Hungary: Challenges in the Post-Offshore Era as 2006 Brings Change to The Corporate Tax Regime by Gabor Szabo
Although the Hungarian corporate taxation regime faces some important changes towards the end of 2005, the Government’s intention to continuously develop an investor friendly economic environment remains in place. Many tax benefits and breaks mutatis mutandis will survive the dawn of the offshore regime, making the country an exiting tax planning vehicle in the future.The end of the offshore regime is not the beginning of the end but the end of the beginning The classical, however very discrete, Hungarian offshore regime (re: 4% tax on profit as the only kind of corporate tax) will end on the December 31, 2005. By this date every Hungarian offshore company will automatically lose this status and fall under the regular corporate tax regime which implies the following: · 16% corporate tax (CT) on the profit, · 0-2% local business tax (LBT) on the net income and · max. 0,2% innovation contribution (IC) on the net income. The “normal” rate of the CT is still one of the lowest worldwide and itself alone would be a very promising tax planning vehicle. However the other two elements of the corporate taxation seem to destroy the pleasant picture at a first glance. Nevertheless neither will be long-lived. LBT is not only sharply criticized by everyone, but ? being classical turnover tax ? simply against the 6th VAT Directive of the European Union. The first few court petitions have been already filed against this tax, and even the financial government has announced to abolish it for 2007. The other “masterpiece”, IC is the typical example of how a bureaucrat creates a tax which results in inadequate income but disproportionately heavy administration and cost. By the way, IC is also against the 6th Directive. This is enough reason to abolish this tax together with (or sooner than) LBT. After all, over a longer period of time we only have to consider the 16 % tax on profit. However, in those fields where Hungary was popular before and during the offshore era (holding, licensing, corporate/group financing) some EU compatible refined tax benefits will change the “rough” offshore tax breaks.Tax on Dividend As of January 1, 2006 the dividend paid to foreign corporate owner, member or shareholder will be free of any withholding tax irrespective of the resident country of the beneficiary of the dividend. (The received dividend has been tax-free for many years.) This means a tax-free exit for dividends not only from Hungary but also from the EU. With this planning solution, Hungary may compensate the labour and connecting costs that are generally higher than in the Central-Eastern European neighbourhood. For the time being Hungary does not provide a participation exemption for capital gains. Therefore, the capital gains are taxed at 16%. As a tax planning opportunity, a tax-free realisation of the profit on the transfer of participation can be achieved by including an intermediate holding company and transferring the participation at a gain. Afterwards, the profit would be distributed to the Hungarian company in the form of exempt dividend, which can be distributed tax-free exit out of the country or EU.Tax on Royalty Beside the abolishment of dividend tax, enterprises are also allowed to reduce their corporate income tax base by 50% of their royalty income received from either abroad or Hungary. There is no restriction in relation to the company’s activity. Any company which arises income from the sale or license of any kind of intellectual property (IP) like patent, know how, trade mark, image right, copyright etc., can enjoy this benefit no matter if the licensing activity is the main object of the company or not. The benefit is available to any company, which holds the right of the intellectual property even if the legal owner is a different entity. This allows back-to back licensing arrangements to take advantage from the incentive. Moreover, for self-developed IPs, the tax base can be reduced by the research and development (R&D) costs. An additional advantage is that the royalty income will be free also from the LBT (see above) as of January 1, 2006. All of this has as a result that the total corporate tax burden of a pure licensing company is only 8% on the profit. Useless to say, that the benefits target first of all the R&D industry. The Government’s message is as follows: come and set your R&D business up in Hungary which can provide you with not only well-trained and relatively cheap labour force and rapidly developing infrastructure but a very friendly tax environment too. But there is a second and less shrill part of the message: anybody can enjoy this tax benefit who shows activity in any part of the IP industry. The result is self-explanatory: a unique IP and R&D friend tax regime.Tax on Interest Similarly to royalty income, also in 2006 taxpayers shall continue to reduce their corporate income tax base by 50% of the interest income they receive from related parties that exceeds their interest expense paid (or payable) to related parties. This benefit is qualified to make Hungary more attractive as a group financing centre. Traditionally several multinational group used and are still using the country for this purpose. Probably more others will join the “club”. Purely in the case of group financing, the thin capitalisation rules shall be also taken into account. The debt to equity ratio is 3:1, which is quite unfavourable to use back-to-back arrangements. Basically it means that interest paid on debts is non-deductible to the extent that the debts exceed three times the equity of the Hungarian company. Therefore group financing seems to remain the game only for the highly capitalized “Big Boys”.