of the asset;
f) for capital sourced from capital increases via addition of profit reserves, retained earnings and net profit capital, the registration date;
g) for shares received in return for cash capital, the payment date; for shares received in return for capital in kind, the transfer date of the ownership of these assets; for shares received in return for dividends, the registration date of the capital necessary to participate in the company;
h) for non-monetary provisions, the adjustment date of the relevant asset.
As stated above, the advance tax declarations of taxpayers are also made according to inflation adjustment principles. However, after the conditions for inflation accounting are met the previous advance tax declarations within the same year do not need to be corrected for this purpose. Hence, assuming that an inflation adjustment is required for 2021, there will not be a requirement to re-file the Q1-Q2-Q3 advance corporate tax returns. (Please also note that since the Ministry of Finance has the authority to determine the financial statements subject to inflation adjustment, as applied in the past, advance tax periods might be determined to be out of scope of the inflation adjustment if the Ministry decides so).
Inflation adjustment – impact on the corporate tax base
In general, the inflation adjustment is performed as follows (depending on the adjustment practice in 2004):
1. balance sheet items are classified as monetary and non-monetary items;
2. the values of the non-monetary items used as the basis for the inflation adjustment are determined;
3. these items are adjusted by multiplying them by the relevant adjustment indices;
4. the non-monetary items are booked in the balance sheet with their adjusted values, whereas no adjustment will be made to monetary items;
5. the difference between the inflation adjustment values of the non-monetary assets and the non-monetary liabilities will be deemed to be profit/loss for corporate taxation purposes.
Although it is not crystal clear in the legislation (and will need to be clarified with the Ministry of Finance), based on our interpretation of the current legislation, if the conditions are satisfied for 2021 and the inflation adjustment thus becomes applicable, profits and losses arising from the inflation adjustment for the years between 2004 and 2020 will not be taxable or tax deductible, yet the profits and losses arising from the inflation adjustment for the year 2021 will be taxable/tax deductible.
Tax deductible carry forward losses declared in corporate tax returns (which can be carried forward for 5 years) are not restated.
The adjustment amounts are subject to tax in the period in which the inflation difference accounts of the liabilities are transferred to another account or withdrawn from the company for any reason. Inflation differences pertaining to equity items can be deducted from the previous year's losses as a result of the inflation adjustment or added to capital by corporate taxpayers. Such transactions are not deemed as profit distribution.
If the balance sheet items subjected to inflation adjustment are disposed of, the relevant inflation adjustment differences are considered to be the cost for these items. That is, the capital gain/loss is calculated based on the restated amount of the asset.
Inflation adjustment - uncertainties
- PPI of December 2021 to be announced by 3 January 2022:
As per the figures as of November 2021, the last 36 months (3 years) of the PPI exceed 100% and hence the conditions for inflation adjustment are achieved. Therefore, in order to be free from the inflation adjustment requirement, the PPI for December 2021 should be negative 1.5% (considering the current fluctuations in the value of TRY it seems that the inflation figures for December 2021 will continue to post an increase).
- Change of Tax Procedural Law rep. art. 298:
As mentioned above, two conditions must be met to result in inflation adjustment. The application of inflation adjustment in 2021 can be abolished through a legislative change (for instance, the threshold for the PPI for the last three annual tax periods could be re-determined to be 150% rather than 100%).
- Authority of the Ministry of Finance:
As mentioned above, the Ministry of Finance has the authority to determine the details of the inflation adjustment. Therefore, the potential impact of the inflation adjustment could vary depending on how the authority present in the current law (TPL rep. art. 298(8)) is used (i.e., setting high thresholds, limiting the scope, exclusion of certain industries such as financial institutions, etc.)
We will keep you informed of the developments in due course. If an inflation adjustment will be required for 2021, more comprehensive explanations on its implementation will follow this bulletin.
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