Tax Planning for U.S. Inbound Licenses of Intellectual Property in a Post U.S.-Hungary Tax Treaty World

By Anthony Diosdi and Istvan Csovari
The U.S. is the world’s largest recipient of foreign direct investment. Much of this investment is in the firm of foreign owned intellectual property. Creators of foreign owned intellectual property typically will transfer some or all of their intellectual property rights through an inbound U.S. licensing agreement. Under U.S. domestic laws, a foreign person generally is subject to to 30 percent U.S. federal tax on the gross amount of U.S. source income received from a licensing agreement. This tax is collected through so-called (“withholding agents”). All U.S. persons (“withholding agents”) making U.S. sourced fixed, determinable, annual, or periodical (“FDAP”) payments to foreign persons generally must report FDAP payments, such as royalties to the Internal Revenue Service (“IRS”) and withhold the 30 percent tax. Withholding agents are permitted to withhold at a lower rate if the beneficial owner of the intellectual property certifies their eligibility for a lower rate allowed under the Internal Revenue Code or a tax treaty.

Many Hungarian owned businesses license technology to the U.S. through license agreements. As a result of the U.S.- Hungarian bilateral tax treaty enacted in 1979, Hungarian owned businesses have avoided the 30 percent withholding tax as a result of a bilateral income tax treaty on FDAP income treated as U.S. source royalty income. The favorable tax treatment Hungarian businesses have enjoyed as of the U.S.-Hungary tax treaty is about to end.

On July 8, 2022, the Biden administration announced that it will terminate the U.S.-Hungary Income Tax Treaty that was enacted in 1979. The provisions of the tax treaty will no longer apply after January 1, 2024. According to a July 8 article in the Wall Street Journal, the Treasury Department explained its action based on long-standing concerns with Hungary’s tax system and the treaty itself, and a lack of satisfactory action by Hungary to remedy these concerns in coordination with other EU member countries that are seeking to implement the OECD Pillar Two global minimum tax proposal. The treaty termination will apply to U.S.-source dividends, interest, and royalties for payments made on or after January 1, 2024. A new U.S. income tax treaty with Hungary was agreed to in 2010 (to replace the 1979 tax treaty), primarily to add a Limitation of Benefits article or (“LOB”). However, the 2010 tax treaty has not been ratified due to objections of Senator Rand Paul. In addition, according to a Treasury spokesperson, the new treaty is not supported by the Biden administration because Hungary recently reduced its corporate tax rate.1

The termination of the U.S.-Hungary tax treaty will impact many Hungarian start-ups, VC funds, IP/Software/IT, and other tech companies, including SaaS providers. The article discusses how certain Hungarian entities can potentially utilize tax treaties (other than the current U.S.-Hungary bilateral income tax treaty) to reduce or eliminate U.S. withholding taxes on U.S.-source royalties for payments made on or after January 1, 2024.

Effect of Treaties on U.S. Withholding Taxes

The U.S. has entered into various bilateral income tax treaties in order to avoid double taxation. Tax treaties generally reduce or eliminate withholding taxes on specified items of U.S.-source income that is not attributable to a permanent establishment in the United States. In order to qualify for the benefits under an income tax treaty, a foreign individual or entity must not only be a resident of one of the countries party to the treaty, but also satisfy additional restrictions set forth in a LOB article contained in the treaty. LOB articles have arisen in tax treaties to curtail the practice of “treaty shopping.” In the corporate context, most treaties deem a corporation that is organized under the laws of the country party to the bilateral treaty as a resident of that country. Historically, being a resident of a contracting state was all that was needed for a corporation to claim treaty benefits. This single requirement, together with the relative ease with which corporations could be formed and operated under the laws of many jurisdictions, led companies to form corporate entities in a third country specifically chosen to take advantage of that country’s favorable tax treaty. For this reason, LOB articles require a corporation who is a resident of a contracting state to also satisfy one of the article’s corporate tests before such corporation can claim benefits under the treaty. Among these tests are the “publicly traded company test,” the “ownership-base erosion test,” and the “derivative benefits test.” A corporate resident needs to meet only one of these tests. The tests are generally designed to ensure that there is sufficient nexus between the corporation and its country.

LOB Corporate Tests under the Treaties

Although the LOB articles of the income tax treaties entered into by the U.S. vary (and in some cases quite significantly), the general provisions of the three LOB corporate tests mentioned above are set forth in the 2016 U.S. Model Income Tax Treaty, which are summarized below.

Under the publicly traded company test, a corporation must be a “publicly traded company” which is defined as a corporation whose principal class of shares is “regularly traded” on one or more recognized stock exchanges and either 1) such shares are also primarily traded on one or more recognized stock exchanges located in the contracting state where the corporation is a resident or 2) the corporation’s primary place of management and control is in the contracting state where the corporation is a resident.

The second test, referred to as the ownership-base erosion test, consists of two parts, both of which must be satisfied. The first part addresses the composition of the corporation’s owners and requires that at least 50 percent of the aggregate voting power and value of the corporation’s shares be owned, directly or indirectly, by owners who are residents of the same contracting state where the corporation is a resident. These owners must own their shares in the corporation for a period of time equal to at least one-half of the corporation’s taxable year, and each such owner must be either an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization. The second part of the ownership-base erosion test addresses erosion of the corporation’s tax base. Specifically, this second part provides that certain payments made by the corporation in the taxable year must not total 50 percent or more of its gross income for such year. A payment is subject to this 50 percent limitation if it is deductible for tax purposes in the contracting state where the corporation is a resident and if such payment is made by the corporation to a restricted recipient. Restricted recipients include 1) recipients who are not residents of either contracting state and are not entitled to the benefits of the treaty as an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization and 2) recipients who are connected to the corporation (by at least a 50 percent ownership interest) and benefit from a special tax regime with respect to the deductible payment. The payments limited by this second part of the test do not include arm’s-length payments made in the ordinary course of business for services or tangible property.

The third test is the derivative benefits test. Its purpose is actually to expand treaty benefits to a corporate resident in either contracting state with respect to an item of income. This test applies to closely held corporations that cannot otherwise qualify for treaty benefits to obtain treaty relief. Similar to the ownership-base erosion test, the derivative benefits test also consists of two parts, both of which must be satisfied. The first part requires at least 95 percent of the aggregate voting power and value of the corporation be owned, directly or indirectly, by seven or fewer shareholders who are equivalent beneficiaries. An “equivalent beneficiary” is a person who is the resident of another country that has entered into its own bilateral income tax treaty with the U.S. and who is entitled to the benefits of that other treaty as either an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization within the meaning of the other treaty. However, the benefits afforded to the person by the other treaty (or by any domestic law or other international agreement) must be at least as favorable as the ones afforded by the current treaty under which the person is an equivalent beneficiary. For example, if the other treaty subjects the person to a rate of tax on dividends, interest, or royalties that is higher than the rate applicable under the current treaty, then the person would be disqualified from being an equivalent beneficiary under the current treaty.

The second part of the derivative benefits test mirrors that of the ownership-base erosion test in that it too limits the corporation’s payments that are deductible for tax purposes in the contracting state where the corporation is a resident to be less than 50 percent of its gross income for the taxable year. However, the second parts of both tests differ in who they define to be a restricted recipient of the deductible payment. In the case of the derivative benefits test, restricted recipients include 1) recipients who are not equivalent beneficiaries, 2) recipients who are equivalent beneficiaries only because they function as a headquarters company for a multinational corporate group consisting of the corporation and its subsidiaries, and 3) recipients who are equivalent beneficiaries that are connected to the corporation (by at least a 50 percent ownership interest) and benefit from a special tax regime with respect to the deductible payment. Like the ownership-base erosion test, the payments limited by this second part of the test do not include arm’s-length payments made in the ordinary course of business for services or tangible property.

“Equivalent Beneficiaries” under the Derivative Benefits Test of Various Treaties

The following U.S. income tax treaties contain a derivative benefits provision in their LOB articles: Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Ireland, Jamaica, Luxembourg, Malta, Mexico, the Netherlands, Sweden, Switzerland, and the United Kingdom.

Each of these treaties has a specific “equivalent beneficiary” definition. For example, the U.S. treaties with Canada and Jamaica, like the 2016 U.S. Model Income Tax Treaty, broadly allow residents of any jurisdiction that has an income tax treaty with the U.S. to be treated as equivalent beneficiaries. In contrast, the U.S. treaties with Belgium, Sweden, and Finland limit equivalent beneficiaries to residents of a country in the EU or EEA, residents of a NAFTA country, and residents of Switzerland. The U.S. treaty with Mexico is even narrower, limiting equivalent beneficiaries to residents of a NAFTA country.

In addition to these country residency requirements, each treaty has other requirements that the equivalent beneficiary must satisfy in order to meet the derivative benefits test. For example, the derivative benefits tests in most treaties are similar to the one in the 2016 U.S. Model Income Tax Treaty in that they require the equivalent beneficiary to be entitled to the benefits under the other bilateral income tax treaty as an individual, a qualified contracting state (or subdivision), a publicly traded company, or a pension fund or tax-exempt entity within the meaning of that other treaty. As a consequence, a person who is an equivalent beneficiary under such a derivative benefits test in one treaty cannot be counted as a qualifying owner under the ownership-base erosion test in the same treaty (and also cannot meet the active trade or business test, in any, in such treaty). Treaties that contain this requirement include the U.S. treaties with Belgium, Denmark, France, Germany, Iceland, Malta, Mexico, the Netherlands, Sweden, and Switzerland.

Moreover, these treaties provide that if another country’s tax treaty with the United States lacks a LOB provision, then a person resident in that other country can still be an equivalent beneficiary under the current tax treaty if such person would otherwise qualify as an individual, a contracting state (or subdivision), a publicly traded company, or a pension fund or tax exempt entity within the meaning of the current tax treaty.
The income tax treaty with Luxembourg allows an equivalent beneficiary to satisfy the derivative benefits test by qualifying as an equivalent beneficiary to satisfy the derivative benefits test by qualifying under the active trade or business test (as well as by qualifying as one of the four types of persons described above). For example, assume residents  of Hungary establish a U.K. company that has an active trade or business in the U.K. Also assume that the U.K. company establishes a subsidiary in Luxembourg that owns intellectual property that is licensed to the U.S. The combined rate of withholding on royalties under both the U.S.- Luxembourg and U.S.-U.K. income tax treaties is zero. Luxembourg has a favorable regime for taxation of intellectual property resulting in an effective corporate income tax rate of approximately 5 percent.

The royalties paid from the U.S. to Luxembourg would qualify for the 0 percent withholding rate under the U.S.-Luxembourg income tax treaty because the U.K. company would be an equivalent beneficiary, despite the fact that it is owned by nonresidents of the U.K., is not publicly traded in the U.K., is not a subdivision of the U.K. government, and is not a U.K. pension fund or tax-exempt organization. This provides a significant opportunity for Hungarian investors to qualify for Luxembourg’s favorable regime on the taxation of intellectual property when they desire to license intellectual property to the United States, so long as a lower rate of withholding on the royalties is not already being obtained. 

There are additional options available to Hungarian companies utilizing other tax treaties under an “equivalent beneficiary” theory. However, any planning involving the tax treaties with any third countries under an “equivalent beneficiary” to reduce or eliminate a U.S. withholding tax should be carefully reviewed.

Provisions that May Deny Treaty Benefits

The conduit financing regulations enacted Internal Revenue Code Section 7701(1) prevent claiming treaty benefits with respect to royalty payments. The Treasury was authorized under Internal Revenue Code Section 7701(1) to issue regulations that would allow multi-party financing arrangements to be reclassified as transactions directly between any two or more parties involved. In accordance with Section 7701(1), the Treasury introduced regulations in 1995 to clarify when the IRS can recharacterize multi-party financing transactions for U.S. withholding tax purposes. Under these regulations, the IRS can ignore the involvement of an intermediate entity in a multi-party financial arrangement for withholding tax purposes if the intermediate entity is deemed to be a conduit entity. A conduit entity is an entity whose participation in the financing arrangement is designed to minimize U.S. withholding tax liability and is part of a tax avoidance plan, and is one that is either related to the financing/financed entity or entered into the transaction as a result of the financing entity.

These regulations permitted the IRS to disregard the participation of one or more “intermediate entities” in a “financing arrangement” where such entities are acting as conduit entities. The regulations define a financing arrangement as a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities). 2  The regulations grant the IRS discretion to disregard, for purposes of Internal Revenue Code Sections 871, 881, 1441, and 1442, the participation of one or more “intermediate entities” in certain “financing arrangements” involving multiple parties. A financing transaction included a debt, lease or license.3

Prior to the enactment of the 2017 Tax Cuts and Jobs Act, with certain exceptions, under the conduit regulations, an instrument that was classified as equity for U.S. tax purposes did not constitute a financing transaction.Thus, it was common for non-U.S. persons and non-U.S. entities to utilize hybrid instruments (an instrument treated as debt for foreign tax purposes but equity for U.S. purposes) to capitalize an intellectual property holding company that would hold intellectual property. The intellectual property company would then license the intellectual property to a U.S. person in exchange of a royalty payment. The payment of the royalties to the foreign holding company was classified as interest for foreign income tax purposes and a dividend for U.S. income tax purposes. These structures were not subject to the conduit financing rules because the subsequent payment by the intellectual holding company was treated as a dividend.

Recently, the IRS and Treasury issued final and proposed anti-conduit regulations. These regulations will cause the conduit financing regulations to expand the types of equity interests that are treated as financing transactions. The regulations will include a financing transaction of so-called hybrid instruments. As a result, a non-U.S. taxpayer is prevented from claiming treaty benefits in situations similar to the one described above.

Potential Planning Option Utilizing the Portfolio Interest Rules

Although the conduit financing regulations may prevent strategies involving the capitalization of intellectual property holding companies, a foreign intellectual property owner may potentially utilize a strategy in which there is a leveraged purchase of intellectual property by a foreign licensor. The leveraged purchase of intellectual property is then followed by a license of such intellectual property to the U.S. As noted above, a loan followed by a license typically would be treated as a conduit financing arrangement. This is because both transactions are treated as financing transactions.

Where a royalty payment is followed by an interest payment, the royalty is recharacterized as interest. The question is whether these transactions should be carved out from the conduit financing regulations if the interest payment would have been eligible for an exemption from U.S. withholding tax. An exception to the U.S. withholding tax is under the portfolio interest rules. Portfolio interest received by a foreign corporation or nonresident alien individual is exempt from U.S. withholding tax. 4 Generally speaking, portfolio interest is any U.S.-source interest (other than interest effectively connected with the conduct of a U.S. trade or business) paid or accrued on debt obligations. Congress has enacted various restrictions in order to protect against the unauthorized use of the portfolio interest exemption by U.S. persons. In the case of registered debt obligations, the exemption applies only if the U.S. withholding agent has received a statement that the beneficial owner of the obligation is not a U.S. person.

In the case of unregistered or bearer debt obligations, the exemption applies only if the following requirements are satisfied:

1) There are arrangements reasonably designed to ensure that the obligation will be sold or resold to persons who are not U.S. persons;

2) Interest on the obligation is payable only outside the U.S. and its possessions;

3) There is a statement on the face of the obligation that any U.S. person who holds the obligation will be subject to limitations under the U.S. income tax laws. 5

In addition, the following types of foreign lenders do not qualify for the portfolio interest exemption:

1) Interest received by a 10 percent shareholder does not qualify for the portfolio interest exemption. If the borrower is a corporation, the 10 percent shareholder rule requires that the recipient of the interest not own 10 percent or more of the combined voting power of all classes of stock of such corporation. If the borrower is a partnership, the 10 percent shareholder requirement is measured by capital or profits interest.

2) Any interest received by a foreign bank on a loan entered into in the ordinary course of its banking business does not qualify for the portfolio interest exemption.

3) The portfolio interest exemption does not apply to payment of interest to a controlled foreign corporation or (“CFC”) that are considered a related person with respect to the borrower. The applicable related party rules in this case are under Internal Revenue Code Section 267(b), and unlike the 10 percent shareholder rules which only consider voting stock, these rules would consider two corporations to be related where a parent corporation owns more than 50 percent of vote or value of the subsidiary corporation. For these purposes, certain attribution rules can apply to attribute stock ownership of a foreign corporation to U.S. persons, especially subsequent to the repeal of Internal Revenue Code Section 958(b)(4) under the Tax Cuts and Jobs Act of 2017.

In the 1995 conduit financing regulations, the IRS noted leveraged leases may be excluded from the definition of a financing transaction because “in substance, the financing arrangement would be the equivalent of a loan from a financing entity entitled to a zero rate of withholding on interest.”6 The IRS noted in the preamble that, under the 1995 conduit finance final regulations, a “leveraged lease generally will not be recharacterized as a conduit arrangement if the ultimate lender would be entitled to an exemption from withholding tax on interest received from the financed entity, even if rental payments made by the financed entity to the financing entity would have been subject to withholding tax.”7 (Leveraged lease refers to a lease agreement wherein the lessor acquires an asset partially financed and leases out the same to the lessee for the agreed lease payments). The 1995 conduit financing regulations’ language appears to support the position that a leveraged acquisition of intellectual property by a foreign licensor followed by a license of such intellectual property for use in the U.S. could be exempt from the conduit financing regulations. That is, as long as the ultimate non-U.S. lender would be eligible for an exemption from U.S. withholding tax on the receipt of interest from the financed entity. Therefore, it would seem that so long as the financing entity would be entitled to an exemption from withholding under the portfolio debt rules, the conduit financing regulations should not apply to a leveraged acquisition of intellectual property.

Conclusion

This article is intended to acquaint readers with some of the principal tax planning issues associated with inbound licenses of intellectual property. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. 

1.  See PWC US Treasury Gives Notice to Terminate US-Hungary income tax treaty (July 2022).
2. Treas. Reg. Section 1.881-3(a)(2)(i)(1)(A)
3. Treas. Reg. Section 1.881-3(a)(2)(ii)(A)
4.  IRC Sections 1441(c)(9) and 1442(a).
5. See IRC Sections 871(h)(2)(A), 881(c)(2)(A), and 163(f)(2)(B).
6. T.D. 8611
7. T.D. 8611.