New Generation Management - Transfer of Family Company Shares to an Investment Fund

In recent years, to promote investments in Turkish lira assets in Türkiye, very encouraging incentives have been introduced regarding different investment instruments. The most striking of these incentives are the tax incentives for investment funds. These tax incentives encourage corporations and natural persons to invest in investment funds when making equity investments. In fact, the tax incentives provided to both individual investors (natural persons) and corporations in terms of investment funds have led to a significant increase in the number of new investment funds, the sizes of investment funds and the number of fund investors. The number of fund investors increased by more than one million in the last year, while the size of investment funds nearly doubled.

Making investments through these private funds has also become easier due to the ability of portfolio management companies (the "PMCs") to establish private funds for particular corporations or natural persons.

In particular, the transfer of the shares of a holding or an umbrella company, incorporating a group of companies in which more than one company operates, or the shares of each company in the relevant group, to funds established as venture capital investment funds (the "VCIFs") under a portfolio management company, is a very advantageous tax planning tool, considering the income generated by the fund and the tax exemptions granted to the income generated from the participation shares to be issued in this way.

In this article, we will, first, discuss the legal structure and taxation of PMC's, and then elaborate on the legal and tax issues regarding the practice of VCIFs, which envisage an advantageous structure in terms of the taxation of the income derived from the shares of companies established in Türkiye.

I. PMC's

PMCs are capital market institutions established as joint-stock companies whose main activity is to establish and manage investment funds.

1. Establishment and Operation Licenses

PMCs need the approval of the Capital Markets Board (the "Board") both for their establishment and for them to become operational. The requirements for obtaining these approvals are set forth in the Communiqué on Principles Regarding Portfolio Management Companies and Their Activities (the "PMC Communiqué").

First, the PMCs must apply to the Board in order to obtain their establishment approval. Establishment applications are decided by the Board within six months following the submission of the required documents. If the application is deemed appropriate by the Board, the PMCs then must apply to the Ministry of Trade to complete their establishment procedures. Afterward, to become operational, the PMCs must apply to the Board for an operation license within three months starting from the date of notification of the establishment approval.

2. Corporate Governance

Pursuant to the PMC Communiqué, there are several standards that PMCs must consider while establishing their corporate structure.

a. Capital requirements: PMCs must have a minimum capital of TRY 30,000,000 to obtain an establishment license. In addition, depending on the size of the portfolios they manage, PMCs are required to meet the following minimum shareholders' equity amounts:

In addition, PMCs that are managing a portfolio of over TRY 72,000,000,000 will also be required to have additional shareholders' equity equal to 0.02% of the amount that exceeds TRY 72,000,000,000. However, PMCs whose shareholders' equity exceeds TRY 200,000,000 will not be required to have additional shareholders'.

b. Board of directors and general manager: The board of directors of PMCs must consist of at least three members who meet the required qualifications. PMCs must also employ a full-time general manager who is employed exclusively and meets the required qualifications. However, the general manager may also serve as a portfolio manager for the PMC, or as a director in entities with which the PMC has a management, audit or capital relationship, or other entities in which the foregoing entities have direct or indirect management, capital or audit control, or stock exchanges and other organized marketplaces, clearing houses and portfolio custodians, and other financial institutions deemed appropriate by the Board; provided that they do not have executive responsibilities in the foregoing entities and these additional roles do not weaken their performance as the general manager of the PMC.

c. Internal control system: PMCs must establish an internal control system and adopt written policies and procedures in order to ensure that their services and transactions are carried out in an orderly, efficient and effective manner and in compliance with their strategy and related legislation, to ensure the integrity and reliability of their accounting practices, the timely and accurate availability of information in their data systems, and to prevent and detect errors, fraud and irregularities. In this regard, the PMCs are obliged to designate one of the nonexecutive members of the board as the director responsible for internal control system and, as a rule, to employ at least one internal control staff member to fulfill the foregoing tasks.

d. Risk management system: PMCs are required to establish a risk management system, to adopt written policies and establish a risk management unit within their organization. The risk management system must aim to identify and control the main risks to which the managed portfolio may be exposed. In this context, PMCs are obliged to employ risk management personnel who meet the required qualifications to perform risk management tasks.

e. Inspection units: PMCs are also obliged to establish inspection units to inspect and supervise all activities of the PMC, particularly the internal control and risk management systems. As a rule, PMCs must employ enough inspectors to work exclusively in the inspection unit.

f. Fund service unit: Fund service units perform tasks such as keeping accounting records, performing cash reconciliations, controlling participation share purchase and sale orders, and preparing fund reports, the balance sheet and the income statements, and must be staffed by a fund manager and enough personnel.

g. Research unit: To become operational, PMCs must establish research units consisting of enough research experts that will carry out research activities.

h. Portfolio managers: The PMCs are required to employ enough portfolio managers (portföy yöneticisi) depending on the size of the portfolio under management. The portfolio managers must be employed full time and exclusively to fulfill these duties.

i. Book and record-keeping and independent audit obligation: PMCs must comply with the regulations of the Board on financial reporting and independent audit, and publish their financial reports on the Public Disclosure Platform. To become operational, PMCs must establish an adequate organizational structure that ensures the integrity of their accounting, recording, information and document systems, the orderly functioning of their regular work flow and internal communication methods, and employ personnel exclusively tasked to operate this organizational structure, and establish the necessary IT infrastructure.

j. Custody of assets: The assets in the client portfolios managed by the PMCs must be kept under custody pursuant to the Board's regulations on portfolio custody services and by institutions authorized to provide such services. İstanbul Takas ve Saklama Bankası A.Ş. ("Takasbank"), banks and brokers authorized by the Board may provide portfolio custody services, if the conditions in the regulation are met. An agreement must be signed between the custodian and the PMC, which will include the rights and obligations of the parties, regulate the information flow and contain the minimum elements required by the applicable legislation.

k. Venture capital PMC's: Pursuant to the PMC Communiqué, the PMCs can also be founded exclusively to establish and manage VCIFs (or to establish and manage real estate and VCIFs). Some of the obligations imposed under the law for other PMCs have been eased or removed for such PMCs. For example, the obligation to employ a certain number of portfolio managers depending on the size of the portfolio under management does not apply to the PMCs founded exclusively to establish and manage VCIFs (the "Venture Capital PMC"). In that respect, it is sufficient for the Venture Capital PMCs to employ at least one portfolio manager for the management of the money and capital market instruments included in their portfolio, or to procure investment consultancy and/or portfolio management services from other PMCs. Similarly, the initial capital amount required for the establishment of a PMC and the minimum amount of equity capital to be provided according to the size of the portfolio under management are halved for the Venture Capital PMCs. Further, the duties to be undertaken by the internal control personnel required to be employed by the PMCs can also be fulfilled by the inspectors for the Venture Capital PMCs. Moreover, the accounting personnel can also fulfill the duties normally undertaken by the fund service unit in the PMCs, without the need to establish a separate unit.

There are also certain obligations that apply solely to the Venture Capital PMCs pursuant to the PMC Communiqué. Accordingly, at least one member of the board of directors of a Venture Capital PMC must have at least five years of experience in venture capital investments, and the general manager must hold a Capital Markets Activities Level 3 License or have at least five years of experience in venture capital investments. In addition, the Venture Capital PMCs are also required to establish an investment committee to be made up of a person with four years of higher education and at least five years of experience in venture capital investments, and the board member and the general manager whose qualifications are explained above.

3. Taxation of PMCs

The tax liabilities of the PMCs that are established as joint-stock companies and liable or responsible for tax matters for the profits generated from their transactions can be summarized as follows:

a. Corporate income tax: As PMCs are corporate income taxpayers and are also capital market corporations, they are subject to corporate income tax at a rate of 25% (which is the rate determined for 2023) on their business income.

b. Withholding tax obligation: PMCs are obliged to apply withholding tax on payments that are subject to withholding tax in the income tax and corporate income tax legislation.

c. Banking and insurance transactions tax ("BITT"): BITT is applicable to the monies received in favor within the scope of securities purchase, sale and brokerage activities, and the monies received in favor by the PMCs due to the transactions carried out within the scope of their main fields of activity are subject to BITT.

d. Value-added tax ("VAT"): The PMCs' transactions are subject to BITT only for those transactions that are within the scope of their main fields of activity and these activities are exempt from VAT. However, the PMCs' transactions that do not fall within the scope of BITT and of their main field of activity are subject to VAT.

e. Stamp duty: As they are established as joint-stock companies, the papers issued related to the incorporation of PMCs are exempt from stamp duty. However, stamp duty liability may arise depending on the nature of other papers issued by the PMCs.

II. VCIFs

The Communiqué on Principles of Venture Capital Investment Funds (the "VCIF Communiqué") defines the VCIFs as asset groups without a separate legal personality. The VCIFs are established by PMCs or Venture Capital PMCs for a specific period that must be specified in the fund's bylaws (içtüzük) and the issuance document (ihraç belgesi). As a rule, the founder is responsible for and authorized to represent, manage and supervise the fund, and to protect the interests of the stakeholders in accordance with the provisions of the bylaws and issuance document. However, the founder may also procure portfolio management services from other PMCs or Venture Capital PMCs.

In line with the regulations on investment funds, the assets of the VCIFs are segregated from the assets of the founder, the portfolio custodian and the portfolio manager. In this respect, as a general principle, the assets of the VCIF cannot be subject to security interests, cannot be seized, cannot be included in the bankruptcy estate and cannot be subject to any injunction.

1. Establishment of a VCIF

For the establishment of a VCIF, the founder must apply to the Board with the draft bylaws, the standard form and other information and documents to be requested by the Board. VCIF bylaws refers to the agreement between the holders of the fund's participation shares, the founder, the portfolio custodian and the portfolio manager, regulating issues such as the management of the fund portfolio in accordance with the principles of fiduciary ownership. The establishment approval is granted only if the founder has signed a custody agreement with the portfolio custodian and the bylaws are approved by the Board. The Board decides on establishment applications within two months following the submission of the required documents.

a. Issuance of participation shares: To issue VCIF participation shares, the founder must apply to the Board, together with the issuance document, the standard form and other information and documents requested by the Board, within six months at the latest starting from the registration of the VCIF bylaws with the trade registry, and also ensure that the necessary workplace, technical equipment and accounting system for the fund's operations have been established and a sufficient number of personnel have been recruited. The issuance document contains information on the VCIF and the terms of sale for its participation shares. The Board examines the issuance document within 20 business days and approves the issuance document if it is determined that the information is consistent, understandable and complete according to the Board's standards. Following the approval, the sale of VCIF participation shares will start on a date that cannot be later than one year following the date on which the founder receives the approved issuance document.

Only qualified investors are eligible to purchase VCIF participation shares. The participation shares may be divided into different share groups to differentiate the rights or obligations granted to the holders, if this is disclosed in the bylaws and the issuance document.

Further, dividends may be distributed to holders of participation shares in accordance with the principles set forth in the issuance document.

b. Funding commitment: According to the VCIF Communiqué, the founder must request qualified investors to make a commitment to fund the VCIF. The minimum amount of funding commitment to be received from qualified investors is TRY 25,000,000 for the 2023, and the minimum fund commitment amount must be disclosed in the issuance document. The minimum funding commitment amounts must be provided to the VCIF within two years at the latest, starting from the date on which the sale of fund participation shares commences.

c. Private fund: Private funds refer to investment funds whose participation shares are allocated to predetermined individuals or organizations. It is also possible to establish VCIFs as private funds.

2. Investments and Corporate Governance

a. Venture capital investments and venture companies: As a rule, at least 80% of the total value of VCIFs must consist of venture capital investments. However, this ratio is applied as 51% if direct investments in venture capital companies that meet the qualifications specified in the Regulation on the Definition, Qualifications and Classification of Small and Medium-Sized Enterprises exceed 10% of the total value of the VCIF. The VCIF Communiqué also defines the scope of venture capital investments.

Thus, the cornerstone concept for venture capital investments is venture companies. According to the VCIF Communiqué, investments in the shares of venture companies, investments in debt instruments issued by venture companies whose shares are not traded on the stock exchange and investments in non-publicly traded shares of publicly traded venture companies are among the investments deemed venture capital investments. Accordingly, the VCIF Communiqué defines venture companies as companies that have the potential to grow and generate added value, that can offer high return expectations by improving their operational, production or sales performance and that are able to realize their operational objectives with the necessary financial and/or managerial support.

Venture companies must be incorporated in Türkiye, or if they are incorporated abroad as of the date of investment, 80% of their assets must consist of subsidiaries or affiliates incorporated in Türkiye according to their latest annual financial statements. In addition, venture companies must be incorporated as joint-stock or limited liability companies. However, venture companies that are incorporated as limited liability companies as of the date of investment must be converted to joint-stock companies within one year following the date of the initial investment.

b. Representation of the VCIF: The founder's board of directors is authorized to represent the VCIF in all of its activities. However, the board of directors may delegate this authority to one or more members or the founder's authorized first signatories. It is also possible to delegate the authority to represent the fund's portfolio to the investment committee by a board decision. However, the fund's establishment, its liquidation, the issuance of fund participation shares, any increase in portfolio management fees and other matters that may affect the investment decisions of holders of participation shares require a board resolution.

3. Tax Implications of the Conversion of Company Shares into Participation Shares within a VCIF

a. Taxes related to the transfer of shares

The transfer of a company's shares to an investment fund is treated as an ordinary transfer of shares for tax purposes and is taxed as follows:

(1) Income tax: If the transferor of a company's shares is a natural person, the gains derived from the disposal of shares are taxed as capital gains. In this context, taxation differs depending on whether the company whose shares are transferred is a joint-stock company or a limited liability company.

If a natural person transfers a joint-stock company's shares bound to a share certificate, if the share certificate has been held for more than two years, the gain arising from the transfer will be exempt from income tax. However, gains derived from the transfer of joint-stock company shares that are not bound to a share certificate or, if bound, have been held for less than two years, are subject to income tax.

In the case of the transfer of limited liability company shares, there is no income tax exemption as in the case of joint-stock company shares. Therefore, if a natural person transfers the shares of a limited liability company to an investment fund, the gain obtained is subject to income tax.

If the shares subject to transfer are transferred to an investment fund by a natural person who is resident abroad, it will be necessary to make an assessment within the scope of the provisions of the double taxation agreement concluded between Türkiye and the country where that natural person is resident. However, in most double taxation agreements, the right of taxation on the disposal of shares held for more than one year is granted to the country of residence of the natural person concerned.

(2) Corporate income tax: For the transfer of joint-stock or limited liability company shares owned by corporate income taxpayers to a fund, 75% of the gain will be exempt from corporate income tax, if the company shares have been held for more than two years and certain conditions are met.[1]

If the shares subject to transfer are transferred to an investment fund by a corporation that is resident abroad, it will be necessary to make an assessment within the scope of the provisions of the double taxation agreement concluded between Türkiye and the country in which the relevant entity is resident. Likewise, double taxation agreements generally give the right to tax the disposal of shares held for more than one year to the country of residence of the related corporation.

(3) VAT: No VAT is applicable to the transfer of the shares of joint-stock companies or limited liability companies by natural persons. For corporate income taxpayers resident in Türkiye, the transfer of shares in a joint-stock company whose shares are bound to share certificates is exempt from VAT. However, in the case of corporate income taxpayers' transfer of the shares of a joint-stock company or a limited liability company whose shares are not bound to shares certificates, the transfer is exempt from VAT if these shares have been held in the assets of the corporate income taxpayer for at least two years. Corporate income taxpayers' transfer of joint-stock company shares and limited liability company shares that have not been held in assets for two years and that are not linked to share certificates, is subject to VAT.

Moreover, the transfer of the shares of companies located in Türkiye by corporations that are resident abroad is not subject to VAT.

(4) Stamp duty: The papers issued related to the transfer of the shares of joint-stock companies and limited liability companies to investment funds are exempt from stamp duty.

b. Taxation of VCIFs

Various tax advantages are provided for VCIFs and these funds are taxed as follows:

(1) Corporate income tax: Under the Corporate Income Tax Law, funds subject to the regulation and supervision of the Board are considered corporations and their earnings are subject to corporate income tax. However, the earnings of VCIFs are exempt from corporate income tax.

(2) BITT: The money earned by VCIFs because of the transactions that they carry out in the money and capital markets are exempt from BITT. However, the amounts received in favor of VCIFs due to transactions that are carried out outside the money and capital markets and that constitute their main field of activity are subject to 5% BITT.

(3) VAT: The activities of VCIFs that fall within the scope of BITT are exempt from VAT. However, the transactions of VCIFs, which lie outside the scope of BITT and do not constitute their main field of activity, are subject to VAT.

(4) Stamp duty: The agreements and the other related papers issued by VCIFs exclusively in relation to venture capital investments are exempt from stamp duty.

c. Taxation of investors' VCIF income

Income obtained from investment funds should be evaluated within the scope of (i) obtaining a participation share dividend, (ii) returning the participation share of an investment fund to the fund or (iii) selling it to a third party. The taxation of each of these income elements differs in terms of corporate income taxpayers and natural persons. The taxation of investment fund income of corporate income taxpayers and natural persons within the scope of current tax regulations is as follows:

(1) Taxation of VCIF incomes of corporate income taxpayers

In accordance with the latest regulations, the profits of corporate income taxpayers from investment funds are taxed as follows:

• Income obtained from receiving participation share dividends from VCIFs or returning the participation shares to the fund are exempt from corporate income tax. Accordingly, if corporate income taxpayers obtain dividends from VCIFs or return their participation shares to the fund, no corporate income tax burden arises.
• If the VCIF participation shares are sold by the corporations to a third party, 75% of the income generated is exempt from corporate income tax if certain conditions are met.[2] To apply this exception, the investment fund participation share must be held by the taxpayer for at least two full years.
• Capital gains realized through the revaluation of VCIF participation shares are also exempt from corporate income tax. Therefore, even if corporate income taxpayers revalue their investment fund participation shares and a profit arises from them, this income is not subject to tax.

Evidently, no tax is imposed on the income of corporate income taxpayers from VCIFs and no tax liability arises even if the participation shares are revalued.

(2) Taxation of VCIF income of natural persons

As a rule, the taxation of income of natural persons from VCIFs managed by PMCs is taxed through withholding. In this context, the income (capital gains and dividend income) of full or limited taxpayer natural persons from VCIFs is subject to tax as follows:

• Income from VCIFs participation shares held for more than two years is subject to 0% withholding tax.
• Income from VCIFs participation shares held for less than two years is subject to 10% withholding tax. However, the withholding tax rate of 0% is applied to the income obtained from investment funds (except variable, mixed, Eurobond, foreign borrowing, foreign, hedge funds and investment funds with the phrase "foreign currency" in their title) acquired between 23.12.2020 and 31.06.2023.
• Natural persons are not required to make any separate declaration for income subject to withholding tax as stated above.

In this context, if natural persons invest through VCIFs, it is feasible for them to generate tax-free income from shares held for more than two years. Whereas, if a natural person invests by purchasing the shares of a private company, dividend income is subject to 10% withholding tax and half of the dividend income is subject to an annual declaration; and income from the sale of joint-stock company shares and limited liability company shares held for less than two years is also subject to income tax.

III. Conclusion

As explained above in detail, taxation of the income to be obtained from the participation shares generated by transferring the shares to a VCIF is particularly advantageous for natural persons holding shares of publicly traded companies, as the table below demonstrates. Moreover, the gains of the VCIF itself are exempt from corporate income tax. Therefore, we anticipate that these structures, which are very attractive for natural persons holding private company shares, will be used more often in the future.

[1] To apply this exemption, the exempt portion of the gain from the sale of shares must be kept in a private fund account as a liability until the end of the fifth year following the year of sale and the sale price must be collected before the end of the second calendar year following the year of sale.

[2] To apply this exemption, the exempt portion of the gain from the sale of shares must be kept in a private fund account as a l iability until the end of the fifth year following the year of sale and the sales price must be collected before the end of the second calendar year following the year of sale.

Tagged with: Esin Attorney Partnership, Muhsin Keskin, Orhan Pala, Senem Özbilen, Bora Kılıç, Eren Akarca, Ali Çetin, Banking, Finance & Capital Markets, Banka, Banking