The U.S. Treasury Department announced on July 8, 2022, that it was terminating the 1979 International Treaty for the Avoidance of Double Taxation with Hungary (“DTT”). Provided that no agreement is reached between the two parties, the provisions of the convention currently in force will no longer apply from January 1, 2024. In order to prepare for such an event, BékésPartners has closely examined the potential adverse tax consequences of the termination and we will present our findings in a two-part article series.
The termination of the treaty dissolves tax-benefits enjoyed by individual and corporate taxpayers under the DTT. As a result, benefits of lower tax rates on certain passive income (e.g., dividend, interest, etc.), exclusion for certain employment income, as well as relief from double taxation would expire with the termination. This could give rise to double taxation without relief and higher international assignment costs.
It must be noted that we are currently in a transitional state wherein the provisions of the DTT are still in force but shall expire on the final day of present calendar year, i.e., December 31, 2023. In short, the reasoning behind the termination can be linked to the outdated nature of the DTT inasmuch as it did not contain provisions promoting general anti-avoidance rules such as the limitation of benefits (LOB clause) allowing benefits to only be taken advantage of by qualified persons.
The conclusions we have come to below shall be effective as of January 1, 2024. Therefore, the DTT shall cease to be effective for those taxable periods (tax years) beginning on or after this date.
To prepare a thorough and detailed notice of the consequences of the termination, we have decided that we would deal with its effects on individuals (natural persons) and corporate taxpayers separately; in each case we will touch on the topics of fiscal domicile; permanent establishment (for companies); active income; passive income; and income realized via a sale of immoveable property.
In the second part herein, we will present the tax effects that the DTT termination will have on legal entities.
Under the term companies we mean those that were considered as such under the DTT Article 3 paragraph 1.b), or rather “any body corporate or any entity, which is treated as a body corporate for tax purposes.”
One of the foremost purposes of the DTT was to resolve the issue of a single company being interpreted as having tax residency in two separate states based on a discrepancy of domestic rules used to determine the tax residency of said company. Based on the DTT – namely Article 4 Paragraph 1 and 3 – the determining factor in resolving the discrepancy is the place of management or place of incorporation of the company, in case of a conflict the latter shall be the determining factor. Since the primary quality of tax residency is place of management, the factors that have been used to determine this are not constricted to where the company has been incorporated but rather where the company is being coordinated, such as the location of workforce; the branch where the bank account has been opened; etc.
Subsequent to the termination of the DTT, it could be anticipated that each state shall interpret a company as being a tax resident in their own state based on entirely different factors. In Hungary, Act LXXXI of 1996 on Corporate Income Tax (“CIT Act”) stipulates the personal scope of corporate income taxpayers.
In this regard, a domestic taxpayer is:
- a specified legal entity (company, cooperative, association, law firm, etc.) which has been incorporated through the domestic laws of Hungary [CIT Act Section 2 Subsection 2];
- a foreign legal entity, which has a place of effective management in Hungary [CIT Act Section 2 Subsection 3];
- a foreign legal entity, or a legal entity with a foreign place of effective management, if said entity realizes taxable income through a permanent establishment or through the transfer or withdrawal of participating interest in a company with real estate holdings [CIT Act Section 2 Subsection 4].
Furthermore, Section 3 of CIT Act stipulates that the tax obligations of a domestic taxpayer in Hungary extends to domestic and foreign income (worldwide income), while a foreign entity’s tax obligation in Hungary is restricted to taxable income realized from its Hungarian permanent establishment.
Considering the above, if a legal entity falls under the scope of the abovementioned Hungarian qualities and simultaneously the relevant tax laws of the US draw in a legal entity within its own personal scope then it may be anticipated that the worldwide income of the Hungarian entity shall be taxed both in the US and in Hungary.
As is the case with the tax residency, the term permanent establishment (“PE”) stipulated in Article 5 of the DTT must now also be reconsidered. The qualities that make a PE are no longer limited to those listed in the DTT but shall be determined by each of the relevant Hungarian tax laws (i.e. the CIT Act) and the relevant tax laws of the US. The change in terminology may result in a reclassification of certain fixed places of businesses as PE based on domestic laws.
Under the DTT, the term PE meant a fixed place of business or production through which activities of an enterprise are wholly or partially carried on. Specifically, it meant that a PE was established under the following instances:
- through a place of management, branch, office, factory, workshop, mine, oil or gas well, or any other place of extraction of natural resources;
- a building site or construction or installation project, or an installation or drilling rig or ship used for the exploration or development of natural resources provided that it lasts more than 24 months;
- through a person acting on behalf of the enterprise, who habitually exercises the authority to conclude contracts in the name of such enterprise, a PE shall be established in respect to any activities that said person undertakes for the enterprise.
The term PE as defined in the CIT Act is in many regards identical to the term defined in the DTT. However, in those instances wherein there is a discrepancy, the outcome of the reclassification could be substantial. Emphasis needs to be placed on two specific instances in which a PE shall be established once the DTT is no longer in effect.
Firstly, a PE shall be established through a site of construction or assembly operations (hereinafter referred to collectively as “construction site”), including supervisory activities related thereto, if such construction continues for a total of at least three months (with or without interruption) with regard to individual construction sites irrespective of whether such activity is based on several independent contracts or whether it was commissioned by several parties; any construction project constituting one unit from an economic, business and geographical point of view shall be recognized as one construction site [CIT Act Section 4 Paragraph 33 Subparagraph b]. Hungary’s right to tax has broadened because while under the DTT, a construction site established a PE provided that the construction site was existent for a period longer than 24 months, whereas now the Hungarian domestic law shall establish such PE after only 3 months.
Secondly, a PE shall also be established through the supply of services through a natural person employed by a foreign person under contract of employment or carrying out the same activity under another form of legal relationship, provided that the service is supplied for 183 days or more continuously or with interruptions during any twelve-month period, with the provision that related and associated services shall be taken into account on the aggregate [CIT Act Section 4 Paragraph 33 Subparagraph i]. The DTT had not established a PE for the latter and as such US companies must be wary that the employment or a similar legal relationship shall in itself establish a PE in Hungary.
Active taxable income (Business Profits)
The realization of business profit is closely intertwined with the previously discussed topics of personal scope and PE. Under the umbrella of the DTT, a potential clash of legal provisions on tax residency between the two states was resolved by stipulating that the determining factor in this issue is the company’s place of incorporation. Subsequent to the tax residency having been determined, the worldwide income (i.e. the business profits) of said company would only be taxed in that state; while any taxable income realized in a PE found in the other state would be taxed in that state.
Without a DTT, a situation may now arise that all taxable income of a company shall be taxed in both the USA and Hungary if – in accordance with our observations under “Fiscal domicile” – both states determine the tax residency in their own state. In relation to a PE, any taxable income that is realized in a PE is taxed in the PE state but without a tax-exemption being applied by the resident state. However, the double taxation may be partially resolved in Hungary through the crediting method described in detail under the paragraph on the avoidance of double taxation.
Income from immovable property
Under the umbrella of the DTT, income from immovable property was in all instances taxed in the state where the property was located therefore tax exempt in Hungary or credited in the USA. From January 1, 2023, the tax treatment of sale of immovable property shall be determined based on domestic laws. In Hungary, the CIT Act declares that the utilization or sale of an immovable property in Hungary establishes a PE for a foreign company in Hungary. As such a foreign company shall be taxed on its Hungarian immovable property based on the establishment of a PE. [CIT Act Section 4 Paragraph 33 Subparagraph d]
Passive taxable income (dividends, interest, royalties)
If a company is deemed as a tax resident of only one of the two states but it realizes passive income (dividends, interest, royalties) from the interests/transactions in the other state then the termination of the DTT shall deeply affect the tax treatment of this passive income with regards to withholding taxes applied to the income.
In terms of interest, the DTT allowed only the resident state to tax interest income. Without a DTT, Hungarian legal entities receiving interest income from the USA can principally expect a 30% withholding tax to be applied, except ECI interest and those connected to portfolio debt obligations, short-term obligations, bank deposits and certain bonds.
The exception from the withholding tax mentioned above covers quite a wide range of transactions and therefore it is a subject that needs to be addressed. It is expected that the US shall not apply a withholding tax to certain types of exempted interest income.
- An ECI, or effectively connected income means any income that is connected with trade or business in the US. ECI can be attributed to either income generated from the use of an asset or to the conducting of business activities in the US; in terms of interest income, this can be interpreted most specifically in relation to interest received from the active conduct of banking, financing, or similar business, or by a corporation the principal business of which is trading in stocks and securities on its own behalf.
- Interest from portfolio debt obligations is interest that has arisen from a debt instrument that does not qualify as an ECI and meets the required conditions, those being that the debt is in a registered form (or bearer form prior to March 18, 2012); that it is not paid to a shareholder with more than 10% shareholding; it is not received by a controlled foreign company; it is not a contingent interest; and – if received by a bank – it is received through a loan agreement concluded in its ordinary course of business. The failure to meet any of these criteria shall result in the disqualification of the exemption.
- A short-term obligation is an obligation that is repayable within 183 days of original issue date.
- Bank deposit interest income is simply income generated from the depositing of cash in a bank account at a US bank.
US legal entities should not expect repercussions as Hungary does not apply withholding taxes on interest income.
In terms of dividends, the DTT allowed for both states to tax this type of income; however, the withholding tax in the source state was restricted to an amount of 5% or 15% dependent on whether the shareholding was above 10%. The resident state then allowed the tax to be credited when the company filed its tax return. Without a DTT, Hungarian legal entities receiving dividends from the USA can expect a 30% withholding tax to be applied.
US legal entities should not expect repercussions as Hungary does not apply withholding taxes on dividends.
In terms of royalties, the DTT allowed only the resident state to tax royalty income. Without a DTT, Hungarian legal entities receiving royalty income from the USA can expect a 30% withholding tax to be applied,.
US legal entities should not expect repercussions as Hungary does not apply withholding taxes on royalty income.
Avoidance of double taxation
The CIT Act includes domestic avoidance of double taxation rules that apply for cases in which there is a double taxation treaty and also those cases where there is a lack thereof. In the context of these rules, the tax authority allows for the crediting of taxes paid on taxable income in a foreign jurisdiction by the Hungarian company. If there is no treaty then the tax that may be credited in Hungary shall not exceed the less of the following two options between either (1) 90% of the tax paid in the foreign jurisdiction, or (2) the tax calculated for the taxable income on the average tax rate applied to that specific type of income in Hungary. [CIT Act Section 28 Subsections 2-6]
Taking into consideration the high withholding tax rates as well as a higher corporate income tax rate in the USA, it can be anticipated that of the two options, the latter shall be applied leading to a substantial amount of foreign tax paid that cannot be credited in the Hungarian tax return.
We trust that decisions brought by the US and Hungarian government will not have a substantial detrimental effect on the undertakings and livelihood of the affected parties. In order to mitigate any undesired consequences, BékésPartners is offering its services to those hoping for the best but preparing for the worst.