Aim of the double tax treaties Life after the US–Hungary double tax treaty
The main purpose of conventions on the avoidance of double taxation is to prevent income from being taxed twice by different countries. In such bilateral tax treaties, countries agree on the country in which each item may be taxed, and that the other country waives part or all its right to do the same. If there is no such convention between two countries, it is only and exclusively the domestic legislation of the countries that determines how much tax is imposed on certain income and whether and to what extent the tax paid abroad is considered in assessing the tax liability.
Corporate tax changes after the termination of the US-Hungary tax treaty
Withholding tax after the US–Hungary double tax treaty
The double taxation treaty specifies exactly which income is subject to withholding tax in the country from which it originates and, where applicable, the maximum rate of the withholding tax. The US-Hungary tax treaty, which is still in force this year, only allows withholding tax on dividends, with a maximum withholding tax rate of 5 to 15% depending on the level of ownership. Interest, royalties and service fees are not subject to withholding tax under the treaty, as the right to tax them is transferred to the country of residence of the income earner.
In terms of withholding tax, there is a significant difference in practice between the US and Hungary.
- Hungary does not impose withholding tax on income paid to foreign companies, either with or without a treaty. Thus, US companies will not be adversely affected by the absence of a tax treaty in terms of withholding taxes, as the income of US companies from Hungary will not be subject to withholding taxes in the absence of a tax treaty.
- In contrast, in the US, high withholding taxes are deducted from payments made to countries with which the US does not have a double tax treaty in force. At the federal level, the general withholding tax rate is 30%. This withholding tax does not only apply to capital income from US source but also to service fees paid to Hungarian companies. In addition, in the US, not only can the tax liability arise at the federal level, but individual states can also deduct withholding taxes according to their own rules.
Based on the above, the termination of the US-Hungary tax treaty could be painful for Hungarian companies that receive income from the US. The good news is that, to some extent, tax deducted in the US can be considered for determining the Hungarian tax liability even in the absence of a treaty. In fact, 90% of the US withholding tax will be deductible for Hungarian corporate income tax purposes, but the amount of the deduction cannot exceed the average tax on the income, so that in effect no more than 9% of the tax paid abroad can be taken into account.
Special case of companies holding real estate after the termination of the US-Hungary tax treaty
There may also be some US companies that could be adversely affected from a tax point of view by the denunciation of the treaty, those, for instance, that have a Hungarian subsidiary holding real property and that sell their interest in the subsidiary after 2023.
The currently effective US-Hungary treaty is of an old type, which does not allow Hungary to tax this type of income of the US company.
This may change with the termination of the tax treaty, and if a US company has a Hungarian subsidiary with significant Hungarian real property holdings, the US shareholder may be subject to Hungarian corporate income tax on the sale. This could result in a 9 % Hungarian corporate income tax liability for the US owner in Hungary.
The termination of the existing tax treaty will also bring changes to the rules on permanent establishment.
If a foreign company has a so-called permanent establishment in Hungary, it may become subject to corporate income tax in Hungary with respect to this domestic establishment. Until the end of this year, the US-Hungary tax treaty will determine whether or not a US company has a permanent establishment in Hungary. In the absence of a treaty, only Hungarian law will be applicable.
The provision of services also calls for the application of the rules on the permanent establishment under Hungarian law, which may give rise to a tax liability in Hungary. Under the existing tax treaty, the provision of services through a private individual does not create a permanent establishment and thus does not give rise to a corporate income tax liability for US companies in Hungary. However, in the absence of a treaty, 183 days of stay may give rise to a Hungarian tax liability for US companies under the Hungarian CIT Act even in the absence of a physical establishment and assets.
In practice, this would mean that if a US company assigns an employee to Hungary and provides certain services or carries out certain activities here, this could result in a Hungarian corporate income tax liability on the part of the US company. There are still many issues to be clarified about the rules on services, which will become more relevant once the tax treaty is terminated.
How will private individuals be taxed on their US source income and investments from 2024?
Individuals will be more widely affected by the termination of the treaty than companies.
Tax residency issues after the US-Hungary tax treaty
In taxation, the place of tax residence is of great importance, as worldwide income is taxable in the state where the individual is a tax resident. This means that the country of residence has the right to tax all the individual's income, regardless of the country from which it originates.
If a person is resident in both countries under national domestic rules, then as long as the double taxation treaty is in force, the place of residence should be determined based on the treaty. In the absence of a treaty, both countries are entitled to tax the individual's worldwide income, and it is up to domestic rules to decide how and to what extent the tax paid abroad is considered.
For example, if there is no double taxation treaty between Hungary and the US from 1 January 2024, Hungarian individuals living in Hungary will not be the only ones who will have to pay and declare taxes on their US source income. Hungarian citizens who have been living in the United States for years and do not receive any income from Hungary may be liable to pay taxes in Hungary (for example, if they receive dividends or interest income from a US source).
In the absence of a double taxation treaty, if an individual is considered a Hungarian tax resident under the Hungarian Personal Income Tax Act, their Hungarian tax liability also extends to income earned in the United States.
US source capital income of Hungarian individuals after the termination of the US-Hungary tax treaty
Many individuals invest in US securities. The following is a brief discussion of how some typical types of income from US securities will be affected by the termination of the treaty.
- •Dividend income
In the case of dividends paid on US shares, the tax treaty caps the withholding tax deductible in the US at 15%. As long as the tax treaty is in force, the 15% tax paid abroad can be considered in full as a deduction from the Hungarian personal income tax. As the Hungarian personal income tax rate is 15%, there is currently no Hungarian PIT liability on dividends from US sources.
In the absence of a tax treaty, from 1 January 2024, dividend income will be subject to a 30% withholding tax deduction at the federal level under US domestic rules.
In addition, even if the foreign tax burden will be higher than the Hungarian tax liability and even if the tax paid abroad can still be deducted, in the absence of an international treaty, an additional 5% PIT will have to be paid on the income in Hungary. Thus, even if a withholding tax liability arises only at the federal level in the US and the state in question does not deduct withholding tax, a 35% income tax liability may still apply.
The social contribution tax liability will not be affected by the termination of the double tax treaty, so a liability may arise up to the social contribution tax ceiling.
- Interest income
Interest income (such as bond yields) paid to a Hungarian private individual is not subject to withholding tax in the United States under the treaty; so far it has only been subject to income tax in Hungary.
From 2024, the 30% US federal withholding tax on interest income will apply. Also, under the Hungarian rules, interest income from a country with no double tax treaty is considered other income, 89% of which is subject to a 13% social contribution tax in addition to the personal income tax.
The good news is that the personal income tax liability may be reduced by 90% of the tax paid in the US; the bad news is that the social contribution tax burden cannot be reduced at all, and the ceiling does not apply either.
Thus, if 30% withholding tax is deducted from US interest income in the US, there is no personal income tax liability in Hungary, but a social contribution tax of 13% is still payable on 89% of the income.
(Please note that as of 1 July 2023, interest income under the PIT Act is also subject to a social contribution tax without a ceiling if the security is acquired after 30 June 2023.)
- Controlled capital market transactions
If a company sells publicly traded shares through an investment service provider active in an EEA state or in a state with which we have a double tax treaty, the income from the sale is considered to be income from a controlled capital market transaction if certain conditions are met.
A major advantage of controlled capital market transactions is that the amount of the transaction loss recognised in the tax year can be deducted from the transaction gain in the tax year, thus reducing the tax base. In addition, there is a possibility of tax equalisation, i.e. losses realised and declared in the two years preceding the tax year can be set off against the tax year's profit realised on controlled capital market transactions. Importantly, there is no social contribution tax liability on income from controlled capital market transactions either.
The termination of the tax treaty will affect controlled capital market transactions entered into with the assistance of a US bank or investment service provider. Once the double tax treaty between the two countries is terminated, stock exchange transactions conducted with the assistance of a US service provider will no longer be covered by the definition of a controlled capital market transaction. Thus, their taxation will also be adversely affected, as the tax rules applicable to exchange rate gains will apply. That is, from January 2024, the loss will not be offset against the gain and a 13% social contribution tax will be payable up to the social contribution tax ceiling.
It is important to point out that the rules on income from a controlled capital market transaction will continue to apply to US publicly listed and traded shares if the individual has an account with an investment service provider in an EEA state or uses a service provider in a country with which we have a tax treaty in force.
Incomes to be included in the consolidated tax base
It is also important to discuss Hungarian tax residents who, for example, work in Hungary or the US on assignment, or even alternate between the two countries, as well as individuals who earn income from independent activities. With the termination of the tax treaty, the income of Hungarian tax resident private individuals who engage in activities in the United States may also be taxable in the United States, subject to the domestic rules of the United States.
The tax treaty currently still provides for exemption from paying US personal income tax in certain cases: for example, on assignment, if certain conditions are met and the stay in the US does not exceed 183 days in a tax year. The exemptions will no longer apply because of the termination, so the US will be entitled to impose tax on income that is included in the consolidated tax base under the Hungarian PIT Act.
Hungarian citizens doing business in the United States will not lose their Hungarian tax status in the absence of the treaty. As a consequence, the income of individuals from non-independent activities will remain taxable in Hungary, with the condition that 90% of the withholding tax paid abroad can be offset against Hungarian personal income tax up to 15% of the taxable income.
Hungarian source income of US private individuals
And finally, the termination of the tax treaty also affects US individuals who are not considered residents under the PIT Act but who derive income from Hungary. In their case, all income from Hungary will be taxable under Hungarian rules.
Please note that the above list is not exhaustive. It is worth bearing in mind that if you are affected in some way by both the United States and Hungary (for example, if you are a citizen of one country and have income from the other),then from 2024 onwards, you should not proceed by routine in the same way as in previous years. It should be examined in which country the tax is payable on certain income in the absence of a treaty, and if tax is payable in both countries, how and to what extent you can deduct the tax paid abroad.