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The termination of the USA-Hungary double tax convention and its repercussions 

Balázs Károlyi

1.Introduction 

In July 2022, the United States of America (“USA”) sent a notification about its intention to unilaterally terminate its double tax treaty (“US-Hungary DTT”) with Hungary. This notification stirred lots of concerns and questions regarding the future tax treatment of income flows between the two countries that were covered by the US-Hungary DTT. Furthermore, the US-Hungary DTT also served as a legal basis for the exchange of information between the tax authorities of the two states in tax matters and with the termination it became also questionable how the administrative cooperation could be carried on. 

The purpose of this contribution is to shortly present the most outstanding issues revolving around the termination. First, the circumstances that have led to the termination of US-Hungary DTT, the temporal effects related to the notification of termination will be demonstrated. After that, the most severe substantive and procedural tax consequences of the termination will be elaborated. Then, the legislative response from the Hungarian side to mitigate the adverse implication of the termination will be evaluated. The contribution will close with the future prospects with respect to the conclusion of a new tax treaty between the two states. 


2.The circumstances of the termination  

It came as a surprise when the government of the USA notified Hungary on its intention to terminate the US-Hungary DTT. Besides the existing political tensions between the two administrations, this move has been evaluated in the media and in tax practice circles as a radical reaction to the Hungarian veto for the adoption of the global minimum tax Directive. Although the USA seemingly has nothing to do with EU legislative procedure, the global minimum tax started as a global agreement and cooperation in the field of corporate income taxation under the OECD / Inclusive framework as part of the Two-Pillar solution. Indeed, an agreement for the commitment of implementing the reform has been reached and signed by 137 countries, including the USA and Hungary[1]. But the initial enthusiasm began to lose its momentum and the Member States of the EU also struggled to adopt the Directive. It must be noted that at some point the joint implementation of Pillar One (entailing the reform of transfer pricing rules for in-scope multinationals) and the global minimum tax got off of the table and the focus was directed solely on the latter. The blocking of the development frustrated the USA and used the termination as a strong tool to place pressure on the blocking country, i.e., Hungary. Nevertheless, eventually Hungary agreed on the adoption of the global minimum tax Directive, while the USA never adopted the rules. Such outcome did not change the fact the US-Hungary DTT has been terminated and the termination has not been reversed and became effective.  

The notification on the intention of unilateral termination has been sent in July, 2022[2]. However, the date of the notification precedes the actual termination of the tax treaty itself. For the timing of the termination, the provisions of Article 26 of the US-Hungary DTT provided for guidance. It stipulated that the termination requires a six-month advance notice from the terminating contracting party. Moreover, the given Article contained further rules regarding when such termination becomes effective in respect of the various provisions of the US-Hungary DTT. There was no specific rules determined for the termination of the procedural Articles of the treaty, meaning that the effective date of the termination of these provisions coincided with the termination of the treaty, i.e., six months from the notification, which is the 8th of January, 2023.  

The effective date for the termination of the provisions that concerned the allocation and restriction of taxing rights, i.e., those that dealt with the elimination or at least mitigation of double taxation has been determined in a more lenient way:  

(1) with respect to taxes withheld at the source, to amounts paid or credited on or after the first day of the next January following the expiration of the six-month period; and 

(2) with respect to other taxes, to taxable periods beginning on or after the first day of the next January following the expiration of the six-month period.  

As the expiration of the six-month notice starting from the notification fell on the beginning of 2023, the termination, from a substantive law perspective, became effective only in connection with payments for taxable periods beginning on or after January 1, 2024. 

 

3.Consequences of the termination of the US-Hungary DTT 


3.1. Procedural consequences 

As it was pointed out in the preceding section, the termination of the US-Hungary DTT has come into effect six months following the notification, that is on 8 January 2023, resulting that the substantive provisions of the DTT would cease to apply from 1 January 2024.   

 

However, the US-Hungary DTT did not only serve as an important agreement to mitigate or eliminate double taxation for cross-border income flows. It also functioned as the legal basis for the exchange of information under the FATCA (Foreign Account Tax Compliance Act) agreement. Consequently, with the effective date of the termination, there was no legal basis for exercising the exchange of information between the tax authorities of the two states and it was in need of remedy by means of creating a new legal basis. As it was a mutual interest of the states, the US and Hungarian governments succeeded in reaching a new Memorandum of Understanding (“MoU”) regarding their FATCA agreement. Pursuant to the MoU, the provisions of the Convention on the Mutual Administrative Assistance in Tax Matters will be relevant and applicable for the purposes of the FATCA agreement and the information falling within the scope of the FATCA can be exchanged on that basis. 

 

According to the Hungarian Minister of Finance, Mihály Varga, it is expected from the MoU that it would lead to a more efficient exchange of information between the tax authorities of the two states, resulting in a limitation on tax avoidance opportunities of taxpayers and, simultaneously, it would provide the compliant taxpayers with better protection. 


3.2. Corporate income tax consequences 

As a result of the termination of the US-Hungary DTT, both states can exercise their taxing rights without any restriction. It hits US and Hungarian taxpayers very differently. 

As Hungary does not levy any withholding tax on Hungarian-sourced passive income (dividend, interest, royalty) based on its domestic law, the US companies earning these types of income from Hungary are not affected by the termination. However, certain structures involving Hungarian operations have become significantly less attractive. For instance, when US business operations were financed from Hungary, i.e., by a Hungarian financing entity that collected interest income on its loans from the US. After the termination of the DTT, such interest income would be subject to a 30% of US withholding tax. Consequently, multinational groups have an incentive to relocate these financing operations to another jurisdiction that can result in a loss of Hungarian tax revenues due to these exits. 

The US imposes withholding taxes on US-sourced passive income at a high, 30% rate. It will adversely affect the Hungarian tax resident taxpayers which derive income from the US. Although Hungary provides for an ordinary credit for the foreign taxes based on its domestic law, it is capped at a level that would be levied by Hungary itself: that is the Hungarian tax burden would be reduced to nil, but the taxpayers would not be capable of receiving a refund on the 30% of foreign tax. Therefore, Hungarian investors realizing dividend, interest or royalty income from the US must face a radical increase in their tax burden. 


3.3. Personal income tax consequences 

Similarly to corporate taxpayers, natural persons subject to personal income tax are also hit by the termination of the US-Hungary DTT. In the new situation, Hungarian tax resident taxpayers earning income (for instance dividend or interest) from the US would be subject to 30% of US withholding tax. Besides this already negative consequence, they will be subject to an additional Hungarian personal income tax obligation because under domestic law, only a maximum of 10% of foreign tax could be credited against the 15% Hungarian tax. It means that there will still be a minimum 5% Hungarian personal income tax payment obligation. 

 

The termination will also exert a negative impact on the taxation of athletes and sportspersons. The DTT did not allow the Hungarian taxation of U.S. athletes and entertainers if they stayed in Hungary only for a short period of time. With the termination, such restriction on the taxation right is lifted. Thus, for instance if a musician / sportsperson from the United States performs a concert or a match in Hungary, the corresponding remuneration will be subject to 15% Hungarian personal income tax irrespective of whether the remuneration is received directly by the individual or via a company.[3]

Nevertheless, the Hungarian parliament adopted certain amendments in the law with the intention to mitigate the negative effects of the termination of the US-Hungary DTT. Pursuant to these changes, there was an extension of the definition of controlled capital market transactions with respect to US stock market investments. It entails that it covers transactions concluded on the markets of OECD countries, including the United States, even in the absence of a DTT. This means that Hungarian private investors would remain entitled to credit losses on US transactions against their profits.[4] 

Moreover, the tax treatment of interest has also been amended. Based on the new rules, interest paid by a person resident in an OECD member state would be treated as interest income of the Hungarian tax resident individuals – and not as their other income. As a result of this change, not only US shares, but also such bonds and government securities could still be traded in Hungarian long-term investment accounts from 2024[5]

Although these legislative changes contributed to mitigate the Hungarian personal income tax consequences of certain transactions, they cannot eliminate the most severe consequence of the termination of the DTT, i.e., US withholding taxation liability arising from US sourced income streams. 


4. Future outlook 

The termination of the US-Hungary DTT ensues a number of bad impacts on the investment environment between the two countries and affects both US and Hungarian taxpayers. The new situation is particularly dire for Hungarian taxpayers with investment or operations in the US. 

Thus, the question arises how the current situation could be changed. There is no available information on the potential commencement of negotiations regarding a new DTT. However, it must be noted that there is another DTT between Hungary and the USA that has been concluded in 2010. It contains some important anti-avoidance provisions, such as the Limitation on Benefits rules and it is more resistant against aggressive tax planning strategies than its predecessor. Nevertheless, it is not applicable because its US ratification has been blocked by Senator Rand Paul (together with other similar DTTs). The senator argued that it gives rise to concerns that the new DTTs would give foreign governments too much access to US citizens' tax information.[6]  

It shows that nowadays not only low taxation by means of tax planning strategies worry the stakeholders but also the observation of taxpayers’ rights that can be jeopardized by aggressive international exchange of information. 

The US Treasury Department took the rare step on July, 8 of providing notice to Hungary that it was terminating the US-Hungary DTT, which has been in operation since 1979. According to an article of the Wall Street Journal, the US Treasury explained its action based on long-standing concerns with Hungary’s tax system and the treaty itself, and a lack of satisfactory action by Hungary to remedy these concerns in coordination with other EU member countries that are seeking to implement the OECD Pillar Two global minimum tax proposal[7]. The treaty termination will apply to US-source dividends, interest, and royalties for payments made on or after January 1, 2024. 

In addition, according to a Treasury spokesperson, the conclusion of a new treaty is not supported by the Biden administration given reductions in Hungary’s corporate tax rate since 2010 and the 2017 changes to US tax law.[8] 




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