* Record fine escalates coverage dispute with government
* Backdrop of concern over Turkish media freedoms
* Shares fall 20 pct (Adds share price reaction, details, background)
ISTANBUL, Sept 8 (Reuters) - Turkey's biggest media company said on Tuesday it was fined $2.5 billion for unpaid taxes, sending its shares 20 percent lower and raising fresh questions about press freedom and the investment climate in the country.
The record tax fine could add to concerns that fear of reprisal is keeping a lid on media criticism of Prime Minister Tayyip Erdogan's administration, in a country that has pledged to improve political standards to join the European Union.
The Finance Ministry's tax authority fined firms controlled by Dogan Yayin DYHOL.IS 3.76 billion lira ($2.53 billion), twice the level of tax arrears that officials assessed at 1.88 billion lira after examining accounts for 2005, 2006 and 2007, Dogan Yayin said in a stock exchange filing.
The fine is equivalent to four-fifths of Dogan Yayin and parent Dogan Holding's (DOHOL.IS) combined market value of $3.1 billion lira.
It was the second major fine this year for Dogan Yayin, which controls more than half of the non-state media market and has been at odds in recent years with Erdogan over its coverage of the Islamist-rooted government.
Officials at the Finance Ministry and the prime minister's office declined to comment further.
A government source, who declined to be named, told Reuters the fine was entirely a decision by the tax authority and that the government has not exerted any pressure.
Dogan Yayin, which owns top-selling daily Hurriyet and the CNN Turk broadcaster, said it would pursue all legal means, including negotiations, to resolve the tax dispute.
"It's inevitable this will have a negative effect on our country, which has a long-standing corporate culture and developed capital markets ... especially during a period when it needs foreign financing and resources," it said in a statement.
Shares in Dogan Yayin and parent Dogan Holding (DOHOL.IS) tumbled 20 percent to 1.31 lira and 1.08 lira, respectively, amid concerns the group will find it tough to raise the collateral it would need to support its appeal, after already using its shares to secure collateral for the February fine. The main share index .XU100 was off 0.65 percent.
"The massive size of the potential liability and the uncertainty attached to the situation is likely to weigh on sentiment on Group shares," wrote Sezgi Bizce, an analyst at Finans Invest who downgraded her rating on Dogan Yayin to "underperform" following news of the fine.
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"Given the context, this penalty ... does raise concerns," said Anthony Mills, spokesman on press freedom for the Vienna-based International Press Institute. "It comes within a climate of concern in general about media freedom in Turkey."
The government has denied the previous fines -- which are considerably larger than any other company in Turkey has faced -- are politically motivated, and that it is singling out Dogan. In March a Turkish unit of oil major BP (BP.L) was fined 474 million lira over a tax breach.[ID:nL4885123]
Turkish media has become increasingly polarised between those in favour of the government and those critical of it, and the European Union, which Turkey is seeking to join, and the United States have voiced concerns that criticism is being stifled.
Erdogan has publicly criticised billionaire media magnate Aydin Dogan, and earlier this year he called on ruling AK Party members to refrain from buying his group's newspapers.
Dogan has claimed it faces unprecedented tax penalties because of its newspapers' and television stations' critical coverage of the government last year, particularly over corruption allegations.
"We were to believe the worst was over and he (Erdogan) wanted reconciliation with Dogan and because of that the degree of criticism was toned down," said an editor, who asked not to be named, at a Dogan unit.
"The only explanation is that this is a coup de grace."
The fine comes at a sensitive time, when Erdogan needs all the support he can get for an ambitious reform programme, ranging from addressing decades-old grievances of the Kurdish ethnic minority to normalising ties with Armenia.
He has also faced strong criticism from a conservative secularist establishment, including the armed forces, which suspects him of harbouring an Islamist agenda.
Dogan Yagin was ordered to pay 900 million lira in February for tax irregularities connected with the sale of a 25 percent stake in its television unit to German publisher Axel Springer (SPRGn.DE). It is appealing that ruling.
Dogan Holding began talks with its Austrian partner OMV (OMVV.VI) last month on selling its controlling stake in Petrol Ofisi PTOFS.IS, Turkey's largest fuel retailer.
(Additional reporting by Alexandra Hudson and Selcuk Gokoluk; editing by John Stonestreet and Rupert Winchester)