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 In short, the reasoning behind the termination can be linked to the outdated nature of the DTT inasmuch as it did not contain provisions promoting general anti-avoidance rules such as the limitation of benefits (LOB clause) allowing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 first part herein, we will present the tax effects that the DTT termination will have on private individuals.
1. Tax residency
The DTT is applicable to persons who are residents in either or both contracting states based on their domestic laws. If a private individual is resident in both contracting states based on their domestic rules, the DTT gives a set of rules through which the tax residency of a person can be determined. The significance of the tax residency is that the state of residency has the right to tax a private individual’s worldwide income, while the source state can only tax the income, which originated from there.
Based on the DTT, if a private individual has residency in both states under their domestic rules, then its state of residency is where the individual had a permanent home available to him. If the individual had permanent home in both countries, then the state of residency shall be where the individual’s center of vital interests is located. If the vital interests cannot be determined, then the individual’s nationality shall be the determining factor. If the individual has nationality in both or neither country, then the contracting states shall settle the question by mutual agreement.
The termination of the DTT will mean that a private individual can be considered tax resident both the US and in Hungary, and therefore might be taxed on their worldwide income twice.
The rules of tax residency of a private individual in Hungary are determined in Act CXVII of 1995 on Personal Income Tax (“PIT Act”) as follows:
- any citizen of Hungary (with the exception of dual citizens without a permanent or habitual residence in Hungary);
- any natural person who exercises his/her right of free movement and the right of residence for a period exceeding three months in the territory of Hungary in the calendar year in question for at least 183 days, including the day of entry and the day of exit;
- who falls under the scope of the Act on the Admission and Residence of Third-Country Nationals and has permanent residence status, or is a stateless person;
- any natural person, other than those mentioned above
- whose only permanent residence is in Hungary;
- whose center of vital interests is in Hungary, if there is no permanent residence in Hungary or if Hungary is not the only country where he/she has a permanent residence;
- whose habitual residence is in Hungary, if there is no permanent residence in Hungary or if Hungary is not the only country where he/she has a permanent residence, and if his/her center of vital interests is unknown [PIT Act Section 3 Subsection 2)]
Considering the above, upon the termination of the DTT there could be several situations where an individual might be taxed by both Hungary and the USA. If a private individual falls under the rules of resident in both Hungary and the USA, both countries might tax the individual’s worldwide income.
If a private individual is resident in Hungary, but has income from the USA, then the USA source income might be taxed by both countries. If a private individual is resident in the USA, but has income from Hungary, then the Hungarian source income might be taxed by both countries.
2. General overview of the personal income taxation rules of Hungary
The Hungarian personal income tax system differentiates between income that should be counted together in the consolidated tax base, and income, which is taxed separately.
Income from self-employment activities, income from activities other than self-employment, and other income which is not taxed separately jointly make up the consolidated tax base. These types of income are in the DTT terms income from dependent personal services, and income from independent personal services, while other income should be determined on a case-by-case basis.
Passive income, such as dividends, interests, royalties, or income from the alienation of immovable property is taxed separately from the consolidated income.
3. Taxation of the consolidated tax base
3.1. Income from dependent personal services
Under the DTT income from dependent personal services essentially could only be taxed in the state of residency, unless the work was performed in the other contracting state. Even if the work was performed in that other state, but the individual did not spend more than 183 days there, and the employer does not have a residency in that other state, and the remuneration is not paid by a PE or a fixed place of business which the employer has in the other State, then the income could only be taxed in the state of residency. If the state of residency is Hungary, and the USA has the right to tax such income as source state, then Hungary exempts the income from taxation. If the state of residency is the USA, and Hungary has the right to tax the income as source state, then the tax paid in Hungary can be credited against tax payable on the income in the USA. The withholding tax on such income is 15%.
Upon the termination of the DTT income from dependent services will be taxed in Hungary, if the natural person is Hungarian resident based on the rules set out in Section 1 above, or if the source of the income is Hungary based on Hungary’s domestic rules. Hungary’s domestic rules are in principle not different from that DTT inasmuch as the income is originated from Hungary if the work was performed there. However, there are no special rules depriving Hungary from the right of taxation if the work was performed there, but for example the private individual did not spend more than 183 days in Hungary. Therefore, Hungary’s right of taxation as source state becomes wider. The withholding tax on such income is 15%.
3.2. Income from independent personal services
Under the DTT income from independent personal services essentially can only be taxed in the state of residency unless the work is performed in the other state and if the individual spent more than 183 in that state or if it has a fixed base regularly available to him. If the state of residency is Hungary, and the US has the right to tax such income as source state, then Hungary exempts the income from taxation. If the state of residency is the US, and Hungary has the right to tax the income as source state, then the tax paid in Hungary can be credited against tax payable on the income in the USA. The withholding tax on such income is 15%.
Upon the termination of the DTT income from independent services will be taxed in Hungary, if the natural person is Hungarian resident based on the rules set out in Section 1 above, or if the source of the income is Hungary based on Hungary’s domestic rules. Hungary’s domestic rules stipulate that income from independent personal services shall be originated from Hungary, if the individual is Hungarian resident, or if the activity is performed through a fixed base, and the fixed base is in Hungary. This means that due to the termination Hungary’s right of taxation will be narrower, as in lack of a fixed base the time spent in Hungary in and of itself will not grant Hungary the right of taxation.
3.3. Foreign tax relief
If the individual must pay taxes on income which is taxed in Hungary in the consolidated tax base, then 90% of the tax paid abroad can be credited against the tax payable on the consolidated tax base. The maximum amount of the creditable tax paid abroad cannot be higher than the tax that would have been applied to the income in Hungary.
3.4. Social contribution tax on the consolidated tax base
If an individual has consolidated tax base in Hungary, then it shall pay 13% of social contribution tax based on the consolidated tax base. No foreign tax paid can be credited against social contribution tax.
A non-Hungarian resident individual must not pay however social contribution tax after other income in the consolidated tax base, only after income realized from dependent or independent personal services.
4. Taxation of separately taxed income
4.1. Income from immovable property
Under the DTT income from immovable property, and capital gains realized on the alienation of immovable property shall only be taxed in Hungary, if the immovable property is located in Hungary. If the state of residency is the US, and Hungary has the right to tax the income as source state, then the tax paid in Hungary can be credited against tax payable on the income in the USA. The withholding tax on such income is 15%.
Upon the termination of the DTT income from the alienation of immovable property will be taxed in Hungary, if the natural person is Hungarian resident based on the rules set out in Section 1 above, or if the immovable property is located in Hungary.
Once the DTT is terminated, the income realized by Hungarian individuals through the alienation of US based real property will not pay tax in Hungary after capital gains, but this income will be taxed as other income in the consolidated tax base. This means that the foreign tax relief can be used as described under 3.3, and that further to the 15% personal income tax there will be a 13% social contribution tax levied on the income.
In the Hungarian PIT system income from immovable property, such as rent collected is taxed as independent personal services as set forth in Section 3.2.
4.2. Interest income
Under the DTT interest income shall only be taxable in the state of residency, therefore Hungary may only tax the interest income of Hungarian resident private individuals. In such a case, it shall be taxed with the general 15% rate.
Upon the termination of the DTT interest income will be taxable in Hungary, if the natural person is Hungarian resident based on the rules set out in Section 1 above, or if the residency of the person liable to pay the interest is in Hungary. This means that Hungary’s right of taxation will become broader, as Hungary will be able to tax interest income of US tax resident natural persons, if the person liable for the interest is Hungarian resident. In such cases Hungary will withhold 15% personal income tax.
In the lack of a DTT, interest paid from the US to a Hungarian resident private individual will not be taxed separately under interest income, but in the consolidated tax base as other income. This means that the foreign tax relief can be used as described under 3.3, and that further to the 15% personal income tax there will be a 13% social contribution tax levied on the income.
Non-Hungarian resident private individuals receiving interest income from Hungary as source state will have to pay 15% withholding tax, however they will not have to pay social contribution tax on this income.
4.3. Dividend income
Under the DTT dividend income realized by a natural person can be taxed in Hungary, if the private individual is Hungarian resident, or if the company paying the dividends is a Hungarian resident company. If the state of residency is Hungary, and the US has the right of taxation as source state, then the tax paid can be credited against the tax payable in Hungary. If the state of residency is the US, and Hungary has the right to tax the income as source state, then the tax paid in Hungary can be credited against tax payable on the income in the USA. The withholding tax in Hungary on such income is 15%.
Upon the termination of the DTT dividend income will be taxable in Hungary, if the natural person is Hungarian resident based on the rules set out in Section 1 above, or if the person paying the dividends is a Hungarian resident company.
Hungarian resident persons may credit the US tax paid on this income but must pay at least 5% personal income tax in Hungary. Hungarian resident private individuals must also pay 13% social contribution tax on such income, albeit the private individual must only pay social contribution tax after such income, until the total social contribution tax payable reaches or exceeds 723,840 HUF in 2023.
Non-Hungarian resident private individuals who receive dividend income from Hungarian resident persons shall only pay 15% withholding tax, as in the case of dividend income foreign natural persons shall not pay social contribution tax.
5. Other rules triggered by the termination of the DTT
Within the Hungarian PIT system there are several penalizing rules that get triggered once the DTT will be terminated, since up until now it was assumed any country with which Hungary does not have a DTT is a blacklisted country or tax haven.
Upon the termination of the DTT insurance payments from the USA which were previously free of personal income tax cannot remain tax free, and most likely will be taxed as other income.
It also must be mentioned, that upon the termination of the DTT US based investment service providers will not be able to qualify as investment service providers under the term of income from controlled capital market transactions. This means that private individuals will loose the ability to set off trading losses against trading gains realized through such service providers, and will be taxed based on the gains only.
