[Senate Executive Report 113-5]
[From the U.S. Government Publishing Office]
113th Congress Exec. Rept.
SENATE
2nd Session 113-5
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TAX CONVENTION WITH HUNGARY
_______
April 29, 2014.--Ordered to be printed
_______
Mr. Menendez, from the Committee on Foreign Relations,
submitted the following
REPORT
[To accompany Treaty Doc. 111-7]
The Committee on Foreign Relations, to which was referred
the 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, signed on February 4,
2010, at Budapest, and a related agreement effected by an
exchange of notes on February 4, 2010 (the ``Convention'')
(Treaty Doc. 111-7), having considered the same, reports
favorably thereon with one declaration, as indicated in the
resolution of advice and consent, and recommends that the
Senate give its advice and consent to ratification thereof, as
set forth in this report and the accompanying resolution of
advice and consent.
CONTENTS
Page
I. Purpose..........................................................1
II. Background.......................................................2
III. Major Provisions.................................................2
IV. Entry Into Force.................................................4
V. Implementing Legislation.........................................4
VI. Committee Action.................................................4
VII. Committee Comments...............................................4
VIII.Text of Resolution of Advice and Consent to Ratification.........5
IX. Annex 1.--Technical Explanation..................................7
I. Purpose
The purpose of the new Hungary Convention is to promote and
facilitate trade and investment between the United States and
Hungary. Principally, the Convention provides for reduced
withholding rates on cross-border payments of dividends,
interest, royalties, and other income, as well as the
elimination of withholding taxes on cross-border dividend
payments to pension funds. The Convention contains rigorous
protections designed to protect against ``treaty shopping,''
which is the inappropriate use of a tax treaty by third-country
residents, and provisions to ensure the exchange of information
between tax authorities in both countries. While the proposed
Convention generally follows the 2006 U.S. Model Income Tax
Treaty (the ``U.S. Model''), it deviates from the U.S. Model in
certain respects discussed below.
II. Background
The United States has a tax treaty with Hungary that is
currently in force, which was concluded in 1979 (Convention
between the Government of the United States of America and the
Government of the Hungarian People's Republic for the Avoidance
of Double Taxation and the Prevention of Fiscal Evasion with
Respect to Taxes on Income, signed at Washington, February 12,
1979). The new Convention was negotiated to bring U.S.-Hungary
tax treaty relations into closer conformity with each country's
current tax treaty policies. For example, the proposed
Convention contains comprehensive provisions designed to
address ``treaty-shopping.'' The existing convention with
Hungary signed in 1979 does not contain treaty shopping
protections and, as a result, is susceptible to abuse by third-
country investors.
III. Major Provisions
A detailed article-by-article analysis of the Convention
may be found in the Technical Explanation Published by the
Department of the Treasury on June 7, 2011, which is included
at Annex 1 to this report. In addition, the staff of the Joint
Committee on Taxation prepared an analysis of the Convention,
JCX-32-11 (May 20, 2011), which was of great assistance to the
committee in reviewing the Convention. A summary of the key
provisions of the Convention is set forth below.
GENERAL SCOPE
Article 1 defines the scope of the proposed treaty as
applying only to ``residents'' of the United States and
Hungary, except where the terms of the Convention provide
otherwise. It contains a standard ``saving clause'' pursuant to
which each country retains the right to tax its residents and
citizens as if the treaty had not come into effect. This
article also contains a standard provision providing that the
treaty may not be applied to deny a taxpayer any benefits to
which the taxpayer would be entitled under the domestic law of
a country or under any other agreement between the two
countries.
COVERED TAXES
Article 2 provides that the proposed treaty applies to all
taxes on income, including gains, irrespective of the manner in
which they are levied. Except with respect to the benefits
provided by Article 24 (Non-Discrimination), state and local
taxes, including property taxes, do not fall within the scope
of the proposed treaty.
DIVIDENDS
Articles 10 and 13 provide that dividends and certain gains
derived by a resident of either country from sources within the
other country (residence-country taxation) may be fully taxed
by both countries. However, the proposed treaty limits the rate
of taxation that the source country may impose on certain
dividends paid to a resident of the other country. The
withholding tax rates on dividends are generally consistent
with those contained in the U.S. Model treaty, but they
represent a departure from the exemption from source-country
withholding tax provided by several recent U.S. treaties and
protocols for dividends paid by subsidiaries to parent
corporations resident in the other treaty countries.
INTEREST AND ROYALTIES
Consistent with the existing Convention, the proposed
Convention generally eliminates source-country withholding
taxes on cross-border interest and royalty payments. However,
consistent with existing U.S. tax treaty policy, source-country
tax may be imposed on certain contingent interest and payments
from a U.S. real estate mortgage investment conduit.
PENSIONS
In Article 17, the proposed Convention preserves the
existing Convention's rules that allow for exclusive residence-
country taxation of pensions, and consistent with current U.S.
tax treaty policy, provides for exclusive source-country
taxation of social security payments. The Convention differs
from the Model treaty in that it does not contain express
provisions dealing with annuities, alimony, and child support
payments, or certain provisions that deal with the tax-
treatment of cross-border pension contributions.
LIMITATION ON BENEFITS
Consistent with current U.S. treaty policy, Article 22
includes a ``Limitation on Benefits'' provision, which is
designed to avoid treaty-shopping by limiting the indirect use
of a treaty's benefits by persons who were not intended to take
advantage of those benefits. The limitation of benefits
provision states that a corporation or similar entity resident
in a contracting state (i.e., the United States or Hungary) is
not entitled to the benefits of the treaty unless that entity
meets certain tests, such as carrying on an active trade or
business, or being a publicly-traded company on certain
specified stock exchanges. The provision is designed to
identify entities that have established residency for tax-abuse
purposes. This article's limitation of benefits provision
generally reflects the anti-treaty-shopping provisions included
in the U.S. Model treaty and more recent U.S. income tax
treaties, but differs in a few respects that may permit some
companies to qualify for treaty benefits under tests not found
in the Model. For instance, the proposed treaty contains a
derivative benefits test under which a company could qualify
for treaty benefits if at least 95 percent of the aggregate
voting power and value of its shares (and at least 50 percent
of any disproportionate class of shares) are held by seven or
fewer ``equivalent beneficiaries.'' The proposed treaty also
contains a headquarters company test, under which a resident
company would qualify if it meets the criteria to be considered
a headquarters company of a multinational group.
EXCHANGE OF INFORMATION
Article 26 provides authority for the two countries to
exchange tax information. Under Article 26, the United States
is allowed to obtain information (including from financial
institutions) from Hungary regardless of whether Hungary needs
the information for its own tax purposes.
IV. Entry Into Force
The proposed Convention shall enter into force on the date
when the United States and Hungary exchange instruments of
ratification. The various provisions of this Convention shall
have effect as described in paragraph 2 of Article 28 of the
Convention.
V. Implementing Legislation
As is the case generally with income tax treaties, the
Convention is self-executing and does not require implementing
legislation for the United States.
VI. Committee Action
The committee held a public hearing on the Convention on
February 26, 2014. Testimony was received from Robert Stack,
Deputy Assistant Secretary (International Tax Affairs) at the
U.S. Department of the Treasury, Thomas Barthold, Chief of
Staff of the Joint Committee on Taxation, William Reinsch,
President of the National Foreign Trade Council, Paul Nolan,
Vice President, Tax for McCormick & Company, Inc., and Nancy
McLernon, President & CEO of the Organization for International
Investment. A transcript of the hearing is included in Annex 2
of Executive Report 113-???.
On April 1, 2014, the committee considered the Protocol and
ordered it favorably reported by voice vote, with a quorum
present and without objection.
VII. Committee Comments
The Committee on Foreign Relations believes that the
Convention will stimulate increased trade and investment,
reduce treaty shopping incentives, and promote closer co-
operation between the United States and Hungary. The committee
therefore urges the Senate to act promptly to give advice and
consent to ratification of the Convention, as set forth in this
report and the accompanying resolution of advice and consent.
A. LIMITATION ON BENEFITS
The committee applauds the Treasury Department's
significant efforts to address treaty shopping both in this
Convention and in other bilateral tax treaties. After careful
examination of this Convention, as well as testimony and
responses to questions for the record from the Treasury
Department, the committee is of the view that the Convention's
protections against treaty-shopping are robust and will
substantially deny treaty shoppers the benefit of the
Convention. The committee believes that it is critical for the
Treasury Department to closely monitor and keep the committee
informed on the effectiveness of the above-mentioned provisions
in discouraging and eliminating treaty-shopping under the
Convention.
B. DECLARATION ON THE SELF-EXECUTING NATURE OF THE CONVENTION
The committee has included one declaration in the
recommended resolution of advice and consent. The declaration
states that the Convention is self-executing, as is the case
generally with income tax treaties. Prior to the 110th
Congress, the committee generally included such statements in
the committee's report, but in light of the Supreme Court
decision in Medellin v. Texas, 128 S. Ct. 1346 (2008), the
committee determined that a clear statement in the Resolution
is warranted. A further discussion of the committee's views on
this matter can be found in Section VIII of Executive Report
110-12.
VIII. Text of Resolution of Advice and Consent to Ratification
Resolved (two-thirds of the Senators present concurring
therein),
SECTION 1. SENATE ADVICE AND CONSENT SUBJECT TO A DECLARATION
The Senate advises and consents to the ratification of the
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, signed at Budapest
February 4, 2010, with a related agreement effected by exchange
of notes February 4, 2010 (the ``Convention'') (Treaty Doc.
111-7), subject to the declaration of section 2.
SECTION 2. DECLARATION
The advice and consent of the Senate under section 1 is
subject to the following declaration:
The Convention is self-executing.
IX. Technical Explanation
DEPARTMENT OF THE TREASURY TECHNICAL EXPLANATION OF THE 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.
This is a Technical Explanation of the Convention between
the Government of the United States 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, signed on February 4, 2010 (the ``Convention'').
Negotiations took into account the U.S. Treasury
Department's current tax treaty policy, and the Treasury
Department's Model Income Tax Convention. Negotiations also
took into account the Model Tax Convention on Income and on
Capital, published by the Organisation for Economic Cooperation
and Development (the ``OECD Model''), and recent tax treaties
concluded by both countries.\1\
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\1\On the date of the signing of the Convention, the United States
and Hungary exchanged diplomatic notes (``Exchange of Notes'') setting
forth provisions and understandings related to the Convention and
constituting an agreement between the two governments.
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The Technical Explanation is an official guide to the
Convention and an accompanying Exchange of Notes. It reflects
the policies behind particular provisions in the Convention and
Exchange of Notes, as well as understandings reached during the
negotiations with respect to the application and interpretation
of the Convention and Exchange of Notes. References in the
Technical Explanation to ``he'' or ``his'' should be read to
mean ``he or she'' or ``his and her.''
ARTICLE 1 (GENERAL SCOPE)
Paragraph 1
Paragraph 1 of Article 1 provides that the Convention
applies only to residents of the United States or Hungary
except where the terms of the Convention provide otherwise.
Under Article 4 (Resident) a person is generally treated as a
resident of a Contracting State if that person is, under the
laws of that State, liable to tax therein by reason of his
domicile, citizenship, residence, place of management, place of
incorporation, or any other criterion of a similar nature.
However, if a person is considered a resident of both
Contracting States, Article 4 provides rules for determining a
State of residence (or no State of residence). This
determination governs for all purposes of the Convention.
Certain provisions are applicable to persons who may not be
residents of either Contracting State. For example, paragraph 1
of Article 24 (Non-Discrimination) applies to nationals of the
Contracting States. Under Article 26 (Exchange of Information),
information may be exchanged with respect to residents of third
states.
Paragraph 2
Paragraph 2 states the generally accepted relationship both
between the Convention and domestic law and between the
Convention and other agreements between the Contracting States.
That is, no provision in the Convention may restrict any
exclusion, exemption, deduction, credit or other benefit
accorded by the tax laws of the Contracting States, or by any
other agreement to which both of the Contracting States are
parties. The relationship between the nondiscrimination
provisions of the Convention and other agreements is addressed
not in paragraph 2 but in paragraph 3.
Under paragraph 2, for example, if a deduction would be
allowed under the U.S. Internal Revenue Code (the ``Code'') in
computing the U.S. taxable income of a resident of Hungary, the
deduction also is allowed to that person in computing taxable
income under the Convention. Paragraph 2 also means that the
Convention may not increase the tax burden on a resident of a
Contracting States beyond the burden determined under domestic
law. Thus, a right to tax given by the Convention cannot be
exercised unless that right also exists under internal law.
It follows that, under the principle of paragraph 2, a
taxpayer's U.S. tax liability need not be determined under the
Convention if the Code would produce a more favorable result. A
taxpayer may not, however, choose among the provisions of the
Code and the Convention in an inconsistent manner in order to
minimize tax. Thus, a taxpayer may use the Convention to reduce
its taxable income, but may not combine treaty and Code rules
in a way that would thwart the intent of either set of rules.
For example, assume that a resident of Hungary has three
separate businesses in the United States. One is a profitable
permanent establishment and the other two are trades or
businesses that would earn taxable income under the Code but
that do not meet the permanent establishment threshold tests of
the Convention. One is profitable and the other incurs a loss.
Under the Convention, the income of the permanent establishment
is taxable in the United States, and both the profit and loss
of the other two businesses are ignored. Under the Code, all
three would be subject to tax, but the loss would offset the
profits of the two profitable ventures. The taxpayer may not
invoke the Convention to exclude the profits of the profitable
trade or business and invoke the Code to claim the loss of the
loss trade or business against the profit of the permanent
establishment. (See Rev. Rul. 84-17, 1984-1 C.B. 308.) If,
however, the taxpayer invokes the Code for the taxation of all
three ventures, he would not be precluded from invoking the
Convention with respect, for example, to any dividend income he
may receive from the United States that is not effectively
connected with any of his business activities in the United
States.
Similarly, except as provided in paragraph 3, nothing in
the Convention can be used to deny any benefit granted by any
other agreement to which both the United States and Hungary are
parties. For example, if certain benefits are provided for
military personnel or military contractors under a Status of
Forces Agreement between the United States and Hungary, those
benefits or protections will be available to residents of the
Contracting States regardless of any provisions to the contrary
(or silence) in the Convention.
Paragraph 3
Paragraph 3 relates to non-discrimination obligations of
the Contracting States under the General Agreement on Trade in
Services (the ``GATS''). The provisions of paragraph 3 are an
exception to the rule provided in paragraph 2 of this Article
under which the Convention shall not restrict in any manner any
benefit now or hereafter accorded by any other agreement
between the Contracting States.
Subparagraph (a) of paragraph 3 provides that, unless the
competent authorities determine that a taxation measure is not
within the scope of the Convention, the national treatment
obligations of the GATS shall not apply with respect to that
measure. Further, any question arising as to the interpretation
or application of the Convention, including in particular
whether a measure is within the scope of the Convention shall
be considered only by the competent authorities of the
Contracting States, and the procedures under the Convention
exclusively shall apply to the dispute. Thus, paragraph 3 of
Article XXII (Consultation) of the GATS may not be used to
bring a dispute before the World Trade Organization unless the
competent authorities of both Contracting States have
determined that the relevant taxation measure is not within the
scope of Article 24 (Non-Discrimination) of the Convention.
The term ``measure'' for these purposes is defined broadly
in subparagraph (b) of paragraph 3. It would include a law,
regulation, rule, procedure, decision, administrative action,
or any similar provision or action.
Paragraph 4
Paragraph 4 contains the traditional saving clause found in
all U.S. treaties. The Contracting States reserve their rights,
except as provided in paragraph 5, to tax their residents and
citizens as provided under their domestic laws, notwithstanding
any provisions of the Convention to the contrary. For example,
if a resident of Hungary performs professional services in the
United States and the income from the services is not
attributable to a permanent establishment in the United States,
Article 7 (Business Profits) would by its terms prevent the
United States from taxing the income. If, however, the resident
of Hungary is also a citizen of the United States, the saving
clause permits the United States to include the remuneration in
the worldwide income of the citizen and subject it to tax under
the normal Code rules (i.e., without regard to Code section
894(a)). However, subparagraph 5(a) of Article 1 preserves the
benefits of special foreign tax credit rules applicable to the
U.S. taxation of certain U.S. income of its citizens resident
in Hungary. See paragraph 4 of Article 23 (Relief from Double
Taxation).
For purposes of the saving clause, ``residence'' is
determined under Article 4 (Resident). Thus, an individual who
is a resident of the United States under the Code (but not a
U.S. citizen) but who is determined to be a resident of the
other Contracting State under the tie-breaker rules of Article
4 would be subject to U.S. tax only to the extent permitted by
the Convention. The United States would not be permitted to
apply its domestic law to that person to the extent that its
law is inconsistent with the Convention.
However, the person would still be treated as a U.S.
resident for U.S. tax purposes other than determining the
individual's U.S. tax liability. For example, in determining
under Code section 957 whether a foreign corporation is a
controlled foreign corporation, shares in that corporation held
by the individual would be considered to be held by a U.S.
resident. As a result, other U.S. citizens or residents might
be deemed to be United States shareholders of a controlled
foreign corporation subject to current inclusion of subpart F
income recognized by the corporation. See Treas. Reg. section
301.7701(b)-7(a)(3).
Under paragraph 4, each Contracting State also reserves its
right to tax former citizens and former long-term residents for
a period of ten years following the loss of such status. Thus,
paragraph 4 allows the United States to tax former U.S.
citizens and former U.S. long-term residents in accordance with
Section 877 of the Code. Section 877 generally applies to a
former citizen or long-term resident of the United States who
relinquishes citizenship or terminates long-term residency
before June 17, 2008 if he fails to certify that he has
complied with U.S. tax laws during the 5 preceding years, or if
either of the following criteria exceed established thresholds:
(a) the average annual net income tax of such individual for
the period of 5 taxable years ending before the date of the
loss of status, or (b) the net worth of such individual as of
the date of the loss of status.
The United States defines ``long-term resident'' as an
individual (other than a U.S. citizen) who is a lawful
permanent resident of the United States in at least 8 of the
prior 15 taxable years. An individual is not treated as a
lawful permanent resident for any taxable year if such
individual is treated as a resident of Hungary under the
Convention, or as a resident of any country other than the
United States under the provisions of any other U.S. tax
treaty, and in either case the individual does not waive the
benefits of the relevant treaty.
Paragraph 5
Paragraph 5 sets forth certain exceptions to the saving
clause. The referenced provisions are intended to provide
benefits to citizens and residents even if such benefits do not
exist under domestic law.
Subparagraph (a) lists certain provisions of the Convention
that are applicable to all citizens and residents of a
Contracting State, despite the general saving clause rule of
paragraph 4:
(1) Paragraph 2 of Article 9 (Associated Enterprises)
grants the right to a correlative adjustment with respect to
income tax due on profits reallocated under Article 9.
(2) Paragraphs 1 b) and 2 of Article 17 (Pensions and
Income from Social Security) provide exemptions from source or
residence State taxation for certain pension distributions and
social security payments.
(3) Paragraph 3 of Article 17 provides an exemption for
certain investment income of pension funds located in the other
Contracting State.
(4) Article 23 (Relief from Double Taxation) confers to
citizens and residents of one Contracting State the benefit of
a credit for income taxes paid to the other or an exemption for
income earned in the other State.
(5) Article 24 (Non-Discrimination) protects residents and
nationals of one Contracting State against the adoption of
certain discriminatory practices in the other Contracting
State.
(6) Article 25 (Mutual Agreement Procedure) confers certain
benefits on citizens and residents of the Contracting States in
order to reach and implement solutions to disputes between the
two Contracting States. For example, the competent authorities
are permitted to use a definition of a term that differs from
an internal law definition. The statute of limitations may be
waived for refunds, so that the benefits of an agreement may be
implemented.
Subparagraph (b) of paragraph 5 provides a different set of
exceptions to the saving clause. The benefits referred to are
all intended to be granted to temporary residents of a
Contracting State (for example, in the case of the United
States, holders of non-immigrant visas), but not to citizens or
to persons who have acquired permanent residence in that State.
If beneficiaries of these provisions travel from one of the
Contracting States to the other, and remain in the other long
enough to become residents under its internal law, but do not
acquire permanent residence status (i.e., in the U.S. context,
they do not become ``green card'' holders) and are not citizens
of that State, the host State will continue to grant these
benefits even if they conflict with the statutory rules. The
benefits preserved by this paragraph are the host country
exemptions for government service salaries and pensions under
Article 18 (Government Service), certain income of visiting
students and trainees under Article 19 (Students and Trainees),
certain income of visiting professors and teachers under
Article 20 (Professors and Teachers), and the income of
diplomatic agents and consular officers under Article 27
(Members of Diplomatic Missions and Consular Posts).
Paragraph 6
Paragraph 6 addresses special issues presented by fiscally
transparent entities such as partnerships and certain estates
and trusts. Because different countries frequently take
different views as to when an entity is fiscally transparent,
the risk of both double taxation and double non-taxation are
relatively high. The intention of paragraph 6 is to eliminate a
number of technical problems that arguably would have prevented
investors using such entities from claiming treaty benefits,
even though such investors would be subject to tax on the
income derived through such entities. The provision also
prevents the use of such entities to claim treaty benefits in
circumstances where the person investing through such an entity
is not subject to tax on the income in its State of residence.
The provision, and the corresponding requirements of the other
Articles of the Convention, should be read with those two goals
in mind.
In general, paragraph 6 relates to entities that are not
subject to tax at the entity level, as distinct from entities
that are subject to tax, but with respect to which tax may be
relieved under an integrated system. This paragraph, as
discussed in paragraph 1 of the Exchange of Notes, applies to
any resident of a Contracting State who is entitled to income
derived through an entity organized in either Contracting State
that is treated as fiscally transparent under the laws of
either Contracting State. Entities falling under this
description in the United States include partnerships, common
investment trusts under section 584 and grantor trusts. This
paragraph also applies to U.S. limited liability companies
(``LLCs'') that are treated as partnerships or as disregarded
entities for U.S. tax purposes. Paragraph 1 of the Exchange of
Notes provides further that paragraph 6 does not apply with
respect to income received by an entity that is organized in a
third state.
Under paragraph 6, an item of income, profit or gain
derived by a fiscally transparent entity organized in either
Contracting State will be considered to be derived by a
resident of a Contracting State if a resident is treated under
the taxation laws of that State as deriving the item of income.
For example, if a company that is a resident of Hungary pays
interest to a U.S. entity that is treated as fiscally
transparent for U.S. tax purposes, the interest will be
considered derived by a resident of the U.S. only to the extent
that the taxation laws of the United States treats one or more
U.S. residents (whose status as U.S. residents is determined,
for this purpose, under U.S. tax law) as deriving the interest
for U.S. tax purposes. In the case of a partnership, the
persons who are, under U.S. tax laws, treated as partners of
the entity would normally be the persons whom the U.S. tax laws
would treat as deriving the interest income through the
partnership. Also, it follows that persons whom the United
States treats as partners but who are not U.S. residents for
U.S. tax purposes may not claim a benefit for the interest paid
to the entity under the Convention, because they are not
residents of the United States for purposes of claiming this
treaty benefit. In contrast, if, for example, an entity is
organized under U.S. laws and is classified as a corporation
for U.S. tax purposes, interest paid by a company that is a
resident of Hungary to the U.S. entity will be considered
derived by a resident of the United States since the
U.S. corporation is treated under U.S. taxation laws as a
resident of the United States and as deriving the income.
The same result obtains even if the entity were viewed
differently under the tax laws of Hungary (e.g., as not
fiscally transparent in the first example above where the
entity is treated as a partnership for U.S. tax purposes). The
results follow regardless of whether the entity is disregarded
as a separate entity under the laws of one jurisdiction but not
the other, such as a single owner entity that is viewed as a
branch for U.S. tax purposes and as a corporation for tax
purposes under the laws of Hungary.
For example, income from U.S. sources received by an entity
organized under the laws of the United States, which is treated
for tax purposes under the laws of Hungary as a corporation and
is owned by a shareholder who is a resident of Hungary for its
tax purposes, is not considered derived by the shareholder of
that corporation even if, under the tax laws of the United
States, the entity is treated as fiscally transparent. Rather,
for purposes of the treaty, the income is treated as derived by
the U.S. entity.
These principles also apply to trusts to the extent that
they are fiscally transparent in either Contracting State. For
example, if X, a resident of Hungary, creates a revocable trust
in the United States and names persons resident in a third
country as the beneficiaries of the trust, the trust's income
would be regarded as being derived by a resident of Hungary
only to the extent that the laws of Hungary treat X as deriving
the income for its tax purposes, perhaps through application of
rules similar to the U.S. ``grantor trust'' rules.
Paragraph 6 is not an exception to the saving clause of
paragraph 4. Accordingly, paragraph 6 does not prevent a
Contracting State from taxing an entity that is treated as a
resident of that State under its tax law. For example, if a
U.S. LLC with members who are residents of Hungary elects to be
taxed as a corporation for U.S. tax purposes, the United States
will tax that LLC on its worldwide income on a net basis,
without regard to whether Hungary views the LLC as fiscally
transparent.
ARTICLE 2 (TAXES COVERED)
This Article specifies the U.S. taxes and the taxes of
Hungary to which the Convention applies. With two exceptions,
the taxes specified in Article 2 are the covered taxes for all
purposes of the Convention. A broader coverage applies,
however, for purposes of Articles 24 (Non-Discrimination) and
26 (Exchange of Information and Administrative Assistance).
Article 24 (Non-Discrimination) applies with respect to all
taxes, including those imposed by state and local governments.
Article 26 (Exchange of Information and Administrative
Assistance) applies with respect to all taxes imposed at the
national level.
Paragraph 1
Paragraph 1 identifies the category of taxes to which the
Convention applies. Paragraph 1 is based on the U.S. and OECD
Models and defines the scope of application of the Convention.
The Convention applies to taxes on income, including gains,
imposed on behalf of a Contracting State, irrespective of the
manner in which they are levied. Except with respect to Article
24 (Non-Discrimination), state and local taxes are not covered
by the Convention.
Paragraph 2
Paragraph 2 also is based on the U.S. and OECD Models and
provides a definition of taxes on income and on capital gains.
The Convention covers taxes on total income or any part of
income and includes tax on gains derived from the alienation of
movable or immovable property (real property), and taxes on the
total amounts of wages or salaries paid by enterprises. The
Exchange of Notes provides that the term ``movable property''
refers to all property other than immovable property (real
property) as defined in Article 6 (Income from Immovable
Property (Real Property)). The Convention does not apply,
however, to social security or unemployment taxes, or any other
charges where there is a direct connection between the levy and
individual benefits. Nor does it apply to property taxes,
except with respect to Article 24 (Non-Discrimination).
Paragraph 3
Paragraph 3 lists the taxes in force at the time of
signature of the Convention to which the Convention applies.
The existing covered taxes of Hungary are identified in
subparagraph 3(a) as the personal income tax, the corporate
tax, and the surtax.
Subparagraph 3(b) provides that the existing U.S. taxes
subject to the rules of the Convention are the Federal income
taxes imposed by the Code, together with the excise taxes
imposed with respect to private foundations (Code sections 4940
through 4948). Social security and unemployment taxes (Code
sections 1401, 3101, 3111 and 3301) are specifically excluded
from coverage.
Paragraph 4
Under paragraph 4, the Convention will apply to any taxes
that are identical, or substantially similar, to those
enumerated in paragraph 3, and which are imposed in addition
to, or in place of, the existing taxes after February 4, 2010,
the date of signature of the Convention. The paragraph also
provides that the competent authorities of the Contracting
States will notify each other of any significant changes that
have been made in their taxation laws.
ARTICLE 3 (GENERAL DEFINITIONS)
Article 3 provides general definitions and rules of
interpretation applicable throughout the Convention. Certain
other terms are defined in other articles of the Convention.
For example, the term ``resident of a Contracting State'' is
defined in Article 4 (Resident). The term ``permanent
establishment'' is defined in Article 5 (Permanent
Establishment). These definitions are used consistently
throughout the Convention. Other terms, such as ``dividends,''
``interest'' and ``royalties'' are defined in specific articles
for purposes only of those articles.
Paragraph 1
Paragraph 1 defines a number of basic terms used in the
Convention. The introduction to paragraph 1 makes clear that
these definitions apply for all purposes of the Convention,
unless the context requires otherwise. This latter condition
allows flexibility in the interpretation of the treaty in order
to avoid results not intended by the treaty's negotiators.
Subparagraph 1(a) defines the term ``person'' to include an
individual, an estate, a trust, a partnership, a company and
any other body of persons. The definition is significant for a
variety of reasons. For example, under Article 4, only a
``person'' can be a ``resident'' and therefore eligible for
most benefits under the treaty. Also, all ``persons'' are
eligible to claim relief under Article 25 (Mutual Agreement
Procedure).
The term ``company'' is defined in subparagraph 1(b) as a
body corporate or an entity treated as a body corporate for tax
purposes. The Exchange of Notes provides that partnerships
established in Hungary are taxed by Hungary as corporations,
and therefore fall within the definition of ``company.''
The terms ``enterprise of a Contracting State'' and
``enterprise of the other Contracting State'' are defined in
subparagraph 1(c) as an enterprise carried on by a resident of
a Contracting State and an enterprise carried on by a resident
of the other Contracting State. An enterprise of a Contracting
State need not be carried on in that State. It may be carried
on in the other Contracting State or a third state (e.g., a
U.S. corporation doing all of its business in the other
Contracting State would still be a U.S. enterprise).
Subparagraph 1(c) further provides that these terms also
encompass an enterprise conducted through an entity (such as a
partnership) that is treated as fiscally transparent in the
Contracting State where the entity's owner is resident. The
definition makes this point explicitly to ensure that the
purpose of the Convention is not thwarted by an overly
technical application of the term ``enterprise of a Contracting
State'' to activities carried on through partnerships and
similar entities. In accordance with Article 4 (Resident),
entities that are fiscally transparent in the country in which
their owners are resident are not considered to be residents of
a Contracting State (although income derived by such entities
may be taxed as the income of a resident, if taxed in the hands
of resident partners or other owners). It could be argued that
an enterprise conducted by such an entity is not conducted by a
resident of a Contracting State, and therefore would not
benefit from provisions applicable to enterprises of a
Contracting State. The definition is intended to make clear
that an enterprise conducted by such an entity will be treated
as carried on by a resident of a Contracting State to the
extent its partners or other owners are residents. This
approach is consistent with the Code, which under section 875
attributes a trade or business conducted by a partnership to
its partners and a trade or business conducted by an estate or
trust to its beneficiaries.
Subparagraph 1(d) defines the term ``enterprise'' as any
activity or set of activities that constitutes the carrying on
of a business. The term ``business'' is not defined, but
subparagraph (e) provides that it includes the performance of
professional services and other activities of an independent
character. Both subparagraphs are identical to definitions
added to the OECD Model in connection with the deletion of
Article 14 (Independent Personal Services) from the OECD Model.
The inclusion of the two definitions is intended to clarify
that income from the performance of professional services or
other activities of an independent character is dealt with
under Article 7 (Business Profits) and not Article 21 (Other
Income).
Subparagraph 1(f) defines the term ``international
traffic.'' The term means any transport by a ship or aircraft
except when such transport is solely between places within a
Contracting State. This definition is applicable principally in
the context of Article 8 (Shipping and Air Transport). The
definition combines with paragraphs 2 and 3 of Article 8 to
exempt from tax by the source State income from the rental of
ships or aircraft that is earned both by lessors that are
operators of ships and aircraft and by those lessors that are
not (e.g., a bank or a container leasing company).
The exclusion from international traffic of transport
solely between places within a Contracting State means, for
example, that carriage of goods or passengers solely between
New York and Chicago would not be treated as international
traffic, whether carried by a U.S. or a foreign carrier. The
substantive taxing rules of the Convention relating to the
taxation of income from transport, principally Article 8
(Shipping and Air Transport), therefore, would not apply to
income from such carriage. Thus, if the carrier engaged in
internal U.S. traffic were a resident of Hungary (assuming that
were possible under U.S. law), the United States would not be
required to exempt the income from that transport under Article
8. The income would, however, be treated as business profits
under Article 7 (Business Profits), and therefore would be
taxable in the United States only if attributable to a U.S.
permanent establishment of the foreign carrier, and then only
on a net basis. The gross basis U.S. tax imposed by section 887
would never apply under the circumstances described. If,
however, goods or passengers are carried by a carrier resident
in Hungary from a non-U.S. port to, for example, New York, and
some of the goods or passengers continue on to Chicago, the
entire transport would be international traffic. This would be
true if the international carrier transferred the goods at the
U.S. port of entry from a ship to a land vehicle, from a ship
to a lighter, or even if the overland portion of the trip in
the United States was handled by an independent carrier under
contract with the original internation*al carrier, so long as
both parts of the trip were reflected in original bills of
lading. For this reason, the Convention, following the U.S.
Model, refers, in the definition of ``international traffic,''
to ``such transport'' being solely between places in the other
Contracting State, while the OECD Model refers to the ship or
aircraft being operated solely between such places. The
formulation in the Convention is intended to make clear that,
as in the above example, even if the goods are carried on a
different aircraft for the internal portion of the
international voyage than is used for the overseas portion of
the trip, the definition applies to that internal portion as
well as the external portion.
Finally, a ``cruise to nowhere,'' i.e., a cruise beginning
and ending in a port in the same Contracting State with no
stops in a foreign port, would not constitute international
traffic.
Subparagraph 1(g) designates the ``competent authorities''
for the other Contracting State and the United States. The U.S.
competent authority is the Secretary of the Treasury or his
delegate. The Secretary of the Treasury has delegated the
competent authority function to the Commissioner of Internal
Revenue, who in turn has delegated the authority to the Deputy
Commissioner (International) LMSB. With respect to
interpretative issues, the Deputy Commissioner (International)
LMSB acts with the concurrence of the Associate Chief Counsel
(International) of the Internal Revenue Service. In the case of
Hungary, the competent authority is the Minister of Finance or
his authorized representative.
The geographical scope of the Convention with respect to
Hungary is set out in subparagraph 1(h). The term ``Hungary''
means the Republic of Hungary and, when used in a geographical
sense, means the territory of the Republic of Hungary. The
geographical scope of the Convention with respect to the United
States is set out in subparagraph 1(i). It encompasses the
United States of America, including the states, the District of
Columbia and the territorial sea of the United States. The term
does not include Puerto Rico, the Virgin Islands, Guam or any
other U.S. possession or territory. For certain purposes, the
term ``United States'' includes the sea bed and subsoil of
undersea areas adjacent to the territorial sea of the United
States. This extension applies to the extent that the United
States exercises sovereignty in accordance with international
law for the purpose of natural resource exploration and
exploitation of such areas. This extension of the definition
applies, however, only if the person, property or activity to
which the Convention is being applied is connected with such
natural resource exploration or exploitation. Thus, it would
not include any activity involving the sea floor of an area
over which the United States exercised sovereignty for natural
resource purposes if that activity was unrelated to the
exploration and exploitation of natural resources. This result
is consistent with the result that would be obtained under
Section 638, which treats the continental shelf as part of the
United States for purposes of natural resource exploration and
exploitation.
The term ``national,'' as it relates to the United States
and to Hungary, is defined in subparagraph 1(j). This term is
relevant for purposes of Articles 19 (Government Service) and
24 (Non-Discrimination). A national of one of the Contracting
States is (1) an individual who possesses the nationality
(including, in the case of the United States, the citizenship
as is provided in paragraph 4 of the Exchange of Notes) of that
State, and (2) any legal person, partnership, association or
other entity deriving its status, as such, from the law in
force in the State where it is established.
Subparagraph 1(k) defines the term ``pension fund'' to
include any person established in a Contracting State that is
generally exempt from income taxation in that State and that is
operated principally to provide pension or retirement benefits
or to earn income for the benefit of one or more such
arrangements. In the case of the United States, the term
``pension fund'' includes the following: a trust providing
pension or retirement benefits under a Code section 401(a)
qualified pension plan, profit sharing or stock bonus plan, a
Code section 403(a) qualified annuity plan, a Code section
403(b) plan, a trust that is an individual retirement account
under Code section 408, a Roth individual retirement account
under Code section 408A, or a simple retirement account under
Code section 408(p), a trust providing pension or retirement
benefits under a simplified employee pension plan under Code
section 408(k), a trust described in section 457(g) providing
pension or retirement benefits under a Code section 457(b)
plan, and the Thrift Savings Fund (section 7701(j)). Section
401(k) plans and group trusts described in Revenue Ruling 81-
100 and meeting the conditions of Revenue Ruling 2004-67
qualify as pension funds to the extent that they are covered by
Code section 401(a).
Subparagraph 1(l) defines the terms ``a Contracting State''
and ``the other Contracting State'' to mean Hungary or the
United States as the context requires.
Paragraph 2
Terms that are not defined in the Convention are dealt with
in paragraph 2.
Paragraph 2 provides that in the application of the
Convention, any term used but not defined in the Convention
will have the meaning that it has under the law of the
Contracting State whose tax is being applied, unless the
context requires otherwise, or the competent authorities have
agreed on a different meaning pursuant to Article 25 (Mutual
Agreement Procedure). If the term is defined under both the tax
and non-tax laws of a Contracting State, the definition in the
tax law will take precedence over the definition in the non-tax
laws. Finally, there also may be cases where the tax laws of a
State contain multiple definitions of the same term. In such a
case, the definition used for purposes of the particular
provision at issue, if any, should be used.
If the meaning of a term cannot be readily determined under
the law of a Contracting State, or if there is a conflict in
meaning under the laws of the two States that creates
difficulties in the application of the Convention, the
competent authorities may establish, pursuant to the provisions
of Article 25 (Mutual Agreement Procedure) a common meaning in
order to prevent double taxation or to further any other
purpose of the Convention. This common meaning need not conform
to the meaning of the term under the laws of either Contracting
State.
Under paragraph 2, the relevant law of a Contracting State
is the law in effect at the time the treaty is being applied,
not the law as in effect at the time the treaty was signed. The
use of ``ambulatory'' definitions, however, may lead to results
that are at variance with the intentions of the negotiators and
of the Contracting States when the treaty was negotiated and
ratified. The reference in both paragraphs 1 and 2 to the
``context otherwise requir[ing]'' a definition different from
the treaty definition, in paragraph 1, or from the internal law
definition of the Contracting State whose tax is being imposed,
under paragraph 2, refers to a circumstance where the result
intended by the Contracting States is different from the result
that would obtain under either the paragraph 1 definition or
the statutory definition. Thus, flexibility in defining terms
is necessary and permitted.
ARTICLE 4 (RESIDENT)
This Article sets forth rules for determining whether a
person is a resident of a Contracting State for purposes of the
Convention. As a general matter only residents of the
Contracting States may claim the benefits of the Convention.
The treaty definition of residence is to be used only for
purposes of the Convention. The fact that a person is
determined to be a resident of a Contracting State under
Article 4 does not automatically entitle that person to the
benefits of the Convention. In addition to being a resident, a
person also must qualify for benefits under Article 22
(Limitation on Benefits) in order to receive benefits conferred
on residents of a Contracting State.
The determination of residence for treaty purposes looks
first to a person's liability to tax as a resident under the
respective taxation laws of the Contracting States. As a
general matter, a person who, under those laws, is a resident
of one Contracting State and not of the other need look no
further. For purposes of the Convention, that person is a
resident of the State in which he is resident under internal
law. If, however, a person is resident in both Contracting
States under their respective taxation laws, the Article
proceeds, where possible, to use tie-breaker rules to assign a
single State of residence to such a person for purposes of the
Convention.
Paragraph 1
The term ``resident of a Contracting State'' is defined in
paragraph 1. In general, this definition incorporates the
definitions of residence in U.S. law and that of Hungary by
referring to a resident as a person who, under the laws of a
Contracting State, is liable to tax therein by reason of his
domicile, residence, citizenship, place of management, place of
incorporation or any other similar criterion. Thus, residents
of the United States include aliens who are considered U.S.
residents under Code section 7701(b). Paragraph 1 also
specifically includes the two Contracting States, and political
subdivisions and local authorities of the two States, as
residents for purposes of the Convention.
Certain entities that are nominally liable to tax but that
in practice are rarely required to pay tax also would generally
be treated as residents and therefore accorded treaty benefits.
For example, a U.S. Regulated Investment Company (RIC) and a
U.S. Real Estate Investment Trust (REIT) are residents of the
United States for purposes of the treaty. Although the income
earned by these entities normally is not subject to U.S. tax in
the hands of the entity, they are taxable to the extent that
they do not currently distribute their profits, and therefore
may be regarded as ``liable to tax.'' They also must satisfy a
number of requirements under the Code in order to be entitled
to special tax treatment.
A person who is liable to tax in a Contracting State only
in respect of income from sources within that State or capital
situated therein or of profits attributable to a permanent
establishment in that State will not be treated as a resident
of that Contracting State for purposes of the Convention. Thus,
a consular official of Hungary who is posted in the United
States, who may be subject to U.S. tax on U.S. source
investment income, but is not taxable in the United States on
non-U.S. source income (see Code section 7701(b)(5)(B)), would
not be considered a resident of the United States for purposes
of the Convention. Similarly, an enterprise of Hungary with a
permanent establishment in the United States is not, by virtue
of that permanent establishment, a resident of the United
States. The enterprise generally is subject to U.S. tax only
with respect to its income that is attributable to the U.S.
permanent establishment, not with respect to its worldwide
income, as it would be if it were a U.S. resident.
Paragraph 2
Paragraph 2 provides that certain tax-exempt entities such
as pension funds and charitable organizations will be regarded
as residents of a Contracting State regardless of whether they
are generally liable to income tax in the State where they are
established. The paragraph applies to legal persons organized
under the laws of a Contracting State and established and
maintained in that State to provide pensions or other similar
benefits pursuant to a plan, or exclusively for religious,
charitable, scientific, artistic, cultural, or educational
purposes. Thus, a section 501(c) organization organized in the
United States (such as a U.S. charity) that is generally exempt
from tax under U.S. law is a resident of the United States for
all purposes of the Convention.
Paragraph 3
If, under the laws of the two Contracting States, and,
thus, under paragraph 1, an individual is deemed to be a
resident of both Contracting States, a series of tie-breaker
rules are provided in paragraph 3 to determine a single State
of residence for that individual. These tests are to be applied
in the order in which they are stated. The first test is based
on where the individual has a permanent home. If that test is
inconclusive because the individual has a permanent home
available to him in both States, he will be considered to be a
resident of the Contracting State where his personal and
economic relations are closest (i.e., the location of his
``center of vital interests''). If that test is also
inconclusive, or if he does not have a permanent home available
to him in either State, he will be treated as a resident of the
Contracting State where he maintains a habitual abode. If he
has a habitual abode in both States or in neither of them, he
will be treated as a resident of the Contracting State of which
he is a national. If he is a national of both States or of
neither, the matter will be considered by the competent
authorities, who will assign a single State of residence.
Paragraph 4
Dual residents other than individuals (such as companies,
trusts or estates) are addressed by paragraph 4. If such a
person is, under the rules of paragraph 1, resident in both
Contracting States, the competent authorities shall seek to
determine a single State of residence for that person for
purposes of the Convention. It the competent authorities are
unable to reach such an agreement, that person may not claim
any benefit provided by the Convention, except for those
provided by Article 24 (Non-Discrimination) and Article 25
(Mutual Agreement Procedure).
Dual resident persons may, however, be treated as a
resident of a Contracting State for purposes other than that of
obtaining benefits under the Convention. For example, if a dual
resident company pays a dividend to a resident of Hungary, the
U.S. paying agent would withhold on that dividend at the
appropriate treaty rate because reduced withholding is a
benefit enjoyed by the resident of Hungary, not by the dual
resident company. The dual resident company that paid the
dividend would, for this purpose, be treated as a resident of
the United States under the Convention. In addition,
information relating to dual resident persons can be exchanged
under the Convention because, by its terms, Article 26
(Exchange of Information) is not limited to residents of the
Contracting States.
ARTICLE 5 (PERMANENT ESTABLISHMENT)
This Article defines the term ``permanent establishment,''
a term that is significant for several articles of the
Convention. The existence of a permanent establishment in a
Contracting State is necessary under Article 7 (Business
Profits) for the taxation by that State of the business profits
of a resident of the other Contracting State. Articles 10
(Dividends), 11 (Interest), and 12 (Royalties) provide for
reduced rates of tax at source on payments of these items of
income to a resident of the other State only when the income is
not attributable to a permanent establishment that the
recipient has in the source State. The concept is also relevant
in determining which Contracting State may tax certain gains
under Article 13 (Gains) and certain ``other income'' under
Article 21 (Other Income).
Paragraph 1
The basic definition of the term ``permanent
establishment'' is contained in paragraph 1. As used in the
Convention, the term means a fixed place of business through
which the business of an enterprise is wholly or partly carried
on. As indicated in the OECD Commentary to Article 5 (see
paragraphs 4 through 8), a general principle to be observed in
determining whether a permanent establishment exists is that
the place of business must be ``fixed'' in the sense that a
particular building or physical location is used by the
enterprise for the conduct of its business, and that it must be
foreseeable that the enterprise's use of this building or other
physical location will be more than temporary.
Paragraph 2
Paragraph 2 lists a number of types of fixed places of
business that constitute a permanent establishment. This list
is illustrative and non-exclusive. According to paragraph 2,
the term permanent establishment includes a place of
management, a branch, an office, a factory, a workshop, and a
mine, oil or gas well, quarry or other place of extraction of
natural resources.
Paragraph 3
This paragraph provides rules to determine whether a
building site or a construction, assembly or installation
project, or an installation or drilling rig or ship used for
the exploration of natural resources constitutes a permanent
establishment for the contractor, driller, etc. Such a site or
activity does not create a permanent establishment unless the
site, project, etc. lasts, or the exploration activity
continues, for more than twelve months. It is only necessary to
refer to ``exploration'' and not ``exploitation'' in this
context because exploitation activities are defined to
constitute a permanent establishment under subparagraph 2(f).
Thus, a drilling rig does not constitute a permanent
establishment if a well is drilled in only six months, but if
production begins in the following month the well becomes a
permanent establishment as of that date.
The twelve-month test applies separately to each site or
project. The twelve-month period begins when work (including
preparatory work carried on by the enterprise) physically
begins in a Contracting State. A series of contracts or
projects by a contractor that are interdependent both
commercially and geographically are to be treated as a single
project for purposes of applying the twelve-month threshold
test. For example, the construction of a housing development
would be considered as a single project even if each house were
constructed for a different purchaser.
In applying this paragraph, time spent by a sub-contractor
on a building site is counted as time spent by the general
contractor at the site for purposes of determining whether the
general contractor has a permanent establishment. However, for
the sub-contractor itself to be treated as having a permanent
establishment, the sub-contractor's activities at the site must
last for more than 12 months. If a sub-contractor is on a site
intermittently, then, for purposes of applying the 12-month
rule, time is measured from the first day the sub-contractor is
on the site until the last day (i.e., intervening days that the
sub-contractor is not on the site are counted).
These interpretations of the Article are based on the
Commentary to paragraph 3 of Article 5 of the OECD Model, which
contains language that is substantially the same as that in the
Convention. These interpretations are consistent with the
generally accepted international interpretation of the relevant
language in paragraph 3 of Article 5 of the Convention.
If the twelve-month threshold is exceeded, the site or
project constitutes a permanent establishment from the first
day of activity.
Paragraph 4
This paragraph contains exceptions to the general rule of
paragraph 1, listing a number of activities that may be carried
on through a fixed place of business but which nevertheless do
not create a permanent establishment. The use of facilities
solely to store, display or deliver merchandise belonging to an
enterprise does not constitute a permanent establishment of
that enterprise. The maintenance of a stock of goods belonging
to an enterprise solely for the purpose of storage, display or
delivery, or solely for the purpose of processing by another
enterprise does not give rise to a permanent establishment of
the first-mentioned enterprise. The maintenance of a fixed
place of business solely for the purpose of purchasing goods or
merchandise, or for collecting information, for the enterprise,
or for other activities that have a preparatory or auxiliary
character for the enterprise, such as advertising, or the
supply of information, do not constitute a permanent
establishment of the enterprise. Moreover, subparagraph 4(f)
provides that a combination of the activities described in the
other subparagraphs of paragraph 4 will not give rise to a
permanent establishment if the combination results in an
overall activity that is of a preparatory or auxiliary
character.
Paragraph 5
Paragraphs 5 and 6 specify when activities carried on by an
agent or other person acting on behalf of an enterprise create
a permanent establishment of that enterprise. Under paragraph
5, a person is deemed to create a permanent establishment of
the enterprise if that person has and habitually exercises an
authority to conclude contracts in the name of the enterprise.
If, however, for example, his activities are limited to those
activities specified in paragraph 4 which would not constitute
a permanent establishment if carried on by the enterprise
through a fixed place of business, the person does not create a
permanent establishment of the enterprise.
The Convention uses the OECD Model language ``in the name
of that enterprise,'' rather than the U.S. Model language
``binding on the enterprise.'' Hungary and the United States do
not intend this difference in language to be a substantive
difference. As indicated in paragraph 32.1 to the OECD
Commentaries on Article 5, paragraph 5 of the Article is not
intended to be limited to agents who enter into contracts
literally in the name of the enterprise. The paragraph also
applies to ``an agent who concludes contracts which are binding
on the enterprise even if those contracts are not actually in
the name of the enterprise.''
The contracts referred to in paragraph 5 are those relating
to the essential business operations of the enterprise, rather
than ancillary activities. For example, if the person has no
authority to conclude contracts in the name of the enterprise
with its customers for, say, the sale of the goods produced by
the enterprise, but it can enter into service contracts in the
name of the enterprise for the enterprise's business equipment,
this contracting authority would not fall within the scope of
the paragraph, even if exercised regularly.
Paragraph 6
Under paragraph 6, an enterprise is not deemed to have a
permanent establishment in a Contracting State merely because
it carries on business in that State through an independent
agent, including a broker or general commission agent, if the
agent is acting in the ordinary course of his business as an
independent agent. Thus, there are two conditions that must be
satisfied: the agent must be both legally and economically
independent of the enterprise, and the agent must be acting in
the ordinary course of its business in carrying out activities
on behalf of the enterprise.
Whether the agent and the enterprise are independent is a
factual determination. Among the questions to be considered are
the extent to which the agent operates on the basis of
instructions from the enterprise. An agent that is subject to
detailed instructions regarding the conduct of its operations
or comprehensive control by the enterprise is not legally
independent.
In determining whether the agent is economically
independent, a relevant factor is the extent to which the agent
bears business risk. Business risk refers primarily to risk of
loss. An independent agent typically bears risk of loss from
its own activities. In the absence of other factors that would
establish dependence, an agent that shares business risk with
the enterprise, or has its own business risk, is economically
independent because its business activities are not integrated
with those of the principal. Conversely, an agent that bears
little or no risk from the activities it performs is not
economically independent and therefore is not described in
paragraph 6.
Another relevant factor in determining whether an agent is
economically independent is whether the agent acts exclusively
or nearly exclusively for the principal. Such a relationship
may indicate that the principal has economic control over the
agent. A number of principals acting in concert also may have
economic control over an agent. The limited scope of the
agent's activities and the agent's dependence on a single
source of income may indicate that the agent lacks economic
independence. It should be borne in mind, however, that
exclusivity is not in itself a conclusive test; an agent may be
economically independent notwithstanding an exclusive
relationship with the principal if it has the capacity to
diversify and acquire other clients without substantial
modifications to its current business and without substantial
harm to its business profits. Thus, exclusivity should be
viewed merely as a pointer to further investigation of the
relationship between the principal and the agent. Each case
must be addressed on the basis of its own facts and
circumstances.
Paragraph 7
This paragraph clarifies that a company that is a resident
of a Contracting State is not deemed to have a permanent
establishment in the other Contracting State merely because it
con*trols, or is controlled by, a company that is a resident of
that other Contracting State, or that carries on business in
that other Contracting State. The determination whether a
permanent establishment exists is made solely on the basis of
the factors described in paragraphs 1 through 6 of the Article.
Whether a company is a permanent establishment of a related
company, therefore, is based solely on those factors and not on
the ownership or control relationship between the companies.
ARTICLE 6 (INCOME FROM IMMOVABLE PROPERTY (REAL PROPERTY))
This article deals with the taxation of income from
immovable property (real property) situated in a Contracting
State (the ``situs State''). The Article does not grant an
exclusive taxing right to the situs State; the situs State is
merely given the primary right to tax. The Article does not
impose any limitation in terms of rate or form of tax imposed
by the situs State, except that, as provided in paragraph 5,
the situs State must allow the taxpayer an election to be taxed
on a net basis.
Paragraph 1
The first paragraph of Article 6 states the general rule
that income of a resident of a Contracting State derived from
immovable property (real property) situated in the other
Contracting State may be taxed in the Contracting State in
which the property is situated. The paragraph specifies that
income from immovable property (real property) includes income
from agriculture and forestry. Given the availability of the
net election in paragraph 5, taxpayers generally should be able
to obtain the same tax treatment in the situs country
regardless of whether the income is treated as business profits
or immovable property (real property) income.
Paragraph 2
The term ``immovable property (real property)'' is defined
in paragraph 2 by reference to the internal law definition in
the situs State. In the case of the United States, the term has
the meaning given to it by Reg. 1.897-1(b). In
addition to the statutory definitions in the two Contracting
States, the paragraph specifies certain additional classes of
property that, regardless of internal law definitions, are
within the scope of the term for purposes of the Convention.
This expanded definition conforms to that in the OECD Model.
The definition of ``immovable property (real property)'' for
purposes of Article 6 is more limited than the expansive
definition of ``immovable property (real property)'' in
paragraph 1 of Article 13 (Capital Gains). The Article 13 term
includes not only immovable property (real property) as defined
in Article 6 but certain other interests in immovable property
(real property).
Paragraph 3
Paragraph 3 makes clear that all forms of income derived
from the exploitation of immovable property (real property) are
taxable in the Contracting State in which the property is
situated. This includes income from any use of immovable
property (real property), including, but not limited to, income
from direct use by the owner (in which case income may be
imputed to the owner for tax purposes) and rental income from
the letting of immovable property (real property). In the case
of a net lease of immovable property (real property), if a net
election pursuant to paragraph 5 has not been made, the gross
rental payment (before deductible expenses incurred by the
lessee) is treated as income from the property.
Other income closely associated with immovable property
(real property) is covered by other Articles of the Convention,
however, and not Article 6. For example, income from the
disposition of an interest in immovable property (real
property) is not considered ``derived'' from immovable property
(real property); taxation of that income is addressed in
Article 13 (Gains). Interest paid on a mortgage on immovable
property (real property) would be covered by Article 11
(Interest). Distributions by a U.S. Real Estate Investment
Trust or certain regulated investment companies would fall
under Article 13 in the case of distributions of U.S. real
property gain or Article 10 (Dividends) in the case of
distributions treated as dividends. Finally, distributions from
a United States Real Property Holding Corporation are not
considered to be income from the exploitation of immovable
property (real property); such payments would fall under
Article 10 or 13.
Paragraph 4
This paragraph specifies that the basic rule of paragraph 1
(as elaborated in paragraph 3) applies to income from immovable
property (real property) of an enterprise. This clarifies that
the situs country may tax the immovable property (real
property) income (including rental income) of a resident of the
other Contracting State in the absence of attribution to a
permanent establishment in the situs State. This provision
represents an exception to the general rule under Articles 7
(Business Profits) that income must be attributable to a
permanent establishment in order to be taxable in the situs
state.
Paragraph 5
The paragraph provides that a resident of one Contracting
State that derives immovable property (real property) income
from the other may elect, for any taxable year, to be subject
to tax in that other State on a net basis, as though the income
were attributable to a permanent establishment in that other
State. The election may be terminated with the consent of the
competent authority of the situs State. In the United States,
revocation will be granted in accordance with the provisions of
Treas. Reg. Sec. 1.871-10(d)(2).
ARTICLE 7 (BUSINESS PROFITS)
This Article provides rules for the taxation by a
Contracting State of the business profits of an enterprise of
the other Contracting State.
Paragraph 1
Paragraph 1 states the general rule that business profits
of an enterprise of one Contracting State may not be taxed by
the other Contracting State unless the enterprise carries on
business in that other Contracting State through a permanent
establishment (as defined in Article 5 (Permanent
Establishment)) situated there. When that condition is met, the
State in which the permanent establishment is situated may tax
the enterprise on the income that is attributable to the
permanent establishment.
Although the Convention does not include a definition of
``business profits,'' the term is intended to cover income
derived from any trade or business. In accordance with this
broad definition, the term ``business profits'' includes income
attributable to notional principal contracts and other
financial instruments to the extent that the income is
attributable to a trade or business of dealing in such
instruments or is otherwise related to a trade or business (as
in the case of a notional principal contract entered into for
the purpose of hedging currency risk arising from an active
trade or business). Any other income derived from such
instruments is, unless specifically covered in another article,
dealt with under Article 21 (Other Income).
The term ``business profits'' also includes income derived
by an enterprise from the rental of tangible personal property
(unless such tangible personal property consists of aircraft,
ships or containers, income from which is addressed by Article
8 (Shipping and Air Transport)). The inclusion of income
derived by an enterprise from the rental of tangible personal
property in business profits means that such income earned by a
resident of a Contracting State can be taxed by the other
Contracting State only if the income is attributable to a
permanent establishment maintained by the resident in that
other State, and, if the income is taxable, it can be taxed
only on a net basis. Income from the rental of tangible
personal property that is not derived in connection with a
trade or business is dealt with in Article 21.
In addition, as a result of the definitions of
``enterprise'' and ``business'' in Article 3 (General
Definitions), the term includes income derived from the
furnishing of personal services. Thus, a consulting firm
resident in one State whose employees or partners perform
services in the other State through a permanent establishment
may be taxed in that other State on a net basis under Article
7, and not under Article 14 (Income from Employment), which
applies only to income of employees. With respect to the
enterprise's employees themselves, however, their salary
remains subject to Article 14.
Because this Article applies to income earned by an
enterprise from the furnishing of personal services, the
Article also applies to income derived by a partner resident in
a Contracting State that is attributable to personal services
performed in the other Contracting State through a partnership
with a permanent establishment in that other State. Income
which may be taxed under this Article includes all income
attributable to the permanent establishment in respect of the
performance of the personal services carried on by the
partnership (whether by the partner himself, other partners in
the partnership, or by employees assisting the partners) and
any income from activities ancillary to the performance of
those services (e.g., charges for facsimile services).
Paragraph 2
Paragraph 2 provides rules for the attribution of business
profits to a permanent establishment. The Contracting States
will attribute to a permanent establishment the profits that it
would have earned had it been a distinct and separate
enterprise engaged in the same or similar activities under the
same or similar conditions and dealing wholly independently
with the enterprise of which it is a permanent establishment.
The ``attributable to'' concept of paragraph 2 provides an
alternative to the analogous but somewhat different
``effectively connected'' concept in Code section 864(c).
Depending on the circumstances, the amount of income
``attributable to'' a permanent establishment under Article 7
may be greater or less than the amount of income that would be
treated as ``effectively connected'' to a U.S. trade or
business under Code section 864. In particular, in the case of
financial institutions, the use of internal dealings to
allocate income within an enterprise may produce results under
Article 7 that are significantly different than the results
under the effectively connected income rules. For example,
income from interbranch notional principal contracts may be
taken into account under Article 7, notwithstanding that such
transactions may be ignored for purposes of U.S. domestic law.
The profits attributable to a permanent establishment may
be from sources within or without a Contracting State. However,
the business profits attributable to a permanent establishment
include only those profits derived from the assets used, risks
assumed, and activities performed by the permanent
establishment.
Paragraph 5 of the Exchange of Notes confirms that the
arm's length method of paragraph 2 consists of applying the
OECD Transfer Pricing Guidelines, but taking into account the
different economic and legal circumstances of a single legal
entity (as opposed to separate but associated enterprises).
Thus, any of the methods used in the Transfer Pricing
Guidelines, including profits methods, may be used as
appropriate and in accordance with the Transfer Pricing
Guidelines. However, the use of the Transfer Pricing Guidelines
applies only for purposes of attributing profits within the
legal entity. It does not create legal obligations or other tax
consequences that would result from transactions having
independent legal significance.
One example of the different circumstances of a single
legal entity is that an entity that operates through branches
rather than separate subsidiaries generally will have lower
capital requirements because all of the assets of the entity
are available to support all of the entity's liabilities (with
some exceptions attributable to local regulatory restrictions).
This is the reason that most commercial banks and some
insurance companies operate through branches rather than
subsidiaries. The benefit that comes from such lower capital
costs must be allocated among the branches in an appropriate
manner. This issue does not arise in the case of an enterprise
that operates through separate entities, since each entity will
have to be separately capitalized or will have to compensate
another entity for providing capital (usually through a
guarantee).
Under U.S. domestic regulations, internal ``transactions''
generally are not recognized because they do not have legal
significance. In contrast, the Convention provides that such
internal dealings may be used to attribute income to a
permanent establishment in cases where the dealings accurately
reflect the allocation of risk within the enterprise. One
example is that of global trading in securities. In many cases,
banks use internal swap transactions to transfer risk from one
branch to a central location where traders have the expertise
to manage that particular type of risk. Under the Convention,
such a bank may also use such swap transactions as a means of
attributing income between the branches, if use of that method
is the ``best method'' within the meaning of regulation section
1.482-1(c). The books of a branch will not be respected,
however, when the results are inconsistent with a functional
analysis. So, for example, income from a transaction that is
booked in a particular branch (or home office) will not be
treated as attributable to that location if the sales and risk
management functions that generate the income are performed in
another location.
Because the use of profits methods is permissible under
paragraph 2, it is not necessary for the Convention to include
a provision corresponding to paragraph 4 of Article 7 of the
OECD Model.
Paragraph 3
Paragraph 3 provides that in determining the business
profits of a permanent establishment, deductions shall be
allowed for the expenses incurred for the purposes of the
permanent establishment, ensuring that business profits will be
taxed on a net basis. This rule is not limited to expenses
incurred exclusively for the purposes of the permanent
establishment, but includes expenses incurred for the purposes
of the enterprise as a whole, or that part of the enterprise
that includes the permanent establishment. Deductions are to be
allowed regardless of which accounting unit of the enterprise
books the expenses, so long as they are incurred for the
purposes of the permanent establishment. For example, a portion
of the interest expense recorded on the books of the home
office in one State may be deducted by a permanent
establishment in the other. The amount of the expense that must
be allowed as a deduction is determined by applying the arm's
length principle. If a deduction would be allowed under the
Code in computing the U.S. taxable income, the deduction also
is allowed in computing taxable income under the Convention.
However, a taxpayer may not combine Convention and Code rules
in a way that would thwart the intent of either set of rules.
For example, assume that a Hungarian taxpayer with a permanent
establishment in the United States borrows $100 to purchase
U.S. tax exempt bonds, and that the $100 of tax-exempt bonds
and the $100 of related debt would be treated as assets and
liabilities of the permanent establishment. For purposes of
computing the profits attributable to the permanent
establishment under the Convention, both the tax exempt
interest from the bonds and the interest expense from the
related debt would be excluded. Thus, a taxpayer cannot take
deductions for expenses in computing taxable income under the
Convention to a greater extent than would be allowed under the
Code where doing so would be inconsistent with the intent of
the Code or the Convention.
As noted above, the Exchange of Notes provides that the
OECD Transfer Pricing Guidelines apply, by analogy, in
determining the profits attributable to a permanent
establishment. Accordingly, a permanent establishment may
deduct payments made to its head office or another branch in
compensation for services performed for the benefit of the
branch.
The method to be used in calculating that amount will
depend on the terms of the arrangements between the branches
and head office. For example, the enterprise could have a
policy, expressed in writing, under which each business unit
could use the services of lawyers employed by the head office.
At the end of each year, the costs of employing the lawyers
would be charged to each business unit according to the amount
of services used by that business unit during the year. Since
this appears to be a kind of cost-sharing arrangement and the
allocation of costs is based on the benefits received by each
business unit, such a cost allocation would be an acceptable
means of determining a permanent establishment's deduction for
legal expenses. Alternatively, the head office could agree to
employ lawyers at its own risk, and to charge an arm's length
price for legal services performed for a particular business
unit. If the lawyers were under-utilized, and the ``fees''
received from the business units were less than the cost of
employing the lawyers, then the head office would bear the
excess cost. If the ``fees'' exceeded the cost of employing the
lawyers, then the head office would keep the excess to
compensate it for assuming the risk of employing the lawyers.
If the enterprise acted in accordance with this agreement, this
method would be an acceptable alternative method for
calculating a permanent establishment's deduction for legal
expenses.
A permanent establishment cannot be funded entirely with
debt, but must have sufficient capital to carry on its
activities as if it were a distinct and separate enterprise. To
the extent that the permanent establishment has not been
attributed capital for profit attribution purposes, a
Contracting State may attribute such capital to the permanent
establishment, in accordance with the arm's length principle,
and deny an interest deduction to the extent necessary to
reflect that capital attribution. The method prescribed by U.S.
domestic law for making this attribution is found in Treas.
Reg. section 1.882-5. Both section 1.882-5 and the method
prescribed the Convention start from the premise that all of
the capital of the enterprise supports all of the assets and
risks of the enterprise, and therefore the entire capital of
the enterprise must be allocated to its various businesses and
offices.
However, section 1.882-5 does not take into account the
fact that some assets create more risk for the enterprise than
do other assets. An independent enterprise would need less
capital to support a perfectly-hedged U.S. Treasury security
than it would need to support an equity security or other asset
with significant market and/or credit risk. Accordingly, in
some cases section 1.882-5 would require a taxpayer to allocate
more capital to the United States, and therefore would reduce
the taxpayer's interest deduction more, than is appropriate. To
address these cases, the Convention allows a taxpayer to apply
a more flexible approach that takes into account the relative
risk of its assets in the various jurisdictions in which it
does business. In particular, in the case of financial
institutions other than insurance companies, the amount of
capital attributable to a permanent establishment is determined
by allocating the institution's total equity between its
various offices on the basis of the proportion of the financial
institution's risk-weighted assets attributable to each of
them. This recognizes the fact that financial institutions are
in many cases required to risk-weight their assets for
regulatory purposes and, in other cases, will do so for
business reasons even if not required to do so by regulators.
However, risk-weighting is more complicated than the method
prescribed by section 1.882-5.
Accordingly, to ease this administrative burden, taxpayers
may choose to apply the principles of Treas. Reg. section
1.882-5(c) to determine the amount of capital allocable to its
U.S. permanent establishment, in lieu of determining its
allocable capital under the risk-weighted capital allocation
method provided by the Convention, even if it has otherwise
chosen the principles of Article 7 rather than the effectively
connected income rules of U.S. domestic law.
Paragraph 4
Paragraph 4 provides that no business profits can be
attributed to a permanent establishment merely because it
purchases goods or merchandise for the enterprise of which it
is a part. This paragraph is essentially identical to paragraph
5 of Article 7 of the OECD Model. This rule applies only to an
office that performs functions for the enterprise in addition
to purchasing. The income attribution issue does not arise if
the sole activity of the office is the purchase of goods or
merchandise because such activity does not give rise to a
permanent establishment under Article 5 (Permanent
Establishment). A common situation in which paragraph 4 is
relevant is one in which a permanent establishment purchases
raw materials for the enterprise's manufacturing operation
conducted outside the United States and sells the manu*factured
product. While business profits may be attributable to the
permanent establishment with respect to its sales activities,
no profits are attributable to it with respect to its
purchasing activities.
Paragraph 5
Paragraph 5 provides that profits shall be determined by
the same method each year, unless there is good reason to
change the method used. This rule assures consistent tax
treatment over time for permanent establishments. It limits the
ability of both the Contracting State and the enterprise to
change accounting methods to be applied to the permanent
establishment. It does not, however, restrict a Contracting
State from imposing additional requirements, such as the rules
under Code section 481, to prevent amounts from being
duplicated or omitted following a change in accounting method.
Such adjustments may be necessary, for example, if the taxpayer
switches from using the domestic rules under section 864 in one
year to using the rules of Article 7 in the next. Also, if the
taxpayer switches from Convention-based rules to U.S. domestic
rules, it may need to meet certain deadlines for making
elections that are not necessary when applying the rules of the
Convention.
Paragraph 6
Paragraph 6 coordinates the provisions of Article 7 and
other provisions of the Convention. Under this paragraph, when
business profits include items of income that are dealt with
separately under other articles of the Convention, the
provisions of those articles will, except when they
specifically provide to the contrary, take precedence over the
provisions of Article 7. For example, the taxation of dividends
will be determined by the rules of Article 10 (Dividends), and
not by Article 7, except where, as provided in paragraph 6 of
Article 10, the dividend is attributable to a permanent
establishment. In the latter case the provisions of Article 7
apply. Thus, an enterprise of one State deriving dividends from
the other State may not rely on Article 7 to exempt those
dividends from tax at source if they are not attributable to a
permanent establishment of the enterprise in the other State.
By the same token, if the dividends are attributable to a
permanent establishment in the other State, the dividends may
be taxed on a net income basis at the source State full
corporate tax rate, rather than on a gross basis under Article
As provided in Article 8 (Shipping and Air Transport),
income derived from shipping and air transport activities in
international traffic described in that Article is taxable only
in the country of residence of the enterprise regardless of
whether it is attributable to a permanent establishment
situated in the source State.
Paragraph 7
Paragraph 7 incorporates into the Convention the rule of
Code section 864(c)(6). Like the Code section on which it is
based, paragraph 7 provides that any income or gain
attributable to a permanent establishment during its existence
is taxable in the Contracting State where the permanent
establishment is situated, even if the payment of that income
or gain is deferred until after the permanent establishment
ceases to exist. This rule applies with respect to paragraphs 1
and 2 of Article 7 (Business Profits), paragraph 6 of Article
10, paragraph 4 of Article 11 (Interest), paragraph 3 of
Articles 12 (Royalties), paragraph 5 of Article 13 (Capital
Gains) and paragraph 2 of Article 21 (Other Income).
The effect of this rule can be illustrated by the following
example. Assume a company that is a resident of Hungary and
that maintains a permanent establishment in the United States
winds up the permanent establishment's business and sells the
permanent establishment's inventory and assets to a U.S. buyer
at the end of year 1 in exchange for an interest-bearing
installment obligation payable in full at the end of year 3.
Despite the fact that Article 13's threshold requirement for
U.S. taxation is not met in year 3 because the company has no
permanent establishment in the United States, the United States
may tax the deferred income payment recognized by the company
in year 3.
Relationship to Other Articles
This Article is subject to the saving clause of paragraph 4
of Article 1 (General Scope) of the Model. Thus, if a citizen
of the United States who is a resident of Hungary under the
treaty derives business profits from the United States that are
not attributable to a permanent establishment in the United
States, the United States may, subject to the special foreign
tax credit rules of paragraph 4 of Article 23 (Relief from
Double Taxation), tax those profits, notwithstanding the
provision of paragraph 1 of this Article which would exempt the
income from U.S. tax.
The benefits of this Article are also subject to Article 22
(Limitation on Benefits). Thus, an enterprise of Hungary that
derives income effectively connected with a U.S. trade or
business may not claim the benefits of Article 7 unless the
resident carrying on the enterprise qualifies for such benefits
under Article 22.
ARTICLE 8 (SHIPPING AND AIR TRANSPORT)
This Article governs the taxation of profits from the
operation of ships and aircraft in international traffic. The
term ``international traffic'' is defined in subparagraph 1(f)
of Article 3 (General Definitions).
Paragraph 1
Paragraph 1 provides that profits derived by an enterprise
of a Contracting State from the operation in international
traffic of ships or aircraft are taxable only in that
Contracting State. Because paragraph 6 of Article 7 (Business
Profits) defers to Article 8 with respect to shipping income,
such income derived by a resident of one of the Contracting
States may not be taxed in the other State even if the
enterprise has a permanent establishment in that other State.
Thus, if a U.S. airline has a ticket office in Hungary, Hungary
may not tax the airline's profits attributable to that office
under Article 7. Since entities engaged in international
transportation activities normally will have many permanent
establishments in a number of countries, the rule avoids
difficulties that would be encountered in attributing income to
multiple permanent establish*ments if the income were covered
by Article 7.
Paragraph 2
The income from the operation of ships or aircraft in
international traffic that is exempt from tax under paragraph 1
is defined in paragraph 2.
In addition to income derived directly from the operation
of ships and aircraft in international traffic, this definition
also includes certain items of rental income. First, income of
an enterprise of a Contracting State from the rental of ships
or aircraft on a full basis (i.e., with crew) is income of the
lessor from the operation of ships and aircraft in
international traffic and, therefore, is exempt from tax in the
other Contracting State under paragraph 1. Also, paragraph 2
encompasses income from the lease of ships or aircraft on a
bareboat basis (i.e., without crew), either when the income is
incidental to other income of the lessor from the operation of
ships or aircraft in international traffic, or when the ships
or aircraft are operated in international traffic by the
lessee. If neither of those two conditions apply, income from
the bareboat rentals would constitute business profits. The
coverage of Article 8 is therefore broader than that of Article
8 of the OECD Model, which covers bareboat leasing only when it
is incidental to other income of the lessor from the operation
of ships of aircraft in international traffic.
Paragraph 2 also clarifies, consistent with the Commentary
to Article 8 of the OECD Model, that income earned by an
enterprise from the inland transport of property or passengers
within either Contracting State falls within Article 8 if the
transport is undertaken as part of the international transport
of property or passengers by the enterprise. Thus, if a U.S.
shipping company contracts to carry property from Hungary to a
U.S. city and, as part of that contract, it transports the
property by truck from its point of origin to an airport in
Hungary (or it contracts with a trucking company to carry the
property to the airport) the income earned by the U.S. shipping
company from the overland leg of the journey would be taxable
only in the United States. Similarly, Article 8 also would
apply to all of the income derived from a contract for the
international transport of goods, even if the goods were
transported to the port by a lighter, not by the vessel that
carried the goods in international waters.
Finally, certain non-transport activities that are an
integral part of the services performed by a transport company,
or are ancillary to the enterprise's operation of ships or
aircraft in international traffic, are understood to be covered
in paragraph 1, though they are not specified in paragraph 2.
These include, for example, the provision of goods and services
by engineers, ground and equipment maintenance and staff, cargo
handlers, catering staff and customer services personnel. Where
the enterprise provides such goods to, or performs services
for, other enterprises and such activities are directly
connected with or ancillary to the enterprise's operation of
ships or aircraft in international traffic, the profits from
the provision of such goods and services to other enterprises
will fall under this paragraph.
For example, enterprises engaged in the operation of ships
or aircraft in international traffic may enter into pooling
arrangements for the purposes of reducing the costs of
maintaining facilities needed for the operation of their ships
or aircraft in other countries. For instance, where an airline
enterprise agrees (for example, under an International Airlines
Technical Pool agreement) to provide spare parts or maintenance
services to other airlines landing at a particular location
(which allows it to benefit from these services at other
locations), activities carried on pursuant to that agreement
will be ancillary to the operation of aircraft in international
traffic by the enterprise.
Also, advertising that the enterprise may do for other
enterprises in magazines offered aboard ships or aircraft that
it operates in international traffic or at its business
locations, such as ticket offices, is ancillary to its
operation of these ships or aircraft. Profits generated by such
advertising fall within this paragraph. Income earned by
concessionaires, however, is not covered by Article 8. These
interpretations of paragraph 1 also are consistent with the
Commentary to Article 8 of the OECD Model.
Paragraph 3
Under this paragraph, profits of an enterprise of a
Contracting State from the use, maintenance or rental of
containers (including equipment for their transport) are exempt
from tax in the other Contracting State, unless those
containers are used for transport solely in the other
Contracting State. This result obtains under paragraph 3
regardless of whether the recipient of the income is engaged in
the operation of ships or aircraft in international traffic,
and regardless of whether the enterprise has a permanent
establishment in the other Contracting State. Only income from
the use, maintenance or rental of containers that is incidental
to other income from international traffic is covered by
Article 8 of the OECD Model.
Paragraph 4
This paragraph clarifies that the provisions of paragraphs
1 and 3 also apply to profits derived by an enterprise of a
Contracting State from participation in a pool, joint business
or international operating agency. This refers to various
arrangements for international cooperation by carriers in
shipping and air transport. For example, airlines from two
countries may agree to share the transport of passengers
between the two countries. They each will fly the same number
of flights per week and share the revenues from that route
equally, regardless of the number of passengers that each
airline actually transports. Paragraph 4 makes clear that with
respect to each carrier the income dealt with in the Article is
that carrier's share of the total transport, not the income
derived from the passengers actually carried by the airline.
This paragraph corresponds to paragraph 4 of Article 8 of the
OECD Model.
Relationship to Other Articles
The taxation of gains from the alienation of ships,
aircraft or containers is not dealt with in this Article but in
paragraph 6 of Article 13 (Gains).
As with other benefits of the Convention, the benefit of
exclusive residence country taxation under Article 8 is
available to an enterprise only if it is entitled to benefits
under Article 22 (Limitation on Benefits).
This Article also is subject to the saving clause of
paragraph 4 of Article 1 (General Scope) of the Model. Thus, if
a citizen of the United States who is a resident of Hungary
derives profits from the operation of ships or aircraft in
international traffic, notwithstanding the exclusive residence
country taxation in paragraph 1 of Article 8, the United States
may, subject to the special foreign tax credit rules of
paragraph 4 of Article 23 (Relief from Double Taxation), tax
those profits as part of the worldwide income of the citizen.
(This is an unlikely situation, however, because non-tax
considerations (e.g., insurance) generally result in shipping
activities being carried on in corporate form.)
ARTICLE 9 (ASSOCIATED ENTERPRISES)
This Article incorporates in the Convention the arm's-
length principle reflected in the U.S. domestic transfer
pricing provisions, particularly Code section 482. It provides
that when related enterprises engage in a transaction on terms
that are not arm's-length, the Contracting States may make
appropriate adjustments to the taxable income and tax liability
of such related enterprises to reflect what the income and tax
of these enterprises with respect to the transaction would have
been had there been an arm's-length relationship between them.
Paragraph 1
This paragraph addresses the situation where an enterprise
of a Contracting State is related to an enterprise of the other
Contracting State, and there are arrangements or conditions
imposed between the enterprises in their commercial or
financial relations that are different from those that would
have existed in the absence of the relationship. Under these
circumstances, the Contracting States may adjust the income (or
loss) of the enterprise to reflect what it would have been in
the absence of such a relationship.
The paragraph identifies the relationships between
enterprises that serve as a prerequisite to application of the
Article. As the Commentary to the OECD Model makes clear, the
necessary element in these relationships is effective control,
which is also the standard for purposes of section 482. Thus,
the Article applies if an enterprise of one State participates
directly or indirectly in the management, control, or capital
of the enterprise of the other State. Also, the Article applies
if any third person or persons participate directly or
indirectly in the management, control, or capital of
enterprises of different States. For this purpose, all types of
control are included, i.e., whether or not legally enforceable
and however exercised or exercisable.
The fact that a transaction is entered into between such
related enterprises does not, in and of itself, mean that a
Contracting State may adjust the income (or loss) of one or
both of the enterprises under the provisions of this Article.
If the conditions of the transaction are consistent with those
that would be made between independent persons, the income
arising from that trans*action should not be subject to
adjustment under this Article.
Similarly, the fact that associated enterprises may have
concluded arrangements, such as cost sharing arrangements or
general services agreements, is not in itself an indication
that the two enterprises have entered into a non-arm's-length
transaction that should give rise to an adjustment under
paragraph 1. Both related and unrelated parties enter into such
arrangements (e.g., joint venturers may share some development
costs). As with any other kind of transaction, when related
parties enter into an arrangement, the specific arrangement
must be examined to see whether or not it meets the arm's-
length standard. In the event that it does not, an appropriate
adjustment may be made, which may include modifying the terms
of the agreement or re-characterizing the transaction to
reflect its substance.
It is understood that the ``commensurate with income''
standard for determining appropriate transfer prices for
intangibles, added to Code section 482 by the Tax Reform Act of
1986, was designed to operate consistently with the arm's-
length standard. The implementation of this standard in the
section 482 regulations is in accordance with the general
principles of paragraph 1 of Article 9 of the Convention, as
interpreted by the OECD Transfer Pricing Guidelines.
This Article also permits tax authorities to deal with thin
capitalization issues. They may, in the context of Article 9,
scrutinize more than the rate of interest charged on a loan
between related persons. They also may examine the capital
structure of an enterprise, whether a payment in respect of
that loan should be treated as interest, and, if it is treated
as interest, under what circumstances interest deductions
should be allowed to the payor. Paragraph 2 of the Commentary
to Article 9 of the OECD Model, together with the U.S.
observation set forth in paragraph 15, sets forth a similar
understanding of the scope of Article 9 in the context of thin
capitalization.
Paragraph 2
When a Contracting State has made an adjustment that is
consistent with the provisions of paragraph 1, and the other
Contracting State agrees that the adjustment was appropriate to
reflect arm's-length conditions, that other Contracting State
is obligated to make a correlative adjustment (sometimes
referred to as a ``corresponding adjustment'') to the tax
liability of the related person in that other Contracting
State. Although the OECD Model does not specify that the other
Contracting State must agree with the initial adjustment before
it is obligated to make the correlative adjustment, the
Commentary makes clear that the paragraph is to be read that
way.
As explained in the Commentary to Article 9 of the OECD
Model, Article 9 leaves the treatment of ``secondary
adjustments'' to the laws of the Contracting States. When an
adjustment under Article 9 has been made, one of the parties
will have in its possession funds that it would not have had at
arm's length. The question arises as to how to treat these
funds. In the United States the general practice is to treat
such funds as a dividend or contribution to capital, depending
on the relationship between the parties. Under certain
circumstances, the parties may be permitted to restore the
funds to the party that would have the funds had the
transactions been entered into on arm's length terms, and to
establish an account payable pending restoration of the funds.
See Rev. Proc. 99-32, 1999-2 C.B. 296.
The Contracting State making a secondary adjustment will
take the other provisions of the Convention, where relevant,
into account. For example, if the effect of a secondary
adjustment is to treat a U.S. corporation as having made a
distribution of profits to its parent corporation in the other
Contracting State, the provisions of Article 10 (Dividends)
will apply, and the United States may impose a 5 percent
withholding tax on the dividend. Also, if under Article 23
(Relief from Double Taxation) the other State generally gives a
credit for taxes paid with respect to such dividends, it would
also be required to do so in this case.
The competent authorities are authorized by paragraph 3 of
Article 25 (Mutual Agreement Procedure) to consult, if
necessary, to resolve any differences in the application of
these provisions. For example, there may be a disagreement over
whether an adjustment made by a Contracting State under
paragraph 1 was appropriate.
If a correlative adjustment is made under paragraph 2, it
is to be implemented, pursuant to paragraph 2 of Article 25
(Mutual Agreement Procedure), notwithstanding any time limits
or other procedural limitations in the law of the Contracting
State making the adjustment. If a taxpayer has entered a
closing agreement (or other written settlement) with the United
States prior to bringing a case to the competent authorities,
the U.S. competent authority will endeavor only to obtain a
correlative adjustment from Hungary. See, Rev. Proc. 2006-54,
2006-49 I.R.B. 1035, Section 7.05.
Relationship to Other Articles
The saving clause of paragraph 4 of Article 1 (General
Scope) does not apply to paragraph 2 of Article 9 by virtue of
an exception to the saving clause in subparagraph 5(a) of
Article 1. Thus, even if the statute of limitations has run, a
refund of tax can be made in order to implement a correlative
adjustment. Statutory or procedural limitations, however,
cannot be overridden to impose additional tax, because
paragraph 2 of Article 1 provides that the Convention cannot
restrict any statutory benefit.
ARTICLE 10 (DIVIDENDS)
Article 10 provides rules for the taxation of dividends
paid by a company that is a resident of one Contracting State
to a beneficial owner that is a resident of the other
Contracting State. The Article provides for full residence-
State taxation of such dividends and a limited source-State
right to tax. Article 10 also provides rules for the imposition
of a tax on branch profits by the State of source. Finally, the
Article prohibits a State from imposing taxes on a company
resident in the other Contracting State, other than a branch
profits tax, on undistributed earnings.
Paragraph 1
The right of a shareholder's Contracting State of residence
to tax dividends arising in the source country is preserved by
paragraph 1, which permits a Contracting State to tax its
residents on dividends paid to them by a company that is a
resident of the other Contracting State. For dividends from any
other source paid to a resident, Article 21 (Other Income)
grants the residence country exclusive taxing jurisdiction
(other than for dividends attributable to a permanent
establishment in the other State).
Paragraph 2
The State of source also may tax dividends beneficially
owned by a resident of the other State, subject to the
limitations of paragraphs 2 and 3. Paragraph 2 generally limits
the rate of withholding tax in the State of source on dividends
paid by a company resident in that State to 15 percent of the
gross amount of the dividend. If, however, the beneficial owner
of the dividend is a company resident in the other State and
owns directly shares representing at least 10 percent of the
voting power of the company paying the dividend, then the rate
of withholding tax in the State of source is limited to 5
percent of the gross amount of the dividend. For application of
this paragraph by the United States, shares are considered
voting shares if they provide the power to elect, appoint or
replace any person vested with the powers ordinarily exercised
by the board of directors of a U.S. corporation.
The benefits of paragraph 2 may be granted at the time of
payment by means of reduced rate of withholding tax at source.
It also is consistent with the paragraph for tax to be withheld
at the time of payment at full statutory rates, and the treaty
benefit to be granted by means of a subsequent refund so long
as such procedures are applied in a reasonable manner.
The determination of whether the ownership threshold for
subparagraph 2(a) is met for purposes of the 5 percent maximum
rate of withholding tax is made on the date on which
entitlement to the dividend is determined. Thus, in the case of
a dividend from a U.S. company, the determination of whether
the ownership threshold is met generally would be made on the
dividend record date.
Paragraph 2 does not affect the taxation of the profits out
of which the dividends are paid. The taxation by a Contracting
State of the income of its resident companies is governed by
the internal law of the Contracting State, subject to the
provisions of paragraph 4 of Article 24 (Non- Discrimination).
The term ``beneficial owner'' is not defined in the
Convention, and is, therefore, defined as under the internal
law of the country imposing tax (i.e., the source country). The
beneficial owner of the dividend for purposes of Article 10 is
the person to which the income is attributable under the laws
of the source State. Thus, if a dividend paid by a corporation
that is a resident of one of the States (as determined under
Article 4 (Residence)) is received by a nominee or agent that
is a resident of the other State on behalf of a person that is
not a resident of that other State, the dividend is not
entitled to the benefits of this Article. However, a dividend
received by a nominee on behalf of a resident of that other
State would be entitled to benefits. These limitations are
confirmed by paragraph 12 of the Commentary to Article 10 of
the OECD Model. See also paragraph 24 of the Commentary to
Article 1 of the OECD Model.
Special rules, however, apply to shares that are held
through fiscally transparent entities. In that case, the rules
of paragraph 6 of Article 1 (General Scope) and paragraph 1 of
the Exchange of Notes will apply to determine whether the
dividends should be treated as having been derived by a
resident of a Contracting State. Residence State principles
shall be used to determine who derives the dividend, to assure
that the dividends for which the source State grants benefits
of the Convention will be taken into account for tax purposes
by a resident of the residence State. Source State principles
of beneficial ownership shall then apply to determine whether
the person who derives the dividends, or another resident of
the other Contracting State, is the beneficial owner of the
dividend. If the person who derives the dividend under
paragraph 6 of Article 1 would not be treated a nominee, agent,
custodian, conduit, etc. under the source State's principles
for determining beneficial ownership as, that person will be
treated as the beneficial owner of the income, profits or gains
for purposes of the Convention.
Assume for instance, that a company resident in Hungary
pays a dividend to LLC, an entity organized in the United
States and treated as fiscally transparent for U.S. tax
purposes, but as a company for Hungarian tax purposes. USCo, a
company incorporated in the United States, is the sole interest
holder in LLC. Paragraph 6 of Article 1 provides that USCo
derives the dividend. Hungary's principles of beneficial
ownership shall then be applied to USCo. If under the laws of
Hungary USCo is found not to be the beneficial owner of the
dividend, USCo will not be entitled to the benefits of Article
10 with respect to such dividend. The payment may be entitled
to benefits, however, if USCo is found to be a nominee, agent,
custodian, or conduit for a person who is a resident of the
United States.
Beyond identifying the person to whom the principles of
beneficial ownership shall be applied, the principles of
paragraph 6 of Article 1 will also apply when determining
whether other requirements, such as the ownership threshold of
subparagraph 2(a) have been satisfied.
For example, assume that HCo, a company that is a resident
of Hungary, owns all of the outstanding shares in HDE, an
entity that is disregarded for U.S. tax purposes that is a
resident of Hungary. HDE owns 100% of the stock of USCo.
Hungary views HDE as fiscally transparent under its domestic
law, and taxes HCo currently on the income derived by HDE. In
this case, HCo is treated as deriving the dividends paid by
USCo under paragraph 6 of Article 1. Moreover, HCo is treated
as owning the shares of USCo directly. The Convention does not
address what constitutes direct ownership for purposes of
Article 10. As a result, whether ownership is direct is
determined under the internal law of the country imposing tax
(i.e., the source country) unless the context otherwise
requires. Accordingly, a company that holds stock through such
an entity will generally be considered to directly own such
stock for purposes of Article 10.
The same principles would apply in determining whether
companies holding shares through fiscally transparent entities
such as partnerships, trusts, and estates would qualify for
benefits. As a result, companies holding shares through such
entities may be able to claim the benefits of subparagraph (a)
under certain circumstances. The lower rate applies when the
company's proportionate share of the shares held by the
intermediate entity meets the 10 percent threshold, and the
company meets the requirements of subparagraph 6 of Article 1
(i.e., the company's country of residence treats the
intermediate entity as fiscally transparent) with respect to
the dividend. Whether this ownership threshold is satisfied may
be difficult to determine and often will require an analysis of
the partnership or trust agreement.
Paragraph 3
Paragraph 3 provides that dividends beneficially owned by a
pension fund may not be taxed in the Contracting State of which
the company paying the tax is a resident, unless such dividends
are derived from the carrying on of a business, directly or
indirectly, by the pension fund or through an associated
enterprise. For these purposes, the term ``pension fund'' is
defined in subparagraph 1(k) of Article 3 (General
Definitions).
Paragraph 4
Paragraph 4 imposes limitations on the rate reductions
provided by paragraphs 2 and 3 in the case of dividends paid by
RIC or a REIT.
The first sentence of subparagraph 4(a) provides that
dividends paid by a RIC or REIT are not eligible for the 5
percent rate of withholding tax of subparagraph 2(a).
The second sentence of subparagraph 4(a) provides that the
15 percent maximum rate of withholding tax of subparagraph 2(b)
applies to dividends paid by RICs and that the elimination of
source-country withholding tax of paragraph 3 applies to
dividends paid by RICs and beneficially owned by a pension
fund.
The third sentence of subparagraph 4(a) provides that the
15 percent rate of withholding tax also applies to dividends
paid by a REIT and that the elimination of source-country
withholding tax of paragraph 3 applies to dividends paid by
REITs and beneficially owned by a pension fund, provided that
one of the three following conditions is met. First, the
beneficial owner of the dividend is an individual or a pension
fund, in either case holding an interest of not more than 10
percent in the REIT. Second, the dividend is paid with respect
to a class of stock that is publicly traded and the beneficial
owner of the dividend is a person holding an interest of not
more than 5 percent of any class of the REIT's shares. Third,
the beneficial owner of the dividend holds an interest in the
REIT of not more than 10 percent and the REIT is
``diversified.''
Subparagraph (b) provides a definition of the term
``diversified.'' A REIT is diversified if the gross value of no
single interest in real property held by the REIT exceeds 10
percent of the gross value of the REIT's total interest in real
property. Foreclosure property is not considered an interest in
real property, and a REIT holding a partnership interest is
treated as owning its proportionate share of any interest in
real property held by the partnership. Subparagraph (c)
provides that the rules of paragraph 4 apply also to dividends
paid by companies resident in Hungary that are similar to U.S.
RICs and REITs. No such entities existed under Hungary's
domestic law at the time of signature of the Convention.
Paragraph 5
Paragraph 5 defines the term dividends broadly and
flexibly. The definition is intended to cover all arrangements
that yield a return on an equity investment in a corporation as
determined under the tax law of the state of source, as well as
arrangements that might be developed in the future.
The term includes income from shares, or other corporate
rights that are not treated as debt under the law of the source
State, that participate in the profits of the company. The term
also includes income that is subjected to the same tax
treatment as income from shares by the law of the State of
source. Thus, a constructive dividend that results from a non-
arm's length transaction between a corporation and a related
party is a dividend. In the case of the United States the term
dividend includes amounts treated as a dividend under U.S. law
upon the sale or redemption of shares or upon a transfer of
shares in a reorganization. See, e.g., Rev. Rul. 92-85, 1992-2
C.B. 69 (sale of foreign subsidiary's stock to U.S. sister
company is a deemed dividend to extent of the subsidiary's and
sister company's earnings and profits). Further, a distribution
from a U.S. publicly traded limited partnership, which is taxed
as a corporation under U.S. law, is a dividend for purposes of
Article 10. However, a distribution by a limited liability
company is not taxable by the United States under Article 10,
provided the limited liability company is not characterized as
an association taxable as a corporation under U.S. law.
Finally, a payment denominated as interest that is made by
a thinly capitalized corporation may be treated as a dividend
to the extent that the debt is recharacterized as equity under
the laws of the source State.
Paragraph 6
Paragraph 6 provides a rule for taxing dividends paid with
respect to holdings that form part of the business property of
a permanent establishment. In such case, the rules of Article 7
(Business Profits) shall apply. Accordingly, the dividends will
be taxed on a net basis using the rates and rules of taxation
generally applicable to residents of the State in which the
permanent establishment is located, as such rules may be
modified by the Convention. An example of dividends paid with
respect to the business property of a permanent establishment
would be dividends derived by a dealer in stock or securities
from stock or securities that the dealer held for sale to
customers.
Paragraph 7
The right of a Contracting State to tax dividends paid by a
company that is a resident of the other Contracting State is
restricted by paragraph 7 to cases in which the dividends are
paid to a resident of that Contracting State or are
attributable to a permanent establishment or fixed base in that
Contracting State. Thus, a Contracting State may not impose a
``secondary'' withholding tax on dividends paid by a
nonresident company out of earnings and profits from that
Contracting State.
The paragraph also restricts the right of a Contracting
State to impose corporate level taxes on undistributed profits,
other than a branch profits tax. The paragraph does not
restrict a State's right to tax its resident shareholders on
undistributed earnings of a corporation resident in the other
State. Thus, the authority of the United States to impose taxes
on subpart F income and on earnings deemed invested in U.S.
property, and its tax on income of a passive foreign investment
company that is a qualified electing fund is in no way
restricted by this provision.
Paragraph 8
Paragraph 8 permits a Contracting State to impose a branch
profits tax on a company resident in the other Contracting
State. The tax is in addition to other taxes permitted by the
Convention. The term ``company'' is defined in subparagraph
1(b) of Article 3 (General Definitions).
A Contracting State may impose a branch profits tax on a
company if the company has income attributable to a permanent
establishment in that Contracting State, derives income from
immovable property (real property) in that Contracting State
that is taxed on a net basis under Article 6 (Income from
Immovable Property (Real Property)), or realizes gains taxable
in that State under paragraphs 1 or 4 of Article 13 (Gains). In
the case of the United States, the imposition of such tax is
limited, however, to the portion of the aforementioned items of
income that represents the amount of such income that is the
``dividend equivalent amount.'' This is consistent with the
relevant rules under the U.S. branch profits tax, and the term
dividend equivalent amount is defined under U.S. law. Section
884 defines the dividend equivalent amount as an amount for a
particular year that is equivalent to the income described
above that is included in the corporation's effectively
connected earnings and profits for that year, after payment of
the corporate tax under Articles 6, 7 (Business Profits) or 13,
reduced for any increase in the branch's U.S. net equity during
the year or increased for any reduction in its U.S. net equity
during the year. U.S. net equity is U.S. assets less U.S.
liabilities. See Treas. Reg. section 1.884-1.
The dividend equivalent amount for any year approximates
the dividend that a U.S. branch office would have paid during
the year if the branch had been operated as a separate U.S.
subsidiary company. At the time of signature of the Convention,
Hungary did not impose a branch profits tax. If Hungary chooses
to enact such a tax in the future, the base of its tax must be
limited to an amount that is analogous to the dividend
equivalent amount, and the applicable rate would be subject to
the limitations of clause (ii) of subparagraph 8(b).
As discussed in the Technical Explanations to Articles 1(2)
and 7(2), consistency principles prohibit a taxpayer from
applying provisions of the Code and this Convention
inconsistently. In the context of the branch profits tax, this
consistency requirement means that if a Hungarian company uses
the principles of Article 7 to determine its U.S. taxable
income then it must also use those principles to determine its
dividend equivalent amount. Similarly, if the Hungarian company
instead uses the Code to determine its U.S. taxable income it
must also use the Code to determine its dividend equivalent
amount. As in the case of Article 7, if a Hungarian company,
for example, does not from year to year consistently apply the
Code or the Convention to determine its dividend equivalent
amount, then the Hungarian company must make appropriate
adjustments or recapture amounts that would otherwise be
subject to U.S. branch profits tax if it had consistently
applied the Code or the Convention to determine its dividend
equivalent amount from year to year.
Subparagraph 2(b) provides that the branch profits tax
shall not be imposed at a rate exceeding five percent. It is
intended that subparagraph 2(b) apply equally if a taxpayer
determines its taxable income under the laws of a Contracting
State or under the provisions of Article 7. For example, as
discussed above, consistency principles require a Hungarian
company that determines its U.S. taxable income under the Code
to also determine its dividend equivalent amount under the
Code. In that case, subparagraph 2(b) would apply even though
the Hungarian company did not determine its dividend equivalent
amount using the principles of Article 7.
Relationship to Other Articles
Notwithstanding the foregoing limitations on source country
taxation of dividends, the saving clause of paragraph 4 of
Article 1 permits the United States to tax dividends received
by its residents and citizens, subject to the special foreign
tax credit rules of paragraph 4 of Article 23 (Relief from
Double Taxation), as if the Convention had not come into
effect.
The benefits of this Article are also subject to the
provisions of Article 22 (Limitation on Benefits). Thus, if a
resident of the other Contracting State is the beneficial owner
of dividends paid by a U.S. corporation, the shareholder must
qualify for treaty benefits under at least one of the tests of
Article 22 in order to receive the benefits of this Article.
ARTICLE 11 (INTEREST)
Article 11 specifies the taxing jurisdictions over interest
arising in one Contracting State and beneficially owned bya
resident of the other Contracting State.
Paragraph 1
Paragraph 1 generally grants to the State of residence the
exclusive right to tax interest beneficially owned by its
residents and arising in the other Contracting State.
The term ``beneficial owner'' is not defined in the
Convention, and is, therefore, defined under the internal law
of the State of source. The beneficial owner of the interest
for purposes of Article 11 is the person to which the income is
attributable under the laws of the source State. Thus, if
interest arising in a Contracting State is received by a
nominee or agent that is a resident of the other State on
behalf of a person that is not a resident of that other State,
the interest is not entitled to the benefits of Article 11.
However, interest received by a nominee on behalf of a resident
of that other State would be entitled to benefits. These
limitations are confirmed by paragraph 9 of the OECD Commentary
to Article 11.
Paragraph 2
Paragraph 2 provides anti-abuse exceptions to the source-
country exemption in paragraph 1 for two classes of interest
payments.
The first class of interest, dealt with in subparagraphs
2(a) and 2(b) is so-called ``contingent interest.'' With
respect to Hungary, such interest is defined in subparagraph
2(a) as any interest arising in Hungary that is determined by
reference to the receipts, sales, income, profits or other cash
flow of the debtor or a related person, to any change in the
value of any property of the debtor or a related person or to
any dividend, partnership distribution or similar payment made
by the debtor or a related person. Any such interest may be
taxed in Hungary according to the laws of Hungary. If the
beneficial owner is a resident of the United States, however,
the gross amount of the interest may be taxed at a rate not
exceeding 15 percent. With respect to interest arising in the
United States, subparagraph (b) refers to contingent interest
of a type that does not qualify as portfolio interest under
U.S. domestic law. The cross-reference to the U.S. definition
of contingent interest, which is found in section 871(h)(4) of
the Code, is intended to ensure that the exceptions of section
871(h)(4)(C) will be applicable.
The second class of interest is dealt with in subparagraph
2(c). This exception is consistent with the policy of Code
sections 860E(e) and 860G(b) that excess inclusions with
respect to a real estate mortgage investment conduit (REMIC)
should bear full U.S. tax in all cases.
Paragraph 3
The term ``interest'' as used in Article 11 is defined in
paragraph 3 to include, inter alia, income from debt claims of
every kind, whether or not secured by a mortgage. Penalty
charges for late payment are excluded from the definition of
interest. Interest that is paid or accrued subject to a
contingency is within the ambit of Article 11. This includes
income from a debt obligation carrying the right to participate
in profits. The term does not, however, include amounts that
are treated as dividends under Article 10 (Dividends).
The term interest also includes amounts subject to the same
tax treatment as income from money lent under the law of the
State in which the income arises. Thus, for purposes of the
Convention, amounts that the United States will treat as
interest include (i) the difference between the issue price and
the stated redemption price at maturity of a debt instrument
(i.e., original issue discount (''OID'')), which may be wholly
or partially realized on the disposition of a debt instrument
(section 1273), (ii) amounts that are imputed interest on a
deferred sales contract (section 483), (iii) amounts treated as
interest or OID under the stripped bond rules (section 1286),
(iv) amounts treated as original issue discount under the
below-market interest rate rules (section 7872), (v) a
partner's distributive share of a partnership's interest income
(section 702), (vi) the interest portion of periodic payments
made under a ``finance lease'' or similar contractual
arrangement that in substance is a borrowing by the nominal
lessee to finance the acquisition of property, (vii) amounts
included in the income of a holder of a residual interest in a
REMIC (section 860E), because these amounts generally are
subject to the same taxation treatment as interest under U.S.
tax law, and (viii) interest with respect to notional principal
contracts that are re-characterized as loans because of a
``substantial non-periodic payment.''
Paragraph 4
Paragraph 4 provides an exception to the exclusive
residence taxation rule of paragraph 1 and the source-country
gross taxation rule of paragraph 2 in cases where the
beneficial owner of the interest carries on business through a
permanent establishment in the State of source situated in that
State and the interest is attributable to that permanent
establishment. In such cases the provisions of Article 7
(Business Profits) will apply and the State of source will
retain the right to impose tax on such interest income.
In the case of a permanent establishment that once existed
in the State of source but that no longer exists, the
provisions of paragraph 4 also apply, by virtue of paragraph 7
of Article 7 (Business Profits), to interest that would be
attributable to such a permanent establishment or fixed base if
it did exist in the year of payment or accrual. See the
Technical Explanation of paragraph 7 of Article 7.
Paragraph 5
Paragraph 5 provides that in cases involving special
relationships between the payor and the beneficial owner of
interest income, Article 11 applies only to that portion of the
total interest payments that would have been made absent such
special relationships (i.e., an arm's*length interest payment).
Any excess amount of interest paid remains taxable according to
the laws of the United States and Hungary, respectively, with
due regard to the other provisions of the Convention. Thus, if
the excess amount would be treated under the source country's
law as a distribution of profits by a corporation, such amount
could be taxed as a dividend rather than as interest, but the
tax would be subject, if appropriate, to the rate limitations
of paragraph 2 of Article 10 (Dividends).
The term ``special relationship'' is not defined in the
Convention. In applying this paragraph the United States
considers the term to include the relationships described in
Article 9, which in turn corresponds to the definition of
``control'' for purposes of section 482 of the Code.
This paragraph does not address cases where, owing to a
special relationship between the payer and the beneficial owner
or between both of them and some other person, the amount of
the interest is less than an arm's-length amount. In those
cases a transaction may be characterized to reflect its
substance and interest may be imputed consistent with the
definition of interest in paragraph 3. The United States would
apply section 482 or 7872 of the Code to determine the amount
of imputed interest in those cases.
Relationship to Other Articles
Notwithstanding the foregoing limitations on source country
taxation of interest, the saving clause of paragraph 4 of
Article 1 permits the United States to tax its residents and
citizens, subject to the special foreign tax credit rules of
paragraph 4 of Article 23 (Relief from Double Taxation), as if
the Convention had not come into force.
As with other benefits of the Convention, the benefits of
exclusive residence State taxation of interest under paragraph
1 of Article 11, or limited source taxation under subparagraphs
2(a) and 2(b), are available to a resident of the other State
only if that resident is entitled to those benefits under the
provisions of Article 22 (Limitation on Benefits).
ARTICLE 12 (ROYALTIES)
Article 12 provides rules for the taxation of royalties
arising in one Contracting State and paid to a beneficial owner
that is a resident of the other Contracting State.
Paragraph 1
Paragraph 1 generally grants to the State of residence the
exclusive right to tax royalties beneficially owned by its
residents and arising in the other Contracting State.
The term ``beneficial owner'' is not defined in the
Convention, and is, therefore, defined under the internal law
of the State of source. The beneficial owner of the royalty for
purposes of Article 12 is the person to which the income is
attributable under the laws of the source State. Thus, if a
royalty arising in a Contracting State is received by a nominee
or agent that is a resident of the other State on behalf of a
person that is not a resident of that other State, the royalty
is not entitled to the benefits of Article 12. However, a
royalty received by a nominee on behalf of a resident of that
other State would be entitled to benefits. These limitations
are confirmed by paragraph 4 of the OECD Commentary to Article
12.
Paragraph 2
Paragraph 2 defines the term ``royalties,'' as used in
Article 12, to include any consideration for the use of, or the
right to use, any copyright of literary, artistic, scientific
or other work (such as cinematographic films), any patent,
trademark, design or model, plan, secret formula or process, or
for information concerning industrial, commercial, or
scientific experience. The term ``royalties'' also includes
gain derived from the alienation of any right or property that
would give rise to royalties, to the extent the gain is
contingent on the productivity, use, or further alienation
thereof. Gains that are not so contingent are dealt with under
Article 13 (Gains). The term ``royalties,'' however, does not
include income from leasing personal property.
The term royalties is defined in the Convention and
therefore is generally independent of domestic law. Certain
terms used in the definition are not defined in the Convention,
but these may be defined under domestic tax law. For example,
the term ``secret process or formulas'' is found in the Code,
and its meaning has been elaborated in the context of sections
351 and 367. See Rev. Rul. 55- 17, 1955-1 C.B. 388; Rev. Rul.
64-56, 1964-1 C.B. 133; Rev. Proc. 69- 19, 1969-2 C.B. 301.
Consideration for the use or right to use cinematographic
films, or works on film, tape, or other means of reproduction
in radio or television broadcasting is specifically included in
the definition of royalties. It is intended that, with respect
to any subsequent technological advances in the field of radio
or television broadcasting, consideration received for the use
of such technology will also be included in the definition of
royalties.
If an artist who is resident in one Contracting State
records a performance in the other Contracting State, retains a
copyrighted interest in a recording, and receives payments for
the right to use the recording based on the sale or public
playing of the recording, then the right of such other
Contracting State to tax those payments is governed by Article
12. See Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810
F.2d 209 (D.C. Cir. 1986). By contrast, if the artist earns in
the other Contracting State income covered by Article 16
(Entertainers and Sportsmen), for example, endorsement income
from the artist's attendance at a film screening, and if such
income also is attributable to one of the rights described in
Article 12 (e.g., the use of the artist's photograph in
promoting the screening), Article 16 and not Article 12 is
applicable to such income.
Computer software generally is protected by copyright laws
around the world. Under the Convention, consideration received
for the use, or the right to use, computer software is treated
either as royalties or as business profits, depending on the
facts and circumstances of the transaction giving rise to the
payment.
The primary factor in determining whether consideration
received for the use, or the right to use, computer software is
treated as royalties or as business profits is the nature of
the rights transferred. See Treas. Reg. section 1.861-18. The
fact that the transaction is characterized as a license for
copyright law purposes is not dispositive. For example, a
typical retail sale of ``shrink wrap'' software generally will
not be considered to give rise to royalty income, even though
for copyright law purposes it may be characterized as a
license.
The means by which the computer software is transferred are
not relevant for purposes of the analysis. Consequently, if
software is electronically transferred but the rights obtained
by the transferee are substantially equivalent to rights in a
program copy, the payment will be considered business profits.
The term ``industrial, commercial, or scientific
experience'' (sometimes referred to as ``know-how''). has the
meaning ascribed to it in paragraph 11 et seq. of the
Commentary to Article 12 of the OECD Model. Consistent with
that meaning, the term may include information that is
ancillary to a right otherwise giving rise to royalties, such
as a patent or secret process.
Know-how also may include, in limited cases, technical
information that is conveyed through technical or consultancy
services. It does not include general educational training of
the user's employees, nor does it include information developed
especially for the user, such as a technical plan or design
developed according to the user's specifications. Thus, as
provided in paragraph 11.3 of the Commentary to Article 12 of
the OECD Model, the term ``royalties'' does not include
payments received as consideration for after-sales service, for
services rendered by a seller to a purchaser under a warranty,
or for pure technical assistance.
The term ``royalties'' also does not include payments for
professional services (such as architectural, engineering,
legal, managerial, medical, software development services). For
example, income from the design of a refinery by an engineer
(even if the engineer employed know-how in the process of
rendering the design) or the production of a legal brief by a
lawyer is not income from the transfer of know-how taxable
under Article 12, but is income from services taxable under
either Article 7 (Business Profits) or Article 14 (Income from
Employment). Professional services may be embodied in property
that gives rise to royalties, however. Thus, if a professional
contracts to develop patentable property and retains rights in
the resulting property under the development contract,
subsequent license payments made for those rights would be
royalties.
Paragraph 3
This paragraph provides an exception to the rule of
paragraph 1 that gives the state of residence exclusive taxing
jurisdiction in cases where the beneficial owner of the
royalties carries on business through a permanent establishment
in the state of source and the royalties are attributable to
that permanent establishment. In such cases the provisions of
Article 7 (Business Profits) will apply.
The provisions of paragraph 7 of Article 7 apply to this
paragraph. For example, royalty income that is attributable to
a permanent establishment and that accrues during the existence
of the permanent establishment, but is received after the
permanent establishment no longer exists, remains taxable under
the provisions of Article 7, and not under this Article.
Paragraph 4
Paragraph 4 provides that in cases involving special
relationships between the payor and beneficial owner of
royalties, Article 12 applies only to the extent the royalties
would have been paid absent such special relationships (i.e.,
an arm's-length royalty). Any excess amount of royalties paid
remains taxable according to the laws of the two Contracting
States, with due regard to the other provisions of the
Convention. If, for example, the excess amount is treated as a
distribution of corporate profits under domestic law, such
excess amount will be taxed as a dividend rather than as
royalties, but the tax imposed on the dividend payment will be
subject to the rate limitations of paragraph 2 of Article 10
(Dividends).
Relationship to Other Articles
Notwithstanding the foregoing limitations on source country
taxation of royalties, the saving clause of paragraph 4 of
Article 1 (General Scope) permits the United States to tax its
residents and citizens, subject to the special foreign tax
credit rules of paragraph 4 of Article 23 (Relief from Double
Taxation), as if the Convention had not come into force.
As with other benefits of the Convention, the benefits of
exclusive residence State taxation of royalties under paragraph
1 of Article 12 are available to a resident of the other State
only if that resident is entitled to those benefits under
Article 22 (Limitation on Benefits).
ARTICLE 13 (GAINS)
Article 13 provides rules for the taxation of gains from
the alienation of property.
Paragraph 1
Paragraph 1 of Article 13 preserves the non-exclusive right
of the State of source to tax gains attributable to the
alienation of real property situated in that State. The
paragraph therefore permits the United States to apply section
897 of the Code to tax gains derived by a resident of Hungary
that are attributable to the alienation of real property
situated in the United States (as defined in paragraph 2).
Gains attributable to the alienation of real property include
gains from any other property that is treated as a real
property interest within the meaning of paragraph 2.
Paragraph 1 refers to gains ``attributable to the
alienation of immovable property (real property)'' rather than
the OECD Model phrase ``gains from the alienation'' to clarify
that the United States will look through distributions made by
a REIT and certain RICs. Accordingly, distributions made by a
REIT or certain RICs are taxable under paragraph 1 of Article
13 (not under Article 10 (Dividends)) when they are
attributable to gains derived from the alienation of real
property.
Paragraph 2
This paragraph defines the term ``immovable property (real
property) situated in the other Contracting State'' for
purposes of the application of Article 13 by the United States.
The term includes immovable property (real property) referred
to in Article 6 (i.e., an interest in the real property
itself), and a ``United States real property interest'' (when
the United States is the other Contracting State under
paragraph 1).
Under section 897(c) of the Code, the term ``United States
real property interest'' includes shares in a U.S. corporation
that owns sufficient U.S. real property interests to satisfy an
asset-ratio test on certain testing dates. The term also
includes certain foreign corporations that have elected to be
treated as U.S. corporations for this purpose. Section 897(i).
Paragraph 3
This paragraph defines the term ``immovable property (real
property) situated in the other Contracting State'' for
purposes of the application of Article 13 by Hungary. The term
includes immovable property (real property) referred to in
Article 6.
Paragraph 4
Paragraph 4 preserves the non-exclusive right for Hungary
to tax gains from the alienation of shares or comparable
interests deriving more than 50 percent of their value directly
or indirectly from immovable property (real property) situated
in Hungary.
Paragraph 5
.
Paragraph 5 of Article 13 deals with the taxation of
certain gains from the alienation of movable property forming
part of the business property of a permanent establishment that
an enterprise of a Contracting State has in the other
Contracting State. This also includes gains from the alienation
of such a permanent establishment (alone or with the whole
enterprise). Such gains may be taxed in the State in which the
permanent establishment is located. Paragraph 5 does not,
however, permit the United States to tax gains derived by an
enterprise of Hungary from the sale of shares or comparable
interests deriving more than 50 percent of their value directly
or indirectly from immovable property (real property) situated
in Hungary, even where those shares form a part of the business
property of a permanent establishment maintained by that
enterprise in the United States. The taxation of such shares is
governed instead by paragraph 4.
A resident of Hungary that is a partner in a partnership
doing business in the United States generally will have a
permanent establishment in the United States as a result of the
activities of the partnership, assuming that the activities of
the partnership rise to the level of a permanent establishment.
Rev. Rul. 91-32, 1991-1 C.B. 107. Further, under paragraph 5,
the United States generally may tax a partner's distributive
share of income realized by a partnership on the disposition of
movable property forming part of the business property of the
partnership in the United States.
The gains subject to paragraph 5 may be taxed in the State
in which the permanent establishment is located, regardless of
whether the permanent establishment exists at the time of the
alienation. This rule incorporates the rule of section
864(c)(6) of the Code. Accordingly, income that is attributable
to a permanent establishment, but that is deferred and received
after the permanent establishment no longer exists, may
nevertheless be taxed by the State in which the permanent
establishment was located.
Paragraph 6
This paragraph limits the taxing jurisdiction of the State
of source with respect to gains from the alienation of ships or
aircraft operated in international traffic by the enterprise
alienating the ships or aircraft and from movable property
pertaining to the operation or use of such ships or aircraft.
Under paragraph 6, such income is taxable only in the
Contracting State in which the alienator is resident.
Notwithstanding paragraph 5, the rules of this paragraph apply
even if the income is attributable to a permanent establishment
maintained by the enterprise in the other Contracting State.
This result is consistent with the allocation of taxing rights
under Article 8 (Shipping and Air Transport).
Paragraph 7
Paragraph 7 provides a rule similar to paragraph 6 with
respect to gains from the alienation of containers and related
personal property. Such gains derived by an enterprise of a
Contracting State shall be taxable only in that Contracting
State unless the containers were used for the transport of
goods or merchandise solely within the other Contracting State.
The other Contracting State may not tax the gain even if it is
attributable to a permanent establishment maintained by the
enterprise in that other Contracting State.
Paragraph 8
Paragraph 8 grants to the State of residence of the
alienator the exclusive right to tax gains from the alienation
of property other than property referred to in paragraphs 1
through 7. For example, gain derived from shares, other than
shares described in paragraphs 2, 4, or 5, debt instruments,
and various financial instruments may be taxed only in the
State of residence, to the extent such income is not otherwise
characterized as income taxable under another article (e.g.,
Article 10 (Dividends) or Article 11 (Interest)). Similarly,
gain derived from the alienation of tangible personal property,
other than tangible personal property described in paragraph 5,
may be taxed only in the State of residence of the alienator.
Gain derived from the alienation of any property, such as a
patent or copyright, that produces income covered by Article 12
(Royalties) is governed by the rules of Article 12 and not by
this article, provided that such gain is of the type described
in paragraph 2(b) of Article 12 (i.e., it is contingent on the
productivity, use, or disposition of the property).
Gains derived by a resident of a Contracting State from
immovable property (real property) located in a third state are
not taxable in the other Contracting State, even if the sale is
attributable to a permanent establishment located in the other
Contracting State.
Paragraph 9
Paragraph 9 addresses the situation in which a resident of
one State ceases to be a resident of that State and, as a
result, is subject to special tax rules. This rule is intended
to coordinate United States and Hungarian taxation of gains in
the case of a timing mismatch due to the application of the
mark-to-market exit tax regime for ``covered expatriates''
under Code section 877A. Such a mismatch may occur, for
example, where a U.S. resident recognizes, for
U.S. tax purposes, gain on a deemed sale of all property on
the day before the individual expatriates to Hungary.
To avoid double taxation, paragraph 9 provides that where
an individual who, upon ceasing to be a resident of one
Contracting State, is treated for purposes of taxation by that
State as having alienated a property and is taxed by that State
by reason thereof, the individual may elect to be treated for
the purposes of taxation by the other Contracting State as
having sold and repurchased the property for its fair market
value on the day before the expatriation date. The election in
paragraph 9 therefore will be available to any individual who
expatriates from the United States to Hungary. The election
will have two effects. First, the election will result in the
individual (while still a resident of the United States)
triggering gain on any assets that Hungary is permitted to tax
as the source State (e.g., an interest in Hungarian real
property, or movable property forming part of the business
property of a permanent establishment in Hungary). Second,
regardless of whether Hungarian tax is triggered by the deemed
sale, the individual will be given an adjusted basis for
Hungarian tax purposes equal to the fair market value of the
property as of the date of the deemed alienation in the United
States, with the result that if there is a subsequent
alienation of the property while the individual is a resident
of Hungary, only post-emigration gain will be subject to
Hungarian tax.
If an individual recognizes in one Contracting State losses
and gains from the deemed alienation of multiple properties,
then the individual must apply paragraph 9 consistently with
respect to all such properties. An individual who is deemed to
have alienated multiple properties may only make the election
under paragraph 9 if the deemed alienation of all such
properties results in a net gain.
Taxpayers may make the election provided by paragraph 9
only with respect to property that is treated as sold for its
fair market value under a Contracting State's deemed
disposition rules. At the time the Convention was signed, the
following were the types of property that were excluded from
the deemed disposition rules in the case of individuals who
cease to be citizens or long term residents of the United
States: 1) a deferred compensation item as defined under Code
section 877A(d)(4), 2) a specified tax deferred account as
defined under Code section 877A(e)(2), and 3) an interest in a
non-grantor trust as defined under Code section 877A(f)(3).
Relationship to Other Articles
Notwithstanding the foregoing limitations on taxation of
certain gains by the State of source, the saving clause of
paragraph 4 of Article 1 (General Scope) permits the United
States to tax its citizens and residents as if the Convention
had not come into effect. Thus, any limitation in this Article
on the right of the United States to tax gains does not apply
to gains of a
U.S. citizen or resident.
The benefits of this Article are also subject to the
provisions of Article 22 (Limitation on Benefits). Thus, only a
resident of a Contracting State that satisfies one of the
conditions in Article 22 is entitled to the benefits of this
Article.
ARTICLE 14 (INCOME FROM EMPLOYMENT)
Article 14 apportions taxing jurisdiction over remuneration
derived by a resident of a Contracting State as an employee
between the States of source and residence.
Paragraph 1
The general rule of Article 14 is contained in paragraph 1.
Remuneration derived by a resident of a Contracting State as an
employee may be taxed by the State of residence, and the
remuneration also may be taxed by the other Contracting State
to the extent derived from employment exercised (i.e., services
performed) in that other Contracting State. Paragraph 1 also
provides that the more specific rules of Articles 15
(Directors' Fees), 17 (Pensions and Income from Social
Security), 18 (Government Service), 19 (Students and Trainees),
and 20 (Professors and Teachers) apply in the case of
employment income described in one of those articles. Thus,
even though the State of source has a right to tax employment
income under Article 14, it may not have the right to tax that
income under the Convention if the income is described, for
example, in Article 17 and is not taxable in the State of
source under the provisions of that Article.
Article 14 applies to any form of compensation for
employment, including payments in kind. Paragraph 1.1 of the
Commentary to Article 16 of the OECD Model now confirms that
interpretation.
Consistent with section 864(c)(6) of the Code, Article 14
also applies regardless of the timing of actual payment for
services. Consequently, a person who receives the right to a
future payment in consideration for services rendered in a
Contracting State would be taxable in that State even if the
payment is received at a time when the recipient is a resident
of the other Contracting State. Thus, a bonus paid to a
resident of a Contracting State with respect to services
performed in the other Contracting State with respect to a
particular taxable year would be subject to Article 14 for that
year even if it was paid after the close of the year. An
annuity received for services performed in a taxable year could
be subject to Article 14 despite the fact that it was paid in
subsequent years. In that case, it would be necessary to
determine whether the payment constitutes deferred
compensation, taxable under Article 14, or a qualified pension
subject to the rules of Article 17. Article 14 also applies to
income derived from the exercise of stock options granted with
respect to services performed in the host State, even if those
stock options are exercised after the employee has left the
source country. If Article 14 is found to apply, whether such
payments were taxable in the State where the employment was
exercised would depend on whether the tests of paragraph 2 were
satisfied in the year in which the services to which the
payment relates were performed.
Paragraph 2
Paragraph 2 sets forth an exception to the general rule
that employment income may be taxed in the State where it is
exercised. Under paragraph 2, the State where the employment is
exercised may not tax the income from the employment if three
conditions are satisfied: (a) the individual is present in the
other Contracting State for a period or periods not exceeding
183 days in any 12-month period that begins or ends during the
relevant taxable year (i.e., in the United States, the calendar
year in which the services are performed); (b) the remuneration
is paid by, or on behalf of, an employer who is not a resident
of that other Contracting State; and (c) the remuneration is
not borne as a deductible expense by a permanent establishment
that the employer has in that other State. In order for the
remuneration to be exempt from tax in the source State, all
three conditions must be satisfied. This exception is identical
to that set forth in the OECD Model.
The 183-day period in condition (a) is to be measured using
the ``days of physical presence'' method. Under this method,
the days that are counted include any day in which a part of
the day is spent in the host country. (Rev. Rul. 56-24, 1956-1
C.B. 851.) Thus, days that are counted include the days of
arrival and departure; weekends and holidays on which the
employee does not work but is present within the country;
vacation days spent in the country before, during or after the
employment period, unless the individual's presence before or
after the employment can be shown to be independent of his
presence there for employment purposes; and time during periods
of sickness, training periods, strikes, etc., when the
individual is present but not working. If illness prevented the
individual from leaving the country in sufficient time to
qualify for the benefit, those days will not count. Also, any
part of a day spent in the host country while in transit
between two points outside the host country is not counted. If
the individual is a resident of the host country for part of
the taxable year concerned and a nonresident for the remainder
of the year, the individual's days of presence as a resident do
not count for purposes of determining whether the 183-day
period is exceeded.
Conditions (b) and (c) are intended to ensure that a
Contracting State will not be required to allow a deduction to
the payor for compensation paid and at the same time to exempt
the employee on the amount received. Accordingly, if a foreign
person pays the salary of an employee who is employed in the
host State, but a host State corporation or permanent
establishment reimburses the payor with a payment that can be
identified as a reimbursement, neither condition (b) nor (c),
as the case may be, will be considered to have been fulfilled.
The reference to remuneration ``borne by'' a permanent
establishment is understood to encompass all expenses that
economically are incurred and not merely expenses that are
currently deductible for tax purposes. Accordingly, the
expenses referred to include expenses that are capitalizable as
well as those that are currently deductible. Further, salaries
paid by residents that are exempt from income taxation may be
considered to be borne by a permanent establishment
notwithstanding the fact that the expenses will be neither
deductible nor capitalizable since the payor is exempt from
tax.
Paragraph 3
Paragraph 3 contains a special rule applicable to
remuneration for services performed by a resident of a
Contracting State as an employee aboard a ship or aircraft
operated in international traffic. Such remuneration may be
taxed only in the State of residence of the employee if the
services are performed as a member of the regular complement of
the ship or aircraft. The ``regular complement'' includes the
crew. In the case of a cruise ship, for example, it may also
include others, such as entertainers, lecturers, etc., employed
by the shipping company to serve on the ship throughout its
voyage. The use of the term ``regular complement'' is intended
to clarify that a person who exercises his employment as, for
example, an insurance salesman while aboard a ship or aircraft
is not covered by this paragraph.
If a U.S. citizen who is resident in Hungary performs
services as an employee in the United States and meets the
conditions of paragraph 2 for source country exemption, he
nevertheless is taxable in the United States by virtue of the
saving clause of paragraph 4 of Article 1 (General Scope),
subject to the special foreign tax credit rule of paragraph 4
of Article 23 (Relief from Double Taxation).
ARTICLE 15 (DIRECTORS' FEES)
This Article provides that a Contracting State may tax the
fees and other compensation paid by a company that is a
resident of that State for services performed by a resident of
the other Contracting State in his capacity as a director of
the company. This rule is an exception to the more general
rules of Articles 7 (Business Profits) and 14 (Income from
Employment). Thus, for example, in determining whether a
director's fee paid to a non-employee director is subject to
tax in the country of residence of the corporation, it is not
relevant to establish whether the fee is attributable to a
permanent establishment in that State.
ARTICLE 16 (ENTERTAINERS AND SPORTSMEN)
This Article deals with the taxation in a Contracting State
of entertainers and sportsmen resident in the other Contracting
State from the performance of their services as such. The
Article applies both to the income of an entertainer or
sportsman who performs services on his own behalf and one who
performs services on behalf of another person, either as an
employee of that person, or pursuant to any other arrangement.
The rules of this Article take precedence, in some
circumstances, over those of Articles 7 (Business Profits) and
14 (Income from Employment).
This Article applies only with respect to the income of
entertainers and sportsmen. Others involved in a performance or
athletic event, such as producers, directors, technicians,
managers, coaches, etc., remain subject to the provisions of
Articles 7 and 14. In addition, except as provided in paragraph
2, income earned by juridical persons is not covered by Article
16.
Paragraph 1
Paragraph 1 describes the circumstances in which a
Contracting State may tax the performance income of an
entertainer or sportsman who is a resident of the other
Contracting State. Under the paragraph, income derived by an
individual resident of a Contracting State from activities as
an entertainer or sportsman exercised in the other Contracting
State may be taxed in that other State if the amount of the
gross receipts derived by the performer exceeds $20,000 (or its
equivalent in Hungarian Forints) for the taxable year. The
$20,000 includes expenses reimbursed to the individual or borne
on his behalf. If the gross receipts exceed $20,000, the full
amount, not just the excess, may be taxed in the State of
performance.
The Convention introduces this monetary threshold to
distinguish between two groups of entertainers and athletes--
those who are paid relatively large sums of money for very
short periods of service, and who would, therefore, normally be
exempt from host country tax under the standard personal
services income rules, and those who earn relatively modest
amounts and are, therefore, not easily distinguishable from
those who earn other types of personal service income.
Tax may be imposed under paragraph 1 even if the performer
would have been exempt from tax under Article 7 (Business
Profits) or 14 (Income from Employment). On the other hand, if
the performer would be exempt from host-country tax under
Article 16, but would be taxable under either Article 7 or 14,
tax may be imposed under either of those Articles. Thus, for
example, if a performer derives remuneration from his
activities in an independent capacity, and the performer does
not have a permanent establishment in the host State, he may be
taxed by the host State in accordance with Article 16 if his
remuneration exceeds $20,000 annually, despite the fact that he
generally would be exempt from host State taxation under
Article 7. However, a performer who receives less than the
$20,000 threshold amount and therefore is not taxable under
Article 16 nevertheless may be subject to tax in the host
country under Article 7 or 14 if the tests for host-country
taxability under the relevant Article are met. For example, if
an entertainer who is an independent contractor earns $14,000
of income in a State for the calendar year, but the income is
attributable to his permanent establishment in the State of
performance, that State may tax his income under Article 7.
Since it frequently is not possible to know until year-end
whether the income an entertainer or sportsman derived from
performances in a Contracting State will exceed $20,000,
nothing in the Convention precludes that Contracting State from
withholding tax during the year and refunding it after the
close of the year if the taxability threshold has not been met.
As explained in paragraph 9 of the Commentary to Article 17
of the OECD Model, Article 16 of the Convention applies to all
income connected with a performance by the entertainer, such as
appearance fees, award or prize money, and a share of the gate
receipts. Income derived from a Contracting State by a
performer who is a resident of the other Contracting State from
other than actual performance, such as royalties from record
sales and payments for product endorsements, is not covered by
this Article, but by other articles of the Convention, such as
Article 12 (Royalties) or Article 7. For example, if an
entertainer receives royalty income from the sale of live
recordings, the royalty income would be exempt from source
state tax under Article 12, even if the performance was
conducted in the source country, although the entertainer could
be taxed in the source country with respect to income from the
performance itself under Article 16 if the dollar threshold is
exceeded.
In determining whether income falls under Article 16 or
another Article, the controlling factor will be whether the
income in question is predominantly attributable to the
performance itself or to other activities or property rights.
For instance, a fee paid to a performer for endorsement of a
performance in which the performer will participate would be
considered to be so closely associated with the performance
itself that it normally would fall within Article 16.
Similarly, a sponsorship fee paid by a business in return for
the right to attach its name to the performance would be so
closely associated with the performance that it would fall
under Article 16 as well. As indicated in paragraph 9 of the
Commentary to Article 17 of the OECD Model, however, a
cancellation fee would not be considered to fall within Article
16 but would be dealt with under Article 7 or 14.
As indicated in paragraph 4 of the Commentary to Article 17
of the OECD Model, where an individual fulfills a dual role as
performer and non-performer (such as a player-coach or an
actor-director), but his role in one of the two capacities is
negligible, the predominant character of the individual's
activities should control the characterization of those
activities. In other cases there should be an apportionment
between the performance-related compensation and other
compensation.
Consistent with Article 14, Article 16 also applies
regardless of the timing of actual payment for services. Thus,
a bonus paid to a resident of a Contracting State with respect
to a performance in the other Contracting State during a
particular taxable year would be subject to Article 16 for that
year even if it was paid after the close of the year. The
determination as to whether the $20,000 threshold has been
exceeded is determined separately with respect to each year of
payment. Accordingly, if an actor who is a resident of one
Contracting State receives residual payments over time with
respect to a movie that was filmed in the other Contracting
State, the payments do not have to be aggregated from one year
to another to determine whether the total payments have finally
exceeded $20,000. Otherwise, residual payments received many
years later could retroactively subject all earlier payments to
tax by the other Contracting State.
Paragraph 2
Paragraph 2 is intended to address the potential for
circumvention of the rule in paragraph 1 when a performer's
income does not accrue directly to the performer himself, but
to another person. Foreign performers frequently perform in the
United States as employees of, or under contract with, a
company or other person.
The relationship may truly be one of employee and employer,
with no circumvention of paragraph 1 either intended or
realized. On the other hand, the ``employer'' may, for example,
be a company established and owned by the performer, which is
merely acting as the nominal income recipient in respect of the
remuneration for the performance (a ``star company''). The
performer may act as an ``employee,'' receive a modest salary,
and arrange to receive the remainder of the income from his
performance from the company in another form or at a later
time. In such case, absent the provisions of paragraph 2, the
income arguably could escape host-country tax because the
company earns business profits but has no permanent
establishment in that country. The performer may largely or
entirely escape host-country tax by receiving only a small
salary, perhaps small enough to place him below the dollar
threshold in paragraph 1. The performer might arrange to
receive further payments in a later year, when he is not
subject to host-country tax, perhaps as dividends or
liquidating distributions.
Paragraph 2 seeks to prevent this type of abuse while at
the same time protecting the taxpayers' rights to the benefits
of the Convention when there is a legitimate employee-employer
relationship between the performer and the person providing his
services. Under paragraph 2, when the income accrues to a
person other than the performer, the income may be taxed in the
Contracting State where the performer's services are exercised,
without regard to the provisions of the Convention concerning
business profits (Article 7) or income from employment (Article
14), unless the contract pursuant to which the personal
activities are performed allows the person other than the
performer to designate the individual who is to perform the
personal activities. This rule is based on the U.S. domestic
law provision characterizing income from certain personal
service contracts as foreign personal holding company income in
the context of the foreign personal holding company provisions.
See Code section 954(c)(1)(H). The premise of this rule is
that, in a case where a performer is using another person in an
attempt to circumvent the provisions of paragraph 1, the
recipient of the services of the performer would contract with
a person other than that performer (i.e., a company employing
the performer) only if the recipient of the services were
certain that the performer himself would perform the services.
If instead the person is allowed to designate the individual
who is to perform the services, then likely the person is a
service company not formed to circumvent the provisions of
paragraph 1. The following example illustrates the operation of
this rule:
Example. Company H, a resident of Hungary, is engaged in
the business of operating an orchestra. Company H enters into a
contract with Company A pursuant to which Company H agrees to
carry out two performances in the United States in
consideration of which Company A will pay Company H $200,000.
The contract designates two individuals, a conductor and a
flautist, that must perform as part of the orchestra, and
allows Company H to designate the other members of the
orchestra. Because the contract does not give Company H any
discretion to determine whether the conductor or the flautist
perform personal services under the contract, the portion of
the $200,000 which is attributable to the personal services of
the conductor and the flautist may be taxed by the United
States pursuant to paragraph 2. The remaining portion of the
$200,000, which is attributable to the personal services of
performers that Company H may designate, is not subject to tax
by the United States pursuant to paragraph 2.
In cases where paragraph 2 is applicable, the income of the
``employer'' may be subject to tax in the host Contracting
State even if it has no permanent establishment in the host
country. Taxation under paragraph 2 is on the person providing
the services of the performer. This paragraph does not affect
the rules of paragraph 1, which apply to the performer himself.
The income taxable by virtue of paragraph 2 is reduced to the
extent of salary payments to the performer, which fall under
paragraph 1.
For purposes of paragraph 2, income is deemed to accrue to
another person (i.e., the person providing the services of the
performer) if that other person has control over, or the right
to receive, gross income in respect of the services of the
performer.
Pursuant to Article 1 (General Scope), the Convention only
applies to persons who are residents of one of the Contracting
States. Thus, income of a star company that is not a resident
of either Contracting State would not be eligible for the
benefits of the Convention.
Relationship to other Articles
This Article is subject to the provisions of the saving
clause of paragraph 4 of Article 1 (General Scope). Thus, if an
entertainer or a sportsman who is resident in Hungary is a
citizen of the United States, the United States may tax all of
his income from performances in the United States without
regard to the provisions of this Article (subject to the
special foreign tax credit provisions of paragraph 4 of Article
23 (Relief from Double Taxation)). In addition, benefits of
this Article are subject to the provisions of Article 22
(Limitation on Benefits).
ARTICLE 17 (PENSIONS AND INCOME FROM SOCIAL SECURITY)
This Article deals with the taxation of private (i.e., non-
government service) pensions and social security benefits,.
Paragraph 1
Paragraph 1 provides that distributions from pensions and
other similar remuneration beneficially owned by a resident of
a Contracting State in consideration of past employment are
taxable only in the State of residence of the beneficiary. The
term ``pensions and other similar remuneration'' includes both
periodic and single sum payments.
The phrase ``pensions and other similar remuneration'' is
intended to encompass payments made by qualified private
retirement plans. In the United States, the plans encompassed
by Paragraph 1 include: qualified plans under section 401(a),
individual retirement plans (including individual retirement
plans that are part of a simplified employee pension plan that
satisfies section 408(k), individual retirement accounts and
section 408(p) accounts), section 403(a) qualified annuity
plans, and section 403(b) plans. Distributions from section 457
plans may also fall under Paragraph 1 if they are not paid with
respect to government services covered by Article 19. The
competent authorities may agree that distributions from other
plans that generally meet similar criteria to those applicable
to the listed plans also qualify for the benefits of Paragraph
1.
Pensions in respect of government services covered by
Article 18 are not covered by this paragraph. They are covered
either by paragraph 2 of this Article, if they are in the form
of social security benefits, or by paragraph 2 of Article 18
(Government Service). Thus, Article 18 generally covers section
457, 401(a), 403(b) plans established for government employees,
and the Thrift Savings Plan (section 7701(j)).
Subparagraph 1(b) contains an exception to the State of
residence's right to tax pensions and other similar
remuneration under subparagraph 1(a). Under subparagraph 1(b),
the State of residence must exempt from tax the amount of any
such pensions or other similar remuneration that would be
exempt from tax in the Contracting State in which the pension
fund is established if the recipient were a resident of that
State. Thus, for example, a distribution from a U.S. ``Roth
IRA'' to a resident of Hungary would be exempt from tax in
Hungary to the same extent the distribution would be exempt
from tax in the United States if it were distributed to a U.S.
resident. The same is true with respect to distributions from a
traditional IRA to the extent that the distribution represents
a return of non-deductible contributions. Similarly, if the
distribution were not subject to tax when it was ``rolled
over'' into another U.S. IRA (but not, for example, to a
pension fund in the other Contracting State), then the
distribution would be exempt from tax in Hungary.
Paragraph 2
The treatment of social security benefits is dealt with in
paragraph 2. Subparagraph 2(a) provides that, notwithstanding
the provision of paragraph 1 under which private pensions are
taxable exclusively in the State of residence of the beneficial
owner, payments made by the United States under the provisions
of the social security or similar legislation of the United
States to a resident of Hungary will be taxable only in the
United States. Subparagraph 2(b) provides that payments made by
Hungary under the mandatory pension scheme of Hungary to a
resident or citizen of the United States are taxable only in
Hungary. The reference to U.S. citizens is necessary to ensure
that a social security payment by Hungary to a U.S. citizen who
is not resident in the United States will not be taxable by the
United States.
This paragraph applies to social security and mandatory
pension scheme beneficiaries whether they have contributed to
the system as private sector or Government employees. The
phrase ``similar legislation'' is intended to refer to United
States tier 1 railroad retirement benefits.
Paragraph 3
Paragraph 3 provides that, if a resident of a Contracting
State participates in a pension fund established in the other
Contracting State, the State of residence will not tax the
income of the pension fund with respect to that resident until
a distribution is made from the pension fund. Thus, for
example, if a U.S. citizen contributes to a U.S. qualified plan
while working in the United States and then establishes
residence in the Hungary, paragraph 3 prevents Hungary from
taxing currently the plan's earnings and accretions with
respect to that individual. When the resident receives a
distribution from the pension fund, that distribution may be
subject to tax in the State of residence, subject to paragraph
1.
Relationship to other Articles
Subparagraph 1(a) of Article 17 is subject to the saving
clause of paragraph 4 of Article 1 (General Scope). Thus, a
U.S. citizen who is resident in Hungary and receives a pension
payment from the United States, may be subject to U.S. tax on
the payment, notwithstanding the rules in subparagraph 1(a)
that give the State of residence of the recipient the exclusive
taxing right. Subparagraph 1(b) and paragraphs 2 and 3 are
excepted from the saving clause by virtue of subparagraph 5(a)
of Article 1. Thus, the United States will not tax U.S.
citizens and residents on the income described in those
paragraphs even if such amounts otherwise would be subject to
tax under U.S. law.
ARTICLE 18 (GOVERNMENT SERVICE)
Paragraph 1
Subparagraphs 1(a) and 1(b) deal with the taxation of
government compensation (other than a pension addressed in
paragraph 2). Subparagraph 1(a) provides that remuneration paid
by a Contracting State or a political subdivision or local
authority thereof to any individual who is rendering services
to that State, political subdivision or local authority is
exempt from tax by the other State. Under subparagraph (b),
such payments are, however, taxable exclusively in the other
State (i.e., the host State) if the services are rendered in
that other State and the individual is a resident of that State
who is either a national of that State or a person who did not
become resident of that State solely for purposes of rendering
the services.
Paragraph 2
Paragraph 2 deals with the taxation of pensions paid by, or
out of funds created by, one of the States, or a political
subdivision or a local authority thereof, to an individual in
respect of services rendered to that State or subdivision or
authority. Subparagraph (a) provides that such pensions are
taxable only in that State. Subparagraph (b) provides an
exception under which such pensions are taxable only in the
other State if the individual is a resident of, and a national
of, that other State.
Pensions paid to retired civilian and military employees of
a Government of either State are intended to be covered under
paragraph 2. When benefits paid by a State in respect of
services rendered to that State or a subdivision or authority
are in the form of social security benefits, however, those
payments are covered by paragraph 2 of Article 17 (Pensions and
Income From Social Security). As a general matter, the result
will be the same whether Article 17 or 18 applies, since social
security benefits are taxable exclusively by the source country
and so are government pensions. The result will differ only
when the payment is made to a citizen and resident of the other
Contracting State, who is not also a citizen of the paying
State. In such a case, social security benefits continue to be
taxable at source while government pensions become taxable only
in the residence country.
Paragraph 3
Paragraph 3 provides that the remuneration described in
paragraph 1 will be subject to the rules of Articles 14 (Income
from Employment), 15 (Directors' Fees), 16 (Entertainers and
Sportsmen) or 17 (Pensions and Income From Social Security) if
the recipient of the income is employed by a business conducted
by a government.
Relationship to other Articles
Under subparagraph 5(b) of Article 1 (General Scope), the
saving clause of paragraph 4 of Article 1 does not apply to the
benefits conferred by one of the States under Article 18 if the
recipient of the benefits is neither a citizen of that State,
nor a person who has been admitted for permanent residence
there (i.e., in the United States, a ``green card'' holder).
Thus, a resident of the United States who in the course of
performing functions of a governmental nature becomes a
resident of Hungary (but not a permanent resident), would be
entitled to the benefits of this Article. Similarly, an
individual who receives a pension paid by the Government of
Hungary in respect of services rendered to the Government of
Hungary shall be taxable on this pension only in Hungary unless
the individual is a U.S. citizen or acquires a U.S. green card.
ARTICLE 19 (STUDENTS AND TRAINEES)
This Article provides rules for the taxation of visiting
students and business trainees. Persons who meet the tests of
the Article will be exempt from tax in the State that they are
visiting with respect to designated classes of income. Several
conditions must be satisfied in order for an individual to be
entitled to the benefits of this Article.
First, the visitor must have been, either at the time of
his arrival in the host State or immediately before, a resident
of the other Contracting State.
Second, the primary purpose of the visit must be the
education or training of the visitor. Thus, if the visitor
comes principally to work in the host State but also is a part-
time student, he would not be entitled to the benefits of this
Article, even with respect to any payments he may receive from
abroad for his maintenance or education, and regardless of
whether or not he is in a degree program.
The host-country exemption applies to payments received by
the student or business trainee for the purpose of his
maintenance, education or training that arise outside the host
State.
A payment will be considered to arise outside the host
State if the payer is located outside the host State. Thus, if
an employer from one of the Contracting States sends an
employee to the other Contracting State for training, the
payments the trainee receives from abroad from his employer for
his maintenance or training while he is present in the host
State will be exempt from tax in the host State. Where
appropriate, substance prevails over form in determining the
identity of the payer. Thus, for example, payments made
directly or indirectly by a U.S. person with whom the visitor
is training, but which have been routed through a source
outside the United States (e.g., a foreign subsidiary), are not
treated as arising outside the United States for this purpose.
The Article also provides a limited exemption for
remuneration from personal services rendered in the host State
with a view to supplementing the resources available to him for
such purposes to the extent of $9,000 United States dollars (or
its equivalent in Hungarian Forints) per taxable year. The
specified amount is intended to equalize the position of a U.S.
resident who is entitled to the standard deduction and the
personal exemption with that of a student who files as a non-
resident alien and therefore is not. Accordingly, the competent
authorities are instructed to adjust this amount every five
years, if necessary, to take into account changes in the amount
of the U.S. standard deduction and personal exemption.
In the case of a business trainee, the benefits of the
Article will extend only for a period of one year from the time
that the visitor first arrives in the host country. If,
however, a trainee remains in the host country for a second
year, thus losing the benefits of the Article, he would not
retroactively lose the benefits of the Article for the first
year. The term ``business trainee'' is defined as a person who
is in the country temporarily for the purpose of securing
training that is necessary to qualify to pursue a profession or
professional specialty. Moreover, the person must be employed
or under contract with a resident of the other Contracting
State and must be receiving the training from someone who is
not related to its employer. Thus, a business trainee might
include a lawyer employed by a law firm in one Contracting
State who works for one year as a stagiaire in an unrelated law
firm in the other Contracting State. However, the term would
not include a manager who normally is employed by a parent
company in one Contracting State who is sent to the other
Contracting State to run a factory owned by a subsidiary of the
parent company.
Relationship to other Articles
Under subparagraph 5(b) of Article 1, the saving clause of
paragraph 4 of Article 1 (General Scope) does not apply to this
Article with respect to an individual who is neither a citizen
of the host State nor has been admitted for permanent residence
there. The saving clause, however, does apply with respect to
citizens and permanent residents of the host State. Thus, a
citizen who is a resident of Hungary and who visits the United
States for the primary purpose of attending an accredited
university will not be exempt from U.S. tax on remittances from
abroad that otherwise constitute U.S. taxable income. A person,
however, who is not a citizen, and who visits the United States
as a student and remains long enough to become a resident under
U.S. law, but does not become a permanent resident (i.e., does
not acquire a green card), will be entitled to the full
benefits of the Article.
ARTICLE 20 (PROFESSORS AND TEACHERS)
Paragraph 1
Paragraph 1 provides an exemption from tax in a host
Contracting State for an individual who visits that State for a
period not exceeding two years for the purpose of teaching or
carrying out advanced study (including research) at a
university, college or other recognized research institute or
other establishment for higher education in that State. This
rule applies only if the individual is a resident of the other
Contracting State immediately before his visit begins. The
exemption applies to any remuneration for such teaching or
research. The exemption from tax applies for a period not
exceeding two years from the date he first visits the host
State for the purpose of teaching or engaging in research at a
university, college or other recognized research institute or
other establishment for higher education there. If a professor
or teacher remains in the host State for more than the
specified two year period, he may be subject to tax in that
State, under its law, for the entire period of his presence.
The host State exemption will apply if the teaching or
research is carried on at an accredited university, college,
school or other recognized educational institution.
Paragraph 2
Paragraph 2 provides that the preceding provisions of the
Article shall apply to income from research only if such
research is undertaken by the individual in the public interest
and not primarily for the benefit of a specific person or
persons.
Under subparagraph 5(b) of Article 1 (General Scope), the
saving clause of paragraph 4 of Article 1 does not apply to the
benefits conferred by one of the States under this Article if
the recipient of the benefits is neither a citizen nor a lawful
permanent resident of that State. Thus, a resident of Hungary
who visits the United States for two academic years as a
professor and becomes a U.S. resident according to the Code,
other than by virtue of acquiring a green card, would continue
to be exempt from U.S. tax in accordance with this article so
long as he is not a U.S. citizen and does not acquire immigrant
status in the United States.
ARTICLE 21 (OTHER INCOME)
Article 21 generally assigns taxing jurisdiction over
income not dealt with in the other Articles (Articles 6 through
20) of the Convention to the State of residence of the
beneficial owner of the income. In order for an item of income
to be ``dealt with'' in another Article it must be the type of
income described in the article and, in most cases, it must
have its source in a Contracting State. For example, all
royalty income that arises in a Contracting State and that is
beneficially owned by a resident of the other Contracting State
is ``dealt with'' in Article 12 (Royalties). However, profits
derived in the conduct of a business are ``dealt with'' in
Article 7 (Business Profits) whether or not they have their
source in one of the Contracting States.
Examples of items of income covered by Article 21 include
income from gambling, punitive (but not compensatory) damages
and covenants not to compete. The Article would also apply to
income from a variety of financial transactions, where such
income does not arise in the course of the conduct of a trade
or business. For example, income from notional principal
contracts and other derivatives would fall within Article 21 if
derived by persons not engaged in the trade or business of
dealing in such instruments, unless such instruments were being
used to hedge risks arising in a trade or business. It would
also apply to securities lending fees derived by an
institutional investor. Further, in most cases guarantee fees
paid within an intercompany group would be covered by Article
21, unless the guarantor were engaged in the business of
providing such guarantees to unrelated parties.
Article 21 also applies to items of income that are not
dealt with in the other Articles because of their source or
some other characteristic. For example, Article 11 (Interest)
addresses only the taxation of interest arising in a
Contracting State. Interest arising in a third State that is
not attributable to a permanent establishment, therefore, is
subject to Article 21.
Distributions from partnerships are not generally dealt
with under Article 21 because partnership distributions
generally do not constitute income. Under the Code, partners
include in income their distributive share of partnership
income annually, and partnership distributions themselves
generally do not give rise to income. This would also be the
case under U.S. law with respect to distributions from trusts.
Trust income and distributions that, under the Code, have the
character of the associated distributable net income would
generally be covered by another article of the Convention. See
Code section 641 et seq.
Paragraph 1
The general rule of Article 21 is contained in paragraph 1.
Items of income not dealt with in other Articles and
beneficially owned by a resident of a Contracting State will be
taxable only in the State of residence. This exclusive right of
taxation applies whether or not the residence State exercises
its right to tax the income covered by the Article.
The reference in this paragraph to ``items of income
beneficially owned by a resident of a Contracting State''
rather than simply ``items of income of a resident of a
Contracting State,'' as in the OECD Model, is intended merely
to make explicit the implicit understanding in other treaties
that the exclusive residence taxation provided by paragraph 1
applies only when a resident of a Contracting State is the
beneficial owner of the income. Thus, source taxation of income
not dealt with in other articles of the Convention is not
limited by paragraph 1 if it is nominally paid to a resident of
the other Contracting State, but is beneficially owned by a
resident of a third State. However, income received by a
nominee on behalf of a resident of that other State would be
entitled to benefits.
The term ``beneficially owned'' is not defined in the
Convention, and is, therefore, defined as under the internal
law of the country imposing tax (i.e., the source country). The
person who beneficially owns the income for purposes of Article
21 is the person to which the income is attributable for tax
purposes under the laws of the source State.
Paragraph 2
This paragraph provides an exception to the general rule of
paragraph 1 where the right or property in respect of which the
income is paid is effectively connected with a permanent
establishment maintained in a Contracting State by a resident
of the other Contracting State. The taxation of such income is
governed by the provisions of Article 7 (Business Profits).
Therefore, income arising outside the United States that is
attributable to a permanent establishment maintained in the
United States by a resident of Hungary generally would be
taxable by the United States under the provisions of Article 7.
This would be true even if the income is sourced in a third
State.
Relationship to Other Articles
This Article is subject to the saving clause of paragraph 4
of Article 1 (General Scope). Thus, the United States may tax
the income of a resident of the other Contracting State that is
not dealt with elsewhere in the Convention, if that resident is
a citizen of the United States. The Article is also subject to
the provisions of Article 22 (Limitation on Benefits). Thus, if
a resident of the other Contracting State earns income that
falls within the scope of paragraph 1 of Article 21, but that
is taxable by the United States under U.S. law, the income
would be exempt from
U.S. tax under the provisions of Article 21 only if the
resident satisfies one of the tests of Article 22 for
entitlement to benefits.
ARTICLE 22 (LIMITATION ON BENEFITS)
Article 22 contains anti-treaty-shopping provisions that
are intended to prevent residents of third countries from
benefiting from what is intended to be a reciprocal agreement
between two countries. In general, the provision does not rely
on a determination of purpose or intention but instead sets
forth a series of objective tests. A resident of a Contracting
State that satisfies one of the tests will receive benefits
regardless of its motivations in choosing its particular
business structure.
The structure of the Article is as follows: Paragraph 1
states the general rule that residents are entitled to benefits
otherwise accorded to residents only to the extent provided in
the Article. Paragraph 2 lists a series of attributes of a
resident of a Contracting State, the presence of any one of
which will entitle that person to all the benefits of the
Convention. Paragraph 3 provides that, regardless of whether a
person qualifies for benefits under paragraph 2, benefits may
be granted to that person with regard to certain income earned
in the conduct of an active trade or business. Paragraph 4
provides a so-called ``derivative benefits'' test under which
certain income may qualify for benefits. Paragraph 5 provides
that a so-called headquarters company resident in a Contracting
State may qualify for benefits if certain conditions are met.
Paragraph 6 provides special rules for so-called ``triangular
cases,'' notwithstanding the other provisions of the Article.
Paragraph 7 provides that benefits also may be granted if the
competent authority of the State from which benefits are
claimed determines that it is appropriate to provide benefits
in that case. Paragraph 8 defines certain terms used in the
Article.
Paragraph 1
Paragraph 1 provides that, except as otherwise provided in
Article 22, a resident of a Contracting State will be entitled
to all the benefits otherwise accorded to residents of a
Contracting State under the Convention only to the extent
provided in paragraph 2.
The benefits otherwise accorded to residents under the
Convention include all limitations on source-based taxation
under Articles 6 through 21, the treaty-based relief from
double taxation provided by Article 23, and the protection
afforded to residents of a Contracting State under Article 24.
Some provisions do not require that a person be a resident in
order to enjoy the benefits of those provisions. Article 25 is
not limited to residents of the Contracting States, and Article
27 applies to diplomatic agents or consular officials
regardless of residence. Article 22 accordingly does not limit
the availability of treaty benefits under these provisions.
Article 22 and the anti-abuse provisions of domestic law
complement each other, as Article 22 effectively determines
whether an entity has a sufficient nexus to the Contracting
State to be treated as a resident for treaty purposes, while
domestic anti-abuse provisions (e.g., business purpose,
substance-over-form, step transaction or conduit principles)
determine whether a particular transaction should be recast in
accordance with its substance. Thus, internal law principles of
the source Contracting State may be applied to identify the
beneficial owner of an item of income, and Article 22 then will
be applied to the beneficial owner to determine if that person
is entitled to the benefits of the Convention with respect to
such income.
Paragraph 2
Paragraph 2 has five subparagraphs, each of which describes
a category of residents that are entitled to all benefits of
the Convention.
It is intended that the provisions of paragraph 2 will be
self-executing. Unlike the provisions of paragraph 7, discussed
below, claiming benefits under paragraph 2 does not require
advance competent authority ruling or approval. The tax
authorities may, of course, on review, determine that the
taxpayer has improperly interpreted the paragraph and is not
entitled to the benefits claimed.
Individuals--Subparagraph 2(a)
Subparagraph 2(a) provides that individual residents of a
Contracting State will be entitled to all treaty benefits. If
such an individual receives income as a nominee on behalf of a
third country resident, benefits may be denied under the
respective articles of the Convention by the requirement that
the beneficial owner of the income be a resident of a
Contracting State.
Governments--Subparagraph 2(b)
Subparagraph 2(b) provides that the Contracting States and
any political subdivision or local authority thereof will be
entitled to all benefits of the Convention.
Publicly-Traded Corporations--Subparagraph 2(c)(i)
Subparagraph 2(c) applies to two categories of companies:
publicly traded companies and subsidiaries of publicly traded
companies. A company resident in a Contracting State is
entitled to all the benefits of the Convention under clause (i)
of subparagraph (c) if the principal class of its shares, and
any disproportionate class of shares, is regularly traded on
one or more recognized stock exchanges and the company
satisfies at least one of the following additional
requirements: first, the company's principal class of shares is
primarily traded on one or more recognized stock exchanges
located in the Contracting State of which the company is a
resident, or, in the case of 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, in
the case of a company resident in the United States, on a
recognized stock exchange located in another state that is a
party to the North American Free Trade Agreement; or, second,
the company's primary place of management and control is in its
State of residence.
The term ``recognized stock exchange'' is defined in
subparagraph (a) of paragraph 8. It includes (i) the NASDAQ
System and any stock exchange registered with the Securities
and Exchange Commission as a national securities exchange for
purposes of the Securities Exchange Act of 1934, (ii) the stock
exchange of Budapest, (iii) the stock exchanges of Amsterdam,
Brussels, Frankfurt, London, Paris, Vienna, Warsaw, and Zurich;
and (iv) any other stock exchange agreed upon by the competent
authorities of the Contracting States.
If a company has only one class of shares, it is only
necessary to consider whether the shares of that class meet the
relevant trading requirements. If the company has more than one
class of shares, it is necessary as an initial matter to
determine which class or classes constitute the ``principal
class of shares''. The term ``principal class of shares'' is
defined in subparagraph 8(b) to mean the ordinary or common
shares of the company representing the majority of the
aggregate voting power and value of the company. If the company
does not have a class of ordinary or common shares representing
the majority of the aggregate voting power and value of the
company, then the ``principal class of shares'' is that class
or any combination of classes of shares that represents, in the
aggregate, a majority of the voting power and value of the
company. Although in a particular case involving a company with
several classes of shares it is conceivable that more than one
group of classes could be identified that account for more than
50% of the shares, it is only necessary for one such group to
satisfy the requirements of this subparagraph in order for the
company to be entitled to benefits. Benefits would not be
denied to the company even if a second, non-qualifying, group
of shares with more than half of the company's voting power and
value could be identified.
A company whose principal class of shares is regularly
traded on a recognized stock exchange will nevertheless not
qualify for benefits under subparagraph 2(c)(i) if it has a
disproportionate class of shares that is not regularly traded
on a recognized stock exchange. The term ``disproportionate
class of shares'' is defined in subparagraph 8(c). A company
has a disproportionate class of shares if it has outstanding a
class of shares which is subject to terms or other arrangements
that entitle the holder to a larger portion of the company's
income, profit, or gain in the other Contracting State than
that to which the holder would be entitled in the absence of
such terms or arrangements. Thus, for example, a company
resident in Hungary meets the test of subparagraph 8(c) if it
has outstanding a class of ``tracking stock'' that pays
dividends based upon a formula that approximates the company's
return on its assets employed in the United States.
The following example illustrates this result.
Example. HCo is a corporation resident in Hungary. HCo has
two classes of shares: Common and Preferred. The Common shares
are listed and regularly traded on the Budapest Stock Exchange.
The Preferred shares have no voting rights and are entitled to
receive dividends equal in amount to interest payments that HCo
receives from unrelated borrowers in the United States. The
Preferred shares are owned entirely by a single investor that
is a resident of a country with which the United States does
not have a tax treaty. The Common shares account for more than
50 percent of the value of HCo and for 100 percent of the
voting power. Because the owner of the Preferred shares is
entitled to receive payments corresponding to the U.S. source
interest income earned by HCo, the Preferred shares are a
disproportionate class of shares. Because the Preferred shares
are not regularly traded on a recognized stock exchange, MCo
will not qualify for benefits under subparagraph 2(c)(i).
The term ``regularly traded'' is not defined in the
Convention. In accordance with paragraph 2 of Article 3
(General Definitions), this term will be defined by reference
to the domestic tax laws of the State from which treaty
benefits are sought, generally the source State. In the case of
the United States, this term is understood to have the meaning
it has under Treas. Reg. section 1.884-5(d)(4)(i)(B), relating
to the branch tax provisions of the Code. Under these
regulations, a class of shares is considered to be ``regularly
traded'' if two requirements are met: trades in the class of
shares are made in more than de minimis quantities on at least
60 days during the taxable year, and the aggregate number of
shares in the class traded during the year is at least 10
percent of the average number of shares outstanding during the
year. Sections 1.884-5(d)(4)(i)(A), (ii) and (iii) will not be
taken into account for purposes of defining the term
``regularly traded'' under the Convention.
The regular trading requirement can be met by trading on
any recognized exchange or exchanges located in either State.
Trading on one or more recognized stock exchanges may be
aggregated for purposes of this requirement. Thus, a U.S.
company could satisfy the regularly traded requirement through
trading, in whole or in part, on a recognized stock exchange
located in Hungary. Authorized but unissued shares are not
considered for purposes of this test.
The term ``primarily traded'' is not defined in the
Convention. In accordance with paragraph 2 of Article 3, this
term will have the meaning it has under the laws of the State
concerning the taxes to which the Convention applies, generally
the source State. In the case of the United States, this term
is understood to have the meaning it has under Treas. Reg.
section 1.884-5(d)(3), relating to the branch tax provisions of
the Code. Accordingly, stock of a corporation is ``primarily
traded'' if the number of shares in the company's principal
class of shares that are traded during the taxable year on all
recognized stock exchanges in the Contracting State of which
the company is a resident exceeds the number of shares in the
company's principal class of shares that are traded during that
year on established securities markets in any other single
foreign country.
A company whose principal class of shares is regularly
traded on a recognized exchange but cannot meet the primarily
traded test may claim treaty benefits if its primary place of
management and control is in its country of residence. This
test should be distinguished from the ``place of effective
management'' test which is used in the OECD Model and by many
other countries to establish residence. In some cases, the
place of effective management test has been interpreted to mean
the place where the board of directors meets. By contrast, the
primary place of management and control test looks to where
day-to-day responsibility for the management of the company
(and its subsidiaries) is exercised. The company's primary
place of management and control will be located in the State in
which the company is a resident only if the executive officers
and senior management employees exercise day-to-day
responsibility for more of the strategic, financial and
operational policy decision making for the company (including
direct and indirect subsidiaries) in that State than in the
other State or any third state, and the staff that support the
management in making those decisions are also based in that
State. Thus, the test looks to the overall activities of the
relevant persons to see where those activities are conducted.
In most cases, it will be a necessary, but not a
sufficient, condition that the headquarters of the company
(that is, the place at which the CEO and other top executives
normally are based) be located in the Contracting State of
which the company is a resident.
To apply the test, it will be necessary to determine which
persons are to be considered ``executive officers and senior
management employees''. In most cases, it will not be necessary
to look beyond the executives who are members of the Board of
Directors (the ``inside directors'') in the case of a U.S.
company. That will not always be the case, however; in fact,
the relevant persons may be employees of subsidiaries if those
persons make the strategic, financial and operational policy
decisions. Moreover, it would be necessary to take into account
any special voting arrangements that result in certain board
members making certain decisions without the participation of
other board members.
Subsidiaries of Publicly-Traded Corporations--Subparagraph 2(c)(ii)
A company resident in a Contracting State is entitled to
all the benefits of the Convention under subparagraph 2(c)(ii)
if five or fewer publicly traded companies described in
subparagraph 2(c)(i) are the direct or indirect owners of at
least 50 percent of the aggregate vote and value of the
company's shares (and at least 50 percent of any
disproportionate class of shares). If the publicly-traded
companies are indirect owners, however, each of the
intermediate companies must be a resident of one of the
Contracting States.
Thus, for example, a company that is a resident of Hungary,
all the shares of which are owned by another company that is a
resident of Hungary, would qualify for benefits under
subparagraph 2(c) if the principal class of shares (and any
disproportionate classes of shares) of the parent company are
regularly and primarily traded on a recognized stock exchange
in Hungary. However, such a subsidiary would not qualify for
benefits under clause (ii) if the publicly traded parent
company were a resident of a third state, for example, and not
a resident of the United States or Hungary. Furthermore, if a
parent company in Hungary indirectly owned the bottom-tier
company through a chain of subsidiaries, each such subsidiary
in the chain, as an intermediate owner, must be a resident of
the United States or Hungary in order for the subsidiary to
meet the test in clause (ii).
Tax Exempt Organizations--Subparagraph 2(d)
Subparagraph 2(d) provides rules by which the tax exempt
organizations described in paragraph 2 of Article 4 (Resident)
will be entitled to all the benefits of the Convention. A
pension fund will qualify for benefits if more than fifty
percent of the beneficiaries, members or participants of the
organization are individuals resident in either Contracting
State. For purposes of this provision, the term
``beneficiaries'' should be understood to refer to the persons
receiving benefits from the organization. On the other hand, a
tax-exempt organization other than a pension fund automatically
qualifies for benefits, without regard to the residence of its
beneficiaries or members. Entities qualifying under this rule
generally are those that are exempt from tax in their State of
residence and that are organized and operated exclusively to
fulfill religious, charitable, scientific, artistic, cultural,
or educational purposes.
Ownership/Base Erosion--Subparagraph 2(e)
Subparagraph 2(e) provides an additional method to qualify
for treaty benefits that applies to any form of legal entity
that is a resident of a Contracting State. The test provided in
subparagraph (e), the so-called ownership and base erosion
test, is a two-part test. Both prongs of the test must be
satisfied for the resident to be entitled to treaty benefits
under subparagraph 2(e).
The ownership prong of the test, under clause (i), requires
that 50 percent or more of each class of shares or other
beneficial interests in the person is owned, directly or
indirectly, on at least half the days of the person's taxable
year by persons who are residents of the Contracting State of
which that person is a resident and that are themselves
entitled to treaty benefits under subparagraphs 2(a), 2(b),
2(c)(i), or 2(d). In the case of indirect owners, however, each
of the intermediate owners must be a resident of that
Contracting State. Paragraph 6 of the Exchange of Notes
provides that the conditions of clause (i) may be met if the
ownership test is satisfied on at least half of the days of the
taxable year, without regard to whether the days on which the
test is satisfied are consecutive.
Trusts may be entitled to benefits under this provision if
they are treated as residents under Article 4 (Residence) and
they otherwise satisfy the requirements of this subparagraph.
For purposes of this subparagraph, the beneficial interests in
a trust will be considered to be owned by its beneficiaries in
proportion to each beneficiary's actuarial interest in the
trust. The interest of a remainder beneficiary will be equal to
100 percent less the aggregate percentages held by income
beneficiaries. A beneficiary's interest in a trust will not be
considered to be owned by a person entitled to benefits under
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) if it is not
possible to determine the beneficiary's actuarial interest.
Consequently, if it is not possible to determine the actuarial
interest of the beneficiaries in a trust, the ownership test
under clause i) cannot be satisfied, unless all possible
beneficiaries are persons entitled to benefits under
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d).
The base erosion prong of clause (ii) of subparagraph (e)
is satisfied with respect to a person if less than 50 percent
of the person's gross income for the taxable year, as
determined under the tax law in the person's State of
residence, is paid or accrued to persons who are not residents
of either Contracting State entitled to benefits under
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d), in the form of
payments deductible for tax purposes in the payer's State of
residence. These amounts do not include arm's-length payments
in the ordinary course of business for services or tangible
property. Such amounts also do not include payments in respect
of financial obligations to a bank (including, in the case of
Hungary, a credit institution) that is not related to the
payor. Paragraph 7 of the Exchange of Notes provides the term
``accrued'' has the meaning given to it under the domestic law
(including accounting principles applicable for tax purposes)
of the State of residence of the person seeking the benefits of
the Convention. To the extent they are deductible from the
taxable base, trust distributions are deductible payments.
However, depreciation and amortization deductions, which do not
represent payments or accruals to other persons, are
disregarded for this purpose.
Paragraph 3
Paragraph 3 sets forth an alternative test under which a
resident of a Contracting State may receive treaty benefits
with respect to certain items of income that are connected to
an active trade or business conducted in its State of
residence. A resident of a Contracting State may qualify for
benefits under paragraph 3 whether or not it also qualifies
under paragraph 2 or 4.
Subparagraph 3(a) sets forth the general rule that a
resident of a Contracting State engaged in the active conduct
of a trade or business in that State may obtain the benefits of
the Convention with respect to an item of income derived in the
other Contracting State. As provided in paragraph 9 of the
Exchange of Notes, however, the item of income must be derived
in connection with or incidental to that trade or business.
The term ``trade or business'' is not defined in the
Convention. Pursuant to paragraph 2 of Article 3 (General
Definitions), when determining whether a resident of Hungary is
entitled to the benefits of the Convention under paragraph 3 of
this Article with respect to an item of income derived from
sources within the United States, the United States will
ascribe to this term the meaning that it has under the law of
the United States. Accordingly, the U.S. competent authority
will refer to the regulations issued under section 367(a) for
the definition of the term ``trade or business.'' In general,
therefore, a trade or business will be considered to be a
specific unified group of activities that constitute or could
constitute an independent economic enterprise carried on for
profit. Furthermore, a corporation generally will be considered
to carry on a trade or business only if the officers and
employees of the corporation conduct substantial managerial and
operational activities.
The business of making or managing investments for the
resident's own account will be considered to be a trade or
business only when part of insurance or securities activities
conducted by an insurance company or a registered securities
dealer. In the case of a resident of the United States, the
business of making or managing investments for the resident's
own account will also be considered to be a trade or business
when part of banking activities carried on by a bank. In the
case of a resident of Hungary, such a business will be
considered a trade or business when part of regulated financial
services carried on by a financial institution. Paragraph 8 of
the Exchange of Notes provides that the term ``regulated
financial services'' means the services listed in paragraph (1)
of section 3 of Hungarian Act CXII of 1996 on Credit
Institutions and Financial Enterprises, or any subsequently
enacted similar legislation agreed to by the competent
authorities.
Such investment activities conducted by a person other than
a bank, insurance company, registered securities dealer, or
financial institution will not be considered to be the conduct
of an active trade or business, nor would they be considered to
be the conduct of an active trade or business if conducted by a
bank, insurance company, registered securities dealer, or
financial institution, but not as part of the company's
banking, insurance, dealer, or regulated financial services
business. Because a headquarters operation is in the business
of managing investments, a company that functions solely as a
headquarters company will not be considered to be engaged in an
active trade or business for purposes of paragraph 3. It may,
however, qualify for benefits under paragraph 5.
An item of income is derived in connection with a trade or
business if the income-producing activity in the State of
source is a line of business that ``forms a part of'' or is
``complementary'' to the trade or business conducted in the
State of residence by the income recipient.
A business activity generally will be considered to form
part of a business activity conducted in the State of source if
the two activities involve the design, manufacture or sale of
the same products or type of products, or the provision of
similar services. The line of business in the State of
residence may be upstream, downstream, or parallel to the
activity conducted in the State of source. Thus, the line of
business may provide inputs for a manufacturing process that
occurs in the State of source, may sell the output of that
manufacturing process, or simply may sell the same sorts of
products that are being sold by the trade or business carried
on in the State of source.
Example 1. USCo is a corporation resident in the United
States. USCo is engaged in an active manufacturing business in
the United States. USCo owns 100 percent of the shares of HCo,
a corporation resident in Hungary. HCo distributes USCo
products in Hungary. Since the business activities conducted by
the two corporations involve the same products, HCo's
distribution business is considered to form a part of USCo's
manufacturing business.
Example 2. The facts are the same as in Example 1, except
that USCo does not manufacture. Rather, USCo operates a large
research and development facility in the United States that
licenses intellectual property to affiliates worldwide,
including HCo. HCo and other USCo affiliates then manufacture
and market the USCo-designed products in their respective
markets. Since the activities conducted by HCo and USCo involve
the same product lines, these activities are considered to form
a part of the same trade or business.
For two activities to be considered to be
``complementary,'' the activities need not relate to the same
types of products or services, but they should be part of the
same overall industry and be related in the sense that the
success or failure of one activity will tend to result in
success or failure for the other. Where more than one trade or
business is conducted in the State of source and only one of
the trades or businesses forms a part of or is complementary to
a trade or business conducted in the State of residence, it is
necessary to identify the trade or business to which an item of
income is attributable. Royalties generally will be considered
to be derived in connection with the trade or business to which
the underlying intangible property is attributable. Dividends
will be deemed to be derived first out of earnings and profits
of the treaty-benefited trade or business, and then out of
other earnings and profits. Interest income may be allocated
under any reasonable method consistently applied. A method that
conforms to U.S. principles for expense allocation will be
considered a reasonable method.
Example 3. Americair is a corporation resident in the
United States that operates an international airline. HSub is a
wholly-owned subsidiary of Americair resident in Hungary. HSub
operates a chain of hotels in Hungary that are located near
airports served by Americair flights. Americair frequently
sells tour packages that include air travel to Hungary and
lodging at HSub hotels. Although both companies are engaged in
the active conduct of a trade or business, the businesses of
operating a chain of hotels and operating an airline are
distinct trades or businesses. Therefore HSub's business does
not form a part of Americair's business. However, HSub's
business is considered to be complementary to Americair's
business because they are part of the same overall industry
(travel) and the links between their operations tend to make
them interdependent.
Example 4. The facts are the same as in Example 3, except
that HSub owns an office building in Hungary instead of a hotel
chain. No part of Americair's business is conducted through the
office building. HSub's business is not considered to form a
part of or to be complementary to Americair's business. They
are engaged in distinct trades or businesses in separate
industries, and there is no economic dependence between the two
operations.
Example 5. USFlower is a corporation resident in the United
States. USFlower produces and sells flowers in the United
States and other countries. USFlower owns all the shares of
HHolding, a corporation resident in Hungary. HHolding is a
holding company that is not engaged in a trade or business.
HHolding owns all the shares of three corporations that are
resident in Hungary: HFlower, HLawn, and HFish. HFlower
distributes USFlower flowers under the USFlower trademark in
Hungary. HLawn markets a line of lawn care products in Hungary
under the USFlower trademark. In addition to being sold under
the same trademark, HLawn and HFlower products are sold in the
same stores and sales of each company's products tend to
generate increased sales of the other's products. HFish imports
fish from the United States and distributes it to fish
wholesalers in Hungary. For purposes of paragraph 3, the
business of HFlower forms a part of the business of USFlower,
the business of HLawn is complementary to the business of
USFlower, and the business of HFish is neither part of nor
complementary to that of USFlower.
An item of income derived from the State of source is
``incidental to'' the trade or business carried on in the State
of residence if production of the item facilitates the conduct
of the trade or business in the State of residence. An example
of incidental income is the temporary investment of working
capital of a person in the State of residence in securities
issued by persons in the State of source.
Subparagraph 3(b) states a further condition to the general
rule in subparagraph (a) in cases where the trade or business
generating the item of income in question is carried on either
by the person deriving the income or by any associated
enterprises. Subparagraph 3(b) states that the trade or
business carried on in the State of residence, under these
circumstances, must be substantial in relation to the activity
in the State of source. Paragraph 10 of the Exchange of Notes
elaborates on the purpose and application of the substantiality
requirement. The requirement is intended to prevent a narrow
case of treaty-shopping abuses in which a company attempts to
qualify for benefits by engaging in de minimis connected
business activities in the treaty country in which it is
resident (i.e., activities that have little economic cost or
effect with respect to the company business as a whole).
The determination of substantiality is made based upon all
the facts and circumstances and takes into account the
comparative sizes of the trades or businesses in each
Contracting State the nature of the activities performed in
each Contracting State, and the relative contributions made to
that trade or business in each Contracting State. In any case,
in making each determination or comparison, due regard will be
given to the relative sizes of the U.S. and Hungarian
economies. In addition to this subjective rule, paragraph 10 of
the Exchange of Notes provides a safe harbor under which the
trade or business of the income recipient may be deemed to be
substantial based on three ratios that compare the size of the
recipient's activities to those conducted in the other State.
Under this safe harbor, a trade or business will be deemed
substantial if, for the preceding taxable year, or for the
average of the three preceding taxable years, the asset value,
the gross income, and the payroll expense that are related to
the trade or business in the income recipient's State of
residence each equals at least 7.5 percent of the resident's
(and any related parties') proportionate share of the asset
value, gross income, and payroll expense, respectively, that
generated the income in the other Contracting State, and the
average of the three ratios in each such year exceeds 10
percent. For purposes of this safe harbor, if the income
recipient owns, directly or indirectly, less than 100 percent
of an activity conducted in either State, only the income
recipient's proportionate interest in such activity shall be
taken into account.
The determination in subparagraph 3(b) is made separately
for each item of income derived from the State of source. It
therefore is possible that a person would be entitled to the
benefits of the Convention with respect to one item of income
but not with respect to another. If a resident of a Contracting
State is entitled to treaty benefits with respect to a
particular item of income under paragraph 3, the resident is
entitled to all benefits of the Convention insofar as they
affect the taxation of that item of income in the State of
source.
The application of the substantiality requirement only to
income from related parties focuses only on potential abuse
cases, and does not hamper certain other kinds of non-abusive
activities, even though the income recipient resident in a
Contracting State may be very small in relation to the entity
generating income in the other Contracting State. For example,
if a small U.S. research firm develops a process that it
licenses to a very large, unrelated, pharmaceutical
manufacturer in Hungary, the size of the U.S. research firm
would not have to be tested against the size of the
manufacturer. Similarly, a small U.S. bank that makes a loan to
a very large unrelated company operating a business in Hungary
would not have to pass a substantiality test to receive treaty
benefits under Paragraph 3.
Subparagraph 3(c) provides special attribution rules for
purposes of applying the substantive rules of subparagraphs
3(a) and 3(b). Thus, these rules apply for purposes of
determining whether a person meets the requirement in
subparagraph 3(a) that it be engaged in the active conduct of a
trade or business and that the item of income is derived in
connection with that active trade or business, and for making
the comparison required by the ``substantiality'' requirement
in subparagraph 3(b). Subparagraph 3(c) attributes to a person
activities conducted by persons ``connected'' to such person. A
person (``X'') is connected to another person (``Y'') if X
possesses 50 percent or more of the beneficial interest in Y
(or if Y possesses 50 percent or more of the beneficial
interest in X). For this purpose, X is connected to a company
if X owns shares representing fifty percent or more of the
aggregate voting power and value of the company or fifty
percent or more of the beneficial equity interest in the
company. X also is connected to Y if a third person possesses
fifty percent or more of the beneficial interest in both X and
Y. For this purpose, if X or Y is a company, the threshold
relationship with respect to such company or companies is fifty
percent or more of the aggregate voting power and value or
fifty percent or more of the beneficial equity interest.
Finally, X is connected to Y if, based upon all the facts and
circumstances, X controls Y, Y controls X, or X and Y are
controlled by the same person or persons.
Paragraph 4
Paragraph 4 sets forth a derivative benefits test that is
potentially applicable to all treaty benefits, although the
test is applied to individual items of income. In general, a
derivative benefits test entitles certain companies that are
residents of a Contracting State to treaty benefits if the
owner of the company would have been entitled to the same
benefit had the income in question flowed directly to that
owner. To qualify under this paragraph, the company must meet
an ownership test and a base erosion test.
Subparagraph 4(a) sets forth the ownership test. Under this
test, seven or fewer equivalent beneficiaries must own shares
representing at least 95 percent of the aggregate voting power
and value of the company and at least 50 percent of any
disproportionate class of shares. Ownership may be direct or
indirect. In addition, paragraph 11 of the Exchange of Notes
provides that the competent authorities of both countries will
ordinarily grant treaty benefits where a company claiming
derivative benefits under paragraph 4 is owned directly by up
to ten individuals, provided that such individuals are
equivalent beneficiaries and the base erosion requirements of
subparagraph 4(b) and any other requirements for benefits under
the Convention are satisfied.
The term ``equivalent beneficiary'' is defined in
subparagraph 8(e). This definition may be met in two
alternative ways, the first of which has two requirements.
Under the first alternative, a person may be an equivalent
beneficiary because it is entitled to equivalent benefits under
a tax treaty between the country of source and the country in
which the person is a resident. This alternative has two
requirements.
The first requirement is that the person must be a resident
of a member state of the European Union, or European Free Trade
Association, or of a party to the North American Free Trade
Agreement (collectively, ``qualifying States'').
The second requirement of the definition of ``equivalent
beneficiary'' is that the person must be entitled to equivalent
benefits under an applicable treaty. To satisfy the second
requirement, the person must be entitled to all the benefits of
a comprehensive tax treaty between the Contracting State from
which benefits of the Convention are claimed and a qualifying
state under provisions that are analogous to the rules in
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) of this Article. If
the treaty in question does not have a comprehensive limitation
on benefits article, this requirement is met only if the person
would be entitled to treaty benefits under the tests in
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) of this Article if
the person were a resident of one of the Contracting States.
In order to satisfy the second requirement necessary to
qualify as an ``equivalent beneficiary'' under subparagraph
8(e)(i)(B) with respect to dividends, interest, royalties or
branch tax, the person must be entitled to a rate of tax that
is at least as low as the tax rate that would apply under the
Convention to such income. Thus, the rates to be compared are:
(1) the rate of tax that the source State would have imposed if
a qualified resident of the other Contracting State was the
beneficial owner of the income; and (2) the rate of tax that
the source State would have imposed if the third state resident
received the income directly from the source State.
Subparagraph 8(f) provides a special rule to take account
of the fact that withholding taxes on many inter-company
dividends, interest and royalties are exempt within the
European Union by reason of various EU directives, rather than
by tax treaty. If a U.S. company receives such payments from a
Hungarian company, and that U.S. company is owned by a company
resident in a member state of the European Union that would
have qualified for an exemption from withholding tax if it had
received the income directly, the parent company will be
treated as an equivalent beneficiary. This rule is necessary
because many European Union member countries have not re-
negotiated their tax treaties to reflect the exemptions
available under the directives.
The requirement that a person be entitled to ``all the
benefits'' of a comprehensive tax treaty eliminates those
persons that qualify for benefits with respect to only certain
types of income. Accordingly, the fact that a French parent of
a Hungarian company is engaged in the active conduct of a trade
or business in France and therefore would be entitled to the
benefits of the U.S.-France treaty if it received dividends
directly from a U.S. subsidiary of the Hungarian company is not
sufficient for purposes of this paragraph. Further, the French
company cannot be an equivalent beneficiary if it qualifies for
benefits only with respect to certain income as a result of a
``derivative benefits'' provision in the U.S.-France treaty.
However, it would be possible to look through the French
company to its parent company to determine whether the parent
company is an equivalent beneficiary.
The second alternative for satisfying the ``equivalent
beneficiary'' test is available only to residents of one of the
two Contracting States. U.S. or Hungarian residents who are
eligible for treaty benefits by reason of subparagraphs 2(a),
2(b), 2(c)(i), or 2(d) are equivalent beneficiaries for
purposes of the relevant tests in this Article. Thus, a
Hungarian individual will be an equivalent beneficiary without
regard to whether the individual would have been entitled to
receive the same benefits if it received the income directly. A
resident of a third country cannot qualify for treaty benefits
under these provisions by reason of those paragraphs or any
other rule of the treaty, and therefore does not qualify as an
equivalent beneficiary under this alternative. Thus, a resident
of a third country can be an equivalent beneficiary only if it
would have been entitled to equivalent benefits had it received
the income directly.
The second alternative was included in order to clarify
that ownership by certain residents of a Contracting State
would not disqualify a U.S. or Hungarian company under this
paragraph. Thus, for example, if 90 percent of a Hungarian
company is owned by five companies that are resident in member
states of the European Union who satisfy the requirements of
subparagraph 8(d)(i), and 10 percent of the Hungarian company
is owned by a U.S. or Hungarian individual, then the Hungarian
company still can satisfy the requirements of subparagraph
4(a).
Subparagraph 4(b) sets forth the base erosion test. A
company meets this base erosion test if less than 50 percent of
its gross income (as determined in the company's State of
residence) for the taxable period is paid or accrued, directly
or indirectly, to a person or persons who are not equivalent
beneficiaries in the form of payments deductible for tax
purposes in company's State of residence. These amounts do not
include arm's-length payments in the ordinary course of
business for services or tangible property. This test is the
same as the base erosion test in subparagraph 2(e)(ii), except
that the test in paragraph 4(b) focuses on base-eroding
payments to persons who are not equivalent beneficiaries.
Paragraph 5
Paragraph 5 provides that a resident of one of the
Contracting States is entitled to all the benefits of the
Convention if that person functions as a recognized
headquarters company for a multinational corporate group. The
provisions of this paragraph are consistent with the other
U.S. tax treaties where this provision has been adopted.
For this purpose, the multinational corporate group includes
all corporations that the headquarters company supervises and
excludes affiliated corporations not supervised by the
headquarters company. The headquarters company does not have to
own shares in the companies that it supervises. In order to be
considered a headquarters company, the person must meet several
requirements that are enumerated in Paragraph 5. These
requirements are discussed below.
Overall Supervision and Administration
Subparagraph 5(a) provides that the person must provide a
substantial portion of the overall supervision and
administration of the group. This activity may include group
financing, but group financing may not be the principal
activity of the person functioning as the headquarters company.
A person only will be considered to engage in supervision and
administration if it engages in a number of the following
activities: group financing, pricing, marketing, internal
auditing, internal communications, and management. Other
activities also could be part of the function of supervision
and administration.
In determining whether a ``substantial portion'' of the
overall supervision and administration of the group is provided
by the headquarters company, its headquarters-related
activities must be substantial in relation to the same
activities for the same group performed by other entities.
Subparagraph 5(a) does not require that the group that is
supervised include persons in the other State. However, it is
anticipated that in most cases the group will include such
persons, due to the requirement in subparagraph 5(g), discussed
below, that the income derived in the other Contracting State
by the headquarters company be derived in connection with or be
incidental to an active trade or business supervised by the
headquarters company.
Active Trade or Business
Subparagraph 5(b) is the first of several requirements
intended to ensure that the relevant group is truly
``multinational.'' This subparagraph provides that the
corporate group supervised by the headquarters company must
consist of corporations resident in, and engaged in active
trades or businesses in, at least five countries. Furthermore,
at least five countries must each contribute substantially to
the income generated by the group, as the rule requires that
the business activities carried on in each of the five
countries (or groupings of countries) generate at least 10
percent of the gross income of the group. For purposes of the
10 percent gross income requirement, the income from multiple
countries may be aggregated into non-overlapping groupings, as
long as there are at least five individual countries or
groupings that each satisfy the 10 percent requirement. If the
gross income requirement under this subparagraph is not met for
a taxable year, the taxpayer may satisfy this requirement by
applying the 10 percent gross income test to the average of the
gross incomes for the four years preceding the taxable year.
Example 1. HHQ is a corporation resident in Hungary. HHQ
functions as a headquarters company for a group of companies.
These companies are resident in the United States, Canada, New
Zealand, the United Kingdom, Malaysia, the Philippines,
Singapore, and Indonesia. The gross income generated by each of
these companies for 2008 and 2009 is as follows:
For 2008, 10 percent of the gross income of this
group is equal to $13.70. Only the United States,
Canada, and the United Kingdom satisfy this requirement
for that year. The other companies in the group may be
aggregated to meet this requirement. Because New
Zealand and Malaysia have a total gross income of $20,
and the Philippines, Singapore, and Indonesia have a
total gross income of $22, these two groupings of
countries may be treated as the fourth and fifth
members of the group for purposes of subparagraph (b).
In the following year, 10 percent of the gross income
is $15.50. Only the United States, New Zealand, and the
United Kingdom satisfy this requirement. Because Canada
and Malaysia have a total gross income of $27, and the
Philippines, Singapore, and Indonesia have a total
gross income of $28, these two groupings of countries
may be treated as the fourth and fifth members of the
group for purposes of subparagraph (b). The fact that
Canada replaced New Zealand in a group is not relevant
for this purpose. The composition of the grouping may
change from year to year.
Single Country Limitation
Subparagraph 5(c) provides that the business activities
carried on in any one country other than the headquarters
company's State of residence must generate less than 50 percent
of the gross income of the group. If the gross income
requirement under this subparagraph is not met for a taxable
year, the taxpayer may satisfy this requirement applying the 50
percent gross income test to the average of the gross incomes
for the four years preceding the taxable year. The following
example illustrates the application of this subparagraph.
Example. HHQ is a corporation resident in Hungary. HHQ
functions as a headquarters company for a group of companies.
HHQ derives dividend income from a United States subsidiary in
the 2008 taxable year. The state of residence of each of these
companies, the situs of their activities and the amounts of
gross income attributable to each for the years 2008 through
2012 are set forth below.
Because the United States' total gross income of $130 in
2012 is not less than 50 percent of the gross income of the
group, subparagraph (c) is not satisfied with respect to
dividends derived in 2012. However, the United States' average
gross income for the preceding four years may be used in lieu
of the preceding year's average. The United States' average
gross income for the years 2008-11 is $111.00 ($444/4). The
group's total average gross income for these years is $230.75
($923/4). Because $111 represents 48.1 percent of the group's
average gross income for the years 2008 through 2011, the
requirement under subparagraph (c) is satisfied.
Other State Gross Income Limitation
Subparagraph 5(d) provides that no more than 25 percent of
the headquarters company's gross income may be derived from the
other Contracting State. Thus, if the headquarters company's
gross income for the taxable year is $200, no more than $50 of
this amount may be derived from the other Contracting State. If
the gross income requirement under this subparagraph is not met
for a taxable year, the taxpayer may satisfy this requirement
by applying the 25 percent gross income test to the average of
the gross incomes for the four years preceding the taxable
year.
Independent Discretionary Authority
Subparagraph 5(e) requires that the headquarters company
have and exercise independent discretionary authority to carry
out the functions referred to in subparagraph 5(a). Thus, if
the headquarters company was nominally responsible for group
financing, pricing, marketing and other management functions,
but merely implemented instructions received from another
entity, the headquarters company would not be considered to
have and exercise independent discretionary authority with
respect to these functions. This determination is made
individually for each function. For instance, a headquarters
company could be nominally responsible for group financing,
pricing, marketing and internal auditing functions, but another
entity could be actually directing the headquarters company as
to the group financing function. In such a case, the
headquarters company would not be deemed to have independent
discretionary authority for group financing, but it might have
such authority for the other functions. Functions for which the
headquarters company does not have and exercise independent
discretionary authority are considered to be conducted by an
entity other than the headquarters company for purposes of
subparagraph 5(a).
Income Taxation Rules
Subparagraph 5(f) requires that the headquarters company be
subject to the generally applicable income taxation rules in
its country of residence. This reference should be understood
to mean that the company must be subject to the income taxation
rules to which a company engaged in the active conduct of a
trade or business would be subject. Thus, if one of the
Contracting States has or introduces special taxation
legislation that impose a lower rate of income tax on
headquarters companies than is imposed on companies engaged in
the active conduct of a trade or business, or provides for an
artificially low taxable base for such companies, a
headquarters company subject to these rules is not entitled to
the benefits of the Convention under paragraph
In Connection With or Incidental to Trade or Business
Subparagraph 5(g) requires that the income derived in the
other Contracting State be derived in connection with or be
incidental to the active business activities referred to in
subparagraph (b). This determination is made under the
principles set forth in paragraph 3. For instance, assume that
a Hungarian company satisfies the other requirements in
paragraph 5 and acts as a headquarters company for a group that
includes a United States corporation. If the group is engaged
in the design and manufacture of computer software, but the
U.S. company is also engaged in the design and manufacture of
photocopying machines, the income that the Hungarian company
derives from the United States would have to be derived in
connection with or be incidental to the income generated by the
computer business in order to be entitled to the benefits of
the Convention under paragraph 5. Interest income received from
the U.S. company also would be entitled to the benefits of the
Convention under this paragraph as long as the interest was
attributable to the computer business supervised by the
headquarters company Interest income derived from an unrelated
party would normally not, however, satisfy the requirements of
this clause.
Paragraph 6
Paragraph 6 deals with the treatment of income in the
context of a so-called ``triangular case.'' The term
``triangular case'' refers to the use of a structure like the
one described in the following paragraph by a resident of
Hungary to earn income from the United States:
A resident of Hungary, who would, absent paragraph 6,
qualify for benefits under one or more of the provisions of
this Article, sets up a permanent establishment in a third
jurisdiction that imposes only a low rate of tax on the income
of the permanent establishment. The Hungarian resident lends
funds into the United States through the permanent
establishment. The permanent establishment, despite its third-
jurisdiction location, is an integral part of a Hungarian
resident. Therefore the income that it earns on those loans,
absent the provisions of paragraph 6, is entitled to exemption
from U.S. withholding tax under the Convention. Under a current
Hungarian income tax treaty with the host jurisdiction of the
permanent establishment, the income of the permanent
establishment is exempt from Hungarian tax (alternatively,
Hungary may choose to exempt the income of the permanent
establishment from Hungarian income tax). Thus, the interest
income, absent paragraph 6, would be exempt from U.S. tax,
subject to little or no tax in the host jurisdiction of the
permanent establishment, and exempt from Hungarian tax.
Paragraph 6 provides that the tax benefits that would
otherwise apply under the Convention will not apply to any item
of income if the combined aggregate effective tax rate in the
residence State and the third state is less than 60 percent of
the general rate of company tax applicable in the residence
State. In the case of dividends, interest and royalties to
which this paragraph applies, the withholding tax rates under
the Convention are replaced with a 15 percent withholding tax.
Any other income to which the provisions of paragraph 5 apply
is subject to tax under the domestic law of the source State,
notwithstanding any other provisions of the Convention.
In general, the principles employed under Code section
954(b)(4) will be employed to determine whether the profits are
subject to an effective rate of taxation that is above the
specified threshold.
Notwithstanding the level of tax on interest and royalty
income of the permanent establishment, paragraph 6 will not
apply under certain circumstances. In the case of royalties,
paragraph 6 will not apply if the royalties are received as
compensation for the use of, or the right to use, intangible
property produced or developed by the permanent establishment
itself. In the case of any other income, paragraph 6 will not
apply if that income 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 state.
The business of making, managing or simply holding investments
is not considered to be an active trade or business, unless
these are securities activities carried on by a registered
securities dealer, or, in the case of an enterprise of the
United States, banking activities carried on by a bank, or, in
the case of an enterprise of Hungary, regulated financial
services (as defined in paragraph 8 of the Exchange of Notes)
carried on by a financial institution.
Paragraph 6 applies reciprocally. However, the United
States does not exempt the profits of a third-jurisdiction
permanent establishment of a U.S. resident from U.S. tax,
either by statute or by treaty.
Paragraph 7
Paragraph 7 provides that a resident of one of the States
that is not entitled to the benefits of the Convention as a
result of paragraphs 1 through 5 still may be granted benefits
under the Convention at the discretion of the competent
authority of the State from which benefits are claimed. In
making determinations under paragraph 7, that competent
authority will take into account as its guideline whether the
establishment, acquisition, or maintenance of the person
seeking benefits under the Convention, or the conduct of such
person's operations, has or had as one of its principal
purposes the obtaining of benefits under the Convention.
Benefits will not be granted, however, solely because a company
was established prior to the effective date of the Convention.
In that case, a company would still be required to establish to
the satisfaction of the competent authority clear non-tax
business reasons for its formation in a Contracting State, or
that the allowance of benefits would not otherwise be contrary
to the purposes of the treaty. Thus, persons that establish
operations in one of the States with a principal purpose of
obtaining the benefits of the Convention ordinarily will not be
granted relief under paragraph 7.
The competent authority's discretion is quite broad. It may
grant all of the benefits of the Convention to the taxpayer
making the request, or it may grant only certain benefits. For
instance, it may grant benefits only with respect to a
particular item of income in a manner similar to paragraph 3.
Further, the competent authority may establish conditions, such
as setting time limits on the duration of any relief granted.
For purposes of implementing paragraph 7, a taxpayer will
be permitted to present his case to the relevant competent
authority for an advance determination based on the facts. In
these circumstances, it is also expected that, if the competent
authority determines that benefits are to be allowed, they will
be allowed retroactively to the time of entry into force of the
relevant treaty provision or the establishment of the structure
in question, whichever is later.
Finally, there may be cases in which a resident of a
Contracting State may apply for discretionary relief to the
competent authority of his State of residence. This would
arise, for example, if the benefit it is claiming is provided
by the residence country, and not by the source country. So,
for example, if a company that is a resident of the United
States would like to claim the benefit of the re-sourcing rule
of paragraph 3 of Article 23 (Relief from Double Taxation), but
it does not meet any of the objective tests of paragraphs 2
through 4, it may apply to the U.S. competent authority for
discretionary relief.
Paragraph 8
Paragraph 8 defines several key terms for purposes of
Article 22. Each of the defined terms is discussed above in the
context in which it is used.
ARTICLE 23 (RELIEF FROM DOUBLE TAXATION)
This Article describes the manner in which each Contracting
State undertakes to relieve double taxation. The United States
uses the foreign tax credit method under its internal law, and
by treaty.
Paragraph 1
Paragraph 1 provides that Hungary will provide relief from
double taxation through a mixture of the credit and exemption
methods.
Subparagraph 1(a) states the general rule that Hungary will
exempt income derived by a resident of Hungary if the income
may be taxed in the United States in accordance with the
Convention. Subparagraph 1(c), however, permits Hungary to
include the income corresponding to the U.S. tax in the
Hungarian resident's tax base in calculating the Hungarian tax
on the remaining income of the resident. This rule provides for
``exemption with progression.'' Under subparagraph 1(b),
Hungary provides for a tax credit rather than an exemption with
respect to limited classes of income. If the income may be
taxed by the United States under the provisions of Article 10
(Dividends) or Article 11 (Interest), Hungary will relieve
double taxation by allowing a credit against Hungarian tax in
an amount equal to the tax paid in the United States on such
income, but limited to the amount of Hungarian tax attributable
to such income. In the case of income that is exempted from
U.S. tax under the provisions of the Convention, or is subject
to reduced U.S. under the provisions of paragraph 2 of Article
10 or paragraph 2 of Article 11, subparagraph 1(d) provides
that Hungary is not required to grant an exemption.
Paragraph 2
The United States agrees, in paragraph 2, to allow to its
citizens and residents a credit against U.S. tax for income
taxes paid or accrued to Hungary. Paragraph 2 also provides
that Hungary's covered taxes are income taxes for U.S.
purposes. This provision is based on the Treasury Department's
review of Hungary's laws.
Subparagraph (b) provides for a deemed-paid credit,
consistent with section 902 of the Code, to a U.S. corporation
in respect of dividends received from a corporation resident in
Hungary of which the U.S. corporation owns at least 10 percent
of the voting stock. This credit is for the tax paid by the
corporation to Hungary on the profits out of which the
dividends are considered paid.
The credits allowed under paragraph 2 are allowed in
accordance with the provisions and subject to the limitations
of U.S. law, as that law may be amended over time, so long as
the general principle of the Article, that is, the allowance of
a credit, is retained. Thus, although the Convention provides
for a foreign tax credit, the terms of the credit are
determined by the provisions, at the time a credit is given, of
the U.S. statutory credit.
Therefore, the U.S. credit under the Convention is subject
to the various limitations of
U.S. law (see, e.g., Code sections 901-909). For example,
the credit against U.S. tax generally is limited to the amount
of U.S. tax due with respect to net foreign source income
within the relevant foreign tax credit limitation category (see
Code section 904(a) and (d)), and the dollar amount of the
credit is determined in accordance with U.S. currency
translation rules (see, e.g., Code section 986). Similarly,
U.S. law applies to determine carryover periods for excess
credits and other inter-year adjustments.
Paragraph 3
Paragraph 3 provides a re-sourcing rule for gross income
covered by paragraph 2. Paragraph 3 is intended to ensure that
a U.S. resident can obtain an appropriate amount of U.S.
foreign tax credit for income taxes paid to Hungary when the
Convention assigns to Hungary primary taxing rights over an
item of gross income.
Accordingly, if the Convention allows Hungary to tax an
item of gross income (as defined under U.S. law) derived by a
resident of the United States, the United States will treat
that item of gross income as gross income from sources within
Hungary for U.S. foreign tax credit purposes. The foreign tax
credit limitation generally applies separately to re-sourced
income. Furthermore, the paragraph 3 re-sourcing rule applies
to gross income, not net income. Accordingly, U.S. expense
allocation and apportionment rules, see, e.g., Treas. Reg.
section 1.861-9, continue to apply to income resourced under
paragraph 3.
Paragraph 4
Paragraph 4 provides special rules for the tax treatment in
both States of certain types of income derived from U.S.
sources by U.S. citizens who are residents of Hungary. Since
U.S. citizens, regardless of residence, are subject to United
States tax at ordinary progressive rates on their worldwide
income, the U.S. tax on the U.S. source income of a U.S.
citizen resident in Hungary may exceed the U.S. tax that may be
imposed under the Convention on an item of U.S. source income
derived by a resident of Hungary who is not a U.S. citizen. The
provisions of paragraph 4 ensure that Hungary does not bear the
cost of U.S. taxation of its citizens who are residents of
Hungary.
Subparagraph 4(a) provides, with respect to items of income
from sources within the United States, special credit rules for
Hungary. These rules apply to items of U.S.-source income that
would be either exempt from U.S. tax or subject to reduced
rates of U.S. tax under the provisions of the Convention if
they had been received by a resident of Hungary who is not a
U.S. citizen. The tax credit provided by Hungary under
subparagraph 4(a) with respect to such items need not exceed
the U.S. tax that may be imposed under the Convention, other
than tax imposed solely by reason of the U.S. citizenship of
the taxpayer under the provisions of the saving clause of
paragraph 4 of Article 1 (General Scope).
For example, if a U.S. citizen resident in Hungary receives
portfolio dividends from sources within the United States, the
foreign tax credit granted by Hungary would be limited to 15
percent of the dividend--the U.S. tax that may be imposed under
subparagraph (b) of paragraph 2 of Article 10 (Dividends)--even
if the shareholder is subject to U.S. net income tax because of
his U.S. citizenship. With respect to royalty or interest
income, the other Contracting State would allow no foreign tax
credit, because its residents are exempt from U.S. tax on these
classes of income under the provisions of Articles 11
(Interest) and 12 (Royalties).
Subparagraph 4(b) eliminates the potential for double
taxation that can arise because subparagraph 4(a) provides that
Hungary need not provide full relief for the U.S. tax imposed
on its citizens resident in Hungary. Subparagraph 4(b) provides
that the United States will credit the income tax paid or
accrued to Hungary, after the application of subparagraph 4(a).
It further provides that in allowing the credit, the United
States will not reduce its tax below the amount that is taken
into account in Hungary in applying subparagraph 4(a).
Since the income described in subparagraph 4(a) generally
will be U.S. source income, special rules are required to re-
source some of the income to Hungary in order for the United
States to be able to credit the tax paid to Hungary. This re-
sourcing is provided for in subparagraph 4(c), which deems the
items of income referred to in subparagraph 4(a) to be from
foreign sources to the extent necessary to avoid double
taxation under paragraph 4(b). Clause (iii) of subparagraph
3(c) of Article 25 (Mutual Agreement Procedure) provides a
mechanism by which the competent authorities can resolve any
disputes regarding whether income is from sources within the
United States.
The following two examples illustrate the application of
paragraph 4 in the case of U.S.-source portfolio dividend
received by a U.S. citizen resident in Hungary. In both
examples, the U.S. rate of tax on residents of Hungary, under
paragraph 2 of Article 10 (Dividends) of the Convention, is 15
percent. In both examples, the U.S. income tax rate on the U.S.
citizen is 35 percent. In example 1, the rate of income tax
imposed in Hungary on its resident (the U.S. citizen) is 25
percent (below the U.S. rate), and in example 2, the rate
imposed on its resident is 40 percent above the U.S. rate).
------------------------------------------------------------------------
Example 1 Example 2
------------------------------------------------------------------------
Subparagraph (a)
U.S. dividend declared...................... $100.00 $100.00
Notional U.S. withholding tax (Article 15.00 15.00
10(2)(b))..................................
Taxable income in Hungary................... 100.00 100.00
Hungarian tax before credit................. 25.00 40.00
Less: tax credit for notional U.S. 15.00 15.00
withholding tax............................
Net post-credit tax paid to Hungary......... 10.00 25.00
========================================================================
Subparagraphs (b) and (c)
U.S. pre-tax income......................... $100.00 $100.00
U.S. pre-credit citizenship tax............. 35.00 35.00
Notional U.S. withholding tax............... 15.00 15.00
U.S. tax eligible to be offset by credit.... 20.00 20.00
Tax paid to Hungary......................... 10.00 25.00
Income re-sourced from U.S. to foreign 28.57 57.14
source (see below).........................
U.S. pre-credit tax on re-sourced income.... 10.00 20.00
U.S. credit for tax paid to Hungary......... 10.00 20.00
Net post-credit U.S. tax.................... 10.00 0.00
Total U.S. tax.............................. 25.00 15.00
------------------------------------------------------------------------
In both examples, in the application of subparagraph 4(a),
Hungary credits a 15 percent U.S. tax against its residence tax
on the U.S. citizen. In the first example, the net tax paid to
Hungary after the foreign tax credit is $10.00; in the second
example, it is $25.00. In the application of subparagraphs (b)
and (c), from the U.S. tax due before credit of $35.00, the
United States subtracts the amount of the U.S. source tax of
$15.00, against which no U.S. foreign tax credit is allowed.
This subtraction ensures that the United States collects the
tax that it is due under the Convention as the State of source.
In both examples, given the 35 percent U.S. tax rate, the
maximum amount of U.S. tax against which credit for the tax
paid to Hungary may be claimed is $20 ($35 U.S. tax minus $15
U.S. withholding tax). Initially, all of the income in both
examples was from sources within the United States. For a U.S.
foreign tax credit to be allowed for the full amount of the tax
paid to Hungary, an appropriate amount of the income must be
re-sourced to Hungary under subparagraph (c).
The amount that must be re-sourced depends on the amount of
tax for which the U.S. citizen is claiming a U.S. foreign tax
credit. In example 1, the tax paid to Hungary was $10. For this
amount to be creditable against U.S. tax, $28.57 ($10 tax
divided by 35 percent U.S. tax rate) must be re-sourced to
Hungary. When the tax is credited against the $10 of U.S. tax
on this re-sourced income, there is a net U.S. tax of $10 due
after credit ($20 U.S. tax eligible to be offset by credit,
minus $10 tax paid to Hungary). Thus, in example 1, there is a
total of $25 in U.S. tax ($15 U.S. withholding tax plus $10
residual U.S. tax).
In example 2, the tax paid to Hungary was $25, but, because
the United States subtracts the U.S. withholding tax of $15
from the total U.S. tax of $35, only $20 of U.S. taxes may be
offset by taxes paid to Hungary. Accordingly, the amount that
must be re-sourced to Hungary is limited to the amount
necessary to ensure a U.S. foreign tax credit for $20 of tax
paid to Hungary, or $57.14 ($20 tax paid to the other
Contracting State divided by 35 percent U.S. tax rate). When
the tax paid to Hungary is credited against the U.S. tax on
this re-sourced income, there is no residual U.S. tax ($20 U.S.
tax minus $25 tax paid to Hungary, subject to the U.S. limit of
$20). Thus, in example 2, there is a total of $15 in U.S. tax
($15 U.S. withholding tax plus $0 residual U.S. tax). Because
the tax paid to Hungary was $25 and the U.S. tax eligible to be
offset by credit was $20, there is $5 of excess foreign tax
credit available for carryover.
Relationship to other Articles
By virtue of subparagraph 5(a) of Article 1 (General
Scope), Article 23 is not subject to the saving clause of
paragraph 4 of Article 1. Thus, the United States will allow a
credit to its citizens and residents in accordance with the
Article, even if such credit were to provide a benefit not
available under the Code (such as the re-sourcing provided by
paragraph 3 and subparagraph 4(c)).
ARTICLE 24 (NON-DISCRIMINATION)
This Article ensures that nationals of a Contracting
State, in the case of paragraph 1, and residents of a
Contracting State, in the case of paragraphs 2 through 5, will
not be subject, directly or indirectly, to discriminatory
taxation in the other Contracting State. Not all differences in
tax treatment, either as between nationals of the two States,
or between residents of the two States, are violations of the
prohibition against discrimination. Rather, the
nondiscrimination obligations of this Article apply only if the
nationals or residents of the two States are comparably
situated.
Each of the relevant paragraphs of the Article provides
that two persons that are comparably situated must be treated
similarly. Although the actual words differ from paragraph to
paragraph (e.g., paragraph 1 refers to two nationals ``in the
same circumstances,'' paragraph 2 refers to two enterprises
``carrying on the same activities'' and paragraph 4 refers to
two enterprises that are ``similar''), the common underlying
premise is that if the difference in treatment is directly
related to a tax-relevant difference in the situations of the
domestic and foreign persons being compared, that difference is
not to be treated as discriminatory (i.e., if one person is
taxable in a Contracting State on worldwide income and the
other is not, or tax may be collectible from one person at a
later stage, but not from the other, distinctions in treatment
would be justified under paragraph 1). Other examples of such
factors that can lead to nondiscriminatory differences in
treatment are noted in the discussions of each paragraph.
The operative paragraphs of the Article also use different
language to identify the kinds of differences in taxation
treatment that will be considered discriminatory. For example,
paragraphs 1 and 4 speak of ``any taxation or any requirement
connected therewith that is other or more burdensome,'' while
paragraph 2 specifies that a tax ``shall not be less favorably
levied.'' Regardless of these differences in language, only
differences in tax treatment that materially disadvantage the
foreign person relative to the domestic person are properly the
subject of the Article.
Paragraph 1
Paragraph 1 provides that a national of one Contracting
State may not be subject to taxation or connected requirements
in the other Contracting State that are other or more
burdensome than the taxes and connected requirements imposed
upon a national of that other State in the same circumstances.
The term ``national'' in relation to a Contracting State is
defined in subparagraph 1(j) of Article 3 (General
Definitions). The term includes both individuals and juridical
persons.
A national of a Contracting State is afforded protection
under this paragraph even if the national is not a resident of
either Contracting State. Thus, a U.S. citizen who is resident
in a third country is entitled, under this paragraph, to the
same treatment in Hungary as a national of Hungary who is in
similar circumstances (i.e., presumably one who is resident in
a third State).
Paragraph 1 provides that, as noted above, whether or not
the two persons are both taxable on worldwide income is
particularly relevant to determining whether they are ``in the
same circumstances.'' United States citizens who are not
residents of the United States but who are, nevertheless,
subject to United States tax on their worldwide income are not
in the same circumstances with respect to United States
taxation as citizens of Hungary who are not United States
residents. Thus, for example, Article 24 would not entitle a
national of Hungary resident in a third country to taxation at
graduated rates on U.S. source dividends or other investment
income that applies to a U.S. citizen resident in the same
third country.
Paragraph 2
Paragraph 2 provides that a Contracting State may not tax a
permanent establishment of an enterprise of the other
Contracting State less favorably than an enterprise of that
first-mentioned State that is carrying on the same activities.
The fact that a U.S. permanent establishment of an
enterprise of Hungary is subject to U.S. tax only on income
that is attributable to the permanent establishment, while a
U.S. corporation engaged in the same activities is taxable on
its worldwide income is not, in itself, a sufficient difference
to provide different treatment for the permanent establishment.
There are cases, however, where the two enterprises would not
be similarly situated and differences in treatment may be
warranted. For instance, it would not be a violation of the
non-discrimination protection of paragraph 2 to require the
foreign enterprise to provide information in a reasonable
manner that may be different from the information requirements
imposed on a resident enterprise, because information may not
be as readily available to the Internal Revenue Service from a
foreign as from a domestic enterprise. Similarly, it would not
be a violation of paragraph 2 to impose penalties on persons
who fail to comply with such a requirement (see, e.g., sections
874(a) and 882(c)(2)). Further, a determination that income and
expenses have been attributed or allocated to a permanent
establishment in conformity with the principles of Article 7
(Business Profits) implies that the attribution or allocation
was not discriminatory. Section 1446 of the Code imposes on any
partnership with income that is effectively connected with a
U.S. trade or business the obligation to withhold tax on
amounts allocable to a foreign partner. In the context of the
Convention, this obligation applies with respect to a share of
the partnership income of a partner resident in Hungary, and
attributable to a U.S. permanent establishment. There is no
similar obligation with respect to the distributive shares of
U.S. resident partners. It is understood, however, that this
distinction is not a form of discrimination within the meaning
of paragraph 2 of the Article. No distinction is made between
U.S. and non-
U.S. partnerships, since the law requires that partnerships
of both U.S. and non-U.S. domicile withhold tax in respect of
the partnership shares of non-U.S. partners. Furthermore, in
distinguishing between U.S. and non-U.S. partners, the
requirement to withhold on the non-U.S. but not the U.S.
partner's share is not discriminatory taxation, but, like other
withholding on nonresident aliens, is merely a reasonable
method for the collection of tax from persons who are not
continually present in the United States, and as to whom it
otherwise may be difficult for the United States to enforce its
tax jurisdiction. If tax has been over-withheld, the partner
can, as in other cases of over-withholding, file for a refund.
Paragraph 3
Paragraph 3 makes clear that the provisions of paragraphs 1
and 2 do not obligate a Contracting State to grant to a
resident of the other Contracting State any tax allowances,
reliefs, etc., that it grants to its own residents on account
of their civil status or family responsibilities. Thus, if a
sole proprietor who is a resident of Hungary has a permanent
establishment in the United States, in assessing income tax on
the profits attributable to the permanent establishment, the
United States is not obligated to allow to the resident of
Hungary the personal allowances for himself and his family that
he would be permitted to take if the permanent establishment
were a sole proprietorship owned and operated by a U.S.
resident, despite the fact that the individual income tax rates
would apply.
Paragraph 4
Paragraph 4 prohibits discrimination in the allowance of
deductions. When an enterprise of a Contracting State pays
interest, royalties or other disbursements to a resident of the
other Contracting State, the first-mentioned Contracting State
must allow a deduction for those payments in computing the
taxable profits of the enterprise as if the payment had been
made under the same conditions to a resident of the first-
mentioned Contracting State. Paragraph 4, however, does not
require a Contracting State to give nonresidents more favorable
treatment than it gives to its own residents. Consequently, a
Contracting State does not have to allow nonresidents a
deduction for items that are not deductible under its domestic
law (for example, expenses of a capital nature).
The term ``other disbursements'' is understood to include a
reasonable allocation of executive and general administrative
expenses, research and development expenses and other expenses
incurred for the benefit of a group of related persons that
includes the person incurring the expense.
An exception to the rule of paragraph 4 is provided for
cases where the provisions of paragraph 1 of Article 9
(Associated Enterprises), paragraph 5 of Article 11 (Interest)
or para*graph 4 of Article 12 (Royalties) apply. All of these
provisions permit the denial of deductions in certain
circumstances in respect of transactions between related
persons. Neither State is forced to apply the non-
discrimination principle in such cases. The exception with
respect to paragraph 5 of Article 11 would include the denial
or deferral of certain interest deductions under Code section
163(j).
Paragraph 4 also provides that any debts of an enterprise
of a Contracting State to a resident of the other Contracting
State are deductible in the first-mentioned Contracting State
for purposes of computing the capital tax of the enterprise
under the same conditions as if the debt had been contracted to
a resident of the first-mentioned Contracting State. Even
though, for general purposes, the Convention covers only income
taxes, under paragraph 7 of this Article, the nondiscrimination
provisions apply to all taxes levied in both Contracting
States, at all levels of government. Thus, this provision may
be relevant for both States. The other Contracting State may
have capital taxes and in the United States such taxes
frequently are imposed by local governments.
Paragraph 5
Paragraph 5 requires that a Contracting State not impose
other or more burdensome taxation or connected requirements on
an enterprise of that State that is wholly or partly owned or
controlled, directly or indirectly, by one or more residents of
the other Contracting State than the taxation or connected
requirements that it imposes on other similar enterprises of
that first-mentioned Contracting State. For this purpose it is
understood that ``similar'' refers to similar activities or
ownership of the enterprise.
This rule, like all non-discrimination provisions, does not
prohibit differing treatment of entities that are in differing
circumstances. Rather, a protected enterprise is only required
to be treated in the same manner as other enterprises that,
from the point of view of the application of the tax law, are
in substantially similar circumstances both in law and in fact.
The taxation of a distributing corporation under section 367(e)
on an applicable distribution to foreign shareholders does not
violate paragraph 5 of the Article because a foreign-owned
corporation is not similar to a domestically-owned corporation
that is accorded non-recognition treatment under sections 337
and 355.
For the reasons given above in connection with the
discussion of paragraph 2 of the Article, it is also understood
that the provision in section 1446 of the Code for withholding
of tax on non-U.S. partners does not violate paragraph 5 of the
Article.
It is further understood that the ineligibility of a U.S.
corporation with nonresident alien shareholders to make an
election to be an ``S'' corporation does not violate paragraph
5 of the Article. If a corporation elects to be an S
corporation, it is generally not subject to income tax and the
shareholders take into account their pro rata shares of the
corporation's items of income, loss, deduction or credit. (The
purpose of the provision is to allow an individual or small
group of individuals the protections of conducting business in
corporate form while paying taxes at individual rates as if the
business were conducted directly.) A nonresident alien does not
pay U.S. tax on a net basis, and, thus, does not generally take
into account items of loss, deduction or credit. Thus, the S
corporation provisions do not exclude corporations with
nonresident alien shareholders because such shareholders are
foreign, but only because they are not net-basis taxpayers.
Similarly, the provisions exclude corporations with other types
of shareholders where the purpose of the provisions cannot be
fulfilled or their mechanics implemented. For example,
corporations with corporate shareholders are excluded because
the purpose of the provision to permit individuals to conduct a
business in corporate form at individual tax rates would not be
furthered by their inclusion.
Finally, it is understood that paragraph 5 does not require
a Contracting State to allow foreign corporations to join in
filing a consolidated return with a domestic corporation or to
allow similar benefits between domestic and foreign
enterprises.
Paragraph 6
Paragraph 6 confirms that no provision of the Article will
prevent either Contracting State from imposing the branch
profits tax described in paragraph 8 of Article 10 (Dividends).
Paragraph 7
As noted above, notwithstanding the specification of taxes
covered by the Convention in Article 2 (Taxes Covered) for
general purposes, for purposes of providing nondiscrimination
protection this Article applies to taxes of every kind and
description imposed by a Contracting State or a political
subdivision or local authority thereof. Customs duties are not
considered to be taxes for this purpose.
Relationship to Other Articles
The saving clause of paragraph 4 of Article 1 (General
Scope) does not apply to this Article by virtue of the
exceptions in paragraph 5(a) of Article 1. Thus, for example, a
U.S. citizen who is a resident of Hungary may claim benefits in
the United States under this Article.
Nationals of a Contracting State may claim the benefits of
paragraph 1 regardless of whether they are entitled to benefits
under Article 22 (Limitation on Benefits), because that
paragraph applies to nationals and not residents. They may not
claim the benefits of the other paragraphs of this Article with
respect to an item of income unless they are generally entitled
to treaty benefits with respect to that income under a
provision of Article 22.
ARTICLE 25 (MUTUAL AGREEMENT PROCEDURE)
This Article provides the mechanism for taxpayers to bring
to the attention of competent authorities issues and problems
that may arise under the Convention. It also provides the
authority for cooperation between the competent authorities of
the Contracting States to resolve disputes and clarify issues
that may arise under the Convention and to resolve cases of
double taxation not provided for in the Convention. The
competent authorities of the two Contracting States are
identified in paragraph 1(g) of Article 3 (General
Definitions).
Paragraph 1
This paragraph provides that where a resident of a
Contracting State considers that the actions of one or both
Contracting States will result in taxation that is not in
accordance with the Convention he may present his case to the
competent authority of the Contracting State of which he is a
resident, or, if his case comes under paragraph 1 of Article 24
(Non-Discrimination), to that of the Contracting State of which
he is a national.
Although the most common cases brought under this paragraph
will involve economic double taxation arising from transfer
pricing adjustments, the scope of this paragraph is not limited
to such cases. For example, a taxpayer could request assistance
from the competent authority if one Contracting State
determines that the taxpayer has received deferred compensation
taxable at source under Article 14 (Income from Employment),
while the taxpayer believes that such income should be treated
as a pension that is taxable only in his country of residence
pursuant to Article 17 (Pensions and Income From Social
Security).
It is not necessary for a person requesting assistance
first to have exhausted the remedies provided under the
national laws of the Contracting States before presenting a
case to the competent authorities, nor does the fact that the
statute of limitations may have passed for seeking a refund
preclude bringing a case to the competent authority. Unlike the
OECD Model, no time limit is provided within which a case must
be brought.
Paragraph 2
Paragraph 2 sets out the framework within which the
competent authorities will deal with cases brought by taxpayers
under paragraph 1. It provides that, if the competent authority
of the Contracting State to which the case is presented judges
the case to have merit, and cannot reach a unilateral solution,
it shall seek an agreement with the competent authority of the
other Contracting State pursuant to which taxation not in
accordance with the Convention will be avoided.
Any agreement is to be implemented even if such
implementation otherwise would be barred by the statute of
limitations or by some other procedural limitation, such as a
closing agreement, provided that the competent authority of the
other State has received notice that such a case exists from
the competent authority of the Contracting State to which the
case was presented within six years of the end of the taxable
year to which the case relates . Paragraph 2 does not prevent
the application of domestic-law procedural limitations that
give effect to the agreement (e.g., a domestic-law requirement
that the taxpayer file a return reflecting the agreement within
one year of the date of the agreement).
Where the taxpayer has entered a closing agreement (or
other written settlement) with the United States before
bringing a case to the competent authorities, the U.S.
competent authority will endeavor only to obtain a correlative
adjustment from Hungary. See Rev. Proc. 2006-54, 2006-49 I.R.B.
1035, 7.05. Because, as specified in paragraph 2 of
Article 1 (General Scope), the Convention cannot operate to
increase a taxpayer's liability, temporal or other procedural
limitations can be overridden only for the purpose of making
refunds and not to impose additional tax.
Paragraph 3
Paragraph 3 authorizes the competent authorities to resolve
difficulties or doubts that may arise as to the application or
interpretation of the Convention. The competent authorities
may, for example, agree to the same allocation of income,
deductions, credits or allowances between an enterprise in one
Contracting State and its permanent establishment in the other
or between related persons. These allocations are to be made in
accordance with the arm's length principle underlying Article 7
(Business Profits) and Article 9 (Associated Enterprises).
Agreements reached may also include agreement on a methodology
for determining an appropriate transfer price, on an acceptable
range of results under that methodology, or on a common
treatment of a taxpayer's cost sharing arrangement.
The competent authorities also may agree to settle a
variety of conflicting applications of the Convention. They may
agree to settle conflicts regarding the characterization of
particular items of income, the characterization of persons,
the application of source rules to particular items of income,
the meaning of a term, or the timing of an item of income.
The competent authorities also may agree as to advance
pricing arrangements. They also may agree as to the application
of the provisions of domestic law regarding penalties, fines,
and interest in a manner consistent with the purposes of the
Convention.
The examples above are not exhaustive, and the competent
authorities may reach agreement on other issues if necessary to
avoid double taxation. For example, the competent authorities
may seek agreement on a uniform set of standards for the use of
exchange rates. Agreements reached by the competent authorities
under paragraph 3 need not conform to the internal law
provisions of either Contracting State.
Finally, paragraph 3 authorizes the competent authorities
to consult for the purpose of eliminating double taxation in
cases not provided for in the Convention and to resolve any
difficulties or doubts arising as to the interpretation or
application of the Convention. This provision is intended to
permit the competent authorities to implement the treaty in
particular cases in a manner that is consistent with its
expressed general purposes. It permits the competent
authorities to deal with cases that are within the spirit of
the provisions but that are not specifically covered. An
example of such a case might be double taxation arising from a
transfer pricing adjustment between two permanent
establishments of a third-country resident, one in the United
States and one in Hungary. Since no resident of a Contracting
State is involved in the case, the Convention does not apply,
but the competent authorities nevertheless may use the
authority of this Article to prevent the double taxation of
income.
Paragraph 4
Paragraph 4 authorizes the competent authorities to
increase any dollar amounts referred to in the Convention to
reflect economic and monetary developments. This refers only to
Article 16 (Entertainers and Sportsmen); Article 19 (Students
and Trainees) separately instructs the competent authorities to
adjust the exemption amount for students and trainees in
accordance with specified guidelines. The rule under paragraph
4 is intended to operate as follows: if, for example, after the
Convention has been in force for some time, inflation rates
have been such as to make the $20,000 exemption threshold for
entertainers unrealistically low in terms of the original
objectives intended in setting the threshold, the competent
authorities may agree to a higher threshold without the need
for formal amendment to the treaty and ratification by the
Contracting States. This authority can be exercised, however,
only to the extent necessary to restore those original
objectives. This provision can be applied only to the benefit
of taxpayers (i.e., only to increase thresholds, not to reduce
them).
Paragraph 5
Paragraph 5 provides that the competent authorities may
communicate with each other for the purpose of reaching an
agreement, including through a joint commission consisting of
themselves or their representatives. This makes clear that the
competent authorities of the two Contracting States may
communicate without going through diplomatic channels. Such
communication may be in various forms, including, where
appropriate, through face-to-face meetings of representatives
of the competent authorities.
Treaty termination in relation to competent authority dispute
resolution
A case may be raised by a taxpayer after the Convention has
been terminated with respect to a year for which a treaty was
in force. In such a case the ability of the competent
authorities to act is limited. They may not exchange
confidential information, nor may they reach a solution that
varies from that specified in its law.
Triangular competent authority solutions
International tax cases may involve more than two taxing
jurisdictions (e.g., transactions among a parent corporation
resident in country A and its subsidiaries resident in
countries B and C). As long as there is a complete network of
treaties among the three countries, it should be possible,
under the full combination of bilateral authorities, for the
competent authorities of the three States to work together on a
three-sided solution. Although country A may not be able to
give information received under Article 26 (Exchange of
Information) from country B to the authorities of country C, if
the competent authorities of the three countries are working
together, it should not be a problem for them to arrange for
the authorities of country B to give the necessary information
directly to the tax authorities of country C, as well as to
those of country A. Each bilateral part of the trilateral
solution must, of course, not exceed the scope of the authority
of the competent authorities under the relevant bilateral
treaty.
Relationship to Other Articles
This Article is not subject to the saving clause of
paragraph 4 of Article 1 (General Scope) by virtue of the
exceptions in subparagraph 5(a) of that Article. Thus, rules,
definitions, procedures, etc. that are agreed upon by the
competent authorities under this Article may be applied by the
United States with respect to its citizens and residents even
if they differ from the comparable Code provisions. Similarly,
as indicated above, U.S. law may be overridden to provide
refunds of tax to a U.S. citizen or resident under this
Article. A person may seek relief under Article 25 regardless
of whether he is generally entitled to benefits under Article
22 (Limitation on Benefits). As in all other cases, the
competent authority is vested with the discretion to decide
whether the claim for relief is justified.
ARTICLE 26 (EXCHANGE OF INFORMATION)
This Article provides for the exchange of information and
administrative assistance between the competent authorities of
the Contracting States.
Paragraph 1
The obligation to obtain and provide information to the
other Contracting State is set out in Paragraph 1. The
information to be exchanged is that which is foreseeably
relevant for carrying out the provisions of the Convention or
the domestic laws of the United States or of Hungary concerning
taxes of every kind applied at the national level. This
language incorporates the standard of the OECD Model. The
parties intend for the phrase ``is foreseeably relevant'' to be
interpreted to permit the exchange of information that ``may be
relevant'' for purposes of 26 U.S.C. Section 7602, which
authorizes the IRS to examine ``any books, papers, records, or
other data which may be relevant or material.'' (emphasis
added) In United States v. Arthur Young & Co., 465 U.S. 805,
814 (1984), the Supreme Court stated that the language ``may
be'' reflects Congress's express intention to allow the IRS to
obtain ``items of even potential relevance to an ongoing
investigation, without reference to its admissibility.''
(emphasis in original) However, the language ``may be'' would
not support a request in which a Contracting State simply asked
for information regarding all bank accounts maintained by
residents of that Contracting State in the other Contracting
State. Thus, the language of paragraph 1 is intended to provide
for exchange of information in tax matters to the widest extent
possible, while clarifying that Contracting States are not at
liberty to engage in ``fishing expeditions'' or otherwise to
request information that is unlikely to be relevant to the tax
affairs of a given taxpayer.
Exchange of information with respect to each State's
domestic law is authorized to the extent that taxation under
domestic law is not contrary to the Convention. Thus, for
example, information may be exchanged with respect to a covered
tax, even if the transaction to which the information relates
is a purely domestic transaction in the requesting State and,
therefore, the exchange is not made to carry out the
Convention. An example of such a case is provided in paragraph
8(b) of the OECD Commentary: a company resident in one
Contracting State and a company resident in the other
Contracting State transact business between themselves through
a third-country resident company. Neither Contracting State has
a treaty with the third State. To enforce their internal laws
with respect to transactions of their residents with the third-
country company (since there is no relevant treaty in force),
the Contracting States may exchange information regarding the
prices that their residents paid in their transactions with the
third-country resident.
Paragraph 1 clarifies that information may be exchanged
that relates to the assessment or collection of, the
enforcement or prosecution in respect of, or the determination
of appeals in relation to, the taxes covered by the Convention.
Thus, the competent authorities may request and provide
information for cases under examination or criminal
investigation, in collection, on appeals, or under prosecution.
The taxes covered by the Convention for purposes of this
Article constitute a broader category of taxes than those
referred to in Article 2 (Taxes Covered). Exchange of
information is authorized with respect to taxes of every kind
imposed by a Contracting State at the national level.
Accordingly, information may be exchanged with respect to U.S.
estate and gift taxes, excise taxes or, with respect to
Hungary, value added taxes.
Information exchange is not restricted by paragraph 1 of
Article 1 (General Scope). Accordingly, information may be
requested and provided under this article with respect to
persons who are not residents of either Contracting State. For
example, if a third-country resident has a permanent
establishment in Hungary, and that permanent establishment
engages in transactions with a U.S. enterprise, the United
States could request information with respect to that permanent
establishment, even though the third-country resident is not a
resident of either Contracting State. Similarly, if a third-
country resident maintains a bank account in Hungary, and the
Internal Revenue Service has reason to believe that funds in
that account should have been reported for U.S. tax purposes
but have not been so reported, information can be requested
from Hungary with respect to that person's account, even though
that person is not the taxpayer under examination.
Although the term ``United States'' does not encompass U.S.
possessions for most purposes of the Convention, Section 7651
of the Code authorizes the Internal Revenue Service to utilize
the provisions of the Internal Revenue Code to obtain
information from the U.S. possessions pursuant to a proper
request made under Article 26. If necessary to obtain requested
information, the Internal Revenue Service could issue and
enforce an administrative summons to the taxpayer, a tax
authority (or a government agency in a U.S. possession), or a
third party located in a U.S. possession.
Paragraph 2
Paragraph 2 provides assurances that any information
exchanged will be treated as secret, subject to the same
disclosure constraints as information obtained under the laws
of the requesting State. Information received may be disclosed
only to persons, including courts and administrative bodies,
concerned with the assessment, collection, or administration
of, the enforcement or prosecution in respect of, or the
determination of the of appeals in relation to, the taxes
covered by the Convention. The information must be used by
these persons in connection with the specified functions.
Information may also be disclosed to legislative bodies, such
as the tax-writing committees of Congress and the Government
Accountability Office, engaged in the oversight of the
preceding activities. Information received by these bodies must
be for use in the performance of their role in overseeing the
administration of U.S. tax laws. Information received may be
disclosed in public court proceedings or in judicial decisions.
Paragraph 3
Paragraph 3 provides that the obligations undertaken in
paragraphs 1 to exchange information do not require a
Contracting State to carry out administrative measures that are
at variance with the laws or administrative practice of either
State. Nor is a Contracting State required to supply
information not obtainable under the laws or administrative
practice of either State, or to disclose trade secrets or other
information, the disclosure of which would be contrary to
public policy.
Thus, a requesting State may be denied information from the
other State if the information would be obtained pursuant to
procedures or measures that are broader than those available in
the requesting State. However, the statute of limitations of
the Contracting State making the request for information should
govern a request for information. Thus, the Contracting State
of which the request is made should attempt to obtain the
information even if its own statute of limitations has passed.
In many cases, relevant information will still exist in the
business records of the taxpayer or a third party, even though
it is no longer required to be kept for domestic tax purposes.
While paragraph 3 states conditions under which a
Contracting State is not obligated to comply with a request
from the other Contracting State for information, the requested
State is not precluded from providing such information, and
may, at its discretion, do so subject to the limitations of its
internal law.
Paragraph 4
Paragraph 4 provides that when information is requested by
a Contracting State in accordance with this Article, the other
Contracting State is obligated to obtain the requested
information as if the tax in question were the tax of the
requested State, even if that State has no direct tax interest
in the case to which the request relates. In the absence of
such a paragraph, some taxpayers have argued that subparagraph
3(a) prevents a Contracting State from requesting information
from a bank or fiduciary that the Contracting State does not
need for its own tax purposes. This paragraph clarifies that
paragraph 3 does not impose such a restriction and that a
Contracting State is not limited to providing only the
information that it already has in its own files.
Paragraph 5
Paragraph 5 provides that a Contracting State may not
decline to provide information because that information is held
by financial institutions, nominees or persons acting in an
agency or fiduciary capacity. Thus, paragraph 5 would
effectively prevent a Contracting State from relying on
paragraph 3 to argue that its domestic bank secrecy laws (or
similar legislation relating to disclosure of financial
information by financial institutions or intermediaries)
override its obligation to provide information under paragraph
1. This paragraph also requires the disclosure of information
regarding the beneficial owner of an interest in a person, such
as the identity of a beneficial owner of bearer shares.
Paragraph 6
Paragraph 6 provides that the requesting State may specify
the form in which information is to be provided (e.g.,
depositions of witnesses and authenticated copies of original
documents). The intention is to ensure that the information may
be introduced as evidence in the judicial proceedings of the
requesting State. The requested State should, if possible,
provide the information in the form requested to the same
extent that it can obtain information in that form under its
own laws and administrative practices with respect to its own
taxes.
ARTICLE 27 (MEMBERS OF DIPLOMATIC MISSIONS AND CONSULAR POSTS)
This Article confirms that any fiscal privileges to which
diplomatic or consular officials are entitled under general
provisions of international law or under special agreements
will apply notwithstanding any provisions to the contrary in
the Convention. The agreements referred to include any
bilateral agreements, such as consular conventions, that affect
the taxation of diplomats and consular officials and any
multilateral agreements dealing with these issues, such as the
Vienna Convention on Diplomatic Relations and the Vienna
Convention on Consular Relations. The U.S. generally adheres to
the latter because its terms are consistent with customary
international law.
The Article does not independently provide any benefits to
diplomatic agents and consular officers. Article 19 (Government
Service) does so, as do Code section 893 and a number of
bilateral and multilateral agreements. In the event that there
is a conflict between the Convention and international law or
such other treaties, under which the diplomatic agent or
consular official is entitled to greater benefits under the
latter, the latter laws or agreements shall have precedence.
Conversely, if the Convention confers a greater benefit than
another agreement, the affected person could claim the benefit
of the tax treaty.
Pursuant to subparagraph 5(b) of Article 1 (General Scope),
the saving clause of paragraph 4 of Article 1 does not apply to
override any benefits of this Article available to an
individual who is neither a citizen of the United States nor
has immigrant status in the United States.
ARTICLE 28 (ENTRY INTO FORCE)
This Article contains the rules for bringing the Convention
into force and giving effect to its provisions.
Paragraph 1
Paragraph 1 provides for the ratification of the Convention
by both Contracting States according to their constitutional
and statutory requirements. Instruments of ratification shall
be exchanged as soon as possible.
In the United States, the process leading to ratification
and entry into force is as follows: Once a treaty has been
signed by authorized representatives of the two Contracting
States, the Department of State sends the treaty to the
President who formally transmits it to the Senate for its
advice and consent to ratification, which requires approval by
two-thirds of the Senators present and voting. Prior to this
vote, however, it generally has been the practice for the
Senate Committee on Foreign Relations to hold hearings on the
treaty and make a recommendation regarding its approval to the
full Senate. Both Government and private sector witnesses may
testify at these hearings. After the Senate gives its advice
and consent to ratification of the treaty, an instrument of
ratification is drafted for the President's signature. The
President's signature and countersignature by the Secretary of
State complete the process in the United States.
Paragraph 2
Paragraph 2 provides that the Convention will enter into
force upon the exchange of instruments of ratification. The
date on which a treaty enters into force is not necessarily the
date on which its provisions take effect. Paragraph 2,
therefore, also contains rules that determine when the
provisions of the treaty will have effect.
Under paragraph 2(a), the Convention will have effect with
respect to taxes withheld at source (principally dividends,
interest and royalties) for amounts paid or credited on or
after the first day of the second month following the date on
which the Convention enters into force. For example, if
instruments of ratification are exchanged on April 25 of a
given year, the withhold*ing rates specified in paragraph 2 of
Article 10 (Dividends) would be applicable to any dividends
paid or credited on or after June 1 of that year. This rule
allows the benefits of the withholding reductions to be put
into effect as soon as possible, without waiting until the
following year. The delay of one to two months is required to
allow sufficient time for withholding agents to be informed
about the change in withholding rates. If for some reason a
withholding agent withholds at a higher rate than that provided
by the Convention (perhaps because it was not able to re-
program its computers before the payment is made), a beneficial
owner of the income that is a resident of the other Contracting
State may make a claim for refund pursuant to section 1464 of
the Code.
For all other taxes, paragraph 2(b) specifies that the
Convention will have effect for any taxable period beginning on
or after January 1 of the year following entry into force.
Paragraph 3
Paragraph 3 provides an exception to the general rule of
paragraph 2. Under paragraph 3, if the prior income tax
convention between the United States and Hungary would have
afforded greater relief from tax than this Convention, that
prior convention shall, at the election of any person that was
entitled to benefits under the prior convention, continue to
have effect in its entirety with respect to such person's taxes
until December 31, 2010.
Thus, if the Convention would otherwise have effect with
respect to a taxpayer prior to December 31, 2010, the taxpayer
may elect to extend the benefits of the prior convention until
December 31, 2010. During the period in which the election is
in effect, the provisions of the prior convention will continue
to apply only insofar as they applied before the entry into
force of the Convention. If the grace period is elected, all of
the provisions of the prior convention must be applied during
the grace period. The taxpayer may not apply certain, more
favorable provisions of the prior convention and, at the same
time, apply other, more favorable provisions of this
Convention. The taxpayer must choose one convention in its
entirety or the other.
The prior convention shall terminate on the last date on
which it has effect with respect to any tax in accordance with
the provisions of Article 28.
Paragraph 4
Paragraph 4 provides that an individual who was entitled to
benefits under Article 18 (Students and Trainees) or Article 17
(Teachers) of the prior convention at the time of the entry
into force of this Convention is ``grandfathered,'' and will
continue to be entitled to the benefits available under the
prior convention until such time as that individual would cease
to be entitled to benefits if the prior convention remained in
force.
ARTICLE 29 (TERMINATION)
The Convention is to remain in effect indefinitely, unless
terminated by one of the Contracting States in accordance with
the provisions of Article 29. The Convention may be terminated
by either State, provided that at least six months' prior
notice has been given through diplomatic channels. Once notice
of termination is given, the provisions of the Convention with
respect to withholding at source will cease to have effect for
amounts paid or credited on or after the first day of January
next following the expiration of six month notice period. For
other taxes, the Convention will cease to have effect as of
taxable periods beginning on or after the the first day of
January next following the expiration of this six month period.
Article 29 relates only to unilateral termination of the
Convention by a Contracting State. Nothing in that Article
should be construed as preventing the Contracting States from
concluding a new bilateral agreement, subject to ratification,
that supersedes, amends or terminates provisions of the
Convention without the six-month notification period.
Customary international law observed by the United States
and other countries, as reflected in the Vienna Convention on
Treaties, allows termination by one Contracting State at any
time in the event of a ``material breach'' of the agreement by
the other Contracting State.