THIS article is about a Hungarian Highest Court case on the relation between double tax treaties and the Hungarian local business tax. ¹ Most of the tax treaties concluded by Hungary covers taxes levied by local governments. Even where treaties do not include taxes imposed by “political subdivisions and/or local authorities” under Article 2(1) they can still list types of local taxes under Article 2(2) in the list of taxes covered. It is also possible to argue that whereas a treaty covers taxes imposed by political subdivisions and/or local authorities and lists (personal or corporate) income tax, in theory it should cover local taxes on income as well.

Local business tax used to be an issue in Hungary because of a famous decision made by the European Court of Justice on the deemed incompatibility with the Sixth VAT Directive. ² But this tax is not only controversial in European context. Local governments are entitled to levy the local business tax. The tax is imposed after the economic activity. The law distinguishes between two kinds of economic activity: permanent and temporary. Permanent economic activity is when the taxpayer has the seat or a permanent establishment there, regardless of the true place of the economic activity. In respect of the permanent economic activity the basis of assessment is the net turnover corresponding to the goods sold or the services provided during a given period, less the purchase price of the goods sold, the value of the intermediary services and the costs of the materials.

In 2008 the Highest Court of Hungary delivered a judgment on the link between the local business tax and tax treaties. ³ A Hungarian company had a seat in Hungary and a PE in Germany. The company performed all its economic activity through the German PE. The company did not pay local business tax in Hungary, but did pay German local business tax in Germany. The Germany-Hungary tax treaty (1977) does not list the local business tax; instead, it does list the local community development contribution. In 2003 the Hungarian tax administration audited tax year 2002 of the company. According to the tax administration the taxpayer should have paid local business tax in Hungary after the activity performed though the PE in Germany. The company claimed that there was no local business tax paying obligation in Hungary relying on a non-binding ruling issued by the relevant Hungarian local government's notary and on the Germany-Hungary double tax treaty. The company believed that the treaty covered the local business tax as they thought that the local business tax was identical or substantially similar tax to the local community development contribution. The tax administration contested this position explaining that the local business tax was not an income tax and therefore could not fall under the scope of the treaty.

The Highest Court had to elaborate on two questions. The first was: did the local business tax fall under the scope of the Germany-Hungary treaty? The Court examined the nature of the local business tax and found that the local business was not a type of income tax therefore it could not fall under the scope of a double tax treaty on income. The basis of assessment was the net turnover corresponding to the goods sold or the services provided during a given period, less the purchase price of the goods sold, the value of the intermediary services and the costs of the materials. In case of an income tax all expenses should be deductible but regarding the local business tax this was not the case. At the same time the exact same local business tax assessment was appealed in front of the European Court of Justice. ⁴The question was if the Hungarian local business tax was same or similar to the European VAT. The European Court of Justice ruled that the local business was a tax “levied on production”⁶ where the burden was “not necessarily passed on” ⁵ to the next taxpayer and therefore could not “be deemed to be a tax which can be characterized as a turnover tax for the purposes of” ⁷the Sixth VAT Directive.

The Hungarian Highest Court included the decision of the European Court of Justice and further added that categories like “direct”, “indirect”, “income” or “turnover” shall not be interlocked, i.e., a “direct” tax was not necessarily an “income” tax and an “indirect” tax would not always be a “turnover” tax as well. The Court found that the local business tax was a kind of direct tax on turnover, but it was not an income tax either as it was attached to the supply of products but not to the income received for the supply.

Second, the Court had to find out whether the local business tax corresponded the local community development contribution. The Court held that the local community contribution did not correspond to the local business tax and could not be interpreted as identical or substantially similar taxes. The local community development contribution does not exist any more: it was in force before 1989. Older Hungarian tax treaties that are still in force (e.g., treaties with Germany, Denmark, Switzerland, Japan and Austria that were concluded before 1989) list this kind of contribution under Article 2(2). The contribution was imposed on natural persons and was based on personal income and privately owned immoveable properties. After 1989 this contribution was abolished. To facilitate the interpretation an expert group of the Highest Court released a common opinion on the classification of the local community contribution. The opinion clearly explained that the local community contribution and the local business tax were not identical or substantially similar taxes because the taxable object and the taxable person were different.

The Hungarian Parliament amended the law on local business tax in 2006 by excluding the economic activity of a foreign permanent establishment from the tax base in Hungary, therefore double taxation cannot occur. However, the local business tax is listed explicitly under Article 2(2) in the double tax treaties with Albania and with Poland. This creates legal uncertainty as certain legal sources treat the local business tax as an income tax, while other sources prove to the contrary.

¹ This case was presented on the Conference on The Impact of the OECD and the UN Model Conventions on Bilateral Tax Treaties organized by the Institute for Austrian and International Tax Law (Vienna University of Economics and Business) in Rust, Austria, July 8-10 2010 and is a part of the forthcoming book on the results of this conference.

² The cases are: C-283/06 and C-312/06 Kogaz and Others. The cases are downloadable from: http://curia.europa.eu/jcms/jcms/j_6/ The cases in brief: according to the Sixth VAT Directive only one VAT-type turnover tax can exist in the European Union. The Hungarian appellants argued that the local business tax was similar to the VAT. In certain business sectors (mostly financial and insurance) the effect of the local business tax is similar to the VAT, but as far as other businesses are concerned the two taxes are definitely not similar. The European Court of Justice decided against the appellants. This was a relatively important case in Hungary, because most of the local governments maintain themselves from the revenue derived from the local business tax. If this tax were abolished because of the incompatibility with the VAT, many local governments would have had serious budgetary problems.

³ Judgment of the Highest Court of Hungary: Kfv.I.35.103/2008/4. The case is downloadable from: http://www.birosag.hu/Engine.aspx (in Hungarian only)

⁴ See cases C-283/06 and C-312/06 Kogaz and Others

⁵ C-283/06 and C-312/06 50 paragraph

⁶C-283/06 and C-312/06 53 paragraph

⁷ C-283/06 and C-312/06 60 paragraph