US Hungary Tax Treaty Termination: What You Need to Know

An income tax treaty is an agreement between two countries to resolve issues of how income earned in one country by a resident of the other is taxed. These agreements aim to prevent the same income from being taxed by both nations, a situation known as double taxation. For decades, a 1979 treaty governed the tax relationship between the United States and Hungary.

The U.S. has unilaterally terminated this agreement, which fundamentally alters the tax landscape for individuals and companies with financial activities connecting the two countries. Without the treaty’s protections, the rules for taxing cross-border income have changed, creating new complexities and potential costs.

The Termination of the US-Hungary Tax Treaty

The U.S. Department of the Treasury formally announced its decision to terminate the 1979 income tax treaty with Hungary on July 8, 2022. The treaty’s provisions included a delayed phase-out period, so benefits for taxes withheld at the source, such as on dividend and interest payments, ceased to apply to amounts paid on or after January 1, 2024. For all other forms of taxation, the treaty stopped having effect for taxable periods beginning on or after that same date.

The primary reason for this action was the outdated nature of the 1979 agreement, which lacked a modern “Limitation on Benefits” (LOB) provision. LOB articles are standard in contemporary tax treaties and are designed to prevent “treaty shopping,” where residents of third countries route investments through a treaty partner to gain tax advantages not intended for them.

Another factor was Hungary’s low corporate income tax rate of 9%. U.S. officials expressed concern that this low rate, combined with the old treaty’s terms, created opportunities for companies to lower their tax burden. These long-standing issues were brought to a head when Hungary blocked the European Union’s implementation of the OECD’s global minimum tax initiative. A new, modernized treaty negotiated in 2010 to address these problems was never ratified by the U.S. Senate.

Tax Consequences for Individuals

The end of the tax treaty significantly increases the likelihood of double taxation for individuals with financial ties to both the U.S. and Hungary. Before, the treaty provided clear rules that assigned taxing rights to one country or the other for specific types of income. Now, individuals must navigate the domestic tax laws of each country, which can result in both nations claiming the right to tax the same income.

For U.S. citizens working in Hungary, a significant loss is the “183-day rule.” Under the treaty, an American’s employment income was generally taxable only in the U.S., provided they were present in Hungary for less than 183 days in a tax year and their salary was not paid by a Hungarian employer. Without this provision, Hungary can tax any income earned for work performed within its borders from the first day, while the U.S. continues to tax its citizens on their worldwide income.

The treatment of retirement income has also changed. The treaty had specific articles that typically gave the country of residence the sole right to tax pension and social security payments. For a U.S. retiree living in Hungary, this meant their U.S. Social Security benefits were generally not subject to Hungarian tax. Without the treaty, these payments may now be exposed to taxation in both countries, subject only to the relief provided by each nation’s internal laws.

Tax Consequences for Businesses and Investments

For businesses and investors, the most immediate impact of the treaty’s termination is the change in withholding tax rates on cross-border payments. The 1979 treaty dramatically reduced or eliminated these taxes, but without it, payments are now subject to the default statutory withholding rates of the source country, which are considerably higher.

For payments from the U.S. to Hungary, the withholding tax on dividends has increased from the treaty rates of 5% or 15% to the standard U.S. statutory rate of 30%. The withholding tax on interest and royalties, which was 0% under the treaty, now also defaults to the 30% U.S. rate. This means a Hungarian parent company receiving a dividend from its U.S. subsidiary will now see 30% of that payment withheld for U.S. taxes, a substantial increase that directly impacts cash flow and investment returns.

Another consequence relates to the concept of a “Permanent Establishment” (PE). Tax treaties provide a detailed definition of what business activities create a taxable presence in another country. Without the treaty’s specific definition, it may become easier for a company’s operations to trigger a taxable presence under that country’s domestic laws. This would require the foreign company to file tax returns and pay income tax in that country on the profits attributable to those activities.

Navigating Cross-Border Taxation Without the Treaty

With the treaty’s protections gone, taxpayers must rely on the domestic laws of each country to avoid double taxation. The primary mechanism available to U.S. citizens and residents is the U.S. Foreign Tax Credit (FTC). The FTC is a non-refundable tax credit that allows taxpayers to reduce their U.S. income tax liability on a dollar-for-dollar basis for income taxes they have already paid to a foreign government.

To claim the credit, individuals must file Form 1116, “Foreign Tax Credit,” with their U.S. income tax return. This form requires a detailed calculation to determine the allowable credit, which is limited to the amount of U.S. tax that would have been owed on that same foreign-source income. While the calculations can be complex, the credit is only available for foreign income taxes; other types of taxes are generally not creditable.

The termination of the income tax treaty has no bearing on the separate U.S.-Hungary Social Security Agreement. This agreement, often called a Totalization Agreement, remains in full effect. Its purpose is to coordinate social security coverage and benefits for people who have worked in both countries, ensuring a worker pays social security taxes to only one country at a time.