By Anthony Diosdi
On July 8, 2022, the Biden administration announced that it will terminate the U.S.-Hungary Income Tax Treaty as a result of that country’s resistance to the implementation of a minimum 15 percent corporate tax. A Treasury spokesperson said that since Hungary lowered its corporate tax rate to 9 percent (less than half the U.S. rate), the tax treaty unilaterally benefits Hungary. There are only a few examples of the United States unilaterally terminating a tax treaty. Probably the most relevant historical precedent is in June 1987 when the Treasury announced the termination of the tax treaty with the Netherlands Antilles. The termination of the U.S.- Hungary Income Tax Treaty is expected to be completed after the Treasury Department sends formal notification to the relevant Hungarian authorities.
As a result of Hungary’s low corporate tax rate and lack of limitation on benefits provision, the U.S.-Hungarian Tax Treaty has provided foreign investors with significant planning opportunities. Although the U.S.- Hungary Tax Treaty will soon likely be terminated, the treaty remains in force for at least the remainder of the 2022 tax year. This means planning opportunities still exist to utilize the United States- Hungarian tax. This article will discuss the unusual provisions of the United States- Hungary Income Tax Treaty.
We will now review the key provisions of the United States- Hungarian Income Tax Treaty and the implications to individuals or corporations attempting to make use of the treaty.
Definition of Resident for Purposes of the Treaty
The determination of an individual’s country of residence is important because the treaty only applies to residents of the United States and Hungary.
The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
In contrast to the U.S. law, individuals are residents in Hungary if they stay in the country at least 183 during a given calendar year or have their permanent home in Hungary.
The treaty covers any U.S. or Hungarian “person” or “company.” The term “person” includes an individual, a partnership, a company or judicial person, an estate, a trust, and any other body of persons. The term “company” means any body corporate or any entity which is treated as a body corporate for tax purposes.
Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States or Hungary for treaty purposes is determined by reference to the internal laws of each country.
For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Hungary under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in the United States- Hungary Income Tax Treaty. The tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 4(2) of the United States- Hungary Income Tax Treaty provides the following tie-breaker for individuals:
a) The individual shall be deemed to be a resident of the Contracting State in which the individual has a permanent home available to him. If the individual has a permanent home available to him in both Contracting States or in neither Contracting State, the individual shall be deemed to be a resident of the Contracting State in which the individual’s center of vital interests is located;
b) If the Contracting State in which he has his central of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode;
c) If the individual has an habitual abode in both Contracting States or in neither of them, the individual shall be deemed to be a resident of the Contracting State of which the individual is a national; and
d) If he is a citizen of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.
Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved.
Illustration 1.
Attila the Hun is a citizen and resident of Hungary. Attila the Hun owns HunCo, a company incorporated in Hungary that is in the trade or business of taking over corporations. HunCo is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Attila the Hun is divorced and maintains an apartment in Budapest, Hungary, where he spends every other weekend visiting his children. Attila the Hun’s first wife, who kept their house in their divorce, has never left Hungary. Attila the Hun becomes a U.S. resident alien under the substantial presence test as he operates HunCo’s U.S. branch. In the United States Attila the Hun owns a luxury condominium in Miami, Florida where he lives with his second wife.
Because Attila the Hun is considered a resident of both the United States and Hungary, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in Hungary and a condominium in the United States, Attila the Hun has a permanent home available in both countries. With Attila’s children and his home office in Hungary as opposed to the lucrative portion of his business and his new wife in the United States, Attila the Hun does not have a center of vital interests in either country. Furthermore, because Attila the Hun regularly spends time in both countries, he arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Attila the Hun may be considered a resident of Hungary because he is a citizen of Hungary.
Business Profits and Permanent Establishment
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
Article 5 of the United States- Hungary Income Tax Treaty defines a permanent establishment as a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity. This includes the following: 1) a place of management; 2) a branch; 3) an office; 4) a factory; 5) a workshop; and 6) a mine, an oil or gas well, a quarry 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, shall constitute a permanent establishment only if it lasts more than 24 months. The term “permanent establishment” shall be deemed not to include: 1) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; 2) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; 3) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; 4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or for collecting information, for the enterprise; 5) the maintenance of a fixed place of business solely for the purpose of carrying on for the enterprise any other activity if it has a preparatory or auxiliary character; and 6) the maintenance of a fixed place of business.
Marketing products in either the United States or Hungary solely through independent brokers or distributors does not create a permanent establishment, regardless of whether these independent agents conclude sales contracts in the exporter’s name. In addition, the mere presence within the importing country does not create a permanent establishment.
Personal Services Income
United States- Hungary Income Tax Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, the employee’s income is typically exempted from taxation by the host country if the employee is present in the host country for 183 days or less.
Income from Real Property
Tax treaties typically do not provide tax exemptions or reductions for income from real property. Consequently, both the home and host country maintain the right to tax real property. Article 6 of the United States- Hungary Income Tax Treaty provides that income derived by a Hungarian resident from U.S. real property may be taxed in the United States and vice-versa.
Dividends, Interest, and Royalties
Foreign investors in the United States seek to utilize tax treaties to reduce or avoid a 30-percent tax on dividends, interest, and royalties referred to as “FDAP income.” The Internal Revenue Code defines FDAP income by specifically listing a series of income forms that are usually of a recurring nature, such as interest, dividends, rents and royalties. The gross amount of such payments, when from U.S. sources but not effectively connected with a U.S. trade or business is subject to the 30-percent tax.
Tax treaties generally provide for the reduction or elimination of withholding taxes on certain items of FDAP income that are not attributed to a permanent establishment in the United States. Historically, under most of the treaties that have come into force, a corporation organized under the laws of a contracting state was entitled to the benefits of applicable treaty provisions. If investors did not reside in a treaty country, the relative ease of corporate organization and operation often led tax planners to establish corporate vehicles in third countries to take advantage of the benefits of a treaty between the third country and the country in which income would be earned. This practice is often characterized as treaty shopping. Because of the way the United States- Hungary Income Tax Treaty Limitation of Benefits Provision is drafted (discussed below) the treaty has been often used by nonresidents of Hungary to invest in the United States to avoid FDAP withholdings.
We will now discuss provisions in the United States- Hungary Income Tax Treaty that provides for a reduction or elimination of withholding on specified items of U.S.- source FDAP income. Article 9 of the United States- Hungary Income Tax Treaty provides that the U.S. withholding tax rate on dividends is 5 percent of the gross amount of the dividends when the beneficial owner is a company resident in the other contracting State and owns, directly, or indirectly, at least 10 percent of the voting stock of the company paying the dividends, and 15 percent of the gross amount of the dividends in all other cases. Article 9(3) defines “dividends” as income from shares or other rights participating in profits, but not debt-claims, and income from other corporate rights taxed in the same way as income from shares under the tax law of the State of which the company making the distribution is a resident.
Article 9(5) of the United States- Hungary Income Tax Treaty also states that where a company is a resident of a Contracting State, the other Contracting State may not impose any tax on the dividends paid by the company, except insofar as: 1) such dividends are paid to a resident of that other State; 2) the holding in respect of which the dividends are paid is effectively connected with a permanent establishment or a fixed base situation in that other State; or 3) such dividends are paid out of profits attributable to a permanent establishment which such company had in that other State, provided that at least 50 percent of such company’s gross income from all sources was attributable to a permanent establishment which such company had in that other State.
Article 10 of the United States- Hungary Income Tax Treaty deals with the taxation by one Contracting State of interest derived by a resident of the other Contracting State. Article 10(1) of the treaty provides that interest arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other State. The treaty contains a complete exemption from withholding tax on interest income. The term “interest” for purposes of the treaty is defined as income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities and income from bonds or debentures, including premiums or prizes attaching to bonds or debentures.
Article 11 of the United States- Hungary Income Tax Treaty discusses the taxation of royalties arising in a Contracting State and paid to a resident of the other Contracting State. Article 11(1) of the treaty provides that royalties arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable only in that other State.
The treaty contains a complete exemption from withholdings on royalties. Article 11(2) of the United States- Hungary Income Tax Treaty defines “royalties” as payment received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematographic films or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience.
Besides FDAP reduction, the favorable Hungarian corporate tax rate has encouraged cross-border tax planners to use the United States- Hungary Income Tax Treaty to avoid the Internal Revenue Code Section 267A conduit regulations by advising multinational corporations to transfer U.S. intellectual property to a Hungarian entity to reduce the corporate tax rate on royalty income. Such a strategy may reduce the global tax on royalty income to only a 9 percent Hungarian corporate tax.
Branch Profits Tax
In 1986, the branch profits tax was enacted. The branch profits tax imposes a 30 percent tax on the after-tax earnings of a foreign corporation’s U.S. trade or business that has not been reinvested in the corporation’s U.S. trade or business. As a result of the branch profits tax, the direct ownership of U.S. businesses by foreign corporations is generally not advisable. On the other hand, the branch profits tax may be inapplicable if a foreign investor is from a favorable U.S. treaty country and the foreign investor utilizes a company established in that country. The United States- Hungary Income Tax Treaty or its Technical Explanations does not mention the branch profits tax. This is because the United States- Hungary Income Tax Treaty was negotiated more than seven years before the branch profits tax was enacted. Although the treaty does not discuss the branch profits tax, Notice 87-56, 1987-2 C.B. 367 implies that older treaties such as the U.S.- Hungary Income Tax Treaty could override the branch profits tax.
Favorable Treaty Provisions for Pensions, 401(k) Plans, and Individual Retirement Accounts
Article 15 of the United States- Hungary Income Tax Treaty provides that pensions and similar remuneration beneficially derived by a resident of one Contracting State in consideration of past employment are taxable only in the state of residence of the recipient, but that social security payments and other public pensions paid by one of the Contracting States to a resident of the other state or to a United States citizen are taxable only in the paying state. The first paragraph deals with pensions in consideration of private employment. The second paragraph deals with retirement benefits which are not related to prior employment, such as social security payments.
The term “pension and other similar remuneration,” as used in the treaty, means periodic payments. This provision of the treaty provides an excellent opportunity for a non-resident of the United States to utilize the United States- Hungary Income Tax Treaty to reduce or eliminate the U.S. tax consequences associated with an Individual Retirement Account (“IRA”) or 401(k) plan distribution. For example, let’s assume that Harry Houdini is a Hungarian national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Harry contributed money to an IRA. Harry has returned to Harry and would like to withdraw money from his U.S. based IRA. However, Harry is concerned about the U.S. 20% withholding tax and the 10% early withdrawal penalty.
Since Harry is a citizen of Hungary, a country that the U.S. has a bilateral income tax treaty, Harry may utilize the United States- Hungary Income Tax Treaty to avoid the 20% withholding tax and the early withdrawal penalty. This is because under Article 15, of the United States- Hungary Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explains pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment shall be taxable only in the State [of residency].” This means that under the applicable provisions of the United States- Hungary Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States- Hungary Income Tax treaty. However, the Organisation for Economic Co-operation and Development (“OECD”) defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 15. See OECD 2014 Commentary, Art 18. Thus, although Article 15 of the United States- Hungary Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Harry from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 15 of the United States- Hungarian Income Tax Treaty does not mention the term IRA, the IRS has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Harry is a resident of Hungary, he can utilize the United States- Hungary Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
Lack of Anti-Treaty Shopping Provision (Limitation on Benefits)
Most bilateral tax treaties that the U.S. has entered into with foreign countries contain a limitation on benefits provision or “LOB.” The principal LOB is to ensure that a corporation is a resident of the treaty country it claims the benefits of that country’s income tax treaty. There are a number of different tests to determine if a corporation is a resident of a treaty country. Unlike most treaties, the United States- Hungary Income Tax Treaty does not contain a LOB provision. This has permitted investors that did not reside in Hungary to organize a Hungarian corporate organization with relative ease to take advantage of the benefits of the United States- Hungarian Income Tax Treaty.
Please see Illustration 2 for an example of how treaty shopping operates.
Illustration 2.
USAco is a domestic corporation with a subsidiary in country X. The treaty between the United States and country X provides a 15 percent withholding rate for dividends paid to a controlling shareholder. In contrast, the withholding rate on dividends is 5 percent under the treaty between the United States and Hungary, and 0 percent under the treaty between Hungary and country X. Hungary further exempts foreign dividends from its income tax. Therefore, USAco may be able to reduce the withholding tax rate on earnings repatriated from its Hungarian subsidiary from 15 percent to 5 percent by interposing a Hungarian holding company between itself and the X subsidiary.
Conclusion
The Netherlands Antilles was a favorite country for many years because it was one of the few tax havens with which the U.S. had a treaty. The treaty between the United States- and Netherlands Antilles excluded withholding tax on interest payments by a Netherlands Antilles corporation and provided extremely favorable rates for royalty and dividend income. Because of the extensive exploitation of the U.S.- Netherlands Antilles Tax Treaty by cross-border tax planners, the U.S. Treasury terminated the treaty. It appears that the United States- Hungarian Tax Treaty will follow in the footsteps of the United States- Netherlands Antilles Income Tax Treaty. If you are considering utilizing the United States Hungarian Tax Treaty tax planning purposes, act fast before the treaty is terminated.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
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.