Treasury’s decision came after the Hungarian government decided to block an EU directive that would impose a 15% global minimum tax on multinational corporations to comply with the OECD’s Pillar II global minimum tax regime. The Hungarian government objected on claims that increasing the corporate tax rate on Hungarian companies would damage competitiveness and endanger jobs.
Importantly, the 1979 Treaty lacks an anti-treaty shopping provision, i.e., limitation-on-benefits (LOB). This measure is designed to prevent multinational corporations from strategically directing business to a jurisdiction with the intention to take advantage of lower withholding tax rates provided by a tax treaty. A LOB provision was included in the updated version of the Treaty renegotiated in 2010. However, its ratification was held off by Senator Rand Paul. Therefore, Hungary’s refusal to implement the global minimum tax could further disadvantage the United States under the Treaty’s terms when compared to Hungary, a treaty-shopping jurisdiction.
The Treaty
Under the Treaty, the taxpayers enjoy lower tax rates on certain income, exclusion for certain employment income, as well as relief from double taxation. Several key provisions are briefly reviewed in the text below.
As a preliminary matter, like with other treaties, the double-tax relief granted by the Treaty hinges upon the concept of residency. Generally, a resident is a person taxable under a country’s laws based on domicile, residence, citizenship, place of management, or other factors. Thus, the different interpretations of the term between the US and Hungary could result in a person being considered a resident of both countries. Under such circumstances, the Treaty provides tie- breaker provisions in the sequence of center of vital interests, habitual abode, nationality, with the last resort to the competent authorities of both countries. However, regardless of the residency status, each country retains the authority of taxing the real property within its borders.
Of particular importance to business entities, Article 5 of the Treaty directs that taxation of business profits of a resident of one country is to be exempted by the other country unless the profits are attributable to a permanent establishment in the other country. Permanent establishment constitutes a fixed place of business through which an entity conducts industrial or commercial activity. An enterprise can also have a permanent establishment in the host country if its employees or other dependent agents located in the said country habitually exercise authority to conclude contracts on behalf and in the name of the enterprise. On the other hand, the term does not include the use of facilities or maintenance of goods for the sole purpose of storage, display, delivery, processing, collecting information, etc.
The Treaty provides for a different treatment of dividends, interest, and royalties, applicable to both individuals and corporations. The withholding tax rates on dividends are set at either 15% or 5%, the latter contingent on the existence of beneficial owners and the former applies to all the remaining cases. A beneficial owner is a corporation resident in the other state who owns, directly or indirectly, at least 10% of the voting stock of the dividend-paying entity in the home state. Article 10 and 11 provide that interest or royalty originating from one country and paid to a resident of the other country is only taxable in the other country. There is no withholding for interest or royalty. For example, in the case of the interest paid to a Hungarian resident by a US company, Hungary shall have the taxation authority.
Lastly, the Treaty covers individual income from various sources. In regard to the personal services performed by an employee in the host country, different from his or her resident country, the income is typically taxed in the host country. By comparison, the residence state has the right to tax an individual’s annuities, alimony, child support, and rentals of tangible personal property. Pension rules contain more nuances. Under Article 15, pensions and other similar remuneration beneficially derived by a resident of one country in consideration of past employment shall be taxable only in that county, and social security payments and other public pensions paid by one country to an individual resident of the other country or a US citizen shall be only taxable in the paying country.
Just like many other treaties and notwithstanding any other the provisions, the Treaty contains a "saving clause" (see paragraph 2 of Article 1). The Clause permits each country to reserve the right to tax its own citizens and residents the way that it would in absence of a treaty unless specifically noted otherwise. From a US perspective, its purpose is to prevent a US citizen or resident from using the Treaty for tax-avoidance purpose.
Consequences of termination
It is clear that once the Treaty is terminated, anyone with investments or tax exposure connected to Hungary will be affected. The termination will be more significant to Hungarian companies invested in the United States, who will now become subject to a 30% withholding tax on US-source income not effectively connected to US trade or business. From the US perspective, the termination will impact any US residents or US corporations with connections to Hungary.
Such termination will not affect the parties immediately, rather the treaty will cease to have effect on 1 January 2024. Yet, the treaty terminations may signal growing tension between two countries and therefore deter foreign direct investments upon announcement of the termination. These repercussions are going to be felt before any shift in the economy of two countries, if not already.
From the financial standpoint and as stated above, the termination will cause any US investment income generated by Hungarians to become subject to 30% tax, with no reduction in tax currently available under the Treaty. For individuals, it will also cause full inclusion of their employment income. Finally, there will be no relief from double taxation. Dividends, interest and royalties paid to US corporations are expected to remain tax free as long as there is no withholding tax in Hungary under domestic rules. However, if the Hungarian government decides to introduce withholding taxes on these types of income, there will be no reduction in tax without a treaty. Moreover, US corporations holding shares in Hungarian companies heavily invested in real estate will fall under Hungarian corporate taxation for capital gains realized on the sale of those shares.
Individuals and companies will no longer be able to look into the Treaty. Instead, they will have to look into the domestic law. Unfortunately, many times domestic courts are proved to be slower and biased while a treaty environment is generally perceived as more efficient, providing numerous beneficial international arbitration provisions. When the only reliance is on domestic law, the situation becomes even more complicated if there are significant differences between the laws of two counties, such as the case is with the laws of the US and Hungary.
US persons, who have transactions with or businesses in Hungary should evaluate how the loss of treaty benefits will affect them. Depending on the significance of the potential tax exposure, they may consider limiting if not fully avoiding a Hungarian business, or restructuring the businesses to either avoid or minimize the exposure.
