There are deep concerns among companies and individuals as a result of the United States commencing the termination process of the rather old 1979 US-Hungarian Double Tax Treaty on the 8th of July. The treaty has been in force for more than 40 years. The flood of questions and speculative articles questioning the following:
- What will happen with companies now that have a US presence and vice versa?
- What steps should be taken by companies to ensure not to be adversely affected by the termination of the current Treaty?
- What additional tax burden could individuals be faces if they receive income from the US or if they trade, for example, with shares of US companies?
These and countless other questions arise about this extraordinary news. In this article, we briefly review these issues and draw the attention to some of the most significant consequences of the termination of the Treaty, as the subject is extremely wide but the scope of this article is rather limited.
What types of businesses are affected by the termination of the 1979 US-Hungary Tax Treaty?
As known, the US-Hungary Tax Treaty’s aims to promote economic and trade cooperation between companies established in the US or in Hungary, as well as the employment and investments of individuals in relation to the US and Hungary. For this reason, all Hungarian and US companies and individuals who have presence or activities (e.g. business profits, income from employment, capital gains, income from other sources) in both countries and who generate income or revenues in both countries will be affected by the termination of the Treaty.
Do Hungarian companies having presence in the US and US companies doing business in Hungary face adverse tax consequences?
In some cases of course yes, because the purpose of the Treaty is to avoid and manage double taxation as well as at the level of companies to decide which of the two countries is entitled to tax the relevant income, such as business profits, dividends, interest, royalties, etc., with the aim of avoiding double taxation of the same income as far as possible. So, the termination of the 1979 Treaty will not only hurt Hungary and Hungarian companies doing business with the US, but also the United States and US companies doing business in Hungary, and ultimately result in additional tax burden for entities and individuals, and most likely result in double taxation.
As an example, - if the termination of the Treaty will be in force and it should be eliminated, - a Hungarian company with a US subsidiary that would receive dividends from the US, will no longer be able to rely on the favorable 5% or 15% US withholding tax (relating to its ownership stake) under the dividend article of the 1979 Treat. Instead, it will be subject to 30% withholding tax under US domestic rules.
The situation is even more painful if a Hungarian company receives interest or royalties from the US, because in these cases today there should not be a 30% withholding tax at source (in the US) under the current 1979 Treaty and the income received is taxable only in the hands of the Hungarian recipient company. In the absence of the Treaty, 30% withholding tax should be withheld at source (in the US) and can be partially offset in the Hungarian tax return (in practice 90% of the US withholding tax can be deducted from corporate income tax payable of the Hungarian entity, however, this is capped at the average tax rate of the Hungarian company in question).
From the other side (US), the situation is rather different, as if a Hungarian company pays dividends, interest or royalties to its US counterpart, it remains exempt from Hungarian withholding tax regardless of the termination of the 1979 Treaty. In this case, the exemption from Hungarian withholding tax is possible under Hungarian domestic legislation and Hungarian tax policy which can certainly be changed by a one off Hungarian legislative amendment. I.e. the exemption is granted since Hungary does not impose any withholding taxes in relation to any foreign countries if the beneficiary is a company and not an individual and dividend, interest or royalties are paid. (For individuals, of course there is a 15% Hungarian personal income tax payable).
Does the termination of the 1979 Treaty affect the Hungarian tax presence of US companies?
Certainly yes, and not in a small extent, because the Treaty provides exemption from the creation of corporate income tax PEs (permanent establishments) in Hungary, as it aims to strengthen economic relations between the two countries. In the case of a building site or construction, or in case of an installation project performed in Hungary, for example, the 1979 Treaty requires US companies to register for Hungarian corporate income tax purposes only if they have been present in Hungary for more than 24 months. In contrast, in the absence of the Treaty, the 3-month period provided in the Hungarian domestic law (i.e. the Corporate Income Tax Act) must be applied. This means that after three months of business presence (e.g. construction or installation) of US entities in Hungary, these US companies will have to establish some form of legal presence (e.g. a branch office) in Hungary and will be subject to Hungarian corporate tax, furthermore, should have accounting records and submit tax returns. Let us not even mention the PE rules regarding the provision of services in the territory of Hungary.
What happens to the investments and income of Hungarian individuals from US sources?
Without the Treaty, dividend, interest or royalties received would be subject to taxes in both countries concerned. For example, Hungarians will suffer from a 30% US withholding tax on dividends from their US shares, instead of the 15% that they are currently entitled to under the relevant articles of the 1979 Treaty.
In the absence of an international treaty with the US, transactions at the US stock exchange will be no longer considered as income at a controlled capital market, thus it will be considered as income from (regular) capital gains, and therefore, the related gains would be subject not only to 15% personal income tax, but also to 13% social contribution tax.
Moreover, income from the US, after the deduction of the 30% US withholding tax, would also be subject to the minimum 5% personal income tax in Hungary, because there is a minimum personal income tax to be paid to the Hungarian budget for such cases, even in the case of foreign tax credits provided in Hungarian domestic legislation.
What type of processes could be started as a result of the commencement of the termination proceedings of the 1979 US-Hungary Tax Treaty and which industries could be mostly affected?
After the initial shock, the Hungarian and US companies concerned will certainly looking for ways to prevent or at least reduce the increase of their overall tax burden. One possible way of doing this is for Hungarian companies with a US subsidiary to transfer their economic activities to a North American country with which Hungary (still) has a tax treaty, such as Canada, with which Hungary has favorable withholding tax rules similar to those of the 1979 US-Hungary Tax Treaty (e.g. 5% or 15% withholding tax for dividends, taking into account, for example, the size of the shareholding of the recipient entity).
Another way could be for these groups of companies with Hungarian-American business interests to make actions to achieve the same overall tax burden (effective tax rate) by changing their contractual relationship and link a third (foreign) country in their agreements and business model. Certainly in line with economic rationale and in a way not to be successfully accused of tax evasion in any of the countries involved. The third country is optimal for tax purposes if the treaty withholding taxes of the third country with Hungary (and with US) provides overall a better withholding tax burden compared to the 30% US-Hungary withholding tax. In other words, a kind of "treaty shopping" tendency could be restarted.
In our opinion, several sectors in Hungary could be severely affected by the termination of the Treaty, but especially those, who have been able to operate tax-free in Hungary for a longer period of time under the Treaty.
When will the favorable provisions of the 1979 US -Hungary Tax Treaty cease to exist?
Hungary received the official notification about the commencement of the termination proceedings through diplomatic channel from the US on 8th of July. Thus, according to Article 26 of the Treaty, the provisions will cease to exist after 6 months. However, the termination of the treaty benefits will not be immediate, but will be grandfathered. Regarding withholding taxes, for example, the treaty benefits will cease to apply from 1 January following the expiry of the 6-month notice period, i.e. 1st of January 2024.
Will the new US-Hungary Tax Treaty signed in 2010 and already ratified in Hungary be automatically utilized after the termination of the 1979 Treaty?
Provided that the new 2010 US-Hungary Tax Treaty has not been ratified by the US Senate for more than 10 years, it will not be automatically applicable under current rules. However, there is a realistic chance that this new treaty would likely replace the outdated 1979 Treaty in medium term.
As shown, there are a lot of tax issues surrounding the commencement of the termination proceedings of the 1979 US-Hungary Tax Treaty, if we review only the business presence of Hungarian companies in the US and the transactions of Hungarian individuals in the US. Therefore, we recommend our readers considering how their activities will be affected by the termination of the 1979 US-Hungary Treaty and what issues are worth analyzing and considering and, if necessary, what actions should be taken without delay.