The great budgetary difficulties faced by governments globally made the efforts to crack down on tax avoidance schemes stronger than ever, reaching out for means that may bring in the hidden revenues. Hungary has been no exception, and the effort to broaden the income tax net has induced some sweeping changes in the tax regime. After a long, ongoing lawmaking process and several fine-tuning proposals, the Parliament has finally laid down the cornerstones of the new controlled foreign company (CFC) regime, that will bring about a whole new era for out-bound Hungarian investments.
Historically, Hungary has always had an interesting approach to the CFC concept. Despite the many back and forth changes in the definition of CFCs in terms of the necessary “substance requirement” and its permissive attitude towards EU and OECD locations, it has been uniquely consistent in catching not only controlled businesses, but also those low-taxed businesses, not controlled by the investor group, if a related party of the Hungarian company held some interest (no matter how insignificant) in the foreign company. The CFC regime, although barring the application of certain tax benefits with respect to investments caught by it, overall has been less dominant in Hungary in setting the tax climate than in other countries. Establishing a more substantial CFC regime is one of the major new forces put in place to crack down on tax avoidance. Therefore, it came as little surprise that this time, as of January 2010, we are facing a brand new CFC definition along with rules which capture and tax CFC profits in Hungary in an unprecedented way at the level of both corporate and individual investors.
From January 1, 2010 a foreign company which either (i) has a beneficial owner who is a Hungarian tax resident private individual holding a ten percent interest during the majority of the tax year or (ii) derives the majority of its income from Hungarian sources, will be treated as a CFC, provided that it does not meet the comparable taxes requirement, and it does not have real economic presence and tax residence in an OECD or treaty country.
Comparable taxes mean that the company in the given tax year pays or is required to pay taxes at the effective tax rate not lower than 12.67 percent. In case of results being zero or negative, the statutory income tax rate of the foreign country must reach this threshold. In practice this means that entities, not only in low tax countries but in countries providing significant tax benefits with an otherwise high statutory rate, may also be caught by the definition.
Even if the comparable taxes test is not met, a foreign company with real economic presence in an OECD or treaty country will not be considered a CFC. Real economic presence means that at least 50 percent of revenues are derived either from manufacturing, processing, agricultural, service, investment or commercial activity using its own equipment and employees within a given country. Although holding and financing are explicitly listed in the law as activities securing substance, collecting royalties has not been mentioned as such, which raises the question of whether the popular tax efficient royalty regimes such as the “Dutch patent box” may also be caught. The substance of this test, clearly, remains open to interpretation, which will surely be frequently on the agenda of both the legislator and the authorities.
But how does the CFC regime operate? As mentioned above, the CFC regime, although its framework is set out in the Act on corporate income tax, affects both corporate and individual taxpayers. We have outlined the most important points to remember below.
- Hungarian corporate taxpayers with at least 25 percent of voting rights or shareholding, or controlling interest in a CFC that has no direct or indirect individual shareholders, should include the part of the non-distributed positive after-tax profit of the CFC that is proportionate to their interest in the CFC in their profits subject to corporate tax.
- Furthermore, as an adverse impact for corporate taxpayers, considerations paid to CFCs are deemed to be expenditures that do not occur in the course of furtherance of trading activity, unless proved to the contrary by the taxpayer. Therefore, these expenses are not deductible by default, for corporate tax purposes. There is no room to eliminate the same presumption with respect to grants and aids provided without the obligation of repayment, funds or assets transferred permanently or liabilities undertaken without consideration during the tax year and any value added taxes accounted for as expenditures in relation to these allowances. None of these items are considered to be business expenses, and therefore are not deductible expenditures for corporate income tax purposes.
- Dividend income received from a CFC is taxable income of the corporate taxpayer as opposed to dividends received from other entities. Under the participation exemption rule of reported shares, capital gains realized on shares are not taxable for corporate income tax purposes, provided that the shareholder (i) acquires at least 30 percent shareholding, (ii) reports the acquisition to the tax authority within 30 days and (iii) holds those shares for at least one year. This tax benefit is not applicable to participations in CFCs.
- Private individual members of a CFC, who directly or indirectly alone or together with their close relatives hold at least 25 percent of the shares or voting rights of the CFC, are subject to personal income tax on that part of the undistributed taxed profit of the CFC that is proportionate to their interest.
The introduction of the concept that levying personal income tax on undistributed profits of CFCs most probably puts an end to the era of the popular Cypriot professional service companies held by Hungarian individuals, with no local employees engaged. It will no longer be a viable option to earn and accumulate revenues by a Cypriot company with the view to finance investments in the future. The undistributed taxed profit of the company will be subject to the hefty Hungarian personal income tax and social security contribution charges.
Also, given that the comparable taxes test threshold applies to the effective tax rate of the foreign entity, many entities, registered in European jurisdictions with high standard tax rates, may still be regarded as CFCs, should tax refund, tax credit or preferential rates be applied to them. As an example, we may take again the Dutch Patent Box regime, under which Dutch entities with income realized from intangible assets, are taxed at a reduced rate of ten percent, up to a set threshold. In this case, irrespective of the standard corporate income tax rate of 25.5 percent in the Netherlands, the Dutch entity will become a CFC.
Similarly, the application of the tax refund system and the foreign tax credit administration in Malta, and the taxation of certain passive income in Ireland, result in effective tax rates being lower than 12.67 percent, which under the new Hungarian CFC rules will surely adversely influence the outbound investment spirit on passive activities, other than holding or financing functions.
Practitioners are facing a challenging time in the application of the new CFC regulations in practice, particularly given that it is not yet clear how widely the authorities and legislators are going to interpret the law and whether the original intention was indeed to capture such a wide scope of entities and activities.