New Hungary-U.S. Income Tax Treaty

February 11, 2010 New Hungary-U.S. Income Tax Treaty

A New Income Tax Treaty Between Hungary and the United States Has Been Signed

SUMMARY On February 4, 2010, Hungary and the United States signed a new income tax treaty (the “New Treaty”)1 that will enter into force when instruments of ratification are exchanged. The New Treaty will replace the existing treaty, which was ratified in 1979 (the “Existing Treaty”), and is more closely aligned with the current U.S. Model Income Tax Treaty and other recently negotiated U.S. tax treaties. The most significant change is the inclusion of a limitation on benefits article, which is absent from the Existing Treaty and reflects the concern of the U.S. Treasury Department that the absence of a limitation on benefits article in the Existing Treaty had facilitated tax treaty shopping – that is, the use of Hungarian finance corporations by third-country entities – particularly because the Existing Treaty exempts interest payments from withholding tax.2

Other significant changes in the New Treaty include:

• A withholding tax exemption for dividends paid to pension funds;

• Provisions providing for greater exchange of information, including information held by financial institutions; and

• Interest and dividend withholding provisions that conform to recently negotiated U.S. tax treaties in the case of dividends paid by RICs and REITs and in the case of “contingent” interest.

The withholding tax provisions of the New Treaty will generally take effect on the first day of the second month following the date the New Treaty enters into force, and if the New Treaty enters into force in 2010, the other provisions will apply to taxable periods beginning on or after January 1, 2011. The New Treaty provides a grace period through December 31, 2010 for which a taxpayer entitled to greater relief under

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the Existing Treaty may elect to apply the Existing Treaty rather than the New Treaty, but only if the Existing Treaty is applied in its entirety.

The U.S. Treasury Department normally releases a technical explanation in advance of the U.S. Senate’s consideration of a new treaty, and Hungary and the U.S. may also issue a Memorandum of Understanding elaborating upon certain provisions of the New Treaty. These documents will provide additional guidance on the application and interpretation of the New Treaty.

DISCUSSION

Limitation on Benefits The U.S. Treasury Department believes that the Existing Treaty has been exploited, particularly in the case of interest, by Hungarian finance corporations ultimately owned by persons from third countries that either are not covered by an income tax treaty with the U.S. or covered by a treaty that did not eliminate source-country withholding tax on interest. According to a 2007 study by the U.S. Treasury Department, data compiled from U.S. corporate tax returns indicate that total interest payments from foreign-controlled U.S. corporations to related parties in Hungary had surged from 1996 through 2004.3 In order to address this concern, the New Treaty includes a comprehensive limitation on benefits article. Under the New Treaty, a resident of Hungary or the U.S. would be eligible to claim benefits only if the resident also belongs to at least one of the categories described below or satisfies at least one of the tests described below:

Individuals & Qualified Governmental Entities Individual residents and governmental authorities of Hungary or the U.S. will be entitled to all benefits of the New Treaty.

Publicly Traded Corporation Test A company resident in Hungary or the U.S. will be entitled to all benefits of the New Treaty if the “principal class”4 as well as any “disproportionate class”5 of the company’s shares is regularly traded on one or more “recognized stock exchanges”, and either:

• The company’s principal class of shares is primarily traded on one or more “recognized stock exchanges”6:

• Located in the company’s country of residence;

• For a company resident in Hungary, on a recognized stock exchange located within the European Union or in any other European Free Trade Association state; or

• For a company resident in the U.S., on a recognized stock exchange in a state that is party to NAFTA; or

• The company’s primary place of management and control is in the country in which it is resident, which means that the executive officers and senior management employees as well as their staff

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exercise day-to-day responsibility for more of the strategic, financial and operational policy decision- making for the company (including its subsidiaries) and the activities necessary for preparing and making those decisions in its country of residence than in any other country.

Subsidiary of Publicly Traded Corporation Test A company resident in Hungary or the U.S. will be entitled to all benefits of the New Treaty if at least 50% of the aggregate vote and value of its shares and at least 50% of any disproportionate class of its shares is owned directly or indirectly by five or fewer companies that qualify under the publicly traded corporation test above, but only if, in the case of indirect ownership, each intermediate owner is a resident of either Hungary or the U.S.

Tax-Exempt Organizations and Pension Funds A tax-exempt organization that is established and maintained in the U.S. or Hungary exclusively for religious, charitable, scientific, artistic, cultural or educational purposes will qualify for all New Treaty benefits. In addition, a pension fund7 established in Hungary or the U.S. will qualify for all New Treaty benefits, so long as more than 50% of its beneficiaries, members or participants are individuals resident in Hungary or the U.S.

Ownership/Base Erosion Test In order to qualify for all New Treaty benefits under this test, a legal entity resident in Hungary or the U.S. must satisfy each of the following two requirements:

• Ownership Test. 50% or more of shares or beneficial interests representing at least 50% of the aggregate voting power and value (and at least 50% of any disproportionate class of shares) must be owned on at least half the days of the entity’s taxable year by persons who are themselves entitled to New Treaty benefits either as individuals, governmental authorities, publicly traded corporations, tax- exempt organizations or pension funds. The ownership may be indirect if each intermediate entity is resident in the same country as the entity seeking to qualify for benefits.

• Base Erosion Test. Less than 50% of the entity’s gross income for the taxable year (as determined in the entity’s country of residence) is paid or accrued, directly or indirectly, to persons not entitled to New Treaty benefits (either as individuals, governmental authorities, publicly traded corporations, tax- exempt organizations, or pension funds) in the form of payments that are tax-deductible in the entity’s state of residence (excluding arm’s-length payments in the ordinary course of business for services or tangible property and payments in respect of financial obligations to a bank (including, in the case of Hungary, a credit institution) that is not related to the payer).

Active Trade or Business Test A resident of Hungary or the U.S. that is not generally entitled to New Treaty benefits will nevertheless be entitled to receive benefits with respect to items of income that are connected to an active trade or business conducted in its country of residence if the following three requirements are satisfied:

• The resident is engaged in the active conduct of a trade or business in its country of residence (for example, a Hungarian company must conduct a trade or business in Hungary);

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• The income derived from the other country (in our example, the U.S.) is derived in connection with, or is incidental to, that trade or business; and

• The trade or business is substantial in relation to the activity in the other country that generated the item of income (in our example, the Hungarian trade or business is substantial in relation to the activity in the U.S.).

With respect to the first requirement of this three-part test, the New Treaty provides that the business of making or managing investments for the resident’s own account will not be considered an active trade or business, unless the activity is either an insurance or securities activity carried on by an insurance company or registered securities dealer, or in the case of a U.S. resident, a banking activity carried on by a bank, or in the case of a Hungarian resident, a regulated financial service carried on by a financial institution.

With respect to the third requirement of the three-part test, the New Treaty indicates that the determination of whether a trade or business is “substantial” will depend on “all the facts and circumstances.” The U.S. Treasury Department technical explanation of the New Treaty, which is usually released in advance of the Senate’s consideration of a new treaty, may provide (as other technical explanations typically do) additional insight into this test.

Activities of connected entities will be attributed to each other for the purpose of the active trade or business test. For these purposes, a person is connected to another if one person owns 50% of the beneficial interests of the other (or, in the case of a company, the aggregate vote and value of the company’s equity interest) or a third person satisfies such ownership requirements for both entities. Furthermore, if one entity “controls” another (or two entities are under the control of the same person or persons) under a facts-and-circumstances analysis, these entities will be treated as connected.

Equivalent Beneficiary Test Under this test, a company resident in Hungary or the U.S. will be entitled to New Treaty benefits if:

• At least 95% of the aggregate voting power and value of its shares (and at least 50% of any disproportionate class of shares) is owned directly or indirectly by seven or fewer persons that are “equivalent beneficiaries”; and

• Less than 50% of the company’s gross income (as determined in the company’s state of residence) for the taxable year is paid or accrued, directly or indirectly, to persons who are not “equivalent beneficiaries,” in the form of payments that are tax-deductible in the company’s state of residence (excluding arm’s-length payments in the ordinary course of business for services or tangible property).

An “equivalent beneficiary” for this purpose means either:

• A resident of Hungary or the U.S. entitled to benefits under the New Treaty as an individual, governmental authority, a publicly traded corporation, tax-exempt organization or pension fund; or

• A resident of a member state of the European Union or of any other European Free Trade Association state or of a party to NAFTA but only if such resident would be entitled to all the benefits -4- New Hungary-U.S. Income Tax Treaty February 11, 2010

of a tax treaty between such state and the state from which New Treaty benefits are being claimed (under provisions analogous to the tests for individuals, governmental authorities, publicly traded corporations, tax-exempt organizations and pension funds) and, for purposes of claiming reduced withholding tax on dividends, interest or royalties, would be entitled under such other treaty to withholding tax on such income at a rate equal to or lower than the applicable rate under the New Treaty. However, if the other treaty does not provide for a comprehensive limitation on benefits article, the resident may qualify as an equivalent beneficiary if it would be eligible for benefits under the New Treaty (assuming that it was a resident of Hungary or the U.S.) either as an individual, governmental authority, publicly traded corporation, tax-exempt organization or pension fund.

Headquarters Company for a Multinational Corporate Group Test A company resident in Hungary or the U.S. will be entitled to New Treaty benefits if the company functions as a headquarters company for a multinational corporate group. In order to qualify as a headquarters company for this purpose:

1) The company must provide a substantial portion of the overall supervision and administration of the multinational corporate group (which may include but cannot be principally comprised of group financing) and must have and exercise independent discretionary authority to carry out these activities;

2) The multinational group must consist of corporations resident in and engaged in an active business in at least five countries, and the business activities carried on in each of the five countries (or five groupings of countries) must generate at least 10% of the gross income of the group;

3) The business activities carried on in any one country other than the country of residence of the headquarters company must generate less than 50% of the gross income of the group;

4) No more than 25% of the company’s gross income may be derived from Hungary, in the case of a U.S. company, or the U.S., in the case of a Hungarian company;

5) The company must be subject to the same income taxation rules in its country of residence as companies that would qualify under the active business or trade test described above; and

6) The income derived in Hungary by a U.S. company or in the U.S. by a Hungarian company must be either derived in connection with or incidental to the active business described in (2) above.

While the New Treaty does not specify when the gross income requirements described in (2), (3) and (4) above need to be satisfied, it does state that they may be deemed satisfied by averaging the gross income of the preceding four years. It may be the case that additional details will be provided at a future date.

Effective Rate of Tax Test for Third Country Permanent Establishments If a Hungarian enterprise derives income from the U.S. and that income is attributable to a permanent establishment of the Hungarian enterprise in a third country, the tax benefits of the New Treaty will not apply to the income if the profits of that permanent establishment are subject to a combined aggregate effective rate of tax in Hungary and the third country that is less than 60% of the general rate of company tax applicable in Hungary. In such case, any dividends, interest or royalties attributable to the permanent establishment would be subject to tax in the U.S. at a rate not greater than 15%, and any other income

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attributable to the permanent establishment would be subject to tax under U.S. domestic law. This rule will not apply if:

• In the case of royalties, the royalties are received as compensation for the use of, or the right to use, intangible property produced or developed by the permanent establishment; or

• In the case of any other income, the income derived from the source country is derived in connection with or is incidental to the active conduct of a trade or business carried on by the permanent establishment in the third country other than the business of making, managing or simply holding investments for the enterprise’s own account, unless such activities are securities activities carried on by a registered securities dealer or are regulated financial services carried on by a Hungarian financial institution.

Determination of the Competent Authority If a resident of Hungary or the U.S. is not otherwise entitled to New Treaty benefits, the competent authority of the non-residence country may grant benefits if it determines that the establishment, acquisition or conduct of such resident and its operations does not have as one of its principal purposes the obtaining of benefits. The New Treaty specifies that the competent authority of the non-residence country will consult with the competent authority of the country of residence before denying benefits.

Effective Date The withholding tax provisions of the New Treaty will generally take effect on the first day of the second month following the date the New Treaty enters into force, and if the New Treaty enters into force in 2010, the other provisions of the New Treaty will apply to taxable periods beginning on or after January 1, 2011. The New Treaty provides a grace period through December 31, 2010 for which a taxpayer entitled to greater relief under the Existing Treaty may elect to apply the Existing Treaty but only in its entirety. In addition, an individual entitled to benefits under Article 18 (Students and Trainees) or Article 17 (Teachers) of the Existing Treaty at the time the New Treaty enters into force will continue to be entitled to such benefits of the Existing Treaty until such time as the individual would have ceased to be entitled to such benefits under the Existing Treaty.

Other Highlights of the New Treaty Other highlights of the New Treaty that may be of general interest include:

• Fiscally Transparent Entities. The New Treaty provides that income derived by an entity that is fiscally transparent under U.S. or Hungarian law (e.g., in the case of the U.S., a partnership or disregarded entity) is treated as derived by a resident of such country, and thus is eligible for the New Treaty’s benefits, only to the extent that the income is taxable in that country as the income of a resident.

• Covered Taxes. Unlike the Existing Treaty, the U.S. excise taxes imposed by Section 4371 of the U.S. Internal Revenue Code on insurance and reinsurance premiums paid to Hungarian insurers are not covered by the New Treaty.

• Permanent Establishment. The New Treaty, consistent with U.S. tax law principles, allows certain types of income or gain (including dividends, interest, royalties and capital gain) attributable to a -6- New Hungary-U.S. Income Tax Treaty February 11, 2010

permanent establishment to be taxed by the country where the permanent establishment was located even if payment or accrual of the relevant income or gain is deferred until after the permanent establishment has ceased to exist.

• Inland Transport. Under the New Treaty, inland transport that is part of international traffic will qualify for the exemption from source-state taxation of international traffic.

• Real Property.

• The New Treaty clarifies that income derived from agriculture or forestry or from a U.S. real property interest will be treated as income derived from real property for New Treaty purposes.

• The New Treaty allows a resident of either Hungary or the U.S. who would be liable to tax on a gross basis with respect to income derived from real property located in the other country to elect to be taxed on such income on a net basis in the other country as if such income were net profits of a permanent establishment. Such an election would be binding for that taxable year and subsequent taxable years, unless the competent authority of the country where the real property is located consents to revoking the election.

• Arm’s-Length Adjustments. The New Treaty provides that where a U.S. enterprise and Hungarian enterprise are connected (through direct or indirect participation in management, control or capital of one of the enterprises), the U.S. and Hungarian governments may adjust the profits of the enterprises and tax them accordingly to reflect arm’s-length terms and conditions that would have been made between two independent enterprises and the other government will make appropriate correlative adjustments. The New Treaty further provides that where there is a special relationship between the payer and the beneficial owner of interest or royalties and the amount of interest or royalties exceeds the amount that would have been agreed to by independent parties, only the arm’s-length amount of interest and royalties will be eligible for benefits under the New Treaty and the excess will be subject to taxation under the domestic laws of each country.

• Dividends.

• Unlike a number of other newly negotiated U.S. tax treaties, the New Treaty does not eliminate the withholding tax on subsidiary-parent dividends. However, the New Treaty exempts from withholding taxes dividends paid to a pension fund that is a resident of Hungary or the U.S., so long as the dividends are not derived from a trade or business conducted by the pension fund or an associated enterprise.

• The New Treaty provides that dividends paid by a RIC (or a similar Hungarian entity) will be taxed at a 15% rate (and not eligible for the reduced 5% rate allowed to 10% or greater corporate shareholders) unless exempt because paid to a pensions fund.8

• Dividends paid by a REIT (or a similar Hungarian entity) will be taxed at a 15% rate, unless exempt because paid to a pension fund, but only if:

• The beneficial owner of the dividends is an individual or pension fund that holds no more than 10% of the REIT; • The dividends are paid with respect to a class of stock that is publicly traded and the beneficial owner holds no more than 5% of any class of the REIT’s stock; or • The beneficial owner of the dividends holds no more than 10% of the REIT and the REIT is “diversified.”9 Otherwise, ordinary dividends paid by a REIT (or a similar Hungarian entity) will be subject to a 30% withholding tax.

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• It should be noted that the U.S. Treasury Department generally takes the view that the 15% rate will not apply to dividends paid by REITs or certain RICs attributable to gains from the sale of United States real property interests.10

• Interest. The New Treaty retains the general 0% withholding rate on interest payments under the Existing Treaty but subjects the following categories of interest to 15% withholding:

• Contingent interest arising in Hungary paid to a U.S. resident (i.e., interest that is determined by reference to (i) receipts, sales, income, profits or other cash flow of the payer or a related person, (ii) any change in the value of any property of the payer or a related person or (iii) any dividend, partnership distribution or similar payment made by the payer or a related person); and

• Contingent interest arising in the U.S. paid to a Hungarian resident that does not qualify as portfolio interest under U.S. tax law.

Under the New Treaty, an excess inclusion of the holder of a residual interest in a REMIC is taxed by the U.S. at a 30% rate.

• Capital Gains. The New Treaty provides that, if an individual changes residency from Hungary to the U.S. or vice versa and is taxed in his or her former country of residence on the fair market value of any property deemed disposed of as a result of becoming a non-resident, the individual may elect to step up his or her basis in such property to reflect the fair market value of the property at the time of the deemed disposition for purposes of taxation in his or her new country of residence.

• Directors’ Fees. The New Treaty provides that directors’ fees and other compensation received by a resident of Hungary or the U.S. in his or her capacity as a member of the board of directors of a company resident in the other country may be taxed by that other country.

• Exchange of Information. The New Treaty significantly strengthens the exchange of information provisions of the Existing Treaty. If information is requested by Hungary or the U.S. pursuant to the Exchange of Information article, the other country would be obligated to use its information gathering measures to obtain the requested information even if it does not need such information for its own tax purposes. The New Treaty is explicit that Hungary or the U.S. may not “decline to supply information because it has no domestic interest in such information.”11 Further, the New Treaty provides that neither Hungary nor the U.S. may decline to supply requested information on the grounds that the information is held by a bank, financial institution, nominee or other person acting in an agency or fiduciary capacity or on the grounds that the requested information relates to ownership interests in a person. These provisions are similar to the new provisions of the 2009 protocol to the U.S. income tax treaty with Switzerland.

• Mutual Agreement Procedure. The New Treaty retains the mutual agreement procedure of the Existing Treaty, whereby the competent authorities of each country will endeavor to resolve by mutual agreement disputes under the treaty. Unlike some recently negotiated U.S. tax treaties and protocols (for example, with Italy and Germany), the New Treaty does not provide for arbitration.

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ENDNOTES

1 Convention between the Government of the United States of America and the Government of the Republic of Hungary for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income. 2 See “Treasury Reports to Congress on International Tax Issues,” 2007 TNT 230-17, Tax Analysts, November 28, 2007. 3 Id., p. 70. 4 A company’s “principal class of shares” means the ordinary or common shares of the company (or, if the ordinary or common shares do not represent a majority of the company’s voting power and value, then those classes of shares that in the aggregate represent a majority of its aggregate voting power and value). 5 A “disproportionate class of shares” for this purpose is any class of shares that entitles the shareholder of a company resident in one of the countries (e.g., the U.S.) to disproportionately higher participation (e.g., through dividends or redemption payments) in the earnings generated in the other country (in this example, Hungary). 6 A “recognized stock exchange” for this purpose means NASDAQ, any national securities exchange registered with the U.S. Securities and Exchange Commission, the stock exchanges of Budapest, Amsterdam, Brussels, Frankfurt, London, Paris, Vienna, Warsaw and Zurich, and any other stock exchange that the competent authorities may agree to include. 7 A “pension fund” for this purpose is defined as an entity that is generally exempt from income taxation in either Hungary or the U.S. and operated principally either to administer or provide pension or retirement benefits or to earn income for the benefit of such a fund. 8 Certain dividends paid by a RIC are exempt from U.S. withholding tax under U.S. law (i.e., certain interest-related dividends and short-term capital gain dividends, as provided under Sections 871(k) and 881(e) of the U.S. Internal Revenue Code). 9 A REIT is diversified for this purpose if the value of no single interest in real property exceeds 10% of its total interests in real property. The New Treaty provides an exception that foreclosure property will not be treated as a real property interest for this purpose, and a look-through rule applies so that a REIT holding an interest in a partnership will be treated as owning its proportionate share of the underlying property held by the partnership. In addition, the U.S. Treasury Department generally takes the view that the 15% rate will not apply to dividends paid by REITs or certain RICs attributable to gains from the sale of United States real property interests. 10 See U.S. Treasury Department Technical Explanation of the U.S. Model Income Tax Convention of November 15, 2006, Paragraph 1 of Article 13. 11 See Paragraph 4 of Article 26 of the New Treaty.

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