Hungarian Tax Incentives: Keeping Hungary's Tax System Attractive For Multinational Group Investors Following EU Accession

Traditionally, Hungarian tax rules undergo significant amendment at the beginning of a new year: loopholes exploited by taxpayers are closed and the budget is always in need of further income. The year 2004 brings changes on an even greater scale, as Hungary's coming accession to the European Union on 1 May 2004 requires domestic tax legislation to comply fully with EC law.

Abolition of the HOC-regime

Firstly, it should be mentioned that Hungary's coming EU membership inevitably has some negative effects on tax rules. As of 1 January 2003 the so-called Hungarian offshore companies ("HOCs") can no longer be entered into the relevant register of the Hungarian tax authority. Also, already-existing HOCs lose their tax advantageous status if the majority member (shareholder) of a HOC is changed or if the HOC is affected by a merger (an amalgamation or an absorption). Nevertheless, until 1 May 2004 the majority interest in a HOC can be transferred to a related party of the HOC without the loss of beneficial tax status (the "related party exemption"). All special rules applicable to HOCs (e.g. the beneficial corporate tax rate of 4%) will cease to have effect from 1 January 2006. The above "related party exemption" rule will also be repealed as of 1 May 2004.

Nevertheless, Hungary has taken a number of steps to ensure that it remains a preferred jurisdiction for multinational groups establishing their holding companies of investments in the CEE region, which have resulted in new and exciting benefits for investors.

Corporate tax rate

One such benefit is the highly competitive corporate income tax rate of 16% (for comparison, Slovakia has a rate of 20%, while Austria has 34%).

Dividends received

The beneficial taxation of inbound dividends should also be noted, namely that dividends received by Hungarian tax resident companies are tax exempt, irrespective of the percentage of holdings, unless the payer is a Controlled Foreign Company ("CFC").

CFC in this context means a non-Hungarian tax resident, provided that:

· it has its registered seat in a state where the effective rate of corporate income tax is less than 2/3 of 16% (i.e. approx. 10,67%);

· a Hungarian tax resident subject to Hungarian corporate income tax, or its related party, has holdings in it; and

· it has no active, genuine business in the state of its registered seat.

Interest & royalty income

It is also useful to pay special attention to the so-called "50% Deduction Rule", which allows additional tax deductions in respect of interest income received from related parties.

According to this "50% Deduction Rule", as set out in Act LXXXI of 1996 on Corporate Income Tax and Dividend Tax ("CIT Act"), a company may decrease its corporate income tax base by:

50% of the interest income

· received by (or due to) the company from its related parties; and

· accounted for and recorded by the company as interest income;

which is

· in excess of the interest paid (or payable) by the company to its related parties; and

· accounted for as expenses by the company.

The "50% Deduction Rule" cannot be applied if the company qualifies as a small enterprise on the last day of the tax year and, according to the CIT Act, the total amount of such deductions, together with certain other deductions, may not exceed 50% of the pre-tax profits of the company in question.

Another decreasing item, similar to the above rule, is the possibility of deducting royalty income. This rule provides that 50% of the royalty income received during the tax year is deductible from taxable profits, subject to some limitations in the CIT Act.

Outbound interest & royalty payments

As of 1 January 2004, interest and royalties sourced in Hungary and paid to a non-Hungarian resident company are exempt from Hungarian withholding tax under the respective provisions of Hungarian domestic legislation.

Tax treaty network

Lastly, it should be noted that Hungary has an extensive treaty network (of more than 55 treaties), most of which are based on the OECD Model Convention and generally adhere to the more favourable exemption method. Furthermore, with Hungary's EU membership, EC law (e.g. the Parent/Subsidiary and Merger Directives, and Interest and Royalty Directives etc) will become applicable in Hungary as of 1 May 2004.