By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify United States and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The United States currently has income tax treaties with approximately 58 countries. This article discusses the highly controversial United States- Hungary Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Hungary Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Hungary Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under Article 4 of the United States- Hungary Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. 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.
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. Please see Illustration 2 and Illustration 3.
USAco, a domestic corporation, markets its products through the internet to Hungarian customers. Under the United States- Hungary Income Tax Treaty, the mere solicitation of orders through the internet does not constitute a permanent establishment. Therefore, USAco’s export profits are not subject to Hungarian income tax.
USAco decided to expand its Hungarian marketing activities by leasing retail store space in Budapest, Hungary in order to display its goods and keep an inventory from which to fill foreign orders. Under the United States- Hungary Income Tax Treaty, USAco’s business profits would still not be subject to Hungarian income taxation as long as USAco does not conclude any sales through its foreign office. However, if USAco’s employees start concluding sales at the Budapest office, USAco may have a permanent establishment in Hungary,
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
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 suh 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 does not provide for a withholding for “interest.” 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 does not provide for a withholding for royalty income. 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.
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.
All Other Income
Under Article 19 of the United States Hungary Income Tax Treaty, annuities, alimony, child support payments, and rentals of tangible personal property shall be taxable only in the residence State.
Lack of Anti-Treaty Shopping Provision (Limitation on Benefits)
Because tax treaties provide lower withholding tax rates on dividend, interest, and royalty income, a multinational corporation may be able to reduce its foreign withholding taxes by owning its subsidiaries throughout strategically located holding companies. This practice is known as “treaty shopping.” Please see Illustration 4 and Illustration 5 for examples of “outbound” and “inbound” “treaty shopping.”
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.
FORco is a country B corporation with a subsidiary in the United States. Country B does not have an income tax treaty with the United States. Therefore, the U.S. withholding tax rate on any dividends received by FORco from its U.S. subsidiary is 30 percent. However, the withholding tax rate on dividends is zero percent under the treaty between the United States and country C, and 10 percent under the treaty between countries C and B. Country C further exempts dividends from C’s income tax. Therefore, FORco may be able to reduce the withholding tax on dividend distributions from its U.S. subsidiary from 30 percent to 10 percent by interposing a country C holding company between itself and the U.S. subsidiary.
Because Hungary has both an extensive treaty network and has favorable taxation rules for foreign source dividends, a Hungarian holding company has historically been a popular choice for multinational corporations attempting to reduce taxes through treaty shopping. Although there have been discussions of changing the United States- Hungary Treaty, the current treaty between the United States and Hungary, which entered into force in 1979, does not contain an anti-treaty shopping provision that restricts the ability of taxpayers to engage in treaty shopping.
Anti-treaty provisions are also known as limitation on benefits or “LOB” provisions. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country to obtain the benefits of that country’s income tax treaty. A limitation on benefits provision denies suh corporations the benefits of the treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirement of the treaty’s LOB provision. Under the limitation on benefits provision found in article 22 of the U.S. Model Treaty, a corporation that is a resident of treaty country generally is entitled to treaty benefits only if the corporation meets one of the following additional requirements: 1) more than 50 percent of the corporation’s stock is regularly traded on a recognized stock exchange and the corporation’s primary place of management is in its country of incorporation; 2) the corporation is a 50 percent or more owned by 5 or fewer companies entitled to treaty benefits, or 3) the corporation meets both a stock ownership test (at least 50 percent of the corporation’s stock is owned by residents who are entitled to treaty benefits), and a base erosion test (less than 50 percent of the corporation’s gross income is used to make deductible payments to persons who are not residents of either treaty country).
The lack of a LOB and favorable treaty provisions has resulted in foreign investors utilizing the United States- Hungary Income Tax Treaty for purposes of creative inbound tax planning strategies. For example, foreign investors have established Hungarian companies and Swiss finance branches to invest in the United States. The Hungarian entity would lend money through a Swiss branch to an entity established in the United States and, in return, would receive interest on such loans. The interest would be deductible in the United States and would be exempt from U.S. withholdings under the United States- Hungary Income Tax Treaty. This is just one example of previous planning opportunities utilizing the United States- Hungary Income Tax Treaty. The treaty has been used in countless other outbound and inbound tax planning scenarios.
Although the United States- Hungary Income Tax Treaty continues to be used for creative tax planning due to the treaty’s lack of a LOB, this does not mean such strategies cannot be challenged by the Internal Revenue Service (“IRS”). The seminal case in this area is Aiken Industries, Inc. v. Commissioner, 56 TC 925 (1972). In Aiken, the IRS successfully denied treaty benefits for back-to-back loan arrangements. Internal Revenue Code Section 7701(1) also gives the IRS the authority to disregard the existence of an intermediary or conduit entity with respect to treaty shopping that results in the avoidance of U.S. taxes. In addition, Section 267A of the Internal Revenue Code generally disallows a deduction for any “disqualified related party amount” paid or accrued “pursuant to a hybrid transaction or by, or to, a hybrid entity.” The “disqualified related party amount” is any interest or royalty paid or accrued to a related party, and that related party does not include the payment in income under foreign tax law, or is allowed a corresponding deduction with respect to such amount.
Any strategy that utilizes the United States- Hungarian Income Tax Treaty must include a careful analysis of Internal Revenue Code Section 7701(1), Section 267A, and applicable case law before any plan is executed.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
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: 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.