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14 November 2008
The planned abolition of the 4% solidarity surtax from January 1 2009 would reduce the general Hungarian corporate income tax burden to 16%, one of the lowest tax rates in Europe (for further details please see "Abolition of Solidarity Surtax: New Opportunities for Holdings"). Although the abolition may not enter into force in 2009, a number of provisions in Hungarian tax legislation already favour various types of tax structure.
Under Hungary’s participation exemption regime, dividends flowing from entities other than controlled foreign corporations (CFCs) are exempt from corporate income tax and solidarity surtax (16% plus 4%), regardless of the entity’s home jurisdiction. The availability of this exemption was recently extended by significantly narrowing Hungary's CFC restrictions to exclude all EU member states, Organization for Economic Cooperation and Development countries and Hungary’s treaty partners(1) from their adverse tax consequences.
The participation exemption is available not only for dividends received, but also for capital gains accrued on a non-CFC share of at least 30% (if held for at least one year and reported to the tax administration on acquisition). This provision favours corporate investors and participants in various corporate transformations and reorganizations.
In order to encourage related-party financing, a 50% notional deduction from intra-group interest spreads is allowed within certain limits,(2) which effectively results in a corporate income tax burden of only 8% (plus 4%).(3) This tax rate is almost unrivalled and can be further reduced by careful planning. Generally, this deduction is available if the interest payer makes a corresponding increase in its corporate income tax base. However, this restriction does not apply to cross-border interest payments.
In the opposite case, if a related-party interest expense exceeds the related-party interest income, 50% of the difference will be added to the corporate income tax base as a rule. However, an exemption can be sought if the relevant related parties that receive or pay interest are notified or if they are foreign entities falling outside the scope of Hungarian corporate income tax law.
Thus, the 50% intra-group financing regime is especially favourable for cross-border investments, including back-to-back financing arrangements, but can also be widely applied in Hungarian financing structures, as only a few types of interest (eg, discount securities) are excluded from the regime.
A 50% notional deduction from the corporate income tax base may be applied to royalties received, whether or not the licensee is a related party. This regime can be used for back-to-back and other licensing arrangements. Unlike the intra-group interest flows described above, the full amount of inbound royalties in such arrangements - not just the spread - is exposed to the 8% plus 4% beneficial tax rates. Thus, outbound royalties can be fully offset against the normal 16% plus 4% tax base. Depending on the circumstances, profits generated on inbound and outbound royalty flows not only may be fully tax exempt, but also may lead to an overall tax saving.
The table below demonstrates some possible combinations of financing, licensing and holding functions and their profit and loss elements, along with their tax effects.
|Related interest received||1,000||1,000||1,000||1,000|
|Related interest paid||-900||-900||-900||-900|
|Other deductible costs||0||0||0||-200|
|Total pre-tax profit||100||200||700||500|
|50% intragroup interest regime (1,000 - 900) x 50% (1)||-50||-50||-50||-50|
|50% royalties regime (1,000 x 50%)||0||-50||-300||-200|
|Dividends received (participation exemption)||0||0||-500||-500|
|Corporate income tax base||50||100||-150||-250|
|Corporate income tax (16%)||8||16||0||0|
|Solidarity surtax base (pre-tax profit minus dividends received)||100||200||200||0|
|Solidarity surtax (4%)||4||8||8||0|
|Total tax burden (corporate income tax plus solidarity surtax)||12||24||8||0|
|Effective tax rate||12%||12%||1.14%||0%|
Scenarios 1 and 2 show that back-to-back financing and licensing arrangements can lead to an effective tax burden of 12%, comprising a reduced 8% corporate income tax rate and a normal 4% solidarity surtax rate. This 12% tax exposure can be further reduced through a combination of income elements. Scenario 3 shows that the participation exemption regime, which allows for the full deduction of non-CFC dividends received from both the corporate income tax and the solidarity surtax bases, allows for a significant tax reduction. Scenario 4 shows that a further reduction can be achieved by adding additional cost elements to the model.
Thus, a well-planned combination of various income and cost elements derived from different activities can reduce the effective Hungarian tax burden to close to zero.
(2) The corporate income tax base reduction due to financing and licensing activities (along with certain other benefits) is capped at 50% of the pre-tax profit. The statutory 3:1 thin capitalization ratio should be observed when planning interest expenses.
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