A&M Tax Advisor Weekly
For decades now, we have been advising clients that the 1979 tax treaty between the U.S. and Hungary (the U.S.-H Treaty) is about to be replaced, any day now, with a new treaty. Then suddenly, on July 8th, the U.S. Treasury Department gave notice that it was terminating the treaty — period, full stop, without replacing it with a new one. Treasury’s surprise move came on the heels of Hungary’s veto of a 15% global minimal corporate income tax, preventing the European Union from proceeding with efforts to implement Pillar 2 of the OECD/G-20-led two-pillar international tax reform regime. Meanwhile, several House Republicans applauded “Hungary’s wisdom” regarding Pillar 1 and Pillar 2, which included not proceeding with the global minimum tax once Pillar 1 had been delayed.
The effects of terminating the treaty will mostly affect structures involving Hungarian holding companies with U.S. subsidiaries. Because the terms of the treaty provide for an extended effective date for a termination, taxpayers generally have until 2024 before the benefits of the treaty expire. That said, taxpayers may want to begin assessing the potential implications for transactions and business and tax planning strategies.
The U.S.-H Treaty, which was ratified in 1979, later caused Treasury concern after learning that U.S. corporations, which were at least 25% foreign-owned, made over $1 billion in interest payments to related parties in Hungary. Thus, in 2010, U.S. and Hungarian officials renegotiated the treaty to, among other things, better align it with the U.S. Model Treaty. For example, the revised treaty incorporated a limitation of benefits provision aimed at eliminating treaty shopping, whereby a resident of a third country (not an intended beneficiary of the treaty) benefits from the treaty’s reduced tax rates compared to investing directly in the U.S. However, the U.S. never ratified the revisions amid unresolved concerns, including more recently, whether the treaty could override the base erosion and anti-abuse tax (BEAT).
Under the terms of the U.S.-H Treaty, the agreement will be considered terminated on January 8, 2023, which is six months after Treasury gave notice to Hungary. However, the treaty provides for a delayed effective date for taxes withheld at the source until January 1, 2024, and for other taxes, effective for tax periods beginning on or after January 1, 2024.
A&M Insight: An oft-asked question is whether Treasury’s decision can be reversed. In addressing treaty termination issues decades ago, the U.S. government determined that, in general, if the notice has not yet resulted in the termination of the treaty, it could be withdrawn. Under that premise, the U.S. could withdraw its July notice of termination, in full or in part, before the end of the six-months’ notice period, as it did in 1987 with the U.S.-Netherlands Antilles tax treaty. However, it seems unlikely that the administration would revert to the 1979 U.S.-H treaty or the 2010 version, which would require U.S. ratification, especially because a Hungarian official said, “we continue our professional consultations on tax issues with our Republican friends.” In the U.S., the President has the power to ratify treaties if two-thirds of the Senate approves, but the Senate isn’t likely to elevate the U.S.-H Treaty to the top of its priority list, either before or after the mid-term elections, regardless of which party has control, and it’s unclear whether there is a version of the treaty that the U.S. and Hungary could agree to.
The U.S.-H treaty mitigates double taxation by generally restricting each country’s right to tax income derived within its jurisdiction by residents of the other jurisdiction. For example, interest and royalties derived within the U.S. or Hungary by a resident of the other country are exempt from tax in the source jurisdiction. Also, dividends paid to a non-resident of the source country are generally limited to a 15% withholding tax while dividends paid by a resident company to a non-resident parent corporation are limited to 5% if the beneficial owner owns directly or indirectly at least 10% of the voting stock of the company.
Without the U.S.-H Treaty, interest, royalties, and dividends will be subject to withholding taxes based on each jurisdiction’s laws. For example, U.S.-sourced fixed, determinable, annual, or periodical payments, such as royalties, interest, and dividend income, not effectively connected to a U.S. trade or business, received by Hungarian residents would generally be subject to a 30% U.S. withholding tax if no exemptions apply. In contrast, under Hungarian domestic law, dividends, royalties, and interest paid to foreign companies are generally not subject to withholding tax, although a 15% withholding tax may apply to distributions paid to individuals.
A&M Insight: Dividend, royalty, and interest payments that a U.S. company receives from a Hungarian company should be exempt from Hungarian withholding taxes upon termination of the U.S.-H treaty. However, for structures involving U.S. subsidiaries of Hungarian parent companies, the lapse of tax treaty benefits in 2024 would generally trigger higher U.S. withholding taxes. In response to the U.S.-H Treaty termination, U.S. companies may want to consider whether to accelerate distributions to before January 1, 2024, while also considering alternative distribution strategies post-treaty termination and whether restructuring opportunities exist for certain businesses, including analyzing U.S. treaties with other countries, which will likely differ from the U.S.-H treaty.
The termination of the U.S.-Hungary tax treaty is a novel event, which may require certain companies to begin assessing the implications, even though, in theory, the U.S. could reverse its decision before January 8, 2023. Changes to withholding taxes represent the primary effect for U.S. companies with a Hungarian parent company to consider in evaluating the termination of the treaty. Generally, under U.S. treaties, companies can leverage the mutual agreement procedure (MAP) process, which allows taxpayers to obtain the assistance from the U.S. competent authority to resolve disputes with the other jurisdiction’s competent authority that involve tax treatment inconsistent with the applicable treaty. However, the MAP process, which will no longer be available when the treaty is terminated, has been infrequently used in the case of the U.S.-H Treaty. If you would like to discuss your situation and the potential implications of the U.S.’ termination of the treaty, including analyzing alternative structures and business and tax strategies, please feel free to contact Kevin M. Jacobs or Alfonso A-Pallete.