By Anthony Diosdi
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.
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 also discusses how certain Hungarian entities can potentially utilize other tax treaties to reduce or eliminate U.S. withholding taxes on U.S.-source dividends, interest, and royalties for payments made on or after January 1, 2024.
Withholding on U.S.-Source Investment Income
The U.S. taxes the gross amount of a foreign person’s U.S.-source nonbusiness (or investment-type) income at a flat rate of 30 percent. No deductions are allowed for purposes of computing the amount of the foreign person’s U.S. source investment-type income subject to U.S. withholding taxes. The person controlling the payment of the income must deduct and withhold U.S. tax at the 30 percent rate. A nonresident alien is an individual who is neither a citizen nor a resident of the U.S. A foreign corporation is a corporation organized or created under the laws of a foreign country. Likewise, a foreign partnership is a partnership organized or created under the laws of a foreign country. A trust is foreign if either no U.S. court is able to exercise primary supervision over the administration of the trust, or no U.S. person has the authority to control all substantial decisions of the trust.
Any person having control, receipt, custody, disposal, or payment of an item of U.S.-source nonbusiness income to a foreign person is obligated to withhold U.S. tax. Examples of withholding agents include corporations distributing dividends, debtors paying interest, tenants paying rents, and licensees paying royalties. A withholding agent who fails to withhold is liable for the uncollected tax.
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.
Like the 2016 Model Treaty, these treaties provide that, if another country’s tax treaty with the United States lacks a LOB provision, then a person who is 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 qualified 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 under the active trade or business test (as well as qualifying as one of the four types of persons described above). Since Hungary is a member of the EU, a Hungarian entity may be treated as an equivalent beneficiary under another tax treaty entered into with another EU country. 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 are zero. Luxembourg has a favorable regime for the taxation of intellectual property resulting in an effective corporate income tax rate of approximately five percent. The royalties paid from the U.S. to Luxembourg would qualify for the zero 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.
The termination of the U.S.-Hungary treaty next year might be a problem for the Luxembourg-United Kingdom- Hungary hypothetical. This is because the first part of the Derivative Benefits Test in the 1986 Luxembourg treaty reads:
“4. Except as provided in subparagraph (c), a company that is a resident of a Contracting State shall be entitled to all the benefits of this Convention if: (a) 95 percent of the company’s [i.e., Luxembourg Subsidiary’s] shares is ultimately owned by seven or fewer residents of a state that is a party to NAFTA or that is a member State of the European Union and with which the other State has a comprehensive income tax convention;…(d)(i) The Term ‘resident of a member State of the European Union’ means a person that would be entitled to the benefits of a comprehensive income tax convention in force between any member State of the European Union and the Contracting State [I.E., the U.S.] from which the benefits of this Convention are claimed..”
The term “ultimately” probably means that there must be a U.S.- Hungary Treaty in effect- i.e., there is look-through such that the Hungarian shareholders are the “ultimate” owners of the whole corporate structure, and the U.S. is the Contracting State from which the benefits of the U.S.-Luxembourg Convention are claimed. Thus, it does not appear that a treaty between Hungary and the U.K. – or a treaty between Hungary and Luxembourg – is enough.
Further, even if the analysis does end at the U.K. Intermediary (and doesn’t look through it to the shareholders of the Hungarian Parent), there could be some uncertainty whether the U.S. Intermediary can still be an “equivalent beneficiary” under the U.S.- Luxembourg treaty after Brexit. While the U.S. and the U.K, have entered into a “Competent Authority Arrangement” between them agreeing that the U.K. is grandfathered under the U.S.-U.K. treaty, this arrangement by itself does not legally apply to the U.S.-Luxembourg treaty or any of the other bilateral treaties that the U.S. has with other countries.
Thus, Hungarian residents may potentially establish corporations in certain countries such as the United Kingdom, Ireland, Austria, and Spain to reduce U.S. withholding tax 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 scrutinized.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.