Hungarian tax liabilities of companies and individuals with U.S. business interests may change significantly from 2024

During recent months, the United States terminating the tax convention for the avoidance of double taxation with Hungary has been a hot topic. The treaty in question was applicable for 30 years. In July 2022, Hungary received a notification of termination from the United States. As of 1 January, 2024, according to the recent publication of the Hungarian Tax Authority this treaty will no longer be applicable. The introduction of a new treaty for the avoidance of double taxation cannot be ruled out, however, this would be a complex and time- consuming process. Thus, we are of the view, that clients should be prepared for a period, potentially several years, where no treaty will be in place between the two countries. Please find below a summary of the most relevant changes affecting our clients.

Personal income tax

Tax residence

The first step in determining tax liabilities is to establish tax residence. In the absence of the double tax treaty, it may occur that both countries consider an individual as a tax resident, i.e. his/her worldwide income - including the employment income, income from investments, and all other types of income - is taxable in both countries. These double taxation situations were resolved by the treaty by determining in which country the individual is considered to be a tax resident and which country has the primary right to tax certain types of income of the individual.

In the absence of the treaty, under Hungarian regulations, Hungarian citizens will be considered Hungarian tax residents regardless of their US ties (i.e. place of residence, place of work) (with the exception of those who are also citizens of another country and do not have a permanent address or temporary place of residence registered in Hungary): Despite these individuals presence in the US during the entire calendar year, their worldwide income will be subject to Hungarian tax. The Hungarian tax liability of US tax residents is limited: it only extends to income derived from Hungary. In these cases, the right to credit the tax paid abroad will also be limited.

Income derived from employment and real estate rentals

Under the treaty, Hungary applies the ‘exemption method’, i.e. income subject to U.S. tax liability (apart from the exceptional case of application of the withholding tax) is exempted from Hungarian tax payment liability, and only data supply/ reporting obligations arise toward the Hungarian tax authority on the U.S. source income exempted from Hungarian taxation.

In Hungary, the income derived from employment and from renting real estate are included in the consolidated tax base. These types of income will remain included in the tax base in Hungary even after the termination of the treaty. Up to 90% of taxes paid in the US – but not more than the total amount of the Hungarian tax liability will be deductible from the Hungarian tax liability. This is equally applicable to the employment income and real estate income of Hungarian tax residents, as well as to the income of US tax residents derived from Hungary (i.e. related to work performed or real estate located in Hungary).

Regarding the effective tax liability, during the term of the treaty the effective tax liability in Hungary will be equal to the US tax liability. However, following the termination of the treaty, it will be aligned to the higher of the Hungarian or US effective tax rate.

Interest income, dividend and income from capital gain

Under the treaty interest income, dividend and income from capital gain are taxable in the country of residence, with the possibility of deducting withholding tax on dividends. Thus, the US source interest income and income derived from the capital gains of Hungarian tax resident individuals are taxable only in Hungary, while the US withholding tax on dividend can be deducted from the Hungarian tax liability.

After the termination of the treaty, the deduction of the tax paid in the US on income derived by Hungarian tax resident individuals in the US from interest, dividend and capital gain cannot be used to reduce the Hungarian tax liability below 5%. As a result, a US tax obligation of 30% can only be taken into account up to 10%, i.e. the effective tax liability will be an overall 35% (taking into account the 30% tax paid in the US and the 5% tax liability arising in Hungary). The Hungarian tax liability on the above types of income derived by US tax resident individuals from Hungary (e.g. interest paid by a Hungarian bank, dividend paid by a Hungarian company) will be 15%. Any rights of deduction or exemption in the US will be defined by US domestic regulations.

Corporate tax

Permanent establishment

US tax resident entities Hungarian tax liability extends solely to the income derived from business activity carried out through permanent establishment situated in Hungary. Following the termination of the treaty, however, an activity in Hungary may create permanent establishment (and hence result in tax liability in Hungary) more often.

The definition of permanent establishment within the scope of the Hungarian corporate tax law is broader than the definition included in the treaty, while the provisions of the treaty as an international agreement and thus a higher source of law, supersede the Hungarian domestic rules. In the absence of a treaty, it may occur that as of 2024, an entity incorporated in the US (without any change to its organisation or business activity in Hungary) will have a permanent establishment in Hungary. Therefore, such entities will incur corporate income tax liability in Hungary.

Such cases include permanent establishments created in connection with construction or mining activities. While during the term of the treaty (i.e. until the end of 2023) solely construction or mining activities carried out for longer than 24 months created a permanent establishment in Hungary, as of 2024 any such activity performed for longer than 3 months will create one.

Supply of services through a natural person employed by an US company under contract of employment or carrying out the same activity under another form of legal relationship will create a Hungarian permanent establishment (“Services PE”) for the US entity if the service is provided for a duration of longer than 183 days over any 12-month period. It is important to note that the definition of the Service PE is narrower than that of the ‘agency permanent establishment’ since the activities of the individual will create a Service PE in Hungary even if the individual is not authorised to enter into agreements on behalf of the US entity.

Withholding tax on dividends

As regards dividend income, the treaty sets forth a limit on tax liability arising in the country of source. Accordingly, the tax liability arising in the US in connection with dividends paid by a US company to a Hungarian one may not be higher than 5%, or 15% (depending on the proportion of ownership held by the beneficial owner entitled to the dividend in the entity paying the dividend).

As of January 2024, this cap will be removed and US domestic regulations will be applicable to withholding tax, when applying the prevailing 30% withholding tax rate will be likely to result in a higher tax charge.

The termination of the treaty will have even more serious consequences for interest income and royalty payments than the removal of the withholding tax cap applicable to dividends. The interest and royalty paid by a US company to a Hungarian tax resident entity have not incurred any tax liability in the US, however, those affected by this change will in the future be subject to a 30% withholding tax liability under US domestic rules.

Real property and income derived from real property

According to the treaty, income from real property may be taxed in the country where the real estate is located. In the past Hungary has applied the exemption method for the avoidance of double taxation. Thus, Hungarian tax resident companies’ income (e.g. rental income) from real estate located in the US has been exempt from Hungarian tax liability. Following the termination of the treaty, however, such income will be included in the Hungarian corporate income tax base as part of the worldwide income.

The termination of the treaty will also affect those Hungarian companies that hold real property located in Hungary and whose direct owner is a US entity. In the absence of a treaty, the gain realised on the sale of a Hungarian seated company (or the capital reduction in a company) holding real property located in Hungary will be subject to 9% corporate income tax. Additionally, these companies may also be subject to tax in the US. Please note that the Hungarian company has unlimited, joint and several liability for the Hungarian corporate income tax assessed by the tax authority yet unpaid by the US owner if the Hungarian company fails to declare to the tax authority that it qualifies as an entity holding real property.

Transfer pricing

Revision of transfer pricing indicators

With the treaty no longer applicable (and with the potential of double taxation), the payment obligations of taxpayers could increase. This increase in costs could affect market prices, as well. Hungarian and US affiliates will need to consider the changes in arm’s length prices when determining prices applied in their related party transactions and when applying transfer pricing adjustments in assessing their corporate income tax base. Particular attention must be paid to financing directed from Hungary to the US where interest received may be subject to withholding tax liability. In the future it will be necessary to thoroughly consider the issues of payment title, actual disbursement of interest, withholding tax, crediting of the WHT and accounting treatment of withholding tax, as well as the transfer pricing implications of all these issues.

Although the current treaty between the US and Hungary will remain applicable for approximately one more year, those with US interests should prepare for the changes taking place in January 2024. Our colleagues would be pleased to assist companies and individuals affected by these changes. We are able to provide support in reviewing incomes and contracts and determining any future additional tax liabilities. Should you have any questions regarding the above, please feel free to contact us.

Did you find this useful?