Those who have kept an eye out for new opportunities in IP planning know that Hungary was among the very first countries in Europe to make efforts to attract IP-related activity by introducing a special royalty regime along R&D incentives as early as 2005, years before the Netherlands, Luxembourg or Switzerland. It may come as a pleasant surprise that this regime has survived the numerous recent changes in Hungarian tax legislation and stayed more or less the same throughout the past ten years, gradually becoming more and more attractive over time.
Hungary’s international tax features provide an ideal environment to optimize the benefits of the royalty regime. Hungary is among the few European countries that do not levy withholding tax on either dividends1 or royalties paid out to foreign recipients worldwide. Withholding tax-free divided distribution has also stood the test of time, and has become a cardinal feature of Hungary’s tax regime. Hungary also has a fairly low corporate income tax rate: The general tax rate is 19 percent, while a reduced rate of 10 percent applies on the first HUF 500 million (€1.7 million) of the tax base2.
Those investors who are not discouraged by Hungary’s tendency to surprise its taxpayers with new industry-specific surtaxes, or frequent changes in its tax legislation, may find the Hungarian IP opportunities very interesting and mostly appealing, indeed.
What Qualifies as Royalty Income?
The Act on Corporate Income Tax defines royalty income very broadly. Royalty income includes any consideration received for the exploitation or sale of the following self-developed or purchased intellectual property: patents, industrial design, other protected intellectual works, know-how exploitation rights, trademarks, trade names, trade secrets and authentic works protected by copyright. This broad scope makes the regime broader than most other European regimes in place today.
The Mechanics of the Royalty Deduction
Hungary provides a deduction for 50 percent of all royalty income when calculating the corporate income tax base. This deductible amount, however, cannot exceed 50 percent of the pre-tax profits. The royalty deduction facilitates a reduced effective corporate income tax rate on the total pre-tax profit of the taxpayer, extending the benefits to non-royalty types of income also. The deduction is especially beneficial to those companies that also receive tax-free dividends and perform substantial R&D.
Before illustrating the mechanics of the royalty deduction, we will introduce another important factor enhancing the benefits of this regime, which is the tax treatment of R&D-related costs.
Tax Treatment of R&D Costs
R&D3 expenditure and amortization realized in the accounts for intellectual property developed as a result of R&D activity are allowed for corporate income tax purposes. In addition, the pre-tax accounting profit of the taxpayer is once more reduced when calculating the taxable base by the direct costs of R&D carried out within the scope of the taxpayer’s own activities (additional deduction). Costs of R&D performed directly or indirectly by third parties may only be deductible if the service provider declares that the R&D services have not been purchased from a Hungarian resident taxpayer, a Hungarian branch of a non-resident entity or a Hungarian private entrepreneur. This practically means that a tax deduction for 200 percent of R&D expenditure can be achieved, either in the year in which it has been incurred or, if capitalized, through the years of amortization.
Illustration of the Royalty Incentive
Now, let’s see the mechanics of the royalty incentive at an IP company with dividend income and R&D activities. The below examples show how the incentives work in scenarios when the 10 percent corporate income tax rate (Table 1) and a when both the 10 percent and 19 percent corporate income tax rates apply.
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As shown in the calculations, the licensing company receives royalty income, other income and dividends, and incurs R&D costs. These figures make up its pre-tax accounting profit. To calculate the corporate income tax base, we will deduct 50 percent of the royalty income from the pre-tax accounting profits. Since the deduction in these cases is less than half the pre-tax accounting profit, we may fully utilize the deduction potential. We may also deduct the dividends, as dividends are tax-free income4 and the R&D costs due to the R&D incentive from the pre-tax accounting profits, and, as a result, we arrive to the corporate income tax base of the company. The first HUF 500 million of the tax base will be subject to 10 percent corporate income tax, while 19 percent corporate income tax will apply above this threshold. The effective corporate tax rates in the above examples, (scaling the tax payable to the pre-tax accounting profits) are 3.00 percent and 5.18 percent. The overall effective tax rate always depends on the ratio of the royalty revenue, the deductible dividends and R&D costs in the given tax year.
The Transfer of Intellectual Property
To make the royalty regime even more attractive, a tax exemption was recently introduced for the transfer of intellectual property assets if the assets were reported to the tax authority within 60 days of their purchase or development. The tax exemption only applies for IP assets owned for at least one year.
This incentive makes the Hungarian regime truly beneficial for non-depreciating assets, or for assets the values of which increase over time. In most other European royalty regimes, reduced rates and benefits do not apply to proceeds of the sale or transfer of the intellectual property itself, which makes the tax-free transfer of Hungarian-held intellectual property unique, and the structure very flexible for future restructuring, if needed.
This short description does introduce all IP-related rules and benefits available in Hungary, but focuses on the main features of a royalty regime which has appealed to many in the past decade. To make it more appealing, the exit from this regime was made tax-free in the recent past, recognizing that flexibility is increasingly becoming one of the most important aspects of international tax planning involving high-value intellectual property.