[Senate Executive Report 112-4]
[From the U.S. Government Publishing Office]


112th Congress                                              Exec. Rept.
                                 SENATE
 1st Session                                                      112-4

======================================================================



 
                      TAX CONVENTION WITH HUNGARY

                                _______
                                

   August 30 (legislative day, August 2), 2011.--Ordered to be printed

                                _______
                                

          Mr. Kerry, from the Committee on Foreign Relations,
                        submitted the following

                              R E P O R T

                    [To accompany Treaty Doc. 111-7]

    The Committee on Foreign Relations, to which was referred 
the Convention between the Government of the United States of 
America and the Government of the Republic of Hungary for the 
Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion with Respect to Taxes on Income, signed on February 4, 
2010, at Budapest, and a related agreement effected by an 
exchange of notes on February 4, 2010 (the ``Convention'') 
(Treaty Doc. 111-7), having considered the same, reports 
favorably thereon with one declaration, as indicated in the 
resolution of advice and consent, and recommends that the 
Senate give its advice and consent to ratification thereof, as 
set forth in this report and the accompanying resolution of 
advice and consent.

                                CONTENTS

                                                                   Page

  I. Purpose..........................................................1
 II. Background.......................................................2
III. Major Provisions.................................................2
 IV. Entry Into Force.................................................4
  V. Implementing Legislation.........................................4
 VI. Committee Action.................................................4
VII. Committee Comments...............................................4
VIII.Text of Resolution of Advice and Consent to Ratification.........5

 IX. Annex 1.--Technical Explanation..................................7

                               I. Purpose

    The purpose of the new Hungary Convention is to promote and 
facilitate trade and investment between the United States and 
Hungary. Principally, the Convention provides for reduced 
withholding rates on cross-border payments of dividends, 
interest, royalties, and other income, as well as the 
elimination of withholding taxes on cross-border dividend 
payments to pension funds. The Convention contains rigorous 
protections designed to protect against ``treaty shopping,'' 
which is the inappropriate use of a tax treaty by third-country 
residents, and provisions to ensure the exchange of information 
between tax authorities in both countries. While the proposed 
Convention generally follows the 2006 U.S. Model Income Tax 
Treaty (the ``U.S. Model''), it deviates from the U.S. Model in 
certain respects discussed below.

                             II. Background

    The United States has a tax treaty with Hungary that is 
currently in force, which was concluded in 1979 (Convention 
between the Government of the United States of America and the 
Government of the Hungarian People's Republic for the Avoidance 
of Double Taxation and the Prevention of Fiscal Evasion with 
Respect to Taxes on Income, signed at Washington, February 12, 
1979). The new Convention was negotiated to bring U.S.-Hungary 
tax treaty relations into closer conformity with each country's 
current tax treaty policies. For example, the proposed 
Convention contains comprehensive provisions designed to 
address ``treaty-shopping.'' The existing convention with 
Hungary signed in 1979 does not contain treaty shopping 
protections and, as a result, is susceptible to abuse by third-
country investors.

                         III. Major Provisions

    A detailed article-by-article analysis of the Convention 
may be found in the Technical Explanation Published by the 
Department of the Treasury on June 7, 2011, which is included 
at Annex 1 to this report. In addition, the staff of the Joint 
Committee on Taxation prepared an analysis of the Convention, 
JCX-32-11 (May 20, 2011), which was of great assistance to the 
committee in reviewing the Convention. A summary of the key 
provisions of the Convention is set forth below.

                             GENERAL SCOPE

    Article 1 defines the scope of the proposed treaty as 
applying only to ``residents'' of the United States and 
Hungary, except where the terms of the Convention provide 
otherwise. It contains a standard ``saving clause'' pursuant to 
which each country retains the right to tax its residents and 
citizens as if the treaty had not come into effect. This 
article also contains a standard provision providing that the 
treaty may not be applied to deny a taxpayer any benefits to 
which the taxpayer would be entitled under the domestic law of 
a country or under any other agreement between the two 
countries.

                             COVERED TAXES

    Article 2 provides that the proposed treaty applies to all 
taxes on income, including gains, irrespective of the manner in 
which they are levied. Except with respect to the benefits 
provided by Article 24 (Non-Discrimination), state and local 
taxes, including property taxes, do not fall within the scope 
of the proposed treaty.

                               DIVIDENDS

    Articles 10 and 13 provide that dividends and certain gains 
derived by a resident of either country from sources within the 
other country (residence-country taxation) may be fully taxed 
by both countries. However, the proposed treaty limits the rate 
of taxation that the source country may impose on certain 
dividends paid to a resident of the other country. The 
withholding tax rates on dividends are generally consistent 
with those contained in the U.S. Model treaty, but they 
represent a departure from the exemption from source-country 
withholding tax provided by several recent U.S. treaties and 
protocols for dividends paid by subsidiaries to parent 
corporations resident in the other treaty countries.

                         INTEREST AND ROYALTIES

    Consistent with the existing Convention, the proposed 
Convention generally eliminates source-country withholding 
taxes on cross-border interest and royalty payments. However, 
consistent with existing U.S. tax treaty policy, source-country 
tax may be imposed on certain contingent interest and payments 
from a U.S. real estate mortgage investment conduit.

                                PENSIONS

    The proposed Convention preserves the existing Convention's 
rules that allow for exclusive residence-country taxation of 
pensions, and consistent with current U.S. tax treaty policy, 
provides for exclusive source-country taxation of social 
security payments. The Convention differs from the Model Treaty 
in that it does not contain express provisions dealing with 
annuities, alimony, and child support payments, or certain 
provisions that deal with the tax-treatment of cross-border 
pension contributions.

                         LIMITATION ON BENEFITS

    Consistent with current U.S. treaty policy, Article 22 
includes a ``Limitation on Benefits'' provision, which is 
designed to avoid treaty-shopping by limiting the indirect use 
of a treaty's benefits by persons who were not intended to take 
advantage of those benefits. The limitation of benefits 
provision states that a corporation or similar entity resident 
in a contracting state (i.e., the United States or Hungary) is 
not entitled to the benefits of the treaty unless that entity 
meets certain tests, such as carrying on an active trade or 
business, or being a publicly-traded company on certain 
specified stock exchanges. The provision is designed to 
identify entities that have established residency for tax-abuse 
purposes. This article's limitation of benefits provision 
generally reflects the anti-treaty-shopping provisions included 
in the U.S. Model treaty and more recent U.S. income tax 
treaties, but differs in a few respects that may permit some 
companies to qualify for treaty benefits under tests not found 
in the Model. For instance, the proposed treaty contains a 
derivative benefits test under which a company could qualify 
for treaty benefits if at least 95% of the aggregate voting 
power and value of its shares (and at least 50% of any 
disproportionate class of shares) are held by seven or fewer 
``equivalent beneficiaries.'' The proposed treaty also contains 
a headquarters company test, under which a resident company 
would qualify if it meets the criteria to be considered a 
headquarters company of a multinational group.

                        EXCHANGE OF INFORMATION

    Articles 26 provides authority for the two countries to 
exchange tax information. Under Article 26, the United States 
is allowed to obtain information (including from financial 
institutions) from Hungary regardless of whether Hungary needs 
the information for its own tax purposes.

                          IV. Entry Into Force

    The proposed Convention shall enter into force on the date 
when the United States and Hungary exchange instruments of 
ratification. The various provisions of this Convention shall 
have effect as described in paragraph 2 of Article 28 of the 
Convention.

                      V. Implementing Legislation

    As is the case generally with income tax treaties, the 
Convention is self-executing and does not require implementing 
legislation for the United States.

                          VI. Committee Action

    The committee held a public hearing on the Convention on 
June 7, 2011. Testimony was received from Manal Corwin, Deputy 
Assistant Secretary (International Tax Affairs) at the Treasury 
Department, and Thomas Barthold, Chief of Staff of the Joint 
Committee on Taxation. A transcript of the hearing is included 
as Annex 2 to Senate Executive Report 112-1.
    On July 26, 2011, the committee considered the Convention 
and ordered it favorably reported by voice vote, with a quorum 
present and without objection.

                        VII. Committee Comments

    The Committee on Foreign Relations believes that the 
Convention will stimulate increased trade and investment, 
reduce treaty shopping incentives, and promote closer co-
operation between the United States and Hungary. The committee 
therefore urges the Senate to act promptly to give advice and 
consent to ratification of the Convention, as set forth in this 
report and the accompanying resolution of advice and consent.

                       A. LIMITATION ON BENEFITS

    The committee applauds the Treasury Department's 
significant efforts to address treaty shopping both in this 
Convention and in other bilateral tax treaties. After careful 
examination of this Convention, as well as testimony and 
responses to questions for the record from the Treasury 
Department, the committee is of the view that the Convention's 
protections against treaty-shopping are robust and will 
substantially deny treaty shoppers the benefit of the 
Convention. The committee believes that it is critical for the 
Treasury Department to closely monitor and keep the committee 
informed on the effectiveness of the above-mentioned provisions 
in discouraging and eliminating treaty-shopping under the 
Convention.

     B. DECLARATION ON THE SELF-EXECUTING NATURE OF THE CONVENTION

    The committee has included one declaration in the 
recommended resolution of advice and consent. The declaration 
states that the Convention is self-executing, as is the case 
generally with income tax treaties. Prior to the 110th 
Congress, the committee generally included such statements in 
the committee's report, but in light of the Supreme Court 
decision in Medellin v. Texas, 128 S. Ct. 1346 (2008), the 
committee determined that a clear statement in the Resolution 
is warranted. A further discussion of the committee's views on 
this matter can be found in Section VIII of Executive Report 
110-12.

     VIII. Text of Resolution of Advice and Consent to Ratification

    Resolved (two-thirds of the Senators present concurring 
therein),

SECTION 1. SENATE ADVICE AND CONSENT SUBJECT TO A DECLARATION

    The Senate advises and consents to the ratification of the 
Convention between the Government of the United States of 
America and the Government of the Republic of Hungary for the 
Avoidance of Double Taxation and the Prevention of Fiscal 
Evasion with Respect to Taxes on Income, signed on February 4, 
2010, at Budapest, and a related agreement effected by an 
exchange of notes on February 4, 2010 (the ``Convention'') 
(Treaty Doc. 111-7), subject to the declaration of section 2.

SECTION 2. DECLARATION

    The advice and consent of the Senate under section 1 is 
subject to the following declaration:
    The Convention is self-executing.
                  IX. Annex 1.--Technical Explanation

  DEPARTMENT OF THE TREASURY TECHNICAL EXPLANATION OF THE CONVENTION 
    BETWEEN THE GOVERNMENT OF THE UNITED STATES OF AMERICA AND THE 
   GOVERNMENT OF THE REPUBLIC OF HUNGARY FOR THE AVOIDANCE OF DOUBLE 
TAXATION AND THE PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON 
                                INCOME.

    This is a Technical Explanation of the Convention between 
the Government of the United States and the Government of the 
Republic of Hungary for the Avoidance of Double Taxation and 
the Prevention of Fiscal Evasion with Respect to Taxes on 
Income, signed on February 4, 2010 (the ``Convention'').
    Negotiations took into account the U.S. Treasury 
Department's current tax treaty policy, and the Treasury 
Department's Model Income Tax Convention. Negotiations also 
took into account the Model Tax Convention on Income and on 
Capital, published by the Organisation for Economic Cooperation 
and Development (the ``OECD Model''), and recent tax treaties 
concluded by both countries.\1\
---------------------------------------------------------------------------
    \1\On the date of the signing of the Convention, the United States 
and Hungary exchanged diplomatic notes (``Exchange of Notes'') setting 
forth provisions and understandings related to the Convention and 
constituting an agreement between the two governments.
---------------------------------------------------------------------------
    The Technical Explanation is an official guide to the 
Convention and an accompanying Exchange of Notes. It reflects 
the policies behind particular provisions in the Convention and 
Exchange of Notes, as well as understandings reached during the 
negotiations with respect to the application and interpretation 
of the Convention and Exchange of Notes. References in the 
Technical Explanation to ``he'' or ``his'' should be read to 
mean ``he or she'' or ``his and her.''

                       ARTICLE 1 (GENERAL SCOPE)

Paragraph 1
    Paragraph 1 of Article 1 provides that the Convention 
applies only to residents of the United States or Hungary 
except where the terms of the Convention provide otherwise. 
Under Article 4 (Resident) a person is generally treated as a 
resident of a Contracting State if that person is, under the 
laws of that State, liable to tax therein by reason of his 
domicile, citizenship, residence, place of management, place of 
incorporation, or any other criterion of a similar nature.
     However, if a person is considered a resident of both 
Contracting States, Article 4 provides rules for determining a 
State of residence (or no State of residence). This 
determination governs for all purposes of the Convention.
    Certain provisions are applicable to persons who may not be 
residents of either Contracting State. For example, paragraph 1 
of Article 24 (Non-Discrimination) applies to nationals of the 
Contracting States. Under Article 26 (Exchange of Information), 
information may be exchanged with respect to residents of third 
states.
Paragraph 2
    Paragraph 2 states the generally accepted relationship both 
between the Convention and domestic law and between the 
Convention and other agreements between the Contracting States. 
That is, no provision in the Convention may restrict any 
exclusion, exemption, deduction, credit or other benefit 
accorded by the tax laws of the Contracting States, or by any 
other agreement to which both of the Contracting States are 
parties. The relationship between the nondiscrimination 
provisions of the Convention and other agreements is addressed 
not in paragraph 2 but in paragraph 3.
    Under paragraph 2, for example, if a deduction would be 
allowed under the U.S. Internal Revenue Code (the ``Code'') in 
computing the U.S. taxable income of a resident of Hungary, the 
deduction also is allowed to that person in computing taxable 
income under the Convention. Paragraph 2 also means that the 
Convention may not increase the tax burden on a resident of a 
Contracting States beyond the burden determined under domestic 
law. Thus, a right to tax given by the Convention cannot be 
exercised unless that right also exists under internal law.
    It follows that, under the principle of paragraph 2, a 
taxpayer's U.S. tax liability need not be determined under the 
Convention if the Code would produce a more favorable result. A 
taxpayer may not, however, choose among the provisions of the 
Code and the Convention in an inconsistent manner in order to 
minimize tax. Thus, a taxpayer may use the Convention to reduce 
its taxable income, but may not combine treaty and Code rules 
in a way that would thwart the intent of either set of rules. 
For example, assume that a resident of Hungary has three 
separate businesses in the United States. One is a profitable 
permanent establishment and the other two are trades or 
businesses that would earn taxable income under the Code but 
that do not meet the permanent establishment threshold tests of 
the Convention. One is profitable and the other incurs a loss. 
Under the Convention, the income of the permanent establishment 
is taxable in the United States, and both the profit and loss 
of the other two businesses are ignored. Under the Code, all 
three would be subject to tax, but the loss would offset the 
profits of the two profitable ventures. The taxpayer may not 
invoke the Convention to exclude the profits of the profitable 
trade or business and invoke the Code to claim the loss of the 
loss trade or business against the profit of the permanent 
establishment. (See Rev. Rul. 84-17, 1984-1 C.B. 308.) If, 
however, the taxpayer invokes the Code for the taxation of all 
three ventures, he would not be precluded from invoking the 
Convention with respect, for example, to any dividend income he 
may receive from the United States that is not effectively 
connected with any of his business activities in the United 
States.
    Similarly, except as provided in paragraph 3, nothing in 
the Convention can be used to deny any benefit granted by any 
other agreement to which both the United States and Hungary are 
parties. For example, if certain benefits are provided for 
military personnel or military contractors under a Status of 
Forces Agreement between the United States and Hungary, those 
benefits or protections will be available to residents of the 
Contracting States regardless of any provisions to the contrary 
(or silence) in the Convention.
Paragraph 3
    Paragraph 3 relates to non-discrimination obligations of 
the Contracting States under the General Agreement on Trade in 
Services (the ``GATS''). The provisions of paragraph 3 are an 
exception to the rule provided in paragraph 2 of this Article 
under which the Convention shall not restrict in any manner any 
benefit now or hereafter accorded by any other agreement 
between the Contracting States.
    Subparagraph (a) of paragraph 3 provides that, unless the 
competent authorities determine that a taxation measure is not 
within the scope of the Convention, the national treatment 
obligations of the GATS shall not apply with respect to that 
measure. Further, any question arising as to the interpretation 
or application of the Convention, including in particular 
whether a measure is within the scope of the Convention shall 
be considered only by the competent authorities of the 
Contracting States, and the procedures under the Convention 
exclusively shall apply to the dispute. Thus, paragraph 3 of 
Article XXII (Consultation) of the GATS may not be used to 
bring a dispute before the World Trade Organization unless the 
competent authorities of both Contracting States have 
determined that the relevant taxation measure is not within the 
scope of Article 24 (Non-Discrimination) of the Convention.
    The term ``measure'' for these purposes is defined broadly 
in subparagraph (b) of paragraph 3. It would include a law, 
regulation, rule, procedure, decision, administrative action, 
or any similar provision or action.
Paragraph 4
    Paragraph 4 contains the traditional saving clause found in 
all U.S. treaties. The Contracting States reserve their rights, 
except as provided in paragraph 5, to tax their residents and 
citizens as provided under their domestic laws, notwithstanding 
any provisions of the Convention to the contrary. For example, 
if a resident of Hungary performs professional services in the 
United States and the income from the services is not 
attributable to a permanent establishment in the United States, 
Article 7 (Business Profits) would by its terms prevent the 
United States from taxing the income. If, however, the resident 
of Hungary is also a citizen of the United States, the saving 
clause permits the United States to include the remuneration in 
the worldwide income of the citizen and subject it to tax under 
the normal Code rules (i.e., without regard to Code section 
894(a)). However, subparagraph 5(a) of Article 1 preserves the 
benefits of special foreign tax credit rules applicable to the 
U.S. taxation of certain U.S. income of its citizens resident 
in Hungary. See paragraph 4 of Article 23 (Relief from Double 
Taxation).
    For purposes of the saving clause, ``residence'' is 
determined under Article 4 (Resident). Thus, an individual who 
is a resident of the United States under the Code (but not a 
U.S. citizen) but who is determined to be a resident of the 
other Contracting State under the tie-breaker rules of Article 
4 would be subject to U.S. tax only to the extent permitted by 
the Convention. The United States would not be permitted to 
apply its domestic law to that person to the extent that its 
law is inconsistent with the Convention.
    However, the person would still be treated as a U.S. 
resident for U.S. tax purposes other than determining the 
individual's U.S. tax liability. For example, in determining 
under Code section 957 whether a foreign corporation is a 
controlled foreign corporation, shares in that corporation held 
by the individual would be considered to be held by a U.S. 
resident. As a result, other U.S. citizens or residents might 
be deemed to be United States shareholders of a controlled 
foreign corporation subject to current inclusion of subpart F 
income recognized by the corporation. See Treas. Reg. section 
301.7701(b)-7(a)(3).
    Under paragraph 4, each Contracting State also reserves its 
right to tax former citizens and former long-term residents for 
a period of ten years following the loss of such status. Thus, 
paragraph 4 allows the United States to tax former U.S. 
citizens and former U.S. long-term residents in accordance with 
Section 877 of the Code. Section 877 generally applies to a 
former citizen or long-term resident of the United States who 
relinquishes citizenship or terminates long-term residency 
before June 17, 2008 if he fails to certify that he has 
complied with U.S. tax laws during the 5 preceding years, or if 
either of the following criteria exceed established thresholds: 
(a) the average annual net income tax of such individual for 
the period of 5 taxable years ending before the date of the 
loss of status, or (b) the net worth of such individual as of 
the date of the loss of status.
    The United States defines ``long-term resident'' as an 
individual (other than a U.S. citizen) who is a lawful 
permanent resident of the United States in at least 8 of the 
prior 15 taxable years. An individual is not treated as a 
lawful permanent resident for any taxable year if such 
individual is treated as a resident of Hungary under the 
Convention, or as a resident of any country other than the 
United States under the provisions of any other U.S. tax 
treaty, and in either case the individual does not waive the 
benefits of the relevant treaty.
Paragraph 5
    Paragraph 5 sets forth certain exceptions to the saving 
clause. The referenced provisions are intended to provide 
benefits to citizens and residents even if such benefits do not 
exist under domestic law.
    Subparagraph (a) lists certain provisions of the Convention 
that are applicable to all citizens and residents of a 
Contracting State, despite the general saving clause rule of 
paragraph 4:

    (1) Paragraph 2 of Article 9 (Associated Enterprises) 
grants the right to a correlative adjustment with respect to 
income tax due on profits reallocated under Article 9.
    (2) Paragraphs 1 b) and 2 of Article 17 (Pensions and 
Income from Social Security) provide exemptions from source or 
residence State taxation for certain pension distributions and 
social security payments.
    (3) Paragraph 3 of Article 17 provides an exemption for 
certain investment income of pension funds located in the other 
Contracting State.
    (4) Article 23 (Relief from Double Taxation) confers to 
citizens and residents of one Contracting State the benefit of 
a credit for income taxes paid to the other or an exemption for 
income earned in the other State.
    (5) Article 24 (Non-Discrimination) protects residents and 
nationals of one Contracting State against the adoption of 
certain discriminatory practices in the other Contracting 
State.
    (6) Article 25 (Mutual Agreement Procedure) confers certain 
benefits on citizens and residents of the Contracting States in 
order to reach and implement solutions to disputes between the 
two Contracting States. For example, the competent authorities 
are permitted to use a definition of a term that differs from 
an internal law definition. The statute of limitations may be 
waived for refunds, so that the benefits of an agreement may be 
implemented.
    Subparagraph (b) of paragraph 5 provides a different set of 
exceptions to the saving clause. The benefits referred to are 
all intended to be granted to temporary residents of a 
Contracting State (for example, in the case of the United 
States, holders of non-immigrant visas), but not to citizens or 
to persons who have acquired permanent residence in that State. 
If beneficiaries of these provisions travel from one of the 
Contracting States to the other, and remain in the other long 
enough to become residents under its internal law, but do not 
acquire permanent residence status (i.e., in the U.S. context, 
they do not become ``green card'' holders) and are not citizens 
of that State, the host State will continue to grant these 
benefits even if they conflict with the statutory rules. The 
benefits preserved by this paragraph are the host country 
exemptions for government service salaries and pensions under 
Article 18 (Government Service), certain income of visiting 
students and trainees under Article 19 (Students and Trainees), 
certain income of visiting professors and teachers under 
Article 20 (Professors and Teachers), and the income of 
diplomatic agents and consular officers under Article 27 
(Members of Diplomatic Missions and Consular Posts).
Paragraph 6
     Paragraph 6 addresses special issues presented by fiscally 
transparent entities such as partnerships and certain estates 
and trusts. Because different countries frequently take 
different views as to when an entity is fiscally transparent, 
the risk of both double taxation and double non-taxation are 
relatively high. The intention of paragraph 6 is to eliminate a 
number of technical problems that arguably would have prevented 
investors using such entities from claiming treaty benefits, 
even though such investors would be subject to tax on the 
income derived through such entities. The provision also 
prevents the use of such entities to claim treaty benefits in 
circumstances where the person investing through such an entity 
is not subject to tax on the income in its State of residence. 
The provision, and the corresponding requirements of the other 
Articles of the Convention, should be read with those two goals 
in mind.
    In general, paragraph 6 relates to entities that are not 
subject to tax at the entity level, as distinct from entities 
that are subject to tax, but with respect to which tax may be 
relieved under an integrated system. This paragraph, as 
discussed in paragraph 1 of the Exchange of Notes, applies to 
any resident of a Contracting State who is entitled to income 
derived through an entity organized in either Contracting State 
that is treated as fiscally transparent under the laws of 
either Contracting State. Entities falling under this 
description in the United States include partnerships, common 
investment trusts under section 584 and grantor trusts. This 
paragraph also applies to U.S. limited liability companies 
(``LLCs'') that are treated as partnerships or as disregarded 
entities for U.S. tax purposes. Paragraph 1 of the Exchange of 
Notes provides further that paragraph 6 does not apply with 
respect to income received by an entity that is organized in a 
third state.
    Under paragraph 6, an item of income, profit or gain 
derived by a fiscally transparent entity organized in either 
Contracting State will be considered to be derived by a 
resident of a Contracting State if a resident is treated under 
the taxation laws of that State as deriving the item of income. 
For example, if a company that is a resident of Hungary pays 
interest to a U.S. entity that is treated as fiscally 
transparent for U.S. tax purposes, the interest will be 
considered derived by a resident of the U.S. only to the extent 
that the taxation laws of the United States treats one or more 
U.S. residents (whose status as U.S. residents is determined, 
for this purpose, under U.S. tax law) as deriving the interest 
for U.S. tax purposes. In the case of a partnership, the 
persons who are, under U.S. tax laws, treated as partners of 
the entity would normally be the persons whom the U.S. tax laws 
would treat as deriving the interest income through the 
partnership. Also, it follows that persons whom the United 
States treats as partners but who are not U.S. residents for 
U.S. tax purposes may not claim a benefit for the interest paid 
to the entity under the Convention, because they are not 
residents of the United States for purposes of claiming this 
treaty benefit. In contrast, if, for example, an entity is 
organized under U.S. laws and is classified as a corporation 
for U.S. tax purposes, interest paid by a company that is a 
resident of Hungary to the U.S. entity will be considered 
derived by a resident of the United States since the
    U.S. corporation is treated under U.S. taxation laws as a 
resident of the United States and as deriving the income.
    The same result obtains even if the entity were viewed 
differently under the tax laws of Hungary (e.g., as not 
fiscally transparent in the first example above where the 
entity is treated as a partnership for U.S. tax purposes). The 
results follow regardless of whether the entity is disregarded 
as a separate entity under the laws of one jurisdiction but not 
the other, such as a single owner entity that is viewed as a 
branch for U.S. tax purposes and as a corporation for tax 
purposes under the laws of Hungary.
    For example, income from U.S. sources received by an entity 
organized under the laws of the United States, which is treated 
for tax purposes under the laws of Hungary as a corporation and 
is owned by a shareholder who is a resident of Hungary for its 
tax purposes, is not considered derived by the shareholder of 
that corporation even if, under the tax laws of the United 
States, the entity is treated as fiscally transparent. Rather, 
for purposes of the treaty, the income is treated as derived by 
the U.S. entity.
    These principles also apply to trusts to the extent that 
they are fiscally transparent in either Contracting State. For 
example, if X, a resident of Hungary, creates a revocable trust 
in the United States and names persons resident in a third 
country as the beneficiaries of the trust, the trust's income 
would be regarded as being derived by a resident of Hungary 
only to the extent that the laws of Hungary treat X as deriving 
the income for its tax purposes, perhaps through application of 
rules similar to the U.S. ``grantor trust'' rules.
    Paragraph 6 is not an exception to the saving clause of 
paragraph 4. Accordingly, paragraph 6 does not prevent a 
Contracting State from taxing an entity that is treated as a 
resident of that State under its tax law. For example, if a 
U.S. LLC with members who are residents of Hungary elects to be 
taxed as a corporation for U.S. tax purposes, the United States 
will tax that LLC on its worldwide income on a net basis, 
without regard to whether Hungary views the LLC as fiscally 
transparent.

                       ARTICLE 2 (TAXES COVERED)

    This Article specifies the U.S. taxes and the taxes of 
Hungary to which the Convention applies. With two exceptions, 
the taxes specified in Article 2 are the covered taxes for all 
purposes of the Convention. A broader coverage applies, 
however, for purposes of Articles 24 (Non-Discrimination) and 
26 (Exchange of Information and Administrative Assistance). 
Article 24 (Non-Discrimination) applies with respect to all 
taxes, including those imposed by state and local governments. 
Article 26 (Exchange of Information and Administrative 
Assistance) applies with respect to all taxes imposed at the 
national level.
Paragraph 1
    Paragraph 1 identifies the category of taxes to which the 
Convention applies. Paragraph 1 is based on the U.S. and OECD 
Models and defines the scope of application of the Convention.
    The Convention applies to taxes on income, including gains, 
imposed on behalf of a Contracting State, irrespective of the 
manner in which they are levied. Except with respect to Article 
24 (Non-Discrimination), state and local taxes are not covered 
by the Convention.
Paragraph 2
    Paragraph 2 also is based on the U.S. and OECD Models and 
provides a definition of taxes on income and on capital gains. 
The Convention covers taxes on total income or any part of 
income and includes tax on gains derived from the alienation of 
movable or immovable property (real property), and taxes on the 
total amounts of wages or salaries paid by enterprises. The 
Exchange of Notes provides that the term ``movable property'' 
refers to all property other than immovable property (real 
property) as defined in Article 6 (Income from Immovable 
Property (Real Property)). The Convention does not apply, 
however, to social security or unemployment taxes, or any other 
charges where there is a direct connection between the levy and 
individual benefits. Nor does it apply to property taxes, 
except with respect to Article 24 (Non-Discrimination).
Paragraph 3
    Paragraph 3 lists the taxes in force at the time of 
signature of the Convention to which the Convention applies.
    The existing covered taxes of Hungary are identified in 
subparagraph 3(a) as the personal income tax, the corporate 
tax, and the surtax.
    Subparagraph 3(b) provides that the existing U.S. taxes 
subject to the rules of the Convention are the Federal income 
taxes imposed by the Code, together with the excise taxes 
imposed with respect to private foundations (Code sections 4940 
through 4948). Social security and unemployment taxes (Code 
sections 1401, 3101, 3111 and 3301) are specifically excluded 
from coverage.
Paragraph 4
    Under paragraph 4, the Convention will apply to any taxes 
that are identical, or substantially similar, to those 
enumerated in paragraph 3, and which are imposed in addition 
to, or in place of, the existing taxes after February 4, 2010, 
the date of signature of the Convention. The paragraph also 
provides that the competent authorities of the Contracting 
States will notify each other of any significant changes that 
have been made in their taxation laws.

                    ARTICLE 3 (GENERAL DEFINITIONS)

    Article 3 provides general definitions and rules of 
interpretation applicable throughout the Convention. Certain 
other terms are defined in other articles of the Convention. 
For example, the term ``resident of a Contracting State'' is 
defined in Article 4 (Resident). The term ``permanent 
establishment'' is defined in Article 5 (Permanent 
Establishment). These definitions are used consistently 
throughout the Convention. Other terms, such as ``dividends,'' 
``interest'' and ``royalties'' are defined in specific articles 
for purposes only of those articles.
Paragraph 1
    Paragraph 1 defines a number of basic terms used in the 
Convention. The introduction to paragraph 1 makes clear that 
these definitions apply for all purposes of the Convention, 
unless the context requires otherwise. This latter condition 
allows flexibility in the interpretation of the treaty in order 
to avoid results not intended by the treaty's negotiators.
    Subparagraph 1(a) defines the term ``person'' to include an 
individual, an estate, a trust, a partnership, a company and 
any other body of persons. The definition is significant for a 
variety of reasons. For example, under Article 4, only a 
``person'' can be a ``resident'' and therefore eligible for 
most benefits under the treaty. Also, all ``persons'' are 
eligible to claim relief under Article 25 (Mutual Agreement 
Procedure).
    The term ``company'' is defined in subparagraph 1(b) as a 
body corporate or an entity treated as a body corporate for tax 
purposes. The Exchange of Notes provides that partnerships 
established in Hungary are taxed by Hungary as corporations, 
and therefore fall within the definition of ``company.''
    The terms ``enterprise of a Contracting State'' and 
``enterprise of the other Contracting State'' are defined in 
subparagraph 1(c) as an enterprise carried on by a resident of 
a Contracting State and an enterprise carried on by a resident 
of the other Contracting State. An enterprise of a Contracting 
State need not be carried on in that State. It may be carried 
on in the other Contracting State or a third state (e.g., a 
U.S. corporation doing all of its business in the other 
Contracting State would still be a U.S. enterprise).
    Subparagraph 1(c) further provides that these terms also 
encompass an enterprise conducted through an entity (such as a 
partnership) that is treated as fiscally transparent in the 
Contracting State where the entity's owner is resident. The 
definition makes this point explicitly to ensure that the 
purpose of the Convention is not thwarted by an overly 
technical application of the term ``enterprise of a Contracting 
State'' to activities carried on through partnerships and 
similar entities. In accordance with Article 4 (Resident), 
entities that are fiscally transparent in the country in which 
their owners are resident are not considered to be residents of 
a Contracting State (although income derived by such entities 
may be taxed as the income of a resident, if taxed in the hands 
of resident partners or other owners). It could be argued that 
an enterprise conducted by such an entity is not conducted by a 
resident of a Contracting State, and therefore would not 
benefit from provisions applicable to enterprises of a 
Contracting State. The definition is intended to make clear 
that an enterprise conducted by such an entity will be treated 
as carried on by a resident of a Contracting State to the 
extent its partners or other owners are residents. This 
approach is consistent with the Code, which under section 875 
attributes a trade or business conducted by a partnership to 
its partners and a trade or business conducted by an estate or 
trust to its beneficiaries.
    Subparagraph 1(d) defines the term ``enterprise'' as any 
activity or set of activities that constitutes the carrying on 
of a business. The term ``business'' is not defined, but 
subparagraph (e) provides that it includes the performance of 
professional services and other activities of an independent 
character. Both subparagraphs are identical to definitions 
added to the OECD Model in connection with the deletion of 
Article 14 (Independent Personal Services) from the OECD Model. 
The inclusion of the two definitions is intended to clarify 
that income from the performance of professional services or 
other activities of an independent character is dealt with 
under Article 7 (Business Profits) and not Article 21 (Other 
Income).
    Subparagraph 1(f) defines the term ``international 
traffic.'' The term means any transport by a ship or aircraft 
except when such transport is solely between places within a 
Contracting State. This definition is applicable principally in 
the context of Article 8 (Shipping and Air Transport). The 
definition combines with paragraphs 2 and 3 of Article 8 to 
exempt from tax by the source State income from the rental of 
ships or aircraft that is earned both by lessors that are 
operators of ships and aircraft and by those lessors that are 
not (e.g., a bank or a container leasing company).
    The exclusion from international traffic of transport 
solely between places within a Contracting State means, for 
example, that carriage of goods or passengers solely between 
New York and Chicago would not be treated as international 
traffic, whether carried by a U.S. or a foreign carrier. The 
substantive taxing rules of the Convention relating to the 
taxation of income from transport, principally Article 8 
(Shipping and Air Transport), therefore, would not apply to 
income from such carriage. Thus, if the carrier engaged in 
internal U.S. traffic were a resident of Hungary (assuming that 
were possible under U.S. law), the United States would not be 
required to exempt the income from that transport under Article 
8. The income would, however, be treated as business profits 
under Article 7 (Business Profits), and therefore would be 
taxable in the United States only if attributable to a U.S. 
permanent establishment of the foreign carrier, and then only 
on a net basis. The gross basis U.S. tax imposed by section 887 
would never apply under the circumstances described. If, 
however, goods or passengers are carried by a carrier resident 
in Hungary from a non-U.S. port to, for example, New York, and 
some of the goods or passengers continue on to Chicago, the 
entire transport would be international traffic. This would be 
true if the international carrier transferred the goods at the 
U.S. port of entry from a ship to a land vehicle, from a ship 
to a lighter, or even if the overland portion of the trip in 
the United States was handled by an independent carrier under 
contract with the original international carrier, so long as 
both parts of the trip were reflected in original bills of 
lading. For this reason, the Convention, following the U.S. 
Model, refers, in the definition of ``international traffic,'' 
to ``such transport'' being solely between places in the other 
Contracting State, while the OECD Model refers to the ship or 
aircraft being operated solely between such places. The 
formulation in the Convention is intended to make clear that, 
as in the above example, even if the goods are carried on a 
different aircraft for the internal portion of the 
international voyage than is used for the overseas portion of 
the trip, the definition applies to that internal portion as 
well as the external portion.
    Finally, a ``cruise to nowhere,'' i.e., a cruise beginning 
and ending in a port in the same Contracting State with no 
stops in a foreign port, would not constitute international 
traffic.
    Subparagraph 1(g) designates the ``competent authorities'' 
for the other Contracting State and the United States. The U.S. 
competent authority is the Secretary of the Treasury or his 
delegate. The Secretary of the Treasury has delegated the 
competent authority function to the Commissioner of Internal 
Revenue, who in turn has delegated the authority to the Deputy 
Commissioner (International) LMSB. With respect to 
interpretative issues, the Deputy Commissioner (International) 
LMSB acts with the concurrence of the Associate Chief Counsel 
(International) of the Internal Revenue Service. In the case of 
Hungary, the competent authority is the Minister of Finance or 
his authorized representative.
    The geographical scope of the Convention with respect to 
Hungary is set out in subparagraph 1(h). The term ``Hungary'' 
means the Republic of Hungary and, when used in a geographical 
sense, means the territory of the Republic of Hungary. The 
geographical scope of the Convention with respect to the United 
States is set out in subparagraph 1(i). It encompasses the 
United States of America, including the states, the District of 
Columbia and the territorial sea of the United States. The term 
does not include Puerto Rico, the Virgin Islands, Guam or any 
other U.S. possession or territory. For certain purposes, the 
term ``United States'' includes the sea bed and subsoil of 
undersea areas adjacent to the territorial sea of the United 
States. This extension applies to the extent that the United 
States exercises sovereignty in accordance with international 
law for the purpose of natural resource exploration and 
exploitation of such areas. This extension of the definition 
applies, however, only if the person, property or activity to 
which the Convention is being applied is connected with such 
natural resource exploration or exploitation. Thus, it would 
not include any activity involving the sea floor of an area 
over which the United States exercised sovereignty for natural 
resource purposes if that activity was unrelated to the 
exploration and exploitation of natural resources. This result 
is consistent with the result that would be obtained under 
Section 638, which treats the continental shelf as part of the 
United States for purposes of natural resource exploration and 
exploitation.
    The term ``national,'' as it relates to the United States 
and to Hungary, is defined in subparagraph 1(j). This term is 
relevant for purposes of Articles 19 (Government Service) and 
24 (Non-Discrimination). A national of one of the Contracting 
States is (1) an individual who possesses the nationality 
(including, in the case of the United States, the citizenship 
as is provided in paragraph 4 of the Exchange of Notes) of that 
State, and (2) any legal person, partnership, association or 
other entity deriving its status, as such, from the law in 
force in the State where it is established.
    Subparagraph 1(k) defines the term ``pension fund'' to 
include any person established in a Contracting State that is 
generally exempt from income taxation in that State and that is 
operated principally to provide pension or retirement benefits 
or to earn income for the benefit of one or more such 
arrangements. In the case of the United States, the term 
``pension fund'' includes the following: a trust providing 
pension or retirement benefits under a Code section 401(a) 
qualified pension plan, profit sharing or stock bonus plan, a 
Code section 403(a) qualified annuity plan, a Code section 
403(b) plan, a trust that is an individual retirement account 
under Code section 408, a Roth individual retirement account 
under Code section 408A, or a simple retirement account under 
Code section 408(p), a trust providing pension or retirement 
benefits under a simplified employee pension plan under Code 
section 408(k), a trust described in section 457(g) providing 
pension or retirement benefits under a Code section 457(b) 
plan, and the Thrift Savings Fund (section 7701(j)). Section 
401(k) plans and group trusts described in Revenue Ruling 81-
100 and meeting the conditions of Revenue Ruling 2004-67 
qualify as pension funds to the extent that they are covered by 
Code section 401(a).
    Subparagraph 1(l) defines the terms ``a Contracting State'' 
and ``the other Contracting State'' to mean Hungary or the 
United States as the context requires.
Paragraph 2
    Terms that are not defined in the Convention are dealt with 
in paragraph 2.
    Paragraph 2 provides that in the application of the 
Convention, any term used but not defined in the Convention 
will have the meaning that it has under the law of the 
Contracting State whose tax is being applied, unless the 
context requires otherwise, or the competent authorities have 
agreed on a different meaning pursuant to Article 25 (Mutual 
Agreement Procedure). If the term is defined under both the tax 
and non-tax laws of a Contracting State, the definition in the 
tax law will take precedence over the definition in the non-tax 
laws. Finally, there also may be cases where the tax laws of a 
State contain multiple definitions of the same term. In such a 
case, the definition used for purposes of the particular 
provision at issue, if any, should be used.
    If the meaning of a term cannot be readily determined under 
the law of a Contracting State, or if there is a conflict in 
meaning under the laws of the two States that creates 
difficulties in the application of the Convention, the 
competent authorities may establish, pursuant to the provisions 
of Article 25 (Mutual Agreement Procedure) a common meaning in 
order to prevent double taxation or to further any other 
purpose of the Convention. This common meaning need not conform 
to the meaning of the term under the laws of either Contracting 
State.
    Under paragraph 2, the relevant law of a Contracting State 
is the law in effect at the time the treaty is being applied, 
not the law as in effect at the time the treaty was signed. The 
use of ``ambulatory'' definitions, however, may lead to results 
that are at variance with the intentions of the negotiators and 
of the Contracting States when the treaty was negotiated and 
ratified. The reference in both paragraphs 1 and 2 to the 
``context otherwise requir[ing]'' a definition different from 
the treaty definition, in paragraph 1, or from the internal law 
definition of the Contracting State whose tax is being imposed, 
under paragraph 2, refers to a circumstance where the result 
intended by the Contracting States is different from the result 
that would obtain under either the paragraph 1 definition or 
the statutory definition. Thus, flexibility in defining terms 
is necessary and permitted.

                          ARTICLE 4 (RESIDENT)

    This Article sets forth rules for determining whether a 
person is a resident of a Contracting State for purposes of the 
Convention. As a general matter only residents of the 
Contracting States may claim the benefits of the Convention. 
The treaty definition of residence is to be used only for 
purposes of the Convention. The fact that a person is 
determined to be a resident of a Contracting State under 
Article 4 does not automatically entitle that person to the 
benefits of the Convention. In addition to being a resident, a 
person also must qualify for benefits under Article 22 
(Limitation on Benefits) in order to receive benefits conferred 
on residents of a Contracting State.
    The determination of residence for treaty purposes looks 
first to a person's liability to tax as a resident under the 
respective taxation laws of the Contracting States. As a 
general matter, a person who, under those laws, is a resident 
of one Contracting State and not of the other need look no 
further. For purposes of the Convention, that person is a 
resident of the State in which he is resident under internal 
law. If, however, a person is resident in both Contracting 
States under their respective taxation laws, the Article 
proceeds, where possible, to use tie-breaker rules to assign a 
single State of residence to such a person for purposes of the 
Convention.
Paragraph 1
    The term ``resident of a Contracting State'' is defined in 
paragraph 1. In general, this definition incorporates the 
definitions of residence in U.S. law and that of Hungary by 
referring to a resident as a person who, under the laws of a 
Contracting State, is liable to tax therein by reason of his 
domicile, residence, citizenship, place of management, place of 
incorporation or any other similar criterion. Thus, residents 
of the United States include aliens who are considered U.S. 
residents under Code section 7701(b). Paragraph 1 also 
specifically includes the two Contracting States, and political 
subdivisions and local authorities of the two States, as 
residents for purposes of the Convention.
    Certain entities that are nominally liable to tax but that 
in practice are rarely required to pay tax also would generally 
be treated as residents and therefore accorded treaty benefits. 
For example, a U.S. Regulated Investment Company (RIC) and a 
U.S. Real Estate Investment Trust (REIT) are residents of the 
United States for purposes of the treaty. Although the income 
earned by these entities normally is not subject to U.S. tax in 
the hands of the entity, they are taxable to the extent that 
they do not currently distribute their profits, and therefore 
may be regarded as ``liable to tax.'' They also must satisfy a 
number of requirements under the Code in order to be entitled 
to special tax treatment.
    A person who is liable to tax in a Contracting State only 
in respect of income from sources within that State or capital 
situated therein or of profits attributable to a permanent 
establishment in that State will not be treated as a resident 
of that Contracting State for purposes of the Convention. Thus, 
a consular official of Hungary who is posted in the United 
States, who may be subject to U.S. tax on U.S. source 
investment income, but is not taxable in the United States on 
non-U.S. source income (see Code section 7701(b)(5)(B)), would 
not be considered a resident of the United States for purposes 
of the Convention. Similarly, an enterprise of Hungary with a 
permanent establishment in the United States is not, by virtue 
of that permanent establishment, a resident of the United 
States. The enterprise generally is subject to U.S. tax only 
with respect to its income that is attributable to the U.S. 
permanent establishment, not with respect to its worldwide 
income, as it would be if it were a U.S. resident.
Paragraph 2
    Paragraph 2 provides that certain tax-exempt entities such 
as pension funds and charitable organizations will be regarded 
as residents of a Contracting State regardless of whether they 
are generally liable to income tax in the State where they are 
established. The paragraph applies to legal persons organized 
under the laws of a Contracting State and established and 
maintained in that State to provide pensions or other similar 
benefits pursuant to a plan, or exclusively for religious, 
charitable, scientific, artistic, cultural, or educational 
purposes. Thus, a section 501(c) organization organized in the 
United States (such as a U.S. charity) that is generally exempt 
from tax under U.S. law is a resident of the United States for 
all purposes of the Convention.
Paragraph 3
    If, under the laws of the two Contracting States, and, 
thus, under paragraph 1, an individual is deemed to be a 
resident of both Contracting States, a series of tie-breaker 
rules are provided in paragraph 3 to determine a single State 
of residence for that individual. These tests are to be applied 
in the order in which they are stated. The first test is based 
on where the individual has a permanent home. If that test is 
inconclusive because the individual has a permanent home 
available to him in both States, he will be considered to be a 
resident of the Contracting State where his personal and 
economic relations are closest (i.e., the location of his 
``center of vital interests''). If that test is also 
inconclusive, or if he does not have a permanent home available 
to him in either State, he will be treated as a resident of the 
Contracting State where he maintains a habitual abode. If he 
has a habitual abode in both States or in neither of them, he 
will be treated as a resident of the Contracting State of which 
he is a national. If he is a national of both States or of 
neither, the matter will be considered by the competent 
authorities, who will assign a single State of residence.
Paragraph 4
    Dual residents other than individuals (such as companies, 
trusts or estates) are addressed by paragraph 4. If such a 
person is, under the rules of paragraph 1, resident in both 
Contracting States, the competent authorities shall seek to 
determine a single State of residence for that person for 
purposes of the Convention. It the competent authorities are 
unable to reach such an agreement, that person may not claim 
any benefit provided by the Convention, except for those 
provided by Article 24 (Non-Discrimination) and Article 25 
(Mutual Agreement Procedure).
    Dual resident persons may, however, be treated as a 
resident of a Contracting State for purposes other than that of 
obtaining benefits under the Convention. For example, if a dual 
resident company pays a dividend to a resident of Hungary, the 
U.S. paying agent would withhold on that dividend at the 
appropriate treaty rate because reduced withholding is a 
benefit enjoyed by the resident of Hungary, not by the dual 
resident company. The dual resident company that paid the 
dividend would, for this purpose, be treated as a resident of 
the United States under the Convention. In addition, 
information relating to dual resident persons can be exchanged 
under the Convention because, by its terms, Article 26 
(Exchange of Information) is not limited to residents of the 
Contracting States.

                  ARTICLE 5 (PERMANENT ESTABLISHMENT)

    This Article defines the term ``permanent establishment,'' 
a term that is significant for several articles of the 
Convention. The existence of a permanent establishment in a 
Contracting State is necessary under Article 7 (Business 
Profits) for the taxation by that State of the business profits 
of a resident of the other Contracting State. Articles 10 
(Dividends), 11 (Interest), and 12 (Royalties) provide for 
reduced rates of tax at source on payments of these items of 
income to a resident of the other State only when the income is 
not attributable to a permanent establishment that the 
recipient has in the source State. The concept is also relevant 
in determining which Contracting State may tax certain gains 
under Article 13 (Gains) and certain ``other income'' under 
Article 21 (Other Income).
Paragraph 1
    The basic definition of the term ``permanent 
establishment'' is contained in paragraph 1. As used in the 
Convention, the term means a fixed place of business through 
which the business of an enterprise is wholly or partly carried 
on. As indicated in the OECD Commentary to Article 5 (see 
paragraphs 4 through 8), a general principle to be observed in 
determining whether a permanent establishment exists is that 
the place of business must be ``fixed'' in the sense that a 
particular building or physical location is used by the 
enterprise for the conduct of its business, and that it must be 
foreseeable that the enterprise's use of this building or other 
physical location will be more than temporary.
Paragraph 2
    Paragraph 2 lists a number of types of fixed places of 
business that constitute a permanent establishment. This list 
is illustrative and non-exclusive. According to paragraph 2, 
the term permanent establishment includes a place of 
management, a branch, an office, a factory, a workshop, and a 
mine, oil or gas well, quarry or other place of extraction of 
natural resources.
Paragraph 3
    This paragraph provides rules to determine whether a 
building site or a construction, assembly or installation 
project, or an installation or drilling rig or ship used for 
the exploration of natural resources constitutes a permanent 
establishment for the contractor, driller, etc. Such a site or 
activity does not create a permanent establishment unless the 
site, project, etc. lasts, or the exploration activity 
continues, for more than twelve months. It is only necessary to 
refer to ``exploration'' and not ``exploitation'' in this 
context because exploitation activities are defined to 
constitute a permanent establishment under subparagraph 2(f). 
Thus, a drilling rig does not constitute a permanent 
establishment if a well is drilled in only six months, but if 
production begins in the following month the well becomes a 
permanent establishment as of that date.
    The twelve-month test applies separately to each site or 
project. The twelve-month period begins when work (including 
preparatory work carried on by the enterprise) physically 
begins in a Contracting State. A series of contracts or 
projects by a contractor that are interdependent both 
commercially and geographically are to be treated as a single 
project for purposes of applying the twelve-month threshold 
test. For example, the construction of a housing development 
would be considered as a single project even if each house were 
constructed for a different purchaser.
    In applying this paragraph, time spent by a sub-contractor 
on a building site is counted as time spent by the general 
contractor at the site for purposes of determining whether the 
general contractor has a permanent establishment. However, for 
the sub-contractor itself to be treated as having a permanent 
establishment, the sub-contractor's activities at the site must 
last for more than 12 months. If a sub-contractor is on a site 
intermittently, then, for purposes of applying the 12-month 
rule, time is measured from the first day the sub-contractor is 
on the site until the last day (i.e., intervening days that the 
sub-contractor is not on the site are counted).
    These interpretations of the Article are based on the 
Commentary to paragraph 3 of Article 5 of the OECD Model, which 
contains language that is substantially the same as that in the 
Convention. These interpretations are consistent with the 
generally accepted international interpretation of the relevant 
language in paragraph 3 of Article 5 of the Convention.
    If the twelve-month threshold is exceeded, the site or 
project constitutes a permanent establishment from the first 
day of activity.
Paragraph 4
    This paragraph contains exceptions to the general rule of 
paragraph 1, listing a number of activities that may be carried 
on through a fixed place of business but which nevertheless do 
not create a permanent establishment. The use of facilities 
solely to store, display or deliver merchandise belonging to an 
enterprise does not constitute a permanent establishment of 
that enterprise. The maintenance of a stock of goods belonging 
to an enterprise solely for the purpose of storage, display or 
delivery, or solely for the purpose of processing by another 
enterprise does not give rise to a permanent establishment of 
the first-mentioned enterprise. The maintenance of a fixed 
place of business solely for the purpose of purchasing goods or 
merchandise, or for collecting information, for the enterprise, 
or for other activities that have a preparatory or auxiliary 
character for the enterprise, such as advertising, or the 
supply of information, do not constitute a permanent 
establishment of the enterprise. Moreover, subparagraph 4(f) 
provides that a combination of the activities described in the 
other subparagraphs of paragraph 4 will not give rise to a 
permanent establishment if the combination results in an 
overall activity that is of a preparatory or auxiliary 
character.
Paragraph 5
    Paragraphs 5 and 6 specify when activities carried on by an 
agent or other person acting on behalf of an enterprise create 
a permanent establishment of that enterprise. Under paragraph 
5, a person is deemed to create a permanent establishment of 
the enterprise if that person has and habitually exercises an 
authority to conclude contracts in the name of the enterprise. 
If, however, for example, his activities are limited to those 
activities specified in paragraph 4 which would not constitute 
a permanent establishment if carried on by the enterprise 
through a fixed place of business, the person does not create a 
permanent establishment of the enterprise.
    The Convention uses the OECD Model language ``in the name 
of that enterprise,'' rather than the U.S. Model language 
``binding on the enterprise.'' Hungary and the United States do 
not intend this difference in language to be a substantive 
difference. As indicated in paragraph 32.1 to the OECD 
Commentaries on Article 5, paragraph 5 of the Article is not 
intended to be limited to agents who enter into contracts 
literally in the name of the enterprise. The paragraph also 
applies to ``an agent who concludes contracts which are binding 
on the enterprise even if those contracts are not actually in 
the name of the enterprise.''
    The contracts referred to in paragraph 5 are those relating 
to the essential business operations of the enterprise, rather 
than ancillary activities. For example, if the person has no 
authority to conclude contracts in the name of the enterprise 
with its customers for, say, the sale of the goods produced by 
the enterprise, but it can enter into service contracts in the 
name of the enterprise for the enterprise's business equipment, 
this contracting authority would not fall within the scope of 
the paragraph, even if exercised regularly.
Paragraph 6
    Under paragraph 6, an enterprise is not deemed to have a 
permanent establishment in a Contracting State merely because 
it carries on business in that State through an independent 
agent, including a broker or general commission agent, if the 
agent is acting in the ordinary course of his business as an 
independent agent. Thus, there are two conditions that must be 
satisfied: the agent must be both legally and economically 
independent of the enterprise, and the agent must be acting in 
the ordinary course of its business in carrying out activities 
on behalf of the enterprise.
    Whether the agent and the enterprise are independent is a 
factual determination. Among the questions to be considered are 
the extent to which the agent operates on the basis of 
instructions from the enterprise. An agent that is subject to 
detailed instructions regarding the conduct of its operations 
or comprehensive control by the enterprise is not legally 
independent.
    In determining whether the agent is economically 
independent, a relevant factor is the extent to which the agent 
bears business risk. Business risk refers primarily to risk of 
loss. An independent agent typically bears risk of loss from 
its own activities. In the absence of other factors that would 
establish dependence, an agent that shares business risk with 
the enterprise, or has its own business risk, is economically 
independent because its business activities are not integrated 
with those of the principal. Conversely, an agent that bears 
little or no risk from the activities it performs is not 
economically independent and therefore is not described in 
paragraph 6.
    Another relevant factor in determining whether an agent is 
economically independent is whether the agent acts exclusively 
or nearly exclusively for the principal. Such a relationship 
may indicate that the principal has economic control over the 
agent. A number of principals acting in concert also may have 
economic control over an agent. The limited scope of the 
agent's activities and the agent's dependence on a single 
source of income may indicate that the agent lacks economic 
independence. It should be borne in mind, however, that 
exclusivity is not in itself a conclusive test; an agent may be 
economically independent notwithstanding an exclusive 
relationship with the principal if it has the capacity to 
diversify and acquire other clients without substantial 
modifications to its current business and without substantial 
harm to its business profits. Thus, exclusivity should be 
viewed merely as a pointer to further investigation of the 
relationship between the principal and the agent. Each case 
must be addressed on the basis of its own facts and 
circumstances.
Paragraph 7
    This paragraph clarifies that a company that is a resident 
of a Contracting State is not deemed to have a permanent 
establishment in the other Contracting State merely because it 
controls, or is controlled by, a company that is a resident of 
that other Contracting State, or that carries on business in 
that other Contracting State. The determination whether a 
permanent establishment exists is made solely on the basis of 
the factors described in paragraphs 1 through 6 of the Article. 
Whether a company is a permanent establishment of a related 
company, therefore, is based solely on those factors and not on 
the ownership or control relationship between the companies.

       ARTICLE 6 (INCOME FROM IMMOVABLE PROPERTY (REAL PROPERTY))

    This article deals with the taxation of income from 
immovable property (real property) situated in a Contracting 
State (the ``situs State''). The Article does not grant an 
exclusive taxing right to the situs State; the situs State is 
merely given the primary right to tax. The Article does not 
impose any limitation in terms of rate or form of tax imposed 
by the situs State, except that, as provided in paragraph 5, 
the situs State must allow the taxpayer an election to be taxed 
on a net basis.
Paragraph 1
    The first paragraph of Article 6 states the general rule 
that income of a resident of a Contracting State derived from 
immovable property (real property) situated in the other 
Contracting State may be taxed in the Contracting State in 
which the property is situated. The paragraph specifies that 
income from immovable property (real property) includes income 
from agriculture and forestry. Given the availability of the 
net election in paragraph 5, taxpayers generally should be able 
to obtain the same tax treatment in the situs country 
regardless of whether the income is treated as business profits 
or immovable property (real property) income.
Paragraph 2
    The term ``immovable property (real property)'' is defined 
in paragraph 2 by reference to the internal law definition in 
the situs State. In the case of the United States, the term has 
the meaning given to it by Reg. 1.897-1(b). In addition to the 
statutory definitions in the two Contracting States, the 
paragraph specifies certain additional classes of property 
that, regardless of internal law definitions, are within the 
scope of the term for purposes of the Convention. This expanded 
definition conforms to that in the OECD Model. The definition 
of ``immovable property (real property)'' for purposes of 
Article 6 is more limited than the expansive definition of 
``immovable property (real property)'' in paragraph 1 of 
Article 13 (Capital Gains). The Article 13 term includes not 
only immovable property (real property) as defined in Article 6 
but certain other interests in immovable property (real 
property).
Paragraph 3
    Paragraph 3 makes clear that all forms of income derived 
from the exploitation of immovable property (real property) are 
taxable in the Contracting State in which the property is 
situated. This includes income from any use of immovable 
property (real property), including, but not limited to, income 
from direct use by the owner (in which case income may be 
imputed to the owner for tax purposes) and rental income from 
the letting of immovable property (real property). In the case 
of a net lease of immovable property (real property), if a net 
election pursuant to paragraph 5 has not been made, the gross 
rental payment (before deductible expenses incurred by the 
lessee) is treated as income from the property.
    Other income closely associated with immovable property 
(real property) is covered by other Articles of the Convention, 
however, and not Article 6. For example, income from the 
disposition of an interest in immovable property (real 
property) is not considered ``derived'' from immovable property 
(real property); taxation of that income is addressed in 
Article 13 (Gains). Interest paid on a mortgage on immovable 
property (real property) would be covered by Article 11 
(Interest). Distributions by a U.S. Real Estate Investment 
Trust or certain regulated investment companies would fall 
under Article 13 in the case of distributions of U.S. real 
property gain or Article 10 (Dividends) in the case of 
distributions treated as dividends. Finally, distributions from 
a United States Real Property Holding Corporation are not 
considered to be income from the exploitation of immovable 
property (real property); such payments would fall under 
Article 10 or 13.
Paragraph 4
    This paragraph specifies that the basic rule of paragraph 1 
(as elaborated in paragraph 3) applies to income from immovable 
property (real property) of an enterprise. This clarifies that 
the situs country may tax the immovable property (real 
property) income (including rental income) of a resident of the 
other Contracting State in the absence of attribution to a 
permanent establishment in the situs State. This provision 
represents an exception to the general rule under Articles 7 
(Business Profits) that income must be attributable to a 
permanent establishment in order to be taxable in the situs 
state.
Paragraph 5
    The paragraph provides that a resident of one Contracting 
State that derives immovable property (real property) income 
from the other may elect, for any taxable year, to be subject 
to tax in that other State on a net basis, as though the income 
were attributable to a permanent establishment in that other 
State. The election may be terminated with the consent of the 
competent authority of the situs State. In the United States, 
revocation will be granted in accordance with the provisions of 
Treas. Reg. Sec. 1.871-10(d)(2).

                      ARTICLE 7 (BUSINESS PROFITS)

    This Article provides rules for the taxation by a 
Contracting State of the business profits of an enterprise of 
the other Contracting State.
Paragraph 1
    Paragraph 1 states the general rule that business profits 
of an enterprise of one Contracting State may not be taxed by 
the other Contracting State unless the enterprise carries on 
business in that other Contracting State through a permanent 
establishment (as defined in Article 5 (Permanent 
Establishment)) situated there. When that condition is met, the 
State in which the permanent establishment is situated may tax 
the enterprise on the income that is attributable to the 
permanent establishment.
    Although the Convention does not include a definition of 
``business profits,'' the term is intended to cover income 
derived from any trade or business. In accordance with this 
broad definition, the term ``business profits'' includes income 
attributable to notional principal contracts and other 
financial instruments to the extent that the income is 
attributable to a trade or business of dealing in such 
instruments or is otherwise related to a trade or business (as 
in the case of a notional principal contract entered into for 
the purpose of hedging currency risk arising from an active 
trade or business). Any other income derived from such 
instruments is, unless specifically covered in another article, 
dealt with under Article 21 (Other Income).
    The term ``business profits'' also includes income derived 
by an enterprise from the rental of tangible personal property 
(unless such tangible personal property consists of aircraft, 
ships or containers, income from which is addressed by Article 
8 (Shipping and Air Transport)). The inclusion of income 
derived by an enterprise from the rental of tangible personal 
property in business profits means that such income earned by a 
resident of a Contracting State can be taxed by the other 
Contracting State only if the income is attributable to a 
permanent establishment maintained by the resident in that 
other State, and, if the income is taxable, it can be taxed 
only on a net basis. Income from the rental of tangible 
personal property that is not derived in connection with a 
trade or business is dealt with in Article 21.
    In addition, as a result of the definitions of 
``enterprise'' and ``business'' in Article 3 (General 
Definitions), the term includes income derived from the 
furnishing of personal services. Thus, a consulting firm 
resident in one State whose employees or partners perform 
services in the other State through a permanent establishment 
may be taxed in that other State on a net basis under Article 
7, and not under Article 14 (Income from Employment), which 
applies only to income of employees. With respect to the 
enterprise's employees themselves, however, their salary 
remains subject to Article 14.
    Because this Article applies to income earned by an 
enterprise from the furnishing of personal services, the 
Article also applies to income derived by a partner resident in 
a Contracting State that is attributable to personal services 
performed in the other Contracting State through a partnership 
with a permanent establishment in that other State. Income 
which may be taxed under this Article includes all income 
attributable to the permanent establishment in respect of the 
performance of the personal services carried on by the 
partnership (whether by the partner himself, other partners in 
the partnership, or by employees assisting the partners) and 
any income from activities ancillary to the performance of 
those services (e.g., charges for facsimile services).
Paragraph 2
    Paragraph 2 provides rules for the attribution of business 
profits to a permanent establishment. The Contracting States 
will attribute to a permanent establishment the profits that it 
would have earned had it been a distinct and separate 
enterprise engaged in the same or similar activities under the 
same or similar conditions and dealing wholly independently 
with the enterprise of which it is a permanent establishment.
    The ``attributable to'' concept of paragraph 2 provides an 
alternative to the analogous but somewhat different 
``effectively connected'' concept in Code section 864(c). 
Depending on the circumstances, the amount of income 
``attributable to'' a permanent establishment under Article 7 
may be greater or less than the amount of income that would be 
treated as ``effectively connected'' to a U.S. trade or 
business under Code section 864. In particular, in the case of 
financial institutions, the use of internal dealings to 
allocate income within an enterprise may produce results under 
Article 7 that are significantly different than the results 
under the effectively connected income rules. For example, 
income from interbranch notional principal contracts may be 
taken into account under Article 7, notwithstanding that such 
transactions may be ignored for purposes of U.S. domestic law.
    The profits attributable to a permanent establishment may 
be from sources within or without a Contracting State. However, 
the business profits attributable to a permanent establishment 
include only those profits derived from the assets used, risks 
assumed, and activities performed by the permanent 
establishment.
    Paragraph 5 of the Exchange of Notes confirms that the 
arm's length method of paragraph 2 consists of applying the 
OECD Transfer Pricing Guidelines, but taking into account the 
different economic and legal circumstances of a single legal 
entity (as opposed to separate but associated enterprises). 
Thus, any of the methods used in the Transfer Pricing 
Guidelines, including profits methods, may be used as 
appropriate and in accordance with the Transfer Pricing 
Guidelines. However, the use of the Transfer Pricing Guidelines 
applies only for purposes of attributing profits within the 
legal entity. It does not create legal obligations or other tax 
consequences that would result from transactions having 
independent legal significance.
    One example of the different circumstances of a single 
legal entity is that an entity that operates through branches 
rather than separate subsidiaries generally will have lower 
capital requirements because all of the assets of the entity 
are available to support all of the entity's liabilities (with 
some exceptions attributable to local regulatory restrictions). 
This is the reason that most commercial banks and some 
insurance companies operate through branches rather than 
subsidiaries. The benefit that comes from such lower capital 
costs must be allocated among the branches in an appropriate 
manner. This issue does not arise in the case of an enterprise 
that operates through separate entities, since each entity will 
have to be separately capitalized or will have to compensate 
another entity for providing capital (usually through a 
guarantee).
    Under U.S. domestic regulations, internal ``transactions'' 
generally are not recognized because they do not have legal 
significance. In contrast, the Convention provides that such 
internal dealings may be used to attribute income to a 
permanent establishment in cases where the dealings accurately 
reflect the allocation of risk within the enterprise. One 
example is that of global trading in securities. In many cases, 
banks use internal swap transactions to transfer risk from one 
branch to a central location where traders have the expertise 
to manage that particular type of risk. Under the Convention, 
such a bank may also use such swap transactions as a means of 
attributing income between the branches, if use of that method 
is the ``best method'' within the meaning of regulation section 
1.482-1(c). The books of a branch will not be respected, 
however, when the results are inconsistent with a functional 
analysis. So, for example, income from a transaction that is 
booked in a particular branch (or home office) will not be 
treated as attributable to that location if the sales and risk 
management functions that generate the income are performed in 
another location.
    Because the use of profits methods is permissible under 
paragraph 2, it is not necessary for the Convention to include 
a provision corresponding to paragraph 4 of Article 7 of the 
OECD Model.
Paragraph 3
    Paragraph 3 provides that in determining the business 
profits of a permanent establishment, deductions shall be 
allowed for the expenses incurred for the purposes of the 
permanent establishment, ensuring that business profits will be 
taxed on a net basis. This rule is not limited to expenses 
incurred exclusively for the purposes of the permanent 
establishment, but includes expenses incurred for the purposes 
of the enterprise as a whole, or that part of the enterprise 
that includes the permanent establishment. Deductions are to be 
allowed regardless of which accounting unit of the enterprise 
books the expenses, so long as they are incurred for the 
purposes of the permanent establishment. For example, a portion 
of the interest expense recorded on the books of the home 
office in one State may be deducted by a permanent 
establishment in the other. The amount of the expense that must 
be allowed as a deduction is determined by applying the arm's 
length principle. If a deduction would be allowed under the 
Code in computing the U.S. taxable income, the deduction also 
is allowed in computing taxable income under the Convention. 
However, a taxpayer may not combine Convention and Code rules 
in a way that would thwart the intent of either set of rules. 
For example, assume that a Hungarian taxpayer with a permanent 
establishment in the United States borrows $100 to purchase 
U.S. tax exempt bonds, and that the $100 of tax-exempt bonds 
and the $100 of related debt would be treated as assets and 
liabilities of the permanent establishment. For purposes of 
computing the profits attributable to the permanent 
establishment under the Convention, both the tax exempt 
interest from the bonds and the interest expense from the 
related debt would be excluded. Thus, a taxpayer cannot take 
deductions for expenses in computing taxable income under the 
Convention to a greater extent than would be allowed under the 
Code where doing so would be inconsistent with the intent of 
the Code or the Convention.
    As noted above, the Exchange of Notes provides that the 
OECD Transfer Pricing Guidelines apply, by analogy, in 
determining the profits attributable to a permanent 
establishment. Accordingly, a permanent establishment may 
deduct payments made to its head office or another branch in 
compensation for services performed for the benefit of the 
branch.
    The method to be used in calculating that amount will 
depend on the terms of the arrangements between the branches 
and head office. For example, the enterprise could have a 
policy, expressed in writing, under which each business unit 
could use the services of lawyers employed by the head office. 
At the end of each year, the costs of employing the lawyers 
would be charged to each business unit according to the amount 
of services used by that business unit during the year. Since 
this appears to be a kind of cost-sharing arrangement and the 
allocation of costs is based on the benefits received by each 
business unit, such a cost allocation would be an acceptable 
means of determining a permanent establishment's deduction for 
legal expenses. Alternatively, the head office could agree to 
employ lawyers at its own risk, and to charge an arm's length 
price for legal services performed for a particular business 
unit. If the lawyers were under-utilized, and the ``fees'' 
received from the business units were less than the cost of 
employing the lawyers, then the head office would bear the 
excess cost. If the ``fees'' exceeded the cost of employing the 
lawyers, then the head office would keep the excess to 
compensate it for assuming the risk of employing the lawyers. 
If the enterprise acted in accordance with this agreement, this 
method would be an acceptable alternative method for 
calculating a permanent establishment's deduction for legal 
expenses.
    A permanent establishment cannot be funded entirely with 
debt, but must have sufficient capital to carry on its 
activities as if it were a distinct and separate enterprise. To 
the extent that the permanent establishment has not been 
attributed capital for profit attribution purposes, a 
Contracting State may attribute such capital to the permanent 
establishment, in accordance with the arm's length principle, 
and deny an interest deduction to the extent necessary to 
reflect that capital attribution. The method prescribed by U.S. 
domestic law for making this attribution is found in Treas. 
Reg. section 1.882-5. Both section 1.882-5 and the method 
prescribed the Convention start from the premise that all of 
the capital of the enterprise supports all of the assets and 
risks of the enterprise, and therefore the entire capital of 
the enterprise must be allocated to its various businesses and 
offices.
    However, section 1.882-5 does not take into account the 
fact that some assets create more risk for the enterprise than 
do other assets. An independent enterprise would need less 
capital to support a perfectly-hedged U.S. Treasury security 
than it would need to support an equity security or other asset 
with significant market and/or credit risk. Accordingly, in 
some cases section 1.882-5 would require a taxpayer to allocate 
more capital to the United States, and therefore would reduce 
the taxpayer's interest deduction more, than is appropriate. To 
address these cases, the Convention allows a taxpayer to apply 
a more flexible approach that takes into account the relative 
risk of its assets in the various jurisdictions in which it 
does business. In particular, in the case of financial 
institutions other than insurance companies, the amount of 
capital attributable to a permanent establishment is determined 
by allocating the institution's total equity between its 
various offices on the basis of the proportion of the financial 
institution's risk-weighted assets attributable to each of 
them. This recognizes the fact that financial institutions are 
in many cases required to risk-weight their assets for 
regulatory purposes and, in other cases, will do so for 
business reasons even if not required to do so by regulators. 
However, risk-weighting is more complicated than the method 
prescribed by section 1.882-5.
    Accordingly, to ease this administrative burden, taxpayers 
may choose to apply the principles of Treas. Reg. section 
1.882-5(c) to determine the amount of capital allocable to its 
U.S. permanent establishment, in lieu of determining its 
allocable capital under the risk-weighted capital allocation 
method provided by the Convention, even if it has otherwise 
chosen the principles of Article 7 rather than the effectively 
connected income rules of U.S. domestic law.
Paragraph 4
    Paragraph 4 provides that no business profits can be 
attributed to a permanent establishment merely because it 
purchases goods or merchandise for the enterprise of which it 
is a part. This paragraph is essentially identical to paragraph 
5 of Article 7 of the OECD Model. This rule applies only to an 
office that performs functions for the enterprise in addition 
to purchasing. The income attribution issue does not arise if 
the sole activity of the office is the purchase of goods or 
merchandise because such activity does not give rise to a 
permanent establishment under Article 5 (Permanent 
Establishment). A common situation in which paragraph 4 is 
relevant is one in which a permanent establishment purchases 
raw materials for the enterprise's manufacturing operation 
conducted outside the United States and sells the manufactured 
product. While business profits may be attributable to the 
permanent establishment with respect to its sales activities, 
no profits are attributable to it with respect to its 
purchasing activities.
Paragraph 5
    Paragraph 5 provides that profits shall be determined by 
the same method each year, unless there is good reason to 
change the method used. This rule assures consistent tax 
treatment over time for permanent establishments. It limits the 
ability of both the Contracting State and the enterprise to 
change accounting methods to be applied to the permanent 
establishment. It does not, however, restrict a Contracting 
State from imposing additional requirements, such as the rules 
under Code section 481, to prevent amounts from being 
duplicated or omitted following a change in accounting method. 
Such adjustments may be necessary, for example, if the taxpayer 
switches from using the domestic rules under section 864 in one 
year to using the rules of Article 7 in the next. Also, if the 
taxpayer switches from Convention-based rules to U.S. domestic 
rules, it may need to meet certain deadlines for making 
elections that are not necessary when applying the rules of the 
Convention.
Paragraph 6
    Paragraph 6 coordinates the provisions of Article 7 and 
other provisions of the Convention. Under this paragraph, when 
business profits include items of income that are dealt with 
separately under other articles of the Convention, the 
provisions of those articles will, except when they 
specifically provide to the contrary, take precedence over the 
provisions of Article 7. For example, the taxation of dividends 
will be determined by the rules of Article 10 (Dividends), and 
not by Article 7, except where, as provided in paragraph 6 of 
Article 10, the dividend is attributable to a permanent 
establishment. In the latter case the provisions of Article 7 
apply. Thus, an enterprise of one State deriving dividends from 
the other State may not rely on Article 7 to exempt those 
dividends from tax at source if they are not attributable to a 
permanent establishment of the enterprise in the other State. 
By the same token, if the dividends are attributable to a 
permanent establishment in the other State, the dividends may 
be taxed on a net income basis at the source State full 
corporate tax rate, rather than on a gross basis under Article
    As provided in Article 8 (Shipping and Air Transport), 
income derived from shipping and air transport activities in 
international traffic described in that Article is taxable only 
in the country of residence of the enterprise regardless of 
whether it is attributable to a permanent establishment 
situated in the source State.
Paragraph 7
    Paragraph 7 incorporates into the Convention the rule of 
Code section 864(c)(6). Like the Code section on which it is 
based, paragraph 7 provides that any income or gain 
attributable to a permanent establishment during its existence 
is taxable in the Contracting State where the permanent 
establishment is situated, even if the payment of that income 
or gain is deferred until after the permanent establishment 
ceases to exist. This rule applies with respect to paragraphs 1 
and 2 of Article 7 (Business Profits), paragraph 6 of Article 
10, paragraph 4 of Article 11 (Interest), paragraph 3 of 
Articles 12 (Royalties), paragraph 5 of Article 13 (Capital 
Gains) and paragraph 2 of Article 21 (Other Income).
    The effect of this rule can be illustrated by the following 
example. Assume a company that is a resident of Hungary and 
that maintains a permanent establishment in the United States 
winds up the permanent establishment's business and sells the 
permanent establishment's inventory and assets to a U.S. buyer 
at the end of year 1 in exchange for an interest-bearing 
installment obligation payable in full at the end of year 3. 
Despite the fact that Article 13's threshold requirement for 
U.S. taxation is not met in year 3 because the company has no 
permanent establishment in the United States, the United States 
may tax the deferred income payment recognized by the company 
in year 3.
Relationship to Other Articles
    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope) of the Model. Thus, if a citizen 
of the United States who is a resident of Hungary under the 
treaty derives business profits from the United States that are 
not attributable to a permanent establishment in the United 
States, the United States may, subject to the special foreign 
tax credit rules of paragraph 4 of Article 23 (Relief from 
Double Taxation), tax those profits, notwithstanding the 
provision of paragraph 1 of this Article which would exempt the 
income from U.S. tax.
    The benefits of this Article are also subject to Article 22 
(Limitation on Benefits). Thus, an enterprise of Hungary that 
derives income effectively connected with a U.S. trade or 
business may not claim the benefits of Article 7 unless the 
resident carrying on the enterprise qualifies for such benefits 
under Article 22.

                 ARTICLE 8 (SHIPPING AND AIR TRANSPORT)

    This Article governs the taxation of profits from the 
operation of ships and aircraft in international traffic. The 
term ``international traffic'' is defined in subparagraph 1(f) 
of Article 3 (General Definitions).
Paragraph 1
    Paragraph 1 provides that profits derived by an enterprise 
of a Contracting State from the operation in international 
traffic of ships or aircraft are taxable only in that 
Contracting State. Because paragraph 6 of Article 7 (Business 
Profits) defers to Article 8 with respect to shipping income, 
such income derived by a resident of one of the Contracting 
States may not be taxed in the other State even if the 
enterprise has a permanent establishment in that other State. 
Thus, if a U.S. airline has a ticket office in Hungary, Hungary 
may not tax the airline's profits attributable to that office 
under Article 7. Since entities engaged in international 
transportation activities normally will have many permanent 
establishments in a number of countries, the rule avoids 
difficulties that would be encountered in attributing income to 
multiple permanent establishments if the income were covered by 
Article 7.
Paragraph 2
    The income from the operation of ships or aircraft in 
international traffic that is exempt from tax under paragraph 1 
is defined in paragraph 2.
    In addition to income derived directly from the operation 
of ships and aircraft in international traffic, this definition 
also includes certain items of rental income. First, income of 
an enterprise of a Contracting State from the rental of ships 
or aircraft on a full basis (i.e., with crew) is income of the 
lessor from the operation of ships and aircraft in 
international traffic and, therefore, is exempt from tax in the 
other Contracting State under paragraph 1. Also, paragraph 2 
encompasses income from the lease of ships or aircraft on a 
bareboat basis (i.e., without crew), either when the income is 
incidental to other income of the lessor from the operation of 
ships or aircraft in international traffic, or when the ships 
or aircraft are operated in international traffic by the 
lessee. If neither of those two conditions apply, income from 
the bareboat rentals would constitute business profits. The 
coverage of Article 8 is therefore broader than that of Article 
8 of the OECD Model, which covers bareboat leasing only when it 
is incidental to other income of the lessor from the operation 
of ships of aircraft in international traffic.
    Paragraph 2 also clarifies, consistent with the Commentary 
to Article 8 of the OECD Model, that income earned by an 
enterprise from the inland transport of property or passengers 
within either Contracting State falls within Article 8 if the 
transport is undertaken as part of the international transport 
of property or passengers by the enterprise. Thus, if a U.S. 
shipping company contracts to carry property from Hungary to a 
U.S. city and, as part of that contract, it transports the 
property by truck from its point of origin to an airport in 
Hungary (or it contracts with a trucking company to carry the 
property to the airport) the income earned by the U.S. shipping 
company from the overland leg of the journey would be taxable 
only in the United States. Similarly, Article 8 also would 
apply to all of the income derived from a contract for the 
international transport of goods, even if the goods were 
transported to the port by a lighter, not by the vessel that 
carried the goods in international waters.
    Finally, certain non-transport activities that are an 
integral part of the services performed by a transport company, 
or are ancillary to the enterprise's operation of ships or 
aircraft in international traffic, are understood to be covered 
in paragraph 1, though they are not specified in paragraph 2. 
These include, for example, the provision of goods and services 
by engineers, ground and equipment maintenance and staff, cargo 
handlers, catering staff and customer services personnel. Where 
the enterprise provides such goods to, or performs services 
for, other enterprises and such activities are directly 
connected with or ancillary to the enterprise's operation of 
ships or aircraft in international traffic, the profits from 
the provision of such goods and services to other enterprises 
will fall under this paragraph.
    For example, enterprises engaged in the operation of ships 
or aircraft in international traffic may enter into pooling 
arrangements for the purposes of reducing the costs of 
maintaining facilities needed for the operation of their ships 
or aircraft in other countries. For instance, where an airline 
enterprise agrees (for example, under an International Airlines 
Technical Pool agreement) to provide spare parts or maintenance 
services to other airlines landing at a particular location 
(which allows it to benefit from these services at other 
locations), activities carried on pursuant to that agreement 
will be ancillary to the operation of aircraft in international 
traffic by the enterprise.
    Also, advertising that the enterprise may do for other 
enterprises in magazines offered aboard ships or aircraft that 
it operates in international traffic or at its business 
locations, such as ticket offices, is ancillary to its 
operation of these ships or aircraft. Profits generated by such 
advertising fall within this paragraph. Income earned by 
concessionaires, however, is not covered by Article 8. These 
interpretations of paragraph 1 also are consistent with the 
Commentary to Article 8 of the OECD Model.
Paragraph 3
    Under this paragraph, profits of an enterprise of a 
Contracting State from the use, maintenance or rental of 
containers (including equipment for their transport) are exempt 
from tax in the other Contracting State, unless those 
containers are used for transport solely in the other 
Contracting State. This result obtains under paragraph 3 
regardless of whether the recipient of the income is engaged in 
the operation of ships or aircraft in international traffic, 
and regardless of whether the enterprise has a permanent 
establishment in the other Contracting State. Only income from 
the use, maintenance or rental of containers that is incidental 
to other income from international traffic is covered by 
Article 8 of the OECD Model.
Paragraph 4
    This paragraph clarifies that the provisions of paragraphs 
1 and 3 also apply to profits derived by an enterprise of a 
Contracting State from participation in a pool, joint business 
or international operating agency. This refers to various 
arrangements for international cooperation by carriers in 
shipping and air transport. For example, airlines from two 
countries may agree to share the transport of passengers 
between the two countries. They each will fly the same number 
of flights per week and share the revenues from that route 
equally, regardless of the number of passengers that each 
airline actually transports. Paragraph 4 makes clear that with 
respect to each carrier the income dealt with in the Article is 
that carrier's share of the total transport, not the income 
derived from the passengers actually carried by the airline. 
This paragraph corresponds to paragraph 4 of Article 8 of the 
OECD Model.
Relationship to Other Articles
    The taxation of gains from the alienation of ships, 
aircraft or containers is not dealt with in this Article but in 
paragraph 6 of Article 13 (Gains).
    As with other benefits of the Convention, the benefit of 
exclusive residence country taxation under Article 8 is 
available to an enterprise only if it is entitled to benefits 
under Article 22 (Limitation on Benefits).
    This Article also is subject to the saving clause of 
paragraph 4 of Article 1 (General Scope) of the Model. Thus, if 
a citizen of the United States who is a resident of Hungary 
derives profits from the operation of ships or aircraft in 
international traffic, notwithstanding the exclusive residence 
country taxation in paragraph 1 of Article 8, the United States 
may, subject to the special foreign tax credit rules of 
paragraph 4 of Article 23 (Relief from Double Taxation), tax 
those profits as part of the worldwide income of the citizen. 
(This is an unlikely situation, however, because non-tax 
considerations (e.g., insurance) generally result in shipping 
activities being carried on in corporate form.)

                   ARTICLE 9 (ASSOCIATED ENTERPRISES)

    This Article incorporates in the Convention the arm's-
length principle reflected in the U.S. domestic transfer 
pricing provisions, particularly Code section 482. It provides 
that when related enterprises engage in a transaction on terms 
that are not arm's-length, the Contracting States may make 
appropriate adjustments to the taxable income and tax liability 
of such related enterprises to reflect what the income and tax 
of these enterprises with respect to the transaction would have 
been had there been an arm's-length relationship between them.
Paragraph 1
    This paragraph addresses the situation where an enterprise 
of a Contracting State is related to an enterprise of the other 
Contracting State, and there are arrangements or conditions 
imposed between the enterprises in their commercial or 
financial relations that are different from those that would 
have existed in the absence of the relationship. Under these 
circumstances, the Contracting States may adjust the income (or 
loss) of the enterprise to reflect what it would have been in 
the absence of such a relationship.
    The paragraph identifies the relationships between 
enterprises that serve as a prerequisite to application of the 
Article. As the Commentary to the OECD Model makes clear, the 
necessary element in these relationships is effective control, 
which is also the standard for purposes of section 482. Thus, 
the Article applies if an enterprise of one State participates 
directly or indirectly in the management, control, or capital 
of the enterprise of the other State. Also, the Article applies 
if any third person or persons participate directly or 
indirectly in the management, control, or capital of 
enterprises of different States. For this purpose, all types of 
control are included, i.e., whether or not legally enforceable 
and however exercised or exercisable.
    The fact that a transaction is entered into between such 
related enterprises does not, in and of itself, mean that a 
Contracting State may adjust the income (or loss) of one or 
both of the enterprises under the provisions of this Article. 
If the conditions of the transaction are consistent with those 
that would be made between independent persons, the income 
arising from that transaction should not be subject to 
adjustment under this Article.
    Similarly, the fact that associated enterprises may have 
concluded arrangements, such as cost sharing arrangements or 
general services agreements, is not in itself an indication 
that the two enterprises have entered into a non-arm's-length 
transaction that should give rise to an adjustment under 
paragraph 1. Both related and unrelated parties enter into such 
arrangements (e.g., joint venturers may share some development 
costs). As with any other kind of transaction, when related 
parties enter into an arrangement, the specific arrangement 
must be examined to see whether or not it meets the arm's-
length standard. In the event that it does not, an appropriate 
adjustment may be made, which may include modifying the terms 
of the agreement or re-characterizing the transaction to 
reflect its substance.
    It is understood that the ``commensurate with income'' 
standard for determining appropriate transfer prices for 
intangibles, added to Code section 482 by the Tax Reform Act of 
1986, was designed to operate consistently with the arm's-
length standard. The implementation of this standard in the 
section 482 regulations is in accordance with the general 
principles of paragraph 1 of Article 9 of the Convention, as 
interpreted by the OECD Transfer Pricing Guidelines.
    This Article also permits tax authorities to deal with thin 
capitalization issues. They may, in the context of Article 9, 
scrutinize more than the rate of interest charged on a loan 
between related persons. They also may examine the capital 
structure of an enterprise, whether a payment in respect of 
that loan should be treated as interest, and, if it is treated 
as interest, under what circumstances interest deductions 
should be allowed to the payor. Paragraph 2 of the Commentary 
to Article 9 of the OECD Model, together with the U.S. 
observation set forth in paragraph 15, sets forth a similar 
understanding of the scope of Article 9 in the context of thin 
capitalization.
Paragraph 2
    When a Contracting State has made an adjustment that is 
consistent with the provisions of paragraph 1, and the other 
Contracting State agrees that the adjustment was appropriate to 
reflect arm's-length conditions, that other Contracting State 
is obligated to make a correlative adjustment (sometimes 
referred to as a ``corresponding adjustment'') to the tax 
liability of the related person in that other Contracting 
State. Although the OECD Model does not specify that the other 
Contracting State must agree with the initial adjustment before 
it is obligated to make the correlative adjustment, the 
Commentary makes clear that the paragraph is to be read that 
way.
    As explained in the Commentary to Article 9 of the OECD 
Model, Article 9 leaves the treatment of ``secondary 
adjustments'' to the laws of the Contracting States. When an 
adjustment under Article 9 has been made, one of the parties 
will have in its possession funds that it would not have had at 
arm's length. The question arises as to how to treat these 
funds. In the United States the general practice is to treat 
such funds as a dividend or contribution to capital, depending 
on the relationship between the parties. Under certain 
circumstances, the parties may be permitted to restore the 
funds to the party that would have the funds had the 
transactions been entered into on arm's length terms, and to 
establish an account payable pending restoration of the funds. 
See Rev. Proc. 99-32, 1999-2 C.B. 296.
    The Contracting State making a secondary adjustment will 
take the other provisions of the Convention, where relevant, 
into account. For example, if the effect of a secondary 
adjustment is to treat a U.S. corporation as having made a 
distribution of profits to its parent corporation in the other 
Contracting State, the provisions of Article 10 (Dividends) 
will apply, and the United States may impose a 5 percent 
withholding tax on the dividend. Also, if under Article 23 
(Relief from Double Taxation) the other State generally gives a 
credit for taxes paid with respect to such dividends, it would 
also be required to do so in this case.
    The competent authorities are authorized by paragraph 3 of 
Article 25 (Mutual Agreement Procedure) to consult, if 
necessary, to resolve any differences in the application of 
these provisions. For example, there may be a disagreement over 
whether an adjustment made by a Contracting State under 
paragraph 1 was appropriate.
    If a correlative adjustment is made under paragraph 2, it 
is to be implemented, pursuant to paragraph 2 of Article 25 
(Mutual Agreement Procedure), notwithstanding any time limits 
or other procedural limitations in the law of the Contracting 
State making the adjustment. If a taxpayer has entered a 
closing agreement (or other written settlement) with the United 
States prior to bringing a case to the competent authorities, 
the U.S. competent authority will endeavor only to obtain a 
correlative adjustment from Hungary. See, Rev. Proc. 2006-54, 
2006-49 I.R.B. 1035, Section 7.05.
Relationship to Other Articles
    The saving clause of paragraph 4 of Article 1 (General 
Scope) does not apply to paragraph 2 of Article 9 by virtue of 
an exception to the saving clause in subparagraph 5(a) of 
Article 1. Thus, even if the statute of limitations has run, a 
refund of tax can be made in order to implement a correlative 
adjustment. Statutory or procedural limitations, however, 
cannot be overridden to impose additional tax, because 
paragraph 2 of Article 1 provides that the Convention cannot 
restrict any statutory benefit.

                         ARTICLE 10 (DIVIDENDS)

    Article 10 provides rules for the taxation of dividends 
paid by a company that is a resident of one Contracting State 
to a beneficial owner that is a resident of the other 
Contracting State. The Article provides for full residence-
State taxation of such dividends and a limited source-State 
right to tax. Article 10 also provides rules for the imposition 
of a tax on branch profits by the State of source. Finally, the 
Article prohibits a State from imposing taxes on a company 
resident in the other Contracting State, other than a branch 
profits tax, on undistributed earnings.
Paragraph 1
    The right of a shareholder's Contracting State of residence 
to tax dividends arising in the source country is preserved by 
paragraph 1, which permits a Contracting State to tax its 
residents on dividends paid to them by a company that is a 
resident of the other Contracting State. For dividends from any 
other source paid to a resident, Article 21 (Other Income) 
grants the residence country exclusive taxing jurisdiction 
(other than for dividends attributable to a permanent 
establishment in the other State).
Paragraph 2
    The State of source also may tax dividends beneficially 
owned by a resident of the other State, subject to the 
limitations of paragraphs 2 and 3. Paragraph 2 generally limits 
the rate of withholding tax in the State of source on dividends 
paid by a company resident in that State to 15 percent of the 
gross amount of the dividend. If, however, the beneficial owner 
of the dividend is a company resident in the other State and 
owns directly shares representing at least 10 percent of the 
voting power of the company paying the dividend, then the rate 
of withholding tax in the State of source is limited to 5 
percent of the gross amount of the dividend. For application of 
this paragraph by the United States, shares are considered 
voting shares if they provide the power to elect, appoint or 
replace any person vested with the powers ordinarily exercised 
by the board of directors of a U.S. corporation.
    The benefits of paragraph 2 may be granted at the time of 
payment by means of reduced rate of withholding tax at source. 
It also is consistent with the paragraph for tax to be withheld 
at the time of payment at full statutory rates, and the treaty 
benefit to be granted by means of a subsequent refund so long 
as such procedures are applied in a reasonable manner.
    The determination of whether the ownership threshold for 
subparagraph 2(a) is met for purposes of the 5 percent maximum 
rate of withholding tax is made on the date on which 
entitlement to the dividend is determined. Thus, in the case of 
a dividend from a U.S. company, the determination of whether 
the ownership threshold is met generally would be made on the 
dividend record date.
    Paragraph 2 does not affect the taxation of the profits out 
of which the dividends are paid. The taxation by a Contracting 
State of the income of its resident companies is governed by 
the internal law of the Contracting State, subject to the 
provisions of paragraph 4 of Article 24 (Non- Discrimination).
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined as under the internal 
law of the country imposing tax (i.e., the source country). The 
beneficial owner of the dividend for purposes of Article 10 is 
the person to which the income is attributable under the laws 
of the source State. Thus, if a dividend paid by a corporation 
that is a resident of one of the States (as determined under 
Article 4 (Residence)) is received by a nominee or agent that 
is a resident of the other State on behalf of a person that is 
not a resident of that other State, the dividend is not 
entitled to the benefits of this Article. However, a dividend 
received by a nominee on behalf of a resident of that other 
State would be entitled to benefits. These limitations are 
confirmed by paragraph 12 of the Commentary to Article 10 of 
the OECD Model. See also paragraph 24 of the Commentary to 
Article 1 of the OECD Model.
    Special rules, however, apply to shares that are held 
through fiscally transparent entities. In that case, the rules 
of paragraph 6 of Article 1 (General Scope) and paragraph 1 of 
the Exchange of Notes will apply to determine whether the 
dividends should be treated as having been derived by a 
resident of a Contracting State. Residence State principles 
shall be used to determine who derives the dividend, to assure 
that the dividends for which the source State grants benefits 
of the Convention will be taken into account for tax purposes 
by a resident of the residence State. Source State principles 
of beneficial ownership shall then apply to determine whether 
the person who derives the dividends, or another resident of 
the other Contracting State, is the beneficial owner of the 
dividend. If the person who derives the dividend under 
paragraph 6 of Article 1 would not be treated a nominee, agent, 
custodian, conduit, etc. under the source State's principles 
for determining beneficial ownership as, that person will be 
treated as the beneficial owner of the income, profits or gains 
for purposes of the Convention.
    Assume for instance, that a company resident in Hungary 
pays a dividend to LLC, an entity organized in the United 
States and treated as fiscally transparent for U.S. tax 
purposes, but as a company for Hungarian tax purposes. USCo, a 
company incorporated in the United States, is the sole interest 
holder in LLC. Paragraph 6 of Article 1 provides that USCo 
derives the dividend. Hungary's principles of beneficial 
ownership shall then be applied to USCo. If under the laws of 
Hungary USCo is found not to be the beneficial owner of the 
dividend, USCo will not be entitled to the benefits of Article 
10 with respect to such dividend. The payment may be entitled 
to benefits, however, if USCo is found to be a nominee, agent, 
custodian, or conduit for a person who is a resident of the 
United States.
    Beyond identifying the person to whom the principles of 
beneficial ownership shall be applied, the principles of 
paragraph 6 of Article 1 will also apply when determining 
whether other requirements, such as the ownership threshold of 
subparagraph 2(a) have been satisfied.
    For example, assume that HCo, a company that is a resident 
of Hungary, owns all of the outstanding shares in HDE, an 
entity that is disregarded for U.S. tax purposes that is a 
resident of Hungary. HDE owns 100% of the stock of USCo. 
Hungary views HDE as fiscally transparent under its domestic 
law, and taxes HCo currently on the income derived by HDE. In 
this case, HCo is treated as deriving the dividends paid by 
USCo under paragraph 6 of Article 1. Moreover, HCo is treated 
as owning the shares of USCo directly. The Convention does not 
address what constitutes direct ownership for purposes of 
Article 10. As a result, whether ownership is direct is 
determined under the internal law of the country imposing tax 
(i.e., the source country) unless the context otherwise 
requires. Accordingly, a company that holds stock through such 
an entity will generally be considered to directly own such 
stock for purposes of Article 10.
    The same principles would apply in determining whether 
companies holding shares through fiscally transparent entities 
such as partnerships, trusts, and estates would qualify for 
benefits. As a result, companies holding shares through such 
entities may be able to claim the benefits of subparagraph (a) 
under certain circumstances. The lower rate applies when the 
company's proportionate share of the shares held by the 
intermediate entity meets the 10 percent threshold, and the 
company meets the requirements of subparagraph 6 of Article 1 
(i.e., the company's country of residence treats the 
intermediate entity as fiscally transparent) with respect to 
the dividend. Whether this ownership threshold is satisfied may 
be difficult to determine and often will require an analysis of 
the partnership or trust agreement.
Paragraph 3
    Paragraph 3 provides that dividends beneficially owned by a 
pension fund may not be taxed in the Contracting State of which 
the company paying the tax is a resident, unless such dividends 
are derived from the carrying on of a business, directly or 
indirectly, by the pension fund or through an associated 
enterprise. For these purposes, the term ``pension fund'' is 
defined in subparagraph 1(k) of Article 3 (General 
Definitions).
Paragraph 4
    Paragraph 4 imposes limitations on the rate reductions 
provided by paragraphs 2 and 3 in the case of dividends paid by 
RIC or a REIT.
    The first sentence of subparagraph 4(a) provides that 
dividends paid by a RIC or REIT are not eligible for the 5 
percent rate of withholding tax of subparagraph 2(a).
    The second sentence of subparagraph 4(a) provides that the 
15 percent maximum rate of withholding tax of subparagraph 2(b) 
applies to dividends paid by RICs and that the elimination of 
source-country withholding tax of paragraph 3 applies to 
dividends paid by RICs and beneficially owned by a pension 
fund.
    The third sentence of subparagraph 4(a) provides that the 
15 percent rate of withholding tax also applies to dividends 
paid by a REIT and that the elimination of source-country 
withholding tax of paragraph 3 applies to dividends paid by 
REITs and beneficially owned by a pension fund, provided that 
one of the three following conditions is met. First, the 
beneficial owner of the dividend is an individual or a pension 
fund, in either case holding an interest of not more than 10 
percent in the REIT. Second, the dividend is paid with respect 
to a class of stock that is publicly traded and the beneficial 
owner of the dividend is a person holding an interest of not 
more than 5 percent of any class of the REIT's shares. Third, 
the beneficial owner of the dividend holds an interest in the 
REIT of not more than 10 percent and the REIT is 
``diversified.''
    Subparagraph (b) provides a definition of the term 
``diversified.'' A REIT is diversified if the gross value of no 
single interest in real property held by the REIT exceeds 10 
percent of the gross value of the REIT's total interest in real 
property. Foreclosure property is not considered an interest in 
real property, and a REIT holding a partnership interest is 
treated as owning its proportionate share of any interest in 
real property held by the partnership. Subparagraph (c) 
provides that the rules of paragraph 4 apply also to dividends 
paid by companies resident in Hungary that are similar to U.S. 
RICs and REITs. No such entities existed under Hungary's 
domestic law at the time of signature of the Convention.
Paragraph 5
    Paragraph 5 defines the term dividends broadly and 
flexibly. The definition is intended to cover all arrangements 
that yield a return on an equity investment in a corporation as 
determined under the tax law of the state of source, as well as 
arrangements that might be developed in the future.
    The term includes income from shares, or other corporate 
rights that are not treated as debt under the law of the source 
State, that participate in the profits of the company. The term 
also includes income that is subjected to the same tax 
treatment as income from shares by the law of the State of 
source. Thus, a constructive dividend that results from a non-
arm's length transaction between a corporation and a related 
party is a dividend. In the case of the United States the term 
dividend includes amounts treated as a dividend under U.S. law 
upon the sale or redemption of shares or upon a transfer of 
shares in a reorganization. See, e.g., Rev. Rul. 92-85, 1992-2 
C.B. 69 (sale of foreign subsidiary's stock to U.S. sister 
company is a deemed dividend to extent of the subsidiary's and 
sister company's earnings and profits). Further, a distribution 
from a U.S. publicly traded limited partnership, which is taxed 
as a corporation under U.S. law, is a dividend for purposes of 
Article 10. However, a distribution by a limited liability 
company is not taxable by the United States under Article 10, 
provided the limited liability company is not characterized as 
an association taxable as a corporation under U.S. law.
    Finally, a payment denominated as interest that is made by 
a thinly capitalized corporation may be treated as a dividend 
to the extent that the debt is recharacterized as equity under 
the laws of the source State.
Paragraph 6
    Paragraph 6 provides a rule for taxing dividends paid with 
respect to holdings that form part of the business property of 
a permanent establishment. In such case, the rules of Article 7 
(Business Profits) shall apply. Accordingly, the dividends will 
be taxed on a net basis using the rates and rules of taxation 
generally applicable to residents of the State in which the 
permanent establishment is located, as such rules may be 
modified by the Convention. An example of dividends paid with 
respect to the business property of a permanent establishment 
would be dividends derived by a dealer in stock or securities 
from stock or securities that the dealer held for sale to 
customers.
Paragraph 7
    The right of a Contracting State to tax dividends paid by a 
company that is a resident of the other Contracting State is 
restricted by paragraph 7 to cases in which the dividends are 
paid to a resident of that Contracting State or are 
attributable to a permanent establishment or fixed base in that 
Contracting State. Thus, a Contracting State may not impose a 
``secondary'' withholding tax on dividends paid by a 
nonresident company out of earnings and profits from that 
Contracting State.
    The paragraph also restricts the right of a Contracting 
State to impose corporate level taxes on undistributed profits, 
other than a branch profits tax. The paragraph does not 
restrict a State's right to tax its resident shareholders on 
undistributed earnings of a corporation resident in the other 
State. Thus, the authority of the United States to impose taxes 
on subpart F income and on earnings deemed invested in U.S. 
property, and its tax on income of a passive foreign investment 
company that is a qualified electing fund is in no way 
restricted by this provision.
Paragraph 8
    Paragraph 8 permits a Contracting State to impose a branch 
profits tax on a company resident in the other Contracting 
State. The tax is in addition to other taxes permitted by the 
Convention. The term ``company'' is defined in subparagraph 
1(b) of Article 3 (General Definitions).
    A Contracting State may impose a branch profits tax on a 
company if the company has income attributable to a permanent 
establishment in that Contracting State, derives income from 
immovable property (real property) in that Contracting State 
that is taxed on a net basis under Article 6 (Income from 
Immovable Property (Real Property)), or realizes gains taxable 
in that State under paragraphs 1 or 4 of Article 13 (Gains). In 
the case of the United States, the imposition of such tax is 
limited, however, to the portion of the aforementioned items of 
income that represents the amount of such income that is the 
``dividend equivalent amount.'' This is consistent with the 
relevant rules under the U.S. branch profits tax, and the term 
dividend equivalent amount is defined under U.S. law. Section 
884 defines the dividend equivalent amount as an amount for a 
particular year that is equivalent to the income described 
above that is included in the corporation's effectively 
connected earnings and profits for that year, after payment of 
the corporate tax under Articles 6, 7 (Business Profits) or 13, 
reduced for any increase in the branch's U.S. net equity during 
the year or increased for any reduction in its U.S. net equity 
during the year. U.S. net equity is U.S. assets less U.S. 
liabilities. See Treas. Reg. section 1.884-1.
    The dividend equivalent amount for any year approximates 
the dividend that a U.S. branch office would have paid during 
the year if the branch had been operated as a separate U.S. 
subsidiary company. At the time of signature of the Convention, 
Hungary did not impose a branch profits tax. If Hungary chooses 
to enact such a tax in the future, the base of its tax must be 
limited to an amount that is analogous to the dividend 
equivalent amount, and the applicable rate would be subject to 
the limitations of clause (ii) of subparagraph 8(b).
    As discussed in the Technical Explanations to Articles 1(2) 
and 7(2), consistency principles prohibit a taxpayer from 
applying provisions of the Code and this Convention 
inconsistently. In the context of the branch profits tax, this 
consistency requirement means that if a Hungarian company uses 
the principles of Article 7 to determine its U.S. taxable 
income then it must also use those principles to determine its 
dividend equivalent amount. Similarly, if the Hungarian company 
instead uses the Code to determine its U.S. taxable income it 
must also use the Code to determine its dividend equivalent 
amount. As in the case of Article 7, if a Hungarian company, 
for example, does not from year to year consistently apply the 
Code or the Convention to determine its dividend equivalent 
amount, then the Hungarian company must make appropriate 
adjustments or recapture amounts that would otherwise be 
subject to U.S. branch profits tax if it had consistently 
applied the Code or the Convention to determine its dividend 
equivalent amount from year to year.
    Subparagraph 2(b) provides that the branch profits tax 
shall not be imposed at a rate exceeding five percent. It is 
intended that subparagraph 2(b) apply equally if a taxpayer 
determines its taxable income under the laws of a Contracting 
State or under the provisions of Article 7. For example, as 
discussed above, consistency principles require a Hungarian 
company that determines its U.S. taxable income under the Code 
to also determine its dividend equivalent amount under the 
Code. In that case, subparagraph 2(b) would apply even though 
the Hungarian company did not determine its dividend equivalent 
amount using the principles of Article 7.
Relationship to Other Articles
    Notwithstanding the foregoing limitations on source country 
taxation of dividends, the saving clause of paragraph 4 of 
Article 1 permits the United States to tax dividends received 
by its residents and citizens, subject to the special foreign 
tax credit rules of paragraph 4 of Article 23 (Relief from 
Double Taxation), as if the Convention had not come into 
effect.
    The benefits of this Article are also subject to the 
provisions of Article 22 (Limitation on Benefits). Thus, if a 
resident of the other Contracting State is the beneficial owner 
of dividends paid by a U.S. corporation, the shareholder must 
qualify for treaty benefits under at least one of the tests of 
Article 22 in order to receive the benefits of this Article.

                         ARTICLE 11 (INTEREST)

    Article 11 specifies the taxing jurisdictions over interest 
arising in one Contracting State and beneficially owned bya 
resident of the other Contracting State.
Paragraph 1
    Paragraph 1 generally grants to the State of residence the 
exclusive right to tax interest beneficially owned by its 
residents and arising in the other Contracting State.
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined under the internal law 
of the State of source. The beneficial owner of the interest 
for purposes of Article 11 is the person to which the income is 
attributable under the laws of the source State. Thus, if 
interest arising in a Contracting State is received by a 
nominee or agent that is a resident of the other State on 
behalf of a person that is not a resident of that other State, 
the interest is not entitled to the benefits of Article 11. 
However, interest received by a nominee on behalf of a resident 
of that other State would be entitled to benefits. These 
limitations are confirmed by paragraph 9 of the OECD Commentary 
to Article 11.
Paragraph 2
    Paragraph 2 provides anti-abuse exceptions to the source-
country exemption in paragraph 1 for two classes of interest 
payments.
    The first class of interest, dealt with in subparagraphs 
2(a) and 2(b) is so-called ``contingent interest.'' With 
respect to Hungary, such interest is defined in subparagraph 
2(a) as any interest arising in Hungary that is determined by 
reference to the receipts, sales, income, profits or other cash 
flow of the debtor or a related person, to any change in the 
value of any property of the debtor or a related person or to 
any dividend, partnership distribution or similar payment made 
by the debtor or a related person. Any such interest may be 
taxed in Hungary according to the laws of Hungary. If the 
beneficial owner is a resident of the United States, however, 
the gross amount of the interest may be taxed at a rate not 
exceeding 15 percent. With respect to interest arising in the 
United States, subparagraph (b) refers to contingent interest 
of a type that does not qualify as portfolio interest under 
U.S. domestic law. The cross-reference to the U.S. definition 
of contingent interest, which is found in section 871(h)(4) of 
the Code, is intended to ensure that the exceptions of section 
871(h)(4)(C) will be applicable.
    The second class of interest is dealt with in subparagraph 
2(c). This exception is consistent with the policy of Code 
sections 860E(e) and 860G(b) that excess inclusions with 
respect to a real estate mortgage investment conduit (REMIC) 
should bear full U.S. tax in all cases.
Paragraph 3
    The term ``interest'' as used in Article 11 is defined in 
paragraph 3 to include, inter alia, income from debt claims of 
every kind, whether or not secured by a mortgage. Penalty 
charges for late payment are excluded from the definition of 
interest. Interest that is paid or accrued subject to a 
contingency is within the ambit of Article 11. This includes 
income from a debt obligation carrying the right to participate 
in profits. The term does not, however, include amounts that 
are treated as dividends under Article 10 (Dividends).
    The term interest also includes amounts subject to the same 
tax treatment as income from money lent under the law of the 
State in which the income arises. Thus, for purposes of the 
Convention, amounts that the United States will treat as 
interest include (i) the difference between the issue price and 
the stated redemption price at maturity of a debt instrument 
(i.e., original issue discount (''OID'')), which may be wholly 
or partially realized on the disposition of a debt instrument 
(section 1273), (ii) amounts that are imputed interest on a 
deferred sales contract (section 483), (iii) amounts treated as 
interest or OID under the stripped bond rules (section 1286), 
(iv) amounts treated as original issue discount under the 
below-market interest rate rules (section 7872), (v) a 
partner's distributive share of a partnership's interest income 
(section 702), (vi) the interest portion of periodic payments 
made under a ``finance lease'' or similar contractual 
arrangement that in substance is a borrowing by the nominal 
lessee to finance the acquisition of property, (vii) amounts 
included in the income of a holder of a residual interest in a 
REMIC (section 860E), because these amounts generally are 
subject to the same taxation treatment as interest under U.S. 
tax law, and (viii) interest with respect to notional principal 
contracts that are re-characterized as loans because of a 
``substantial non-periodic payment.''
Paragraph 4
    Paragraph 4 provides an exception to the exclusive 
residence taxation rule of paragraph 1 and the source-country 
gross taxation rule of paragraph 2 in cases where the 
beneficial owner of the interest carries on business through a 
permanent establishment in the State of source situated in that 
State and the interest is attributable to that permanent 
establishment. In such cases the provisions of Article 7 
(Business Profits) will apply and the State of source will 
retain the right to impose tax on such interest income.
    In the case of a permanent establishment that once existed 
in the State of source but that no longer exists, the 
provisions of paragraph 4 also apply, by virtue of paragraph 7 
of Article 7 (Business Profits), to interest that would be 
attributable to such a permanent establishment or fixed base if 
it did exist in the year of payment or accrual. See the 
Technical Explanation of paragraph 7 of Article 7.
Paragraph 5
    Paragraph 5 provides that in cases involving special 
relationships between the payor and the beneficial owner of 
interest income, Article 11 applies only to that portion of the 
total interest payments that would have been made absent such 
special relationships (i.e., an arm's-length interest payment). 
Any excess amount of interest paid remains taxable according to 
the laws of the United States and Hungary, respectively, with 
due regard to the other provisions of the Convention. Thus, if 
the excess amount would be treated under the source country's 
law as a distribution of profits by a corporation, such amount 
could be taxed as a dividend rather than as interest, but the 
tax would be subject, if appropriate, to the rate limitations 
of paragraph 2 of Article 10 (Dividends).
    The term ``special relationship'' is not defined in the 
Convention. In applying this paragraph the United States 
considers the term to include the relationships described in 
Article 9, which in turn corresponds to the definition of 
``control'' for purposes of section 482 of the Code.
    This paragraph does not address cases where, owing to a 
special relationship between the payer and the beneficial owner 
or between both of them and some other person, the amount of 
the interest is less than an arm's-length amount. In those 
cases a transaction may be characterized to reflect its 
substance and interest may be imputed consistent with the 
definition of interest in paragraph 3. The United States would 
apply section 482 or 7872 of the Code to determine the amount 
of imputed interest in those cases.
Relationship to Other Articles
    Notwithstanding the foregoing limitations on source country 
taxation of interest, the saving clause of paragraph 4 of 
Article 1 permits the United States to tax its residents and 
citizens, subject to the special foreign tax credit rules of 
paragraph 4 of Article 23 (Relief from Double Taxation), as if 
the Convention had not come into force.
    As with other benefits of the Convention, the benefits of 
exclusive residence State taxation of interest under paragraph 
1 of Article 11, or limited source taxation under subparagraphs 
2(a) and 2(b), are available to a resident of the other State 
only if that resident is entitled to those benefits under the 
provisions of Article 22 (Limitation on Benefits).

                         ARTICLE 12 (ROYALTIES)

    Article 12 provides rules for the taxation of royalties 
arising in one Contracting State and paid to a beneficial owner 
that is a resident of the other Contracting State.
Paragraph 1
    Paragraph 1 generally grants to the State of residence the 
exclusive right to tax royalties beneficially owned by its 
residents and arising in the other Contracting State.
    The term ``beneficial owner'' is not defined in the 
Convention, and is, therefore, defined under the internal law 
of the State of source. The beneficial owner of the royalty for 
purposes of Article 12 is the person to which the income is 
attributable under the laws of the source State. Thus, if a 
royalty arising in a Contracting State is received by a nominee 
or agent that is a resident of the other State on behalf of a 
person that is not a resident of that other State, the royalty 
is not entitled to the benefits of Article 12. However, a 
royalty received by a nominee on behalf of a resident of that 
other State would be entitled to benefits. These limitations 
are confirmed by paragraph 4 of the OECD Commentary to Article 
12.
Paragraph 2
     Paragraph 2 defines the term ``royalties,'' as used in 
Article 12, to include any consideration for the use of, or the 
right to use, any copyright of literary, artistic, scientific 
or other work (such as cinematographic films), any patent, 
trademark, design or model, plan, secret formula or process, or 
for information concerning industrial, commercial, or 
scientific experience. The term ``royalties'' also includes 
gain derived from the alienation of any right or property that 
would give rise to royalties, to the extent the gain is 
contingent on the productivity, use, or further alienation 
thereof. Gains that are not so contingent are dealt with under 
Article 13 (Gains). The term ``royalties,'' however, does not 
include income from leasing personal property.
    The term royalties is defined in the Convention and 
therefore is generally independent of domestic law. Certain 
terms used in the definition are not defined in the Convention, 
but these may be defined under domestic tax law. For example, 
the term ``secret process or formulas'' is found in the Code, 
and its meaning has been elaborated in the context of sections 
351 and 367. See Rev. Rul. 55- 17, 1955-1 C.B. 388; Rev. Rul. 
64-56, 1964-1 C.B. 133; Rev. Proc. 69- 19, 1969-2 C.B. 301.
    Consideration for the use or right to use cinematographic 
films, or works on film, tape, or other means of reproduction 
in radio or television broadcasting is specifically included in 
the definition of royalties. It is intended that, with respect 
to any subsequent technological advances in the field of radio 
or television broadcasting, consideration received for the use 
of such technology will also be included in the definition of 
royalties.
    If an artist who is resident in one Contracting State 
records a performance in the other Contracting State, retains a 
copyrighted interest in a recording, and receives payments for 
the right to use the recording based on the sale or public 
playing of the recording, then the right of such other 
Contracting State to tax those payments is governed by Article 
12. See Boulez v. Commissioner, 83 T.C. 584 (1984), aff'd, 810 
F.2d 209 (D.C. Cir. 1986). By contrast, if the artist earns in 
the other Contracting State income covered by Article 16 
(Entertainers and Sportsmen), for example, endorsement income 
from the artist's attendance at a film screening, and if such 
income also is attributable to one of the rights described in 
Article 12 (e.g., the use of the artist's photograph in 
promoting the screening), Article 16 and not Article 12 is 
applicable to such income.
    Computer software generally is protected by copyright laws 
around the world. Under the Convention, consideration received 
for the use, or the right to use, computer software is treated 
either as royalties or as business profits, depending on the 
facts and circumstances of the transaction giving rise to the 
payment.
    The primary factor in determining whether consideration 
received for the use, or the right to use, computer software is 
treated as royalties or as business profits is the nature of 
the rights transferred. See Treas. Reg. section 1.861-18. The 
fact that the transaction is characterized as a license for 
copyright law purposes is not dispositive. For example, a 
typical retail sale of ``shrink wrap'' software generally will 
not be considered to give rise to royalty income, even though 
for copyright law purposes it may be characterized as a 
license.
    The means by which the computer software is transferred are 
not relevant for purposes of the analysis. Consequently, if 
software is electronically transferred but the rights obtained 
by the transferee are substantially equivalent to rights in a 
program copy, the payment will be considered business profits.
    The term ``industrial, commercial, or scientific 
experience'' (sometimes referred to as ``know-how''). has the 
meaning ascribed to it in paragraph 11 et seq. of the 
Commentary to Article 12 of the OECD Model. Consistent with 
that meaning, the term may include information that is 
ancillary to a right otherwise giving rise to royalties, such 
as a patent or secret process.
    Know-how also may include, in limited cases, technical 
information that is conveyed through technical or consultancy 
services. It does not include general educational training of 
the user's employees, nor does it include information developed 
especially for the user, such as a technical plan or design 
developed according to the user's specifications. Thus, as 
provided in paragraph 11.3 of the Commentary to Article 12 of 
the OECD Model, the term ``royalties'' does not include 
payments received as consideration for after-sales service, for 
services rendered by a seller to a purchaser under a warranty, 
or for pure technical assistance.
    The term ``royalties'' also does not include payments for 
professional services (such as architectural, engineering, 
legal, managerial, medical, software development services). For 
example, income from the design of a refinery by an engineer 
(even if the engineer employed know-how in the process of 
rendering the design) or the production of a legal brief by a 
lawyer is not income from the transfer of know-how taxable 
under Article 12, but is income from services taxable under 
either Article 7 (Business Profits) or Article 14 (Income from 
Employment). Professional services may be embodied in property 
that gives rise to royalties, however. Thus, if a professional 
contracts to develop patentable property and retains rights in 
the resulting property under the development contract, 
subsequent license payments made for those rights would be 
royalties.
Paragraph 3
    This paragraph provides an exception to the rule of 
paragraph 1 that gives the state of residence exclusive taxing 
jurisdiction in cases where the beneficial owner of the 
royalties carries on business through a permanent establishment 
in the state of source and the royalties are attributable to 
that permanent establishment. In such cases the provisions of 
Article 7 (Business Profits) will apply.
    The provisions of paragraph 7 of Article 7 apply to this 
paragraph. For example, royalty income that is attributable to 
a permanent establishment and that accrues during the existence 
of the permanent establishment, but is received after the 
permanent establishment no longer exists, remains taxable under 
the provisions of Article 7, and not under this Article.
Paragraph 4
    Paragraph 4 provides that in cases involving special 
relationships between the payor and beneficial owner of 
royalties, Article 12 applies only to the extent the royalties 
would have been paid absent such special relationships (i.e., 
an arm's-length royalty). Any excess amount of royalties paid 
remains taxable according to the laws of the two Contracting 
States, with due regard to the other provisions of the 
Convention. If, for example, the excess amount is treated as a 
distribution of corporate profits under domestic law, such 
excess amount will be taxed as a dividend rather than as 
royalties, but the tax imposed on the dividend payment will be 
subject to the rate limitations of paragraph 2 of Article 10 
(Dividends).
Relationship to Other Articles
    Notwithstanding the foregoing limitations on source country 
taxation of royalties, the saving clause of paragraph 4 of 
Article 1 (General Scope) permits the United States to tax its 
residents and citizens, subject to the special foreign tax 
credit rules of paragraph 4 of Article 23 (Relief from Double 
Taxation), as if the Convention had not come into force.
    As with other benefits of the Convention, the benefits of 
exclusive residence State taxation of royalties under paragraph 
1 of Article 12 are available to a resident of the other State 
only if that resident is entitled to those benefits under 
Article 22 (Limitation on Benefits).

                           ARTICLE 13 (GAINS)

    Article 13 provides rules for the taxation of gains from 
the alienation of property.
Paragraph 1
    Paragraph 1 of Article 13 preserves the non-exclusive right 
of the State of source to tax gains attributable to the 
alienation of real property situated in that State. The 
paragraph therefore permits the United States to apply section 
897 of the Code to tax gains derived by a resident of Hungary 
that are attributable to the alienation of real property 
situated in the United States (as defined in paragraph 2). 
Gains attributable to the alienation of real property include 
gains from any other property that is treated as a real 
property interest within the meaning of paragraph 2.
    Paragraph 1 refers to gains ``attributable to the 
alienation of immovable property (real property)'' rather than 
the OECD Model phrase ``gains from the alienation'' to clarify 
that the United States will look through distributions made by 
a REIT and certain RICs. Accordingly, distributions made by a 
REIT or certain RICs are taxable under paragraph 1 of Article 
13 (not under Article 10 (Dividends)) when they are 
attributable to gains derived from the alienation of real 
property.
Paragraph 2
    This paragraph defines the term ``immovable property (real 
property) situated in the other Contracting State'' for 
purposes of the application of Article 13 by the United States. 
The term includes immovable property (real property) referred 
to in Article 6 (i.e., an interest in the real property 
itself), and a ``United States real property interest'' (when 
the United States is the other Contracting State under 
paragraph 1).
    Under section 897(c) of the Code, the term ``United States 
real property interest'' includes shares in a U.S. corporation 
that owns sufficient U.S. real property interests to satisfy an 
asset-ratio test on certain testing dates. The term also 
includes certain foreign corporations that have elected to be 
treated as U.S. corporations for this purpose. Section 897(i).
Paragraph 3
    This paragraph defines the term ``immovable property (real 
property) situated in the other Contracting State'' for 
purposes of the application of Article 13 by Hungary. The term 
includes immovable property (real property) referred to in 
Article 6.
Paragraph 4
    Paragraph 4 preserves the non-exclusive right for Hungary 
to tax gains from the alienation of shares or comparable 
interests deriving more than 50 percent of their value directly 
or indirectly from immovable property (real property) situated 
in Hungary.
Paragraph 5
    Paragraph 5 of Article 13 deals with the taxation of 
certain gains from the alienation of movable property forming 
part of the business property of a permanent establishment that 
an enterprise of a Contracting State has in the other 
Contracting State. This also includes gains from the alienation 
of such a permanent establishment (alone or with the whole 
enterprise). Such gains may be taxed in the State in which the 
permanent establishment is located. Paragraph 5 does not, 
however, permit the United States to tax gains derived by an 
enterprise of Hungary from the sale of shares or comparable 
interests deriving more than 50 percent of their value directly 
or indirectly from immovable property (real property) situated 
in Hungary, even where those shares form a part of the business 
property of a permanent establishment maintained by that 
enterprise in the United States. The taxation of such shares is 
governed instead by paragraph 4.
    A resident of Hungary that is a partner in a partnership 
doing business in the United States generally will have a 
permanent establishment in the United States as a result of the 
activities of the partnership, assuming that the activities of 
the partnership rise to the level of a permanent establishment. 
Rev. Rul. 91-32, 1991-1 C.B. 107. Further, under paragraph 5, 
the United States generally may tax a partner's distributive 
share of income realized by a partnership on the disposition of 
movable property forming part of the business property of the 
partnership in the United States.
    The gains subject to paragraph 5 may be taxed in the State 
in which the permanent establishment is located, regardless of 
whether the permanent establishment exists at the time of the 
alienation. This rule incorporates the rule of section 
864(c)(6) of the Code. Accordingly, income that is attributable 
to a permanent establishment, but that is deferred and received 
after the permanent establishment no longer exists, may 
nevertheless be taxed by the State in which the permanent 
establishment was located.
Paragraph 6
    This paragraph limits the taxing jurisdiction of the State 
of source with respect to gains from the alienation of ships or 
aircraft operated in international traffic by the enterprise 
alienating the ships or aircraft and from movable property 
pertaining to the operation or use of such ships or aircraft.
    Under paragraph 6, such income is taxable only in the 
Contracting State in which the alienator is resident. 
Notwithstanding paragraph 5, the rules of this paragraph apply 
even if the income is attributable to a permanent establishment 
maintained by the enterprise in the other Contracting State. 
This result is consistent with the allocation of taxing rights 
under Article 8 (Shipping and Air Transport).
Paragraph 7
    Paragraph 7 provides a rule similar to paragraph 6 with 
respect to gains from the alienation of containers and related 
personal property. Such gains derived by an enterprise of a 
Contracting State shall be taxable only in that Contracting 
State unless the containers were used for the transport of 
goods or merchandise solely within the other Contracting State. 
The other Contracting State may not tax the gain even if it is 
attributable to a permanent establishment maintained by the 
enterprise in that other Contracting State.
Paragraph 8
    Paragraph 8 grants to the State of residence of the 
alienator the exclusive right to tax gains from the alienation 
of property other than property referred to in paragraphs 1 
through 7. For example, gain derived from shares, other than 
shares described in paragraphs 2, 4, or 5, debt instruments, 
and various financial instruments may be taxed only in the 
State of residence, to the extent such income is not otherwise 
characterized as income taxable under another article (e.g., 
Article 10 (Dividends) or Article 11 (Interest)). Similarly, 
gain derived from the alienation of tangible personal property, 
other than tangible personal property described in paragraph 5, 
may be taxed only in the State of residence of the alienator.
    Gain derived from the alienation of any property, such as a 
patent or copyright, that produces income covered by Article 12 
(Royalties) is governed by the rules of Article 12 and not by 
this article, provided that such gain is of the type described 
in paragraph 2(b) of Article 12 (i.e., it is contingent on the 
productivity, use, or disposition of the property).
    Gains derived by a resident of a Contracting State from 
immovable property (real property) located in a third state are 
not taxable in the other Contracting State, even if the sale is 
attributable to a permanent establishment located in the other 
Contracting State.
Paragraph 9
    Paragraph 9 addresses the situation in which a resident of 
one State ceases to be a resident of that State and, as a 
result, is subject to special tax rules. This rule is intended 
to coordinate United States and Hungarian taxation of gains in 
the case of a timing mismatch due to the application of the 
mark-to-market exit tax regime for ``covered expatriates'' 
under Code section 877A. Such a mismatch may occur, for 
example, where a U.S. resident recognizes, for
    U.S. tax purposes, gain on a deemed sale of all property on 
the day before the individual expatriates to Hungary.
    To avoid double taxation, paragraph 9 provides that where 
an individual who, upon ceasing to be a resident of one 
Contracting State, is treated for purposes of taxation by that 
State as having alienated a property and is taxed by that State 
by reason thereof, the individual may elect to be treated for 
the purposes of taxation by the other Contracting State as 
having sold and repurchased the property for its fair market 
value on the day before the expatriation date. The election in 
paragraph 9 therefore will be available to any individual who 
expatriates from the United States to Hungary. The election 
will have two effects. First, the election will result in the 
individual (while still a resident of the United States) 
triggering gain on any assets that Hungary is permitted to tax 
as the source State (e.g., an interest in Hungarian real 
property, or movable property forming part of the business 
property of a permanent establishment in Hungary). Second, 
regardless of whether Hungarian tax is triggered by the deemed 
sale, the individual will be given an adjusted basis for 
Hungarian tax purposes equal to the fair market value of the 
property as of the date of the deemed alienation in the United 
States, with the result that if there is a subsequent 
alienation of the property while the individual is a resident 
of Hungary, only post-emigration gain will be subject to 
Hungarian tax.
    If an individual recognizes in one Contracting State losses 
and gains from the deemed alienation of multiple properties, 
then the individual must apply paragraph 9 consistently with 
respect to all such properties. An individual who is deemed to 
have alienated multiple properties may only make the election 
under paragraph 9 if the deemed alienation of all such 
properties results in a net gain.
    Taxpayers may make the election provided by paragraph 9 
only with respect to property that is treated as sold for its 
fair market value under a Contracting State's deemed 
disposition rules. At the time the Convention was signed, the 
following were the types of property that were excluded from 
the deemed disposition rules in the case of individuals who 
cease to be citizens or long term residents of the United 
States: 1) a deferred compensation item as defined under Code 
section 877A(d)(4), 2) a specified tax deferred account as 
defined under Code section 877A(e)(2), and 3) an interest in a 
non-grantor trust as defined under Code section 877A(f)(3).
Relationship to Other Articles
    Notwithstanding the foregoing limitations on taxation of 
certain gains by the State of source, the saving clause of 
paragraph 4 of Article 1 (General Scope) permits the United 
States to tax its citizens and residents as if the Convention 
had not come into effect. Thus, any limitation in this Article 
on the right of the United States to tax gains does not apply 
to gains of a
U.S. citizen or resident.
    The benefits of this Article are also subject to the 
provisions of Article 22 (Limitation on Benefits). Thus, only a 
resident of a Contracting State that satisfies one of the 
conditions in Article 22 is entitled to the benefits of this 
Article.

                  ARTICLE 14 (INCOME FROM EMPLOYMENT)

    Article 14 apportions taxing jurisdiction over remuneration 
derived by a resident of a Contracting State as an employee 
between the States of source and residence.
Paragraph 1
    The general rule of Article 14 is contained in paragraph 1. 
Remuneration derived by a resident of a Contracting State as an 
employee may be taxed by the State of residence, and the 
remuneration also may be taxed by the other Contracting State 
to the extent derived from employment exercised (i.e., services 
performed) in that other Contracting State. Paragraph 1 also 
provides that the more specific rules of Articles 15 
(Directors' Fees), 17 (Pensions and Income from Social 
Security), 18 (Government Service), 19 (Students and Trainees), 
and 20 (Professors and Teachers) apply in the case of 
employment income described in one of those articles. Thus, 
even though the State of source has a right to tax employment 
income under Article 14, it may not have the right to tax that 
income under the Convention if the income is described, for 
example, in Article 17 and is not taxable in the State of 
source under the provisions of that Article.
    Article 14 applies to any form of compensation for 
employment, including payments in kind. Paragraph 1.1 of the 
Commentary to Article 16 of the OECD Model now confirms that 
interpretation.
    Consistent with section 864(c)(6) of the Code, Article 14 
also applies regardless of the timing of actual payment for 
services. Consequently, a person who receives the right to a 
future payment in consideration for services rendered in a 
Contracting State would be taxable in that State even if the 
payment is received at a time when the recipient is a resident 
of the other Contracting State. Thus, a bonus paid to a 
resident of a Contracting State with respect to services 
performed in the other Contracting State with respect to a 
particular taxable year would be subject to Article 14 for that 
year even if it was paid after the close of the year. An 
annuity received for services performed in a taxable year could 
be subject to Article 14 despite the fact that it was paid in 
subsequent years. In that case, it would be necessary to 
determine whether the payment constitutes deferred 
compensation, taxable under Article 14, or a qualified pension 
subject to the rules of Article 17. Article 14 also applies to 
income derived from the exercise of stock options granted with 
respect to services performed in the host State, even if those 
stock options are exercised after the employee has left the 
source country. If Article 14 is found to apply, whether such 
payments were taxable in the State where the employment was 
exercised would depend on whether the tests of paragraph 2 were 
satisfied in the year in which the services to which the 
payment relates were performed.
Paragraph 2
    Paragraph 2 sets forth an exception to the general rule 
that employment income may be taxed in the State where it is 
exercised. Under paragraph 2, the State where the employment is 
exercised may not tax the income from the employment if three 
conditions are satisfied: (a) the individual is present in the 
other Contracting State for a period or periods not exceeding 
183 days in any 12-month period that begins or ends during the 
relevant taxable year (i.e., in the United States, the calendar 
year in which the services are performed); (b) the remuneration 
is paid by, or on behalf of, an employer who is not a resident 
of that other Contracting State; and (c) the remuneration is 
not borne as a deductible expense by a permanent establishment 
that the employer has in that other State. In order for the 
remuneration to be exempt from tax in the source State, all 
three conditions must be satisfied. This exception is identical 
to that set forth in the OECD Model.
    The 183-day period in condition (a) is to be measured using 
the ``days of physical presence'' method. Under this method, 
the days that are counted include any day in which a part of 
the day is spent in the host country. (Rev. Rul. 56-24, 1956-1 
C.B. 851.) Thus, days that are counted include the days of 
arrival and departure; weekends and holidays on which the 
employee does not work but is present within the country; 
vacation days spent in the country before, during or after the 
employment period, unless the individual's presence before or 
after the employment can be shown to be independent of his 
presence there for employment purposes; and time during periods 
of sickness, training periods, strikes, etc., when the 
individual is present but not working. If illness prevented the 
individual from leaving the country in sufficient time to 
qualify for the benefit, those days will not count. Also, any 
part of a day spent in the host country while in transit 
between two points outside the host country is not counted. If 
the individual is a resident of the host country for part of 
the taxable year concerned and a nonresident for the remainder 
of the year, the individual's days of presence as a resident do 
not count for purposes of determining whether the 183-day 
period is exceeded.
    Conditions (b) and (c) are intended to ensure that a 
Contracting State will not be required to allow a deduction to 
the payor for compensation paid and at the same time to exempt 
the employee on the amount received. Accordingly, if a foreign 
person pays the salary of an employee who is employed in the 
host State, but a host State corporation or permanent 
establishment reimburses the payor with a payment that can be 
identified as a reimbursement, neither condition (b) nor (c), 
as the case may be, will be considered to have been fulfilled.
    The reference to remuneration ``borne by'' a permanent 
establishment is understood to encompass all expenses that 
economically are incurred and not merely expenses that are 
currently deductible for tax purposes. Accordingly, the 
expenses referred to include expenses that are capitalizable as 
well as those that are currently deductible. Further, salaries 
paid by residents that are exempt from income taxation may be 
considered to be borne by a permanent establishment 
notwithstanding the fact that the expenses will be neither 
deductible nor capitalizable since the payor is exempt from 
tax.
Paragraph 3
    Paragraph 3 contains a special rule applicable to 
remuneration for services performed by a resident of a 
Contracting State as an employee aboard a ship or aircraft 
operated in international traffic. Such remuneration may be 
taxed only in the State of residence of the employee if the 
services are performed as a member of the regular complement of 
the ship or aircraft. The ``regular complement'' includes the 
crew. In the case of a cruise ship, for example, it may also 
include others, such as entertainers, lecturers, etc., employed 
by the shipping company to serve on the ship throughout its 
voyage. The use of the term ``regular complement'' is intended 
to clarify that a person who exercises his employment as, for 
example, an insurance salesman while aboard a ship or aircraft 
is not covered by this paragraph.
    If a U.S. citizen who is resident in Hungary performs 
services as an employee in the United States and meets the 
conditions of paragraph 2 for source country exemption, he 
nevertheless is taxable in the United States by virtue of the 
saving clause of paragraph 4 of Article 1 (General Scope), 
subject to the special foreign tax credit rule of paragraph 4 
of Article 23 (Relief from Double Taxation).

                      ARTICLE 15 (DIRECTORS' FEES)

    This Article provides that a Contracting State may tax the 
fees and other compensation paid by a company that is a 
resident of that State for services performed by a resident of 
the other Contracting State in his capacity as a director of 
the company. This rule is an exception to the more general 
rules of Articles 7 (Business Profits) and 14 (Income from 
Employment). Thus, for example, in determining whether a 
director's fee paid to a non-employee director is subject to 
tax in the country of residence of the corporation, it is not 
relevant to establish whether the fee is attributable to a 
permanent establishment in that State.

                ARTICLE 16 (ENTERTAINERS AND SPORTSMEN)

    This Article deals with the taxation in a Contracting State 
of entertainers and sportsmen resident in the other Contracting 
State from the performance of their services as such. The 
Article applies both to the income of an entertainer or 
sportsman who performs services on his own behalf and one who 
performs services on behalf of another person, either as an 
employee of that person, or pursuant to any other arrangement. 
The rules of this Article take precedence, in some 
circumstances, over those of Articles 7 (Business Profits) and 
14 (Income from Employment).
    This Article applies only with respect to the income of 
entertainers and sportsmen. Others involved in a performance or 
athletic event, such as producers, directors, technicians, 
managers, coaches, etc., remain subject to the provisions of 
Articles 7 and 14. In addition, except as provided in paragraph 
2, income earned by juridical persons is not covered by Article 
16.
Paragraph 1
    Paragraph 1 describes the circumstances in which a 
Contracting State may tax the performance income of an 
entertainer or sportsman who is a resident of the other 
Contracting State. Under the paragraph, income derived by an 
individual resident of a Contracting State from activities as 
an entertainer or sportsman exercised in the other Contracting 
State may be taxed in that other State if the amount of the 
gross receipts derived by the performer exceeds $20,000 (or its 
equivalent in Hungarian Forints) for the taxable year. The 
$20,000 includes expenses reimbursed to the individual or borne 
on his behalf. If the gross receipts exceed $20,000, the full 
amount, not just the excess, may be taxed in the State of 
performance.
    The Convention introduces this monetary threshold to 
distinguish between two groups of entertainers and athletes--
those who are paid relatively large sums of money for very 
short periods of service, and who would, therefore, normally be 
exempt from host country tax under the standard personal 
services income rules, and those who earn relatively modest 
amounts and are, therefore, not easily distinguishable from 
those who earn other types of personal service income.
    Tax may be imposed under paragraph 1 even if the performer 
would have been exempt from tax under Article 7 (Business 
Profits) or 14 (Income from Employment). On the other hand, if 
the performer would be exempt from host-country tax under 
Article 16, but would be taxable under either Article 7 or 14, 
tax may be imposed under either of those Articles. Thus, for 
example, if a performer derives remuneration from his 
activities in an independent capacity, and the performer does 
not have a permanent establishment in the host State, he may be 
taxed by the host State in accordance with Article 16 if his 
remuneration exceeds $20,000 annually, despite the fact that he 
generally would be exempt from host State taxation under 
Article 7. However, a performer who receives less than the 
$20,000 threshold amount and therefore is not taxable under 
Article 16 nevertheless may be subject to tax in the host 
country under Article 7 or 14 if the tests for host-country 
taxability under the relevant Article are met. For example, if 
an entertainer who is an independent contractor earns $14,000 
of income in a State for the calendar year, but the income is 
attributable to his permanent establishment in the State of 
performance, that State may tax his income under Article 7.
    Since it frequently is not possible to know until year-end 
whether the income an entertainer or sportsman derived from 
performances in a Contracting State will exceed $20,000, 
nothing in the Convention precludes that Contracting State from 
withholding tax during the year and refunding it after the 
close of the year if the taxability threshold has not been met.
    As explained in paragraph 9 of the Commentary to Article 17 
of the OECD Model, Article 16 of the Convention applies to all 
income connected with a performance by the entertainer, such as 
appearance fees, award or prize money, and a share of the gate 
receipts. Income derived from a Contracting State by a 
performer who is a resident of the other Contracting State from 
other than actual performance, such as royalties from record 
sales and payments for product endorsements, is not covered by 
this Article, but by other articles of the Convention, such as 
Article 12 (Royalties) or Article 7. For example, if an 
entertainer receives royalty income from the sale of live 
recordings, the royalty income would be exempt from source 
state tax under Article 12, even if the performance was 
conducted in the source country, although the entertainer could 
be taxed in the source country with respect to income from the 
performance itself under Article 16 if the dollar threshold is 
exceeded.
    In determining whether income falls under Article 16 or 
another Article, the controlling factor will be whether the 
income in question is predominantly attributable to the 
performance itself or to other activities or property rights. 
For instance, a fee paid to a performer for endorsement of a 
performance in which the performer will participate would be 
considered to be so closely associated with the performance 
itself that it normally would fall within Article 16. 
Similarly, a sponsorship fee paid by a business in return for 
the right to attach its name to the performance would be so 
closely associated with the performance that it would fall 
under Article 16 as well. As indicated in paragraph 9 of the 
Commentary to Article 17 of the OECD Model, however, a 
cancellation fee would not be considered to fall within Article 
16 but would be dealt with under Article 7 or 14.
    As indicated in paragraph 4 of the Commentary to Article 17 
of the OECD Model, where an individual fulfills a dual role as 
performer and non-performer (such as a player-coach or an 
actor-director), but his role in one of the two capacities is 
negligible, the predominant character of the individual's 
activities should control the characterization of those 
activities. In other cases there should be an apportionment 
between the performance-related compensation and other 
compensation.
    Consistent with Article 14, Article 16 also applies 
regardless of the timing of actual payment for services. Thus, 
a bonus paid to a resident of a Contracting State with respect 
to a performance in the other Contracting State during a 
particular taxable year would be subject to Article 16 for that 
year even if it was paid after the close of the year. The 
determination as to whether the $20,000 threshold has been 
exceeded is determined separately with respect to each year of 
payment. Accordingly, if an actor who is a resident of one 
Contracting State receives residual payments over time with 
respect to a movie that was filmed in the other Contracting 
State, the payments do not have to be aggregated from one year 
to another to determine whether the total payments have finally 
exceeded $20,000. Otherwise, residual payments received many 
years later could retroactively subject all earlier payments to 
tax by the other Contracting State.
Paragraph 2
    Paragraph 2 is intended to address the potential for 
circumvention of the rule in paragraph 1 when a performer's 
income does not accrue directly to the performer himself, but 
to another person. Foreign performers frequently perform in the 
United States as employees of, or under contract with, a 
company or other person.
    The relationship may truly be one of employee and employer, 
with no circumvention of paragraph 1 either intended or 
realized. On the other hand, the ``employer'' may, for example, 
be a company established and owned by the performer, which is 
merely acting as the nominal income recipient in respect of the 
remuneration for the performance (a ``star company''). The 
performer may act as an ``employee,'' receive a modest salary, 
and arrange to receive the remainder of the income from his 
performance from the company in another form or at a later 
time. In such case, absent the provisions of paragraph 2, the 
income arguably could escape host-country tax because the 
company earns business profits but has no permanent 
establishment in that country. The performer may largely or 
entirely escape host-country tax by receiving only a small 
salary, perhaps small enough to place him below the dollar 
threshold in paragraph 1. The performer might arrange to 
receive further payments in a later year, when he is not 
subject to host-country tax, perhaps as dividends or 
liquidating distributions.
    Paragraph 2 seeks to prevent this type of abuse while at 
the same time protecting the taxpayers' rights to the benefits 
of the Convention when there is a legitimate employee-employer 
relationship between the performer and the person providing his 
services. Under paragraph 2, when the income accrues to a 
person other than the performer, the income may be taxed in the 
Contracting State where the performer's services are exercised, 
without regard to the provisions of the Convention concerning 
business profits (Article 7) or income from employment (Article 
14), unless the contract pursuant to which the personal 
activities are performed allows the person other than the 
performer to designate the individual who is to perform the 
personal activities. This rule is based on the U.S. domestic 
law provision characterizing income from certain personal 
service contracts as foreign personal holding company income in 
the context of the foreign personal holding company provisions. 
See Code section 954(c)(1)(H). The premise of this rule is 
that, in a case where a performer is using another person in an 
attempt to circumvent the provisions of paragraph 1, the 
recipient of the services of the performer would contract with 
a person other than that performer (i.e., a company employing 
the performer) only if the recipient of the services were 
certain that the performer himself would perform the services. 
If instead the person is allowed to designate the individual 
who is to perform the services, then likely the person is a 
service company not formed to circumvent the provisions of 
paragraph 1. The following example illustrates the operation of 
this rule:

    Example. Company H, a resident of Hungary, is engaged in 
the business of operating an orchestra. Company H enters into a 
contract with Company A pursuant to which Company H agrees to 
carry out two performances in the United States in 
consideration of which Company A will pay Company H $200,000. 
The contract designates two individuals, a conductor and a 
flautist, that must perform as part of the orchestra, and 
allows Company H to designate the other members of the 
orchestra. Because the contract does not give Company H any 
discretion to determine whether the conductor or the flautist 
perform personal services under the contract, the portion of 
the $200,000 which is attributable to the personal services of 
the conductor and the flautist may be taxed by the United 
States pursuant to paragraph 2. The remaining portion of the 
$200,000, which is attributable to the personal services of 
performers that Company H may designate, is not subject to tax 
by the United States pursuant to paragraph 2.

    In cases where paragraph 2 is applicable, the income of the 
``employer'' may be subject to tax in the host Contracting 
State even if it has no permanent establishment in the host 
country. Taxation under paragraph 2 is on the person providing 
the services of the performer. This paragraph does not affect 
the rules of paragraph 1, which apply to the performer himself. 
The income taxable by virtue of paragraph 2 is reduced to the 
extent of salary payments to the performer, which fall under 
paragraph 1.
    For purposes of paragraph 2, income is deemed to accrue to 
another person (i.e., the person providing the services of the 
performer) if that other person has control over, or the right 
to receive, gross income in respect of the services of the 
performer.
    Pursuant to Article 1 (General Scope), the Convention only 
applies to persons who are residents of one of the Contracting 
States. Thus, income of a star company that is not a resident 
of either Contracting State would not be eligible for the 
benefits of the Convention.
Relationship to other Articles
    This Article is subject to the provisions of the saving 
clause of paragraph 4 of Article 1 (General Scope). Thus, if an 
entertainer or a sportsman who is resident in Hungary is a 
citizen of the United States, the United States may tax all of 
his income from performances in the United States without 
regard to the provisions of this Article (subject to the 
special foreign tax credit provisions of paragraph 4 of Article 
23 (Relief from Double Taxation)). In addition, benefits of 
this Article are subject to the provisions of Article 22 
(Limitation on Benefits).

         ARTICLE 17 (PENSIONS AND INCOME FROM SOCIAL SECURITY)

    This Article deals with the taxation of private (i.e., non-
government service) pensions and social security benefits,.
Paragraph 1
    Paragraph 1 provides that distributions from pensions and 
other similar remuneration beneficially owned by a resident of 
a Contracting State in consideration of past employment are 
taxable only in the State of residence of the beneficiary. The 
term ``pensions and other similar remuneration'' includes both 
periodic and single sum payments.
    The phrase ``pensions and other similar remuneration'' is 
intended to encompass payments made by qualified private 
retirement plans. In the United States, the plans encompassed 
by Paragraph 1 include: qualified plans under section 401(a), 
individual retirement plans (including individual retirement 
plans that are part of a simplified employee pension plan that 
satisfies section 408(k), individual retirement accounts and 
section 408(p) accounts), section 403(a) qualified annuity 
plans, and section 403(b) plans. Distributions from section 457 
plans may also fall under Paragraph 1 if they are not paid with 
respect to government services covered by Article 19. The 
competent authorities may agree that distributions from other 
plans that generally meet similar criteria to those applicable 
to the listed plans also qualify for the benefits of Paragraph 
1.
    Pensions in respect of government services covered by 
Article 18 are not covered by this paragraph. They are covered 
either by paragraph 2 of this Article, if they are in the form 
of social security benefits, or by paragraph 2 of Article 18 
(Government Service). Thus, Article 18 generally covers section 
457, 401(a), 403(b) plans established for government employees, 
and the Thrift Savings Plan (section 7701(j)).
    Subparagraph 1(b) contains an exception to the State of 
residence's right to tax pensions and other similar 
remuneration under subparagraph 1(a). Under subparagraph 1(b), 
the State of residence must exempt from tax the amount of any 
such pensions or other similar remuneration that would be 
exempt from tax in the Contracting State in which the pension 
fund is established if the recipient were a resident of that 
State. Thus, for example, a distribution from a U.S. ``Roth 
IRA'' to a resident of Hungary would be exempt from tax in 
Hungary to the same extent the distribution would be exempt 
from tax in the United States if it were distributed to a U.S. 
resident. The same is true with respect to distributions from a 
traditional IRA to the extent that the distribution represents 
a return of non-deductible contributions. Similarly, if the 
distribution were not subject to tax when it was ``rolled 
over'' into another U.S. IRA (but not, for example, to a 
pension fund in the other Contracting State), then the 
distribution would be exempt from tax in Hungary.
Paragraph 2
    The treatment of social security benefits is dealt with in 
paragraph 2. Subparagraph 2(a) provides that, notwithstanding 
the provision of paragraph 1 under which private pensions are 
taxable exclusively in the State of residence of the beneficial 
owner, payments made by the United States under the provisions 
of the social security or similar legislation of the United 
States to a resident of Hungary will be taxable only in the 
United States. Subparagraph 2(b) provides that payments made by 
Hungary under the mandatory pension scheme of Hungary to a 
resident or citizen of the United States are taxable only in 
Hungary. The reference to U.S. citizens is necessary to ensure 
that a social security payment by Hungary to a U.S. citizen who 
is not resident in the United States will not be taxable by the 
United States.
    This paragraph applies to social security and mandatory 
pension scheme beneficiaries whether they have contributed to 
the system as private sector or Government employees. The 
phrase ``similar legislation'' is intended to refer to United 
States tier 1 railroad retirement benefits.
Paragraph 3
    Paragraph 3 provides that, if a resident of a Contracting 
State participates in a pension fund established in the other 
Contracting State, the State of residence will not tax the 
income of the pension fund with respect to that resident until 
a distribution is made from the pension fund. Thus, for 
example, if a U.S. citizen contributes to a U.S. qualified plan 
while working in the United States and then establishes 
residence in the Hungary, paragraph 3 prevents Hungary from 
taxing currently the plan's earnings and accretions with 
respect to that individual. When the resident receives a 
distribution from the pension fund, that distribution may be 
subject to tax in the State of residence, subject to paragraph 
1.
Relationship to other Articles
    Subparagraph 1(a) of Article 17 is subject to the saving 
clause of paragraph 4 of Article 1 (General Scope). Thus, a 
U.S. citizen who is resident in Hungary and receives a pension 
payment from the United States, may be subject to U.S. tax on 
the payment, notwithstanding the rules in subparagraph 1(a) 
that give the State of residence of the recipient the exclusive 
taxing right. Subparagraph 1(b) and paragraphs 2 and 3 are 
excepted from the saving clause by virtue of subparagraph 5(a) 
of Article 1. Thus, the United States will not tax U.S. 
citizens and residents on the income described in those 
paragraphs even if such amounts otherwise would be subject to 
tax under U.S. law.

                    ARTICLE 18 (GOVERNMENT SERVICE)

Paragraph 1
    Subparagraphs 1(a) and 1(b) deal with the taxation of 
government compensation (other than a pension addressed in 
paragraph 2). Subparagraph 1(a) provides that remuneration paid 
by a Contracting State or a political subdivision or local 
authority thereof to any individual who is rendering services 
to that State, political subdivision or local authority is 
exempt from tax by the other State. Under subparagraph (b), 
such payments are, however, taxable exclusively in the other 
State (i.e., the host State) if the services are rendered in 
that other State and the individual is a resident of that State 
who is either a national of that State or a person who did not 
become resident of that State solely for purposes of rendering 
the services.
Paragraph 2
    Paragraph 2 deals with the taxation of pensions paid by, or 
out of funds created by, one of the States, or a political 
subdivision or a local authority thereof, to an individual in 
respect of services rendered to that State or subdivision or 
authority. Subparagraph (a) provides that such pensions are 
taxable only in that State. Subparagraph (b) provides an 
exception under which such pensions are taxable only in the 
other State if the individual is a resident of, and a national 
of, that other State.
    Pensions paid to retired civilian and military employees of 
a Government of either State are intended to be covered under 
paragraph 2. When benefits paid by a State in respect of 
services rendered to that State or a subdivision or authority 
are in the form of social security benefits, however, those 
payments are covered by paragraph 2 of Article 17 (Pensions and 
Income From Social Security). As a general matter, the result 
will be the same whether Article 17 or 18 applies, since social 
security benefits are taxable exclusively by the source country 
and so are government pensions. The result will differ only 
when the payment is made to a citizen and resident of the other 
Contracting State, who is not also a citizen of the paying 
State. In such a case, social security benefits continue to be 
taxable at source while government pensions become taxable only 
in the residence country.
Paragraph 3
    Paragraph 3 provides that the remuneration described in 
paragraph 1 will be subject to the rules of Articles 14 (Income 
from Employment), 15 (Directors' Fees), 16 (Entertainers and 
Sportsmen) or 17 (Pensions and Income From Social Security) if 
the recipient of the income is employed by a business conducted 
by a government.
Relationship to other Articles
    Under subparagraph 5(b) of Article 1 (General Scope), the 
saving clause of paragraph 4 of Article 1 does not apply to the 
benefits conferred by one of the States under Article 18 if the 
recipient of the benefits is neither a citizen of that State, 
nor a person who has been admitted for permanent residence 
there (i.e., in the United States, a ``green card'' holder). 
Thus, a resident of the United States who in the course of 
performing functions of a governmental nature becomes a 
resident of Hungary (but not a permanent resident), would be 
entitled to the benefits of this Article. Similarly, an 
individual who receives a pension paid by the Government of 
Hungary in respect of services rendered to the Government of 
Hungary shall be taxable on this pension only in Hungary unless 
the individual is a U.S. citizen or acquires a U.S. green card.

                   ARTICLE 19 (STUDENTS AND TRAINEES)

    This Article provides rules for the taxation of visiting 
students and business trainees. Persons who meet the tests of 
the Article will be exempt from tax in the State that they are 
visiting with respect to designated classes of income. Several 
conditions must be satisfied in order for an individual to be 
entitled to the benefits of this Article.
    First, the visitor must have been, either at the time of 
his arrival in the host State or immediately before, a resident 
of the other Contracting State.
    Second, the primary purpose of the visit must be the 
education or training of the visitor. Thus, if the visitor 
comes principally to work in the host State but also is a part-
time student, he would not be entitled to the benefits of this 
Article, even with respect to any payments he may receive from 
abroad for his maintenance or education, and regardless of 
whether or not he is in a degree program.
    The host-country exemption applies to payments received by 
the student or business trainee for the purpose of his 
maintenance, education or training that arise outside the host 
State.
     A payment will be considered to arise outside the host 
State if the payer is located outside the host State. Thus, if 
an employer from one of the Contracting States sends an 
employee to the other Contracting State for training, the 
payments the trainee receives from abroad from his employer for 
his maintenance or training while he is present in the host 
State will be exempt from tax in the host State. Where 
appropriate, substance prevails over form in determining the 
identity of the payer. Thus, for example, payments made 
directly or indirectly by a U.S. person with whom the visitor 
is training, but which have been routed through a source 
outside the United States (e.g., a foreign subsidiary), are not 
treated as arising outside the United States for this purpose.
    The Article also provides a limited exemption for 
remuneration from personal services rendered in the host State 
with a view to supplementing the resources available to him for 
such purposes to the extent of $9,000 United States dollars (or 
its equivalent in Hungarian Forints) per taxable year. The 
specified amount is intended to equalize the position of a U.S. 
resident who is entitled to the standard deduction and the 
personal exemption with that of a student who files as a non-
resident alien and therefore is not. Accordingly, the competent 
authorities are instructed to adjust this amount every five 
years, if necessary, to take into account changes in the amount 
of the U.S. standard deduction and personal exemption.
    In the case of a business trainee, the benefits of the 
Article will extend only for a period of one year from the time 
that the visitor first arrives in the host country. If, 
however, a trainee remains in the host country for a second 
year, thus losing the benefits of the Article, he would not 
retroactively lose the benefits of the Article for the first 
year. The term ``business trainee'' is defined as a person who 
is in the country temporarily for the purpose of securing 
training that is necessary to qualify to pursue a profession or 
professional specialty. Moreover, the person must be employed 
or under contract with a resident of the other Contracting 
State and must be receiving the training from someone who is 
not related to its employer. Thus, a business trainee might 
include a lawyer employed by a law firm in one Contracting 
State who works for one year as a stagiaire in an unrelated law 
firm in the other Contracting State. However, the term would 
not include a manager who normally is employed by a parent 
company in one Contracting State who is sent to the other 
Contracting State to run a factory owned by a subsidiary of the 
parent company.
Relationship to other Articles
    Under subparagraph 5(b) of Article 1, the saving clause of 
paragraph 4 of Article 1 (General Scope) does not apply to this 
Article with respect to an individual who is neither a citizen 
of the host State nor has been admitted for permanent residence 
there. The saving clause, however, does apply with respect to 
citizens and permanent residents of the host State. Thus, a 
citizen who is a resident of Hungary and who visits the United 
States for the primary purpose of attending an accredited 
university will not be exempt from U.S. tax on remittances from 
abroad that otherwise constitute U.S. taxable income. A person, 
however, who is not a citizen, and who visits the United States 
as a student and remains long enough to become a resident under 
U.S. law, but does not become a permanent resident (i.e., does 
not acquire a green card), will be entitled to the full 
benefits of the Article.

                  ARTICLE 20 (PROFESSORS AND TEACHERS)

Paragraph 1
    Paragraph 1 provides an exemption from tax in a host 
Contracting State for an individual who visits that State for a 
period not exceeding two years for the purpose of teaching or 
carrying out advanced study (including research) at a 
university, college or other recognized research institute or 
other establishment for higher education in that State. This 
rule applies only if the individual is a resident of the other 
Contracting State immediately before his visit begins. The 
exemption applies to any remuneration for such teaching or 
research. The exemption from tax applies for a period not 
exceeding two years from the date he first visits the host 
State for the purpose of teaching or engaging in research at a 
university, college or other recognized research institute or 
other establishment for higher education there. If a professor 
or teacher remains in the host State for more than the 
specified two year period, he may be subject to tax in that 
State, under its law, for the entire period of his presence.
    The host State exemption will apply if the teaching or 
research is carried on at an accredited university, college, 
school or other recognized educational institution.
Paragraph 2
    Paragraph 2 provides that the preceding provisions of the 
Article shall apply to income from research only if such 
research is undertaken by the individual in the public interest 
and not primarily for the benefit of a specific person or 
persons.
    Under subparagraph 5(b) of Article 1 (General Scope), the 
saving clause of paragraph 4 of Article 1 does not apply to the 
benefits conferred by one of the States under this Article if 
the recipient of the benefits is neither a citizen nor a lawful 
permanent resident of that State. Thus, a resident of Hungary 
who visits the United States for two academic years as a 
professor and becomes a U.S. resident according to the Code, 
other than by virtue of acquiring a green card, would continue 
to be exempt from U.S. tax in accordance with this article so 
long as he is not a U.S. citizen and does not acquire immigrant 
status in the United States.

                       ARTICLE 21 (OTHER INCOME)

    Article 21 generally assigns taxing jurisdiction over 
income not dealt with in the other Articles (Articles 6 through 
20) of the Convention to the State of residence of the 
beneficial owner of the income. In order for an item of income 
to be ``dealt with'' in another Article it must be the type of 
income described in the article and, in most cases, it must 
have its source in a Contracting State. For example, all 
royalty income that arises in a Contracting State and that is 
beneficially owned by a resident of the other Contracting State 
is ``dealt with'' in Article 12 (Royalties). However, profits 
derived in the conduct of a business are ``dealt with'' in 
Article 7 (Business Profits) whether or not they have their 
source in one of the Contracting States.
    Examples of items of income covered by Article 21 include 
income from gambling, punitive (but not compensatory) damages 
and covenants not to compete. The Article would also apply to 
income from a variety of financial transactions, where such 
income does not arise in the course of the conduct of a trade 
or business. For example, income from notional principal 
contracts and other derivatives would fall within Article 21 if 
derived by persons not engaged in the trade or business of 
dealing in such instruments, unless such instruments were being 
used to hedge risks arising in a trade or business. It would 
also apply to securities lending fees derived by an 
institutional investor. Further, in most cases guarantee fees 
paid within an intercompany group would be covered by Article 
21, unless the guarantor were engaged in the business of 
providing such guarantees to unrelated parties.
    Article 21 also applies to items of income that are not 
dealt with in the other Articles because of their source or 
some other characteristic. For example, Article 11 (Interest) 
addresses only the taxation of interest arising in a 
Contracting State. Interest arising in a third State that is 
not attributable to a permanent establishment, therefore, is 
subject to Article 21.
    Distributions from partnerships are not generally dealt 
with under Article 21 because partnership distributions 
generally do not constitute income. Under the Code, partners 
include in income their distributive share of partnership 
income annually, and partnership distributions themselves 
generally do not give rise to income. This would also be the 
case under U.S. law with respect to distributions from trusts. 
Trust income and distributions that, under the Code, have the 
character of the associated distributable net income would 
generally be covered by another article of the Convention. See 
Code section 641 et seq.
Paragraph 1
    The general rule of Article 21 is contained in paragraph 1. 
Items of income not dealt with in other Articles and 
beneficially owned by a resident of a Contracting State will be 
taxable only in the State of residence. This exclusive right of 
taxation applies whether or not the residence State exercises 
its right to tax the income covered by the Article.
    The reference in this paragraph to ``items of income 
beneficially owned by a resident of a Contracting State'' 
rather than simply ``items of income of a resident of a 
Contracting State,'' as in the OECD Model, is intended merely 
to make explicit the implicit understanding in other treaties 
that the exclusive residence taxation provided by paragraph 1 
applies only when a resident of a Contracting State is the 
beneficial owner of the income. Thus, source taxation of income 
not dealt with in other articles of the Convention is not 
limited by paragraph 1 if it is nominally paid to a resident of 
the other Contracting State, but is beneficially owned by a 
resident of a third State. However, income received by a 
nominee on behalf of a resident of that other State would be 
entitled to benefits.
    The term ``beneficially owned'' is not defined in the 
Convention, and is, therefore, defined as under the internal 
law of the country imposing tax (i.e., the source country). The 
person who beneficially owns the income for purposes of Article 
21 is the person to which the income is attributable for tax 
purposes under the laws of the source State.
Paragraph 2
    This paragraph provides an exception to the general rule of 
paragraph 1 where the right or property in respect of which the 
income is paid is effectively connected with a permanent 
establishment maintained in a Contracting State by a resident 
of the other Contracting State. The taxation of such income is 
governed by the provisions of Article 7 (Business Profits). 
Therefore, income arising outside the United States that is 
attributable to a permanent establishment maintained in the 
United States by a resident of Hungary generally would be 
taxable by the United States under the provisions of Article 7. 
This would be true even if the income is sourced in a third 
State.
Relationship to Other Articles
    This Article is subject to the saving clause of paragraph 4 
of Article 1 (General Scope). Thus, the United States may tax 
the income of a resident of the other Contracting State that is 
not dealt with elsewhere in the Convention, if that resident is 
a citizen of the United States. The Article is also subject to 
the provisions of Article 22 (Limitation on Benefits). Thus, if 
a resident of the other Contracting State earns income that 
falls within the scope of paragraph 1 of Article 21, but that 
is taxable by the United States under U.S. law, the income 
would be exempt from
    U.S. tax under the provisions of Article 21 only if the 
resident satisfies one of the tests of Article 22 for 
entitlement to benefits.

                  ARTICLE 22 (LIMITATION ON BENEFITS)

    Article 22 contains anti-treaty-shopping provisions that 
are intended to prevent residents of third countries from 
benefiting from what is intended to be a reciprocal agreement 
between two countries. In general, the provision does not rely 
on a determination of purpose or intention but instead sets 
forth a series of objective tests. A resident of a Contracting 
State that satisfies one of the tests will receive benefits 
regardless of its motivations in choosing its particular 
business structure.
    The structure of the Article is as follows: Paragraph 1 
states the general rule that residents are entitled to benefits 
otherwise accorded to residents only to the extent provided in 
the Article. Paragraph 2 lists a series of attributes of a 
resident of a Contracting State, the presence of any one of 
which will entitle that person to all the benefits of the 
Convention. Paragraph 3 provides that, regardless of whether a 
person qualifies for benefits under paragraph 2, benefits may 
be granted to that person with regard to certain income earned 
in the conduct of an active trade or business. Paragraph 4 
provides a so-called ``derivative benefits'' test under which 
certain income may qualify for benefits. Paragraph 5 provides 
that a so-called headquarters company resident in a Contracting 
State may qualify for benefits if certain conditions are met. 
Paragraph 6 provides special rules for so-called ``triangular 
cases,'' notwithstanding the other provisions of the Article. 
Paragraph 7 provides that benefits also may be granted if the 
competent authority of the State from which benefits are 
claimed determines that it is appropriate to provide benefits 
in that case. Paragraph 8 defines certain terms used in the 
Article.
Paragraph 1
    Paragraph 1 provides that, except as otherwise provided in 
Article 22, a resident of a Contracting State will be entitled 
to all the benefits otherwise accorded to residents of a 
Contracting State under the Convention only to the extent 
provided in paragraph 2.
    The benefits otherwise accorded to residents under the 
Convention include all limitations on source-based taxation 
under Articles 6 through 21, the treaty-based relief from 
double taxation provided by Article 23, and the protection 
afforded to residents of a Contracting State under Article 24. 
Some provisions do not require that a person be a resident in 
order to enjoy the benefits of those provisions. Article 25 is 
not limited to residents of the Contracting States, and Article 
27 applies to diplomatic agents or consular officials 
regardless of residence. Article 22 accordingly does not limit 
the availability of treaty benefits under these provisions.
    Article 22 and the anti-abuse provisions of domestic law 
complement each other, as Article 22 effectively determines 
whether an entity has a sufficient nexus to the Contracting 
State to be treated as a resident for treaty purposes, while 
domestic anti-abuse provisions (e.g., business purpose, 
substance-over-form, step transaction or conduit principles) 
determine whether a particular transaction should be recast in 
accordance with its substance. Thus, internal law principles of 
the source Contracting State may be applied to identify the 
beneficial owner of an item of income, and Article 22 then will 
be applied to the beneficial owner to determine if that person 
is entitled to the benefits of the Convention with respect to 
such income.
Paragraph 2
    Paragraph 2 has five subparagraphs, each of which describes 
a category of residents that are entitled to all benefits of 
the Convention.
    It is intended that the provisions of paragraph 2 will be 
self-executing. Unlike the provisions of paragraph 7, discussed 
below, claiming benefits under paragraph 2 does not require 
advance competent authority ruling or approval. The tax 
authorities may, of course, on review, determine that the 
taxpayer has improperly interpreted the paragraph and is not 
entitled to the benefits claimed.
Individuals--Subparagraph 2(a)
    Subparagraph 2(a) provides that individual residents of a 
Contracting State will be entitled to all treaty benefits. If 
such an individual receives income as a nominee on behalf of a 
third country resident, benefits may be denied under the 
respective articles of the Convention by the requirement that 
the beneficial owner of the income be a resident of a 
Contracting State.
Governments--Subparagraph 2(b)
    Subparagraph 2(b) provides that the Contracting States and 
any political subdivision or local authority thereof will be 
entitled to all benefits of the Convention.
Publicly-Traded Corporations--Subparagraph 2(c)(i)
    Subparagraph 2(c) applies to two categories of companies: 
publicly traded companies and subsidiaries of publicly traded 
companies. A company resident in a Contracting State is 
entitled to all the benefits of the Convention under clause (i) 
of subparagraph (c) if the principal class of its shares, and 
any disproportionate class of shares, is regularly traded on 
one or more recognized stock exchanges and the company 
satisfies at least one of the following additional 
requirements: first, the company's principal class of shares is 
primarily traded on one or more recognized stock exchanges 
located in the Contracting State of which the company is a 
resident, or, in the case of a company resident in Hungary, on 
a recognized stock exchange located within the European Union 
or in any other European Free Trade Association state, or, in 
the case of a company resident in the United States, on a 
recognized stock exchange located in another state that is a 
party to the North American Free Trade Agreement; or, second, 
the company's primary place of management and control is in its 
State of residence.
    The term ``recognized stock exchange'' is defined in 
subparagraph (a) of paragraph 8. It includes (i) the NASDAQ 
System and any stock exchange registered with the Securities 
and Exchange Commission as a national securities exchange for 
purposes of the Securities Exchange Act of 1934, (ii) the stock 
exchange of Budapest, (iii) the stock exchanges of Amsterdam, 
Brussels, Frankfurt, London, Paris, Vienna, Warsaw, and Zurich; 
and (iv) any other stock exchange agreed upon by the competent 
authorities of the Contracting States.
    If a company has only one class of shares, it is only 
necessary to consider whether the shares of that class meet the 
relevant trading requirements. If the company has more than one 
class of shares, it is necessary as an initial matter to 
determine which class or classes constitute the ``principal 
class of shares''. The term ``principal class of shares'' is 
defined in subparagraph 8(b) to mean the ordinary or common 
shares of the company representing the majority of the 
aggregate voting power and value of the company. If the company 
does not have a class of ordinary or common shares representing 
the majority of the aggregate voting power and value of the 
company, then the ``principal class of shares'' is that class 
or any combination of classes of shares that represents, in the 
aggregate, a majority of the voting power and value of the 
company. Although in a particular case involving a company with 
several classes of shares it is conceivable that more than one 
group of classes could be identified that account for more than 
50% of the shares, it is only necessary for one such group to 
satisfy the requirements of this subparagraph in order for the 
company to be entitled to benefits. Benefits would not be 
denied to the company even if a second, non-qualifying, group 
of shares with more than half of the company's voting power and 
value could be identified.
    A company whose principal class of shares is regularly 
traded on a recognized stock exchange will nevertheless not 
qualify for benefits under subparagraph 2(c)(i) if it has a 
disproportionate class of shares that is not regularly traded 
on a recognized stock exchange. The term ``disproportionate 
class of shares'' is defined in subparagraph 8(c). A company 
has a disproportionate class of shares if it has outstanding a 
class of shares which is subject to terms or other arrangements 
that entitle the holder to a larger portion of the company's 
income, profit, or gain in the other Contracting State than 
that to which the holder would be entitled in the absence of 
such terms or arrangements. Thus, for example, a company 
resident in Hungary meets the test of subparagraph 8(c) if it 
has outstanding a class of ``tracking stock'' that pays 
dividends based upon a formula that approximates the company's 
return on its assets employed in the United States.
    The following example illustrates this result.
    Example. HCo is a corporation resident in Hungary. HCo has 
two classes of shares: Common and Preferred. The Common shares 
are listed and regularly traded on the Budapest Stock Exchange. 
The Preferred shares have no voting rights and are entitled to 
receive dividends equal in amount to interest payments that HCo 
receives from unrelated borrowers in the United States. The 
Preferred shares are owned entirely by a single investor that 
is a resident of a country with which the United States does 
not have a tax treaty. The Common shares account for more than 
50 percent of the value of HCo and for 100 percent of the 
voting power. Because the owner of the Preferred shares is 
entitled to receive payments corresponding to the U.S. source 
interest income earned by HCo, the Preferred shares are a 
disproportionate class of shares. Because the Preferred shares 
are not regularly traded on a recognized stock exchange, MCo 
will not qualify for benefits under subparagraph 2(c)(i).
    The term ``regularly traded'' is not defined in the 
Convention. In accordance with paragraph 2 of Article 3 
(General Definitions), this term will be defined by reference 
to the domestic tax laws of the State from which treaty 
benefits are sought, generally the source State. In the case of 
the United States, this term is understood to have the meaning 
it has under Treas. Reg. section 1.884-5(d)(4)(i)(B), relating 
to the branch tax provisions of the Code. Under these 
regulations, a class of shares is considered to be ``regularly 
traded'' if two requirements are met: trades in the class of 
shares are made in more than de minimis quantities on at least 
60 days during the taxable year, and the aggregate number of 
shares in the class traded during the year is at least 10 
percent of the average number of shares outstanding during the 
year. Sections 1.884-5(d)(4)(i)(A), (ii) and (iii) will not be 
taken into account for purposes of defining the term 
``regularly traded'' under the Convention.
    The regular trading requirement can be met by trading on 
any recognized exchange or exchanges located in either State. 
Trading on one or more recognized stock exchanges may be 
aggregated for purposes of this requirement. Thus, a U.S. 
company could satisfy the regularly traded requirement through 
trading, in whole or in part, on a recognized stock exchange 
located in Hungary. Authorized but unissued shares are not 
considered for purposes of this test.
    The term ``primarily traded'' is not defined in the 
Convention. In accordance with paragraph 2 of Article 3, this 
term will have the meaning it has under the laws of the State 
concerning the taxes to which the Convention applies, generally 
the source State. In the case of the United States, this term 
is understood to have the meaning it has under Treas. Reg. 
section 1.884-5(d)(3), relating to the branch tax provisions of 
the Code. Accordingly, stock of a corporation is ``primarily 
traded'' if the number of shares in the company's principal 
class of shares that are traded during the taxable year on all 
recognized stock exchanges in the Contracting State of which 
the company is a resident exceeds the number of shares in the 
company's principal class of shares that are traded during that 
year on established securities markets in any other single 
foreign country.
    A company whose principal class of shares is regularly 
traded on a recognized exchange but cannot meet the primarily 
traded test may claim treaty benefits if its primary place of 
management and control is in its country of residence. This 
test should be distinguished from the ``place of effective 
management'' test which is used in the OECD Model and by many 
other countries to establish residence. In some cases, the 
place of effective management test has been interpreted to mean 
the place where the board of directors meets. By contrast, the 
primary place of management and control test looks to where 
day-to-day responsibility for the management of the company 
(and its subsidiaries) is exercised. The company's primary 
place of management and control will be located in the State in 
which the company is a resident only if the executive officers 
and senior management employees exercise day-to-day 
responsibility for more of the strategic, financial and 
operational policy decision making for the company (including 
direct and indirect subsidiaries) in that State than in the 
other State or any third state, and the staff that support the 
management in making those decisions are also based in that 
State. Thus, the test looks to the overall activities of the 
relevant persons to see where those activities are conducted.
     In most cases, it will be a necessary, but not a 
sufficient, condition that the headquarters of the company 
(that is, the place at which the CEO and other top executives 
normally are based) be located in the Contracting State of 
which the company is a resident.
    To apply the test, it will be necessary to determine which 
persons are to be considered ``executive officers and senior 
management employees''. In most cases, it will not be necessary 
to look beyond the executives who are members of the Board of 
Directors (the ``inside directors'') in the case of a U.S. 
company. That will not always be the case, however; in fact, 
the relevant persons may be employees of subsidiaries if those 
persons make the strategic, financial and operational policy 
decisions. Moreover, it would be necessary to take into account 
any special voting arrangements that result in certain board 
members making certain decisions without the participation of 
other board members.
Subsidiaries of Publicly-Traded Corporations--Subparagraph 2(c)(ii)
    A company resident in a Contracting State is entitled to 
all the benefits of the Convention under subparagraph 2(c)(ii) 
if five or fewer publicly traded companies described in 
subparagraph 2(c)(i) are the direct or indirect owners of at 
least 50 percent of the aggregate vote and value of the 
company's shares (and at least 50 percent of any 
disproportionate class of shares). If the publicly-traded 
companies are indirect owners, however, each of the 
intermediate companies must be a resident of one of the 
Contracting States.
    Thus, for example, a company that is a resident of Hungary, 
all the shares of which are owned by another company that is a 
resident of Hungary, would qualify for benefits under 
subparagraph 2(c) if the principal class of shares (and any 
disproportionate classes of shares) of the parent company are 
regularly and primarily traded on a recognized stock exchange 
in Hungary. However, such a subsidiary would not qualify for 
benefits under clause (ii) if the publicly traded parent 
company were a resident of a third state, for example, and not 
a resident of the United States or Hungary. Furthermore, if a 
parent company in Hungary indirectly owned the bottom-tier 
company through a chain of subsidiaries, each such subsidiary 
in the chain, as an intermediate owner, must be a resident of 
the United States or Hungary in order for the subsidiary to 
meet the test in clause (ii).
Tax Exempt Organizations--Subparagraph 2(d)
    Subparagraph 2(d) provides rules by which the tax exempt 
organizations described in paragraph 2 of Article 4 (Resident) 
will be entitled to all the benefits of the Convention. A 
pension fund will qualify for benefits if more than fifty 
percent of the beneficiaries, members or participants of the 
organization are individuals resident in either Contracting 
State. For purposes of this provision, the term 
``beneficiaries'' should be understood to refer to the persons 
receiving benefits from the organization. On the other hand, a 
tax-exempt organization other than a pension fund automatically 
qualifies for benefits, without regard to the residence of its 
beneficiaries or members. Entities qualifying under this rule 
generally are those that are exempt from tax in their State of 
residence and that are organized and operated exclusively to 
fulfill religious, charitable, scientific, artistic, cultural, 
or educational purposes.
Ownership/Base Erosion--Subparagraph 2(e)
    Subparagraph 2(e) provides an additional method to qualify 
for treaty benefits that applies to any form of legal entity 
that is a resident of a Contracting State. The test provided in 
subparagraph (e), the so-called ownership and base erosion 
test, is a two-part test. Both prongs of the test must be 
satisfied for the resident to be entitled to treaty benefits 
under subparagraph 2(e).
    The ownership prong of the test, under clause (i), requires 
that 50 percent or more of each class of shares or other 
beneficial interests in the person is owned, directly or 
indirectly, on at least half the days of the person's taxable 
year by persons who are residents of the Contracting State of 
which that person is a resident and that are themselves 
entitled to treaty benefits under subparagraphs 2(a), 2(b), 
2(c)(i), or 2(d). In the case of indirect owners, however, each 
of the intermediate owners must be a resident of that 
Contracting State. Paragraph 6 of the Exchange of Notes 
provides that the conditions of clause (i) may be met if the 
ownership test is satisfied on at least half of the days of the 
taxable year, without regard to whether the days on which the 
test is satisfied are consecutive.
    Trusts may be entitled to benefits under this provision if 
they are treated as residents under Article 4 (Residence) and 
they otherwise satisfy the requirements of this subparagraph. 
For purposes of this subparagraph, the beneficial interests in 
a trust will be considered to be owned by its beneficiaries in 
proportion to each beneficiary's actuarial interest in the 
trust. The interest of a remainder beneficiary will be equal to 
100 percent less the aggregate percentages held by income 
beneficiaries. A beneficiary's interest in a trust will not be 
considered to be owned by a person entitled to benefits under 
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) if it is not 
possible to determine the beneficiary's actuarial interest. 
Consequently, if it is not possible to determine the actuarial 
interest of the beneficiaries in a trust, the ownership test 
under clause i) cannot be satisfied, unless all possible 
beneficiaries are persons entitled to benefits under 
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d).
    The base erosion prong of clause (ii) of subparagraph (e) 
is satisfied with respect to a person if less than 50 percent 
of the person's gross income for the taxable year, as 
determined under the tax law in the person's State of 
residence, is paid or accrued to persons who are not residents 
of either Contracting State entitled to benefits under 
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d), in the form of 
payments deductible for tax purposes in the payer's State of 
residence. These amounts do not include arm's-length payments 
in the ordinary course of business for services or tangible 
property. Such amounts also do not include payments in respect 
of financial obligations to a bank (including, in the case of 
Hungary, a credit institution) that is not related to the 
payor. Paragraph 7 of the Exchange of Notes provides the term 
``accrued'' has the meaning given to it under the domestic law 
(including accounting principles applicable for tax purposes) 
of the State of residence of the person seeking the benefits of 
the Convention. To the extent they are deductible from the 
taxable base, trust distributions are deductible payments. 
However, depreciation and amortization deductions, which do not 
represent payments or accruals to other persons, are 
disregarded for this purpose.
Paragraph 3
    Paragraph 3 sets forth an alternative test under which a 
resident of a Contracting State may receive treaty benefits 
with respect to certain items of income that are connected to 
an active trade or business conducted in its State of 
residence. A resident of a Contracting State may qualify for 
benefits under paragraph 3 whether or not it also qualifies 
under paragraph 2 or 4.
    Subparagraph 3(a) sets forth the general rule that a 
resident of a Contracting State engaged in the active conduct 
of a trade or business in that State may obtain the benefits of 
the Convention with respect to an item of income derived in the 
other Contracting State. As provided in paragraph 9 of the 
Exchange of Notes, however, the item of income must be derived 
in connection with or incidental to that trade or business.
    The term ``trade or business'' is not defined in the 
Convention. Pursuant to paragraph 2 of Article 3 (General 
Definitions), when determining whether a resident of Hungary is 
entitled to the benefits of the Convention under paragraph 3 of 
this Article with respect to an item of income derived from 
sources within the United States, the United States will 
ascribe to this term the meaning that it has under the law of 
the United States. Accordingly, the U.S. competent authority 
will refer to the regulations issued under section 367(a) for 
the definition of the term ``trade or business.'' In general, 
therefore, a trade or business will be considered to be a 
specific unified group of activities that constitute or could 
constitute an independent economic enterprise carried on for 
profit. Furthermore, a corporation generally will be considered 
to carry on a trade or business only if the officers and 
employees of the corporation conduct substantial managerial and 
operational activities.
    The business of making or managing investments for the 
resident's own account will be considered to be a trade or 
business only when part of insurance or securities activities 
conducted by an insurance company or a registered securities 
dealer. In the case of a resident of the United States, the 
business of making or managing investments for the resident's 
own account will also be considered to be a trade or business 
when part of banking activities carried on by a bank. In the 
case of a resident of Hungary, such a business will be 
considered a trade or business when part of regulated financial 
services carried on by a financial institution. Paragraph 8 of 
the Exchange of Notes provides that the term ``regulated 
financial services'' means the services listed in paragraph (1) 
of section 3 of Hungarian Act CXII of 1996 on Credit 
Institutions and Financial Enterprises, or any subsequently 
enacted similar legislation agreed to by the competent 
authorities.
    Such investment activities conducted by a person other than 
a bank, insurance company, registered securities dealer, or 
financial institution will not be considered to be the conduct 
of an active trade or business, nor would they be considered to 
be the conduct of an active trade or business if conducted by a 
bank, insurance company, registered securities dealer, or 
financial institution, but not as part of the company's 
banking, insurance, dealer, or regulated financial services 
business. Because a headquarters operation is in the business 
of managing investments, a company that functions solely as a 
headquarters company will not be considered to be engaged in an 
active trade or business for purposes of paragraph 3. It may, 
however, qualify for benefits under paragraph 5.
    An item of income is derived in connection with a trade or 
business if the income-producing activity in the State of 
source is a line of business that ``forms a part of'' or is 
``complementary'' to the trade or business conducted in the 
State of residence by the income recipient.
    A business activity generally will be considered to form 
part of a business activity conducted in the State of source if 
the two activities involve the design, manufacture or sale of 
the same products or type of products, or the provision of 
similar services. The line of business in the State of 
residence may be upstream, downstream, or parallel to the 
activity conducted in the State of source. Thus, the line of 
business may provide inputs for a manufacturing process that 
occurs in the State of source, may sell the output of that 
manufacturing process, or simply may sell the same sorts of 
products that are being sold by the trade or business carried 
on in the State of source.
    Example 1. USCo is a corporation resident in the United 
States. USCo is engaged in an active manufacturing business in 
the United States. USCo owns 100 percent of the shares of HCo, 
a corporation resident in Hungary. HCo distributes USCo 
products in Hungary. Since the business activities conducted by 
the two corporations involve the same products, HCo's 
distribution business is considered to form a part of USCo's 
manufacturing business.
    Example 2. The facts are the same as in Example 1, except 
that USCo does not manufacture. Rather, USCo operates a large 
research and development facility in the United States that 
licenses intellectual property to affiliates worldwide, 
including HCo. HCo and other USCo affiliates then manufacture 
and market the USCo-designed products in their respective 
markets. Since the activities conducted by HCo and USCo involve 
the same product lines, these activities are considered to form 
a part of the same trade or business.
    For two activities to be considered to be 
``complementary,'' the activities need not relate to the same 
types of products or services, but they should be part of the 
same overall industry and be related in the sense that the 
success or failure of one activity will tend to result in 
success or failure for the other. Where more than one trade or 
business is conducted in the State of source and only one of 
the trades or businesses forms a part of or is complementary to 
a trade or business conducted in the State of residence, it is 
necessary to identify the trade or business to which an item of 
income is attributable. Royalties generally will be considered 
to be derived in connection with the trade or business to which 
the underlying intangible property is attributable. Dividends 
will be deemed to be derived first out of earnings and profits 
of the treaty-benefited trade or business, and then out of 
other earnings and profits. Interest income may be allocated 
under any reasonable method consistently applied. A method that 
conforms to U.S. principles for expense allocation will be 
considered a reasonable method.
    Example 3. Americair is a corporation resident in the 
United States that operates an international airline. HSub is a 
wholly-owned subsidiary of Americair resident in Hungary. HSub 
operates a chain of hotels in Hungary that are located near 
airports served by Americair flights. Americair frequently 
sells tour packages that include air travel to Hungary and 
lodging at HSub hotels. Although both companies are engaged in 
the active conduct of a trade or business, the businesses of 
operating a chain of hotels and operating an airline are 
distinct trades or businesses. Therefore HSub's business does 
not form a part of Americair's business. However, HSub's 
business is considered to be complementary to Americair's 
business because they are part of the same overall industry 
(travel) and the links between their operations tend to make 
them interdependent.
    Example 4. The facts are the same as in Example 3, except 
that HSub owns an office building in Hungary instead of a hotel 
chain. No part of Americair's business is conducted through the 
office building. HSub's business is not considered to form a 
part of or to be complementary to Americair's business. They 
are engaged in distinct trades or businesses in separate 
industries, and there is no economic dependence between the two 
operations.
    Example 5. USFlower is a corporation resident in the United 
States. USFlower produces and sells flowers in the United 
States and other countries. USFlower owns all the shares of 
HHolding, a corporation resident in Hungary. HHolding is a 
holding company that is not engaged in a trade or business. 
HHolding owns all the shares of three corporations that are 
resident in Hungary: HFlower, HLawn, and HFish. HFlower 
distributes USFlower flowers under the USFlower trademark in 
Hungary. HLawn markets a line of lawn care products in Hungary 
under the USFlower trademark. In addition to being sold under 
the same trademark, HLawn and HFlower products are sold in the 
same stores and sales of each company's products tend to 
generate increased sales of the other's products. HFish imports 
fish from the United States and distributes it to fish 
wholesalers in Hungary. For purposes of paragraph 3, the 
business of HFlower forms a part of the business of USFlower, 
the business of HLawn is complementary to the business of 
USFlower, and the business of HFish is neither part of nor 
complementary to that of USFlower.
    An item of income derived from the State of source is 
``incidental to'' the trade or business carried on in the State 
of residence if production of the item facilitates the conduct 
of the trade or business in the State of residence. An example 
of incidental income is the temporary investment of working 
capital of a person in the State of residence in securities 
issued by persons in the State of source.
    Subparagraph 3(b) states a further condition to the general 
rule in subparagraph (a) in cases where the trade or business 
generating the item of income in question is carried on either 
by the person deriving the income or by any associated 
enterprises. Subparagraph 3(b) states that the trade or 
business carried on in the State of residence, under these 
circumstances, must be substantial in relation to the activity 
in the State of source. Paragraph 10 of the Exchange of Notes 
elaborates on the purpose and application of the substantiality 
requirement. The requirement is intended to prevent a narrow 
case of treaty-shopping abuses in which a company attempts to 
qualify for benefits by engaging in de minimis connected 
business activities in the treaty country in which it is 
resident (i.e., activities that have little economic cost or 
effect with respect to the company business as a whole).
    The determination of substantiality is made based upon all 
the facts and circumstances and takes into account the 
comparative sizes of the trades or businesses in each 
Contracting State the nature of the activities performed in 
each Contracting State, and the relative contributions made to 
that trade or business in each Contracting State. In any case, 
in making each determination or comparison, due regard will be 
given to the relative sizes of the U.S. and Hungarian 
economies. In addition to this subjective rule, paragraph 10 of 
the Exchange of Notes provides a safe harbor under which the 
trade or business of the income recipient may be deemed to be 
substantial based on three ratios that compare the size of the 
recipient's activities to those conducted in the other State. 
Under this safe harbor, a trade or business will be deemed 
substantial if, for the preceding taxable year, or for the 
average of the three preceding taxable years, the asset value, 
the gross income, and the payroll expense that are related to 
the trade or business in the income recipient's State of 
residence each equals at least 7.5 percent of the resident's 
(and any related parties') proportionate share of the asset 
value, gross income, and payroll expense, respectively, that 
generated the income in the other Contracting State, and the 
average of the three ratios in each such year exceeds 10 
percent. For purposes of this safe harbor, if the income 
recipient owns, directly or indirectly, less than 100 percent 
of an activity conducted in either State, only the income 
recipient's proportionate interest in such activity shall be 
taken into account.
    The determination in subparagraph 3(b) is made separately 
for each item of income derived from the State of source. It 
therefore is possible that a person would be entitled to the 
benefits of the Convention with respect to one item of income 
but not with respect to another. If a resident of a Contracting 
State is entitled to treaty benefits with respect to a 
particular item of income under paragraph 3, the resident is 
entitled to all benefits of the Convention insofar as they 
affect the taxation of that item of income in the State of 
source.
    The application of the substantiality requirement only to 
income from related parties focuses only on potential abuse 
cases, and does not hamper certain other kinds of non-abusive 
activities, even though the income recipient resident in a 
Contracting State may be very small in relation to the entity 
generating income in the other Contracting State. For example, 
if a small U.S. research firm develops a process that it 
licenses to a very large, unrelated, pharmaceutical 
manufacturer in Hungary, the size of the U.S. research firm 
would not have to be tested against the size of the 
manufacturer. Similarly, a small U.S. bank that makes a loan to 
a very large unrelated company operating a business in Hungary 
would not have to pass a substantiality test to receive treaty 
benefits under Paragraph 3.
    Subparagraph 3(c) provides special attribution rules for 
purposes of applying the substantive rules of subparagraphs 
3(a) and 3(b). Thus, these rules apply for purposes of 
determining whether a person meets the requirement in 
subparagraph 3(a) that it be engaged in the active conduct of a 
trade or business and that the item of income is derived in 
connection with that active trade or business, and for making 
the comparison required by the ``substantiality'' requirement 
in subparagraph 3(b). Subparagraph 3(c) attributes to a person 
activities conducted by persons ``connected'' to such person. A 
person (``X'') is connected to another person (``Y'') if X 
possesses 50 percent or more of the beneficial interest in Y 
(or if Y possesses 50 percent or more of the beneficial 
interest in X). For this purpose, X is connected to a company 
if X owns shares representing fifty percent or more of the 
aggregate voting power and value of the company or fifty 
percent or more of the beneficial equity interest in the 
company. X also is connected to Y if a third person possesses 
fifty percent or more of the beneficial interest in both X and 
Y. For this purpose, if X or Y is a company, the threshold 
relationship with respect to such company or companies is fifty 
percent or more of the aggregate voting power and value or 
fifty percent or more of the beneficial equity interest. 
Finally, X is connected to Y if, based upon all the facts and 
circumstances, X controls Y, Y controls X, or X and Y are 
controlled by the same person or persons.
Paragraph 4
    Paragraph 4 sets forth a derivative benefits test that is 
potentially applicable to all treaty benefits, although the 
test is applied to individual items of income. In general, a 
derivative benefits test entitles certain companies that are 
residents of a Contracting State to treaty benefits if the 
owner of the company would have been entitled to the same 
benefit had the income in question flowed directly to that 
owner. To qualify under this paragraph, the company must meet 
an ownership test and a base erosion test.
    Subparagraph 4(a) sets forth the ownership test. Under this 
test, seven or fewer equivalent beneficiaries must own shares 
representing at least 95 percent of the aggregate voting power 
and value of the company and at least 50 percent of any 
disproportionate class of shares. Ownership may be direct or 
indirect. In addition, paragraph 11 of the Exchange of Notes 
provides that the competent authorities of both countries will 
ordinarily grant treaty benefits where a company claiming 
derivative benefits under paragraph 4 is owned directly by up 
to ten individuals, provided that such individuals are 
equivalent beneficiaries and the base erosion requirements of 
subparagraph 4(b) and any other requirements for benefits under 
the Convention are satisfied.
    The term ``equivalent beneficiary'' is defined in 
subparagraph 8(e). This definition may be met in two 
alternative ways, the first of which has two requirements.
    Under the first alternative, a person may be an equivalent 
beneficiary because it is entitled to equivalent benefits under 
a tax treaty between the country of source and the country in 
which the person is a resident. This alternative has two 
requirements.
    The first requirement is that the person must be a resident 
of a member state of the European Union, or European Free Trade 
Association, or of a party to the North American Free Trade 
Agreement (collectively, ``qualifying States'').
    The second requirement of the definition of ``equivalent 
beneficiary'' is that the person must be entitled to equivalent 
benefits under an applicable treaty. To satisfy the second 
requirement, the person must be entitled to all the benefits of 
a comprehensive tax treaty between the Contracting State from 
which benefits of the Convention are claimed and a qualifying 
state under provisions that are analogous to the rules in 
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) of this Article. If 
the treaty in question does not have a comprehensive limitation 
on benefits article, this requirement is met only if the person 
would be entitled to treaty benefits under the tests in 
subparagraphs 2(a), 2(b), 2(c)(i), or 2(d) of this Article if 
the person were a resident of one of the Contracting States.
    In order to satisfy the second requirement necessary to 
qualify as an ``equivalent beneficiary'' under subparagraph 
8(e)(i)(B) with respect to dividends, interest, royalties or 
branch tax, the person must be entitled to a rate of tax that 
is at least as low as the tax rate that would apply under the 
Convention to such income. Thus, the rates to be compared are: 
(1) the rate of tax that the source State would have imposed if 
a qualified resident of the other Contracting State was the 
beneficial owner of the income; and (2) the rate of tax that 
the source State would have imposed if the third state resident 
received the income directly from the source State.
    Subparagraph 8(f) provides a special rule to take account 
of the fact that withholding taxes on many inter-company 
dividends, interest and royalties are exempt within the 
European Union by reason of various EU directives, rather than 
by tax treaty. If a U.S. company receives such payments from a 
Hungarian company, and that U.S. company is owned by a company 
resident in a member state of the European Union that would 
have qualified for an exemption from withholding tax if it had 
received the income directly, the parent company will be 
treated as an equivalent beneficiary. This rule is necessary 
because many European Union member countries have not re-
negotiated their tax treaties to reflect the exemptions 
available under the directives.
    The requirement that a person be entitled to ``all the 
benefits'' of a comprehensive tax treaty eliminates those 
persons that qualify for benefits with respect to only certain 
types of income. Accordingly, the fact that a French parent of 
a Hungarian company is engaged in the active conduct of a trade 
or business in France and therefore would be entitled to the 
benefits of the U.S.-France treaty if it received dividends 
directly from a U.S. subsidiary of the Hungarian company is not 
sufficient for purposes of this paragraph. Further, the French 
company cannot be an equivalent beneficiary if it qualifies for 
benefits only with respect to certain income as a result of a 
``derivative benefits'' provision in the U.S.-France treaty. 
However, it would be possible to look through the French 
company to its parent company to determine whether the parent 
company is an equivalent beneficiary.
    The second alternative for satisfying the ``equivalent 
beneficiary'' test is available only to residents of one of the 
two Contracting States. U.S. or Hungarian residents who are 
eligible for treaty benefits by reason of subparagraphs 2(a), 
2(b), 2(c)(i), or 2(d) are equivalent beneficiaries for 
purposes of the relevant tests in this Article. Thus, a 
Hungarian individual will be an equivalent beneficiary without 
regard to whether the individual would have been entitled to 
receive the same benefits if it received the income directly. A 
resident of a third country cannot qualify for treaty benefits 
under these provisions by reason of those paragraphs or any 
other rule of the treaty, and therefore does not qualify as an 
equivalent beneficiary under this alternative. Thus, a resident 
of a third country can be an equivalent beneficiary only if it 
would have been entitled to equivalent benefits had it received 
the income directly.
    The second alternative was included in order to clarify 
that ownership by certain residents of a Contracting State 
would not disqualify a U.S. or Hungarian company under this 
paragraph. Thus, for example, if 90 percent of a Hungarian 
company is owned by five companies that are resident in member 
states of the European Union who satisfy the requirements of 
subparagraph 8(d)(i), and 10 percent of the Hungarian company 
is owned by a U.S. or Hungarian individual, then the Hungarian 
company still can satisfy the requirements of subparagraph 
4(a).
    Subparagraph 4(b) sets forth the base erosion test. A 
company meets this base erosion test if less than 50 percent of 
its gross income (as determined in the company's State of 
residence) for the taxable period is paid or accrued, directly 
or indirectly, to a person or persons who are not equivalent 
beneficiaries in the form of payments deductible for tax 
purposes in company's State of residence. These amounts do not 
include arm's-length payments in the ordinary course of 
business for services or tangible property. This test is the 
same as the base erosion test in subparagraph 2(e)(ii), except 
that the test in paragraph 4(b) focuses on base-eroding 
payments to persons who are not equivalent beneficiaries.
Paragraph 5
    Paragraph 5 provides that a resident of one of the 
Contracting States is entitled to all the benefits of the 
Convention if that person functions as a recognized 
headquarters company for a multinational corporate group. The 
provisions of this paragraph are consistent with the other
    U.S. tax treaties where this provision has been adopted. 
For this purpose, the multinational corporate group includes 
all corporations that the headquarters company supervises and 
excludes affiliated corporations not supervised by the 
headquarters company. The headquarters company does not have to 
own shares in the companies that it supervises. In order to be 
considered a headquarters company, the person must meet several 
requirements that are enumerated in Paragraph 5. These 
requirements are discussed below.
Overall Supervision and Administration
    Subparagraph 5(a) provides that the person must provide a 
substantial portion of the overall supervision and 
administration of the group. This activity may include group 
financing, but group financing may not be the principal 
activity of the person functioning as the headquarters company. 
A person only will be considered to engage in supervision and 
administration if it engages in a number of the following 
activities: group financing, pricing, marketing, internal 
auditing, internal communications, and management. Other 
activities also could be part of the function of supervision 
and administration.
    In determining whether a ``substantial portion'' of the 
overall supervision and administration of the group is provided 
by the headquarters company, its headquarters-related 
activities must be substantial in relation to the same 
activities for the same group performed by other entities.
    Subparagraph 5(a) does not require that the group that is 
supervised include persons in the other State. However, it is 
anticipated that in most cases the group will include such 
persons, due to the requirement in subparagraph 5(g), discussed 
below, that the income derived in the other Contracting State 
by the headquarters company be derived in connection with or be 
incidental to an active trade or business supervised by the 
headquarters company.
Active Trade or Business
    Subparagraph 5(b) is the first of several requirements 
intended to ensure that the relevant group is truly 
``multinational.'' This subparagraph provides that the 
corporate group supervised by the headquarters company must 
consist of corporations resident in, and engaged in active 
trades or businesses in, at least five countries. Furthermore, 
at least five countries must each contribute substantially to 
the income generated by the group, as the rule requires that 
the business activities carried on in each of the five 
countries (or groupings of countries) generate at least 10 
percent of the gross income of the group. For purposes of the 
10 percent gross income requirement, the income from multiple 
countries may be aggregated into non-overlapping groupings, as 
long as there are at least five individual countries or 
groupings that each satisfy the 10 percent requirement. If the 
gross income requirement under this subparagraph is not met for 
a taxable year, the taxpayer may satisfy this requirement by 
applying the 10 percent gross income test to the average of the 
gross incomes for the four years preceding the taxable year.


    Example 1. HHQ is a corporation resident in Hungary. HHQ 
functions as a headquarters company for a group of companies. 
These companies are resident in the United States, Canada, New 
Zealand, the United Kingdom, Malaysia, the Philippines, 
Singapore, and Indonesia. The gross income generated by each of 
these companies for 2008 and 2009 is as follows:

          For 2008, 10 percent of the gross income of this 
        group is equal to $13.70. Only the United States, 
        Canada, and the United Kingdom satisfy this requirement 
        for that year. The other companies in the group may be 
        aggregated to meet this requirement. Because New 
        Zealand and Malaysia have a total gross income of $20, 
        and the Philippines, Singapore, and Indonesia have a 
        total gross income of $22, these two groupings of 
        countries may be treated as the fourth and fifth 
        members of the group for purposes of subparagraph (b).
          In the following year, 10 percent of the gross income 
        is $15.50. Only the United States, New Zealand, and the 
        United Kingdom satisfy this requirement. Because Canada 
        and Malaysia have a total gross income of $27, and the 
        Philippines, Singapore, and Indonesia have a total 
        gross income of $28, these two groupings of countries 
        may be treated as the fourth and fifth members of the 
        group for purposes of subparagraph (b). The fact that 
        Canada replaced New Zealand in a group is not relevant 
        for this purpose. The composition of the grouping may 
        change from year to year.
Single Country Limitation
    Subparagraph 5(c) provides that the business activities 
carried on in any one country other than the headquarters 
company's State of residence must generate less than 50 percent 
of the gross income of the group. If the gross income 
requirement under this subparagraph is not met for a taxable 
year, the taxpayer may satisfy this requirement applying the 50 
percent gross income test to the average of the gross incomes 
for the four years preceding the taxable year. The following 
example illustrates the application of this subparagraph.
    Example. HHQ is a corporation resident in Hungary. HHQ 
functions as a headquarters company for a group of companies. 
HHQ derives dividend income from a United States subsidiary in 
the 2008 taxable year. The state of residence of each of these 
companies, the situs of their activities and the amounts of 
gross income attributable to each for the years 2008 through 
2012 are set forth below.
    Because the United States' total gross income of $130 in 
2012 is not less than 50 percent of the gross income of the 
group, subparagraph (c) is not satisfied with respect to 
dividends derived in 2012. However, the United States' average 
gross income for the preceding four years may be used in lieu 
of the preceding year's average. The United States' average 
gross income for the years 2008-11 is $111.00 ($444/4). The 
group's total average gross income for these years is $230.75 
($923/4). Because $111 represents 48.1 percent of the group's 
average gross income for the years 2008 through 2011, the 
requirement under subparagraph (c) is satisfied.
Other State Gross Income Limitation
    Subparagraph 5(d) provides that no more than 25 percent of 
the headquarters company's gross income may be derived from the 
other Contracting State. Thus, if the headquarters company's 
gross income for the taxable year is $200, no more than $50 of 
this amount may be derived from the other Contracting State. If 
the gross income requirement under this subparagraph is not met 
for a taxable year, the taxpayer may satisfy this requirement 
by applying the 25 percent gross income test to the average of 
the gross incomes for the four years preceding the taxable 
year.
Independent Discretionary Authority
    Subparagraph 5(e) requires that the headquarters company 
have and exercise independent discretionary authority to carry 
out the functions referred to in subparagraph 5(a). Thus, if 
the headquarters company was nominally responsible for group 
financing, pricing, marketing and other management functions, 
but merely implemented instructions received from another 
entity, the headquarters company would not be considered to 
have and exercise independent discretionary authority with 
respect to these functions. This determination is made 
individually for each function. For instance, a headquarters 
company could be nominally responsible for group financing, 
pricing, marketing and internal auditing functions, but another 
entity could be actually directing the headquarters company as 
to the group financing function. In such a case, the 
headquarters company would not be deemed to have independent 
discretionary authority for group financing, but it might have 
such authority for the other functions. Functions for which the 
headquarters company does not have and exercise independent 
discretionary authority are considered to be conducted by an 
entity other than the headquarters company for purposes of 
subparagraph 5(a).
Income Taxation Rules
    Subparagraph 5(f) requires that the headquarters company be 
subject to the generally applicable income taxation rules in 
its country of residence. This reference should be understood 
to mean that the company must be subject to the income taxation 
rules to which a company engaged in the active conduct of a 
trade or business would be subject. Thus, if one of the 
Contracting States has or introduces special taxation 
legislation that impose a lower rate of income tax on 
headquarters companies than is imposed on companies engaged in 
the active conduct of a trade or business, or provides for an 
artificially low taxable base for such companies, a 
headquarters company subject to these rules is not entitled to 
the benefits of the Convention under paragraph 5.
In Connection With or Incidental to Trade or Business
    Subparagraph 5(g) requires that the income derived in the 
other Contracting State be derived in connection with or be 
incidental to the active business activities referred to in 
subparagraph (b). This determination is made under the 
principles set forth in paragraph 3. For instance, assume that 
a Hungarian company satisfies the other requirements in 
paragraph 5 and acts as a headquarters company for a group that 
includes a United States corporation. If the group is engaged 
in the design and manufacture of computer software, but the 
U.S. company is also engaged in the design and manufacture of 
photocopying machines, the income that the Hungarian company 
derives from the United States would have to be derived in 
connection with or be incidental to the income generated by the 
computer business in order to be entitled to the benefits of 
the Convention under paragraph 5. Interest income received from 
the U.S. company also would be entitled to the benefits of the 
Convention under this paragraph as long as the interest was 
attributable to the computer business supervised by the 
headquarters company Interest income derived from an unrelated 
party would normally not, however, satisfy the requirements of 
this clause.
Paragraph 6
    Paragraph 6 deals with the treatment of income in the 
context of a so-called ``triangular case.'' The term 
``triangular case'' refers to the use of a structure like the 
one described in the following paragraph by a resident of 
Hungary to earn income from the United States:
    A resident of Hungary, who would, absent paragraph 6, 
qualify for benefits under one or more of the provisions of 
this Article, sets up a permanent establishment in a third 
jurisdiction that imposes only a low rate of tax on the income 
of the permanent establishment. The Hungarian resident lends 
funds into the United States through the permanent 
establishment. The permanent establishment, despite its third-
jurisdiction location, is an integral part of a Hungarian 
resident. Therefore the income that it earns on those loans, 
absent the provisions of paragraph 6, is entitled to exemption 
from U.S. withholding tax under the Convention. Under a current 
Hungarian income tax treaty with the host jurisdiction of the 
permanent establishment, the income of the permanent 
establishment is exempt from Hungarian tax (alternatively, 
Hungary may choose to exempt the income of the permanent 
establishment from Hungarian income tax). Thus, the interest 
income, absent paragraph 6, would be exempt from U.S. tax, 
subject to little or no tax in the host jurisdiction of the 
permanent establishment, and exempt from Hungarian tax.
    Paragraph 6 provides that the tax benefits that would 
otherwise apply under the Convention will not apply to any item 
of income if the combined aggregate effective tax rate in the 
residence State and the third state is less than 60 percent of 
the general rate of company tax applicable in the residence 
State. In the case of dividends, interest and royalties to 
which this paragraph applies, the withholding tax rates under 
the Convention are replaced with a 15 percent withholding tax. 
Any other income to which the provisions of paragraph 5 apply 
is subject to tax under the domestic law of the source State, 
notwithstanding any other provisions of the Convention.
    In general, the principles employed under Code section 
954(b)(4) will be employed to determine whether the profits are 
subject to an effective rate of taxation that is above the 
specified threshold.
    Notwithstanding the level of tax on interest and royalty 
income of the permanent establishment, paragraph 6 will not 
apply under certain circumstances. In the case of royalties, 
paragraph 6 will not apply if the royalties are received as 
compensation for the use of, or the right to use, intangible 
property produced or developed by the permanent establishment 
itself. In the case of any other income, paragraph 6 will not 
apply if that income is derived in connection with, or is 
incidental to, the active conduct of a trade or business 
carried on by the permanent establishment in the third state. 
The business of making, managing or simply holding investments 
is not considered to be an active trade or business, unless 
these are securities activities carried on by a registered 
securities dealer, or, in the case of an enterprise of the 
United States, banking activities carried on by a bank, or, in 
the case of an enterprise of Hungary, regulated financial 
services (as defined in paragraph 8 of the Exchange of Notes) 
carried on by a financial institution.
    Paragraph 6 applies reciprocally. However, the United 
States does not exempt the profits of a third-jurisdiction 
permanent establishment of a U.S. resident from U.S. tax, 
either by statute or by treaty.
Paragraph 7
    Paragraph 7 provides that a resident of one of the States 
that is not entitled to the benefits of the Convention as a 
result of paragraphs 1 through 5 still may be granted benefits 
under the Convention at the discretion of the competent 
authority of the State from which benefits are claimed. In 
making determinations under paragraph 7, that competent 
authority will take into account as its guideline whether the 
establishment, acquisition, or maintenance of the person 
seeking benefits under the Convention, or the conduct of such 
person's operations, has or had as one of its principal 
purposes the obtaining of benefits under the Convention. 
Benefits will not be granted, however, solely because a company 
was established prior to the effective date of the Convention. 
In that case, a company would still be required to establish to 
the satisfaction of the competent authority clear non-tax 
business reasons for its formation in a Contracting State, or 
that the allowance of benefits would not otherwise be contrary 
to the purposes of the treaty. Thus, persons that establish 
operations in one of the States with a principal purpose of 
obtaining the benefits of the Convention ordinarily will not be 
granted relief under paragraph 7.
    The competent authority's discretion is quite broad. It may 
grant all of the benefits of the Convention to the taxpayer 
making the request, or it may grant only certain benefits. For 
instance, it may grant benefits only with respect to a 
particular item of income in a manner similar to paragraph 3. 
Further, the competent authority may establish conditions, such 
as setting time limits on the duration of any relief granted.
    For purposes of implementing paragraph 7, a taxpayer will 
be permitted to present his case to the relevant competent 
authority for an advance determination based on the facts. In 
these circumstances, it is also expected that, if the competent 
authority determines that benefits are to be allowed, they will 
be allowed retroactively to the time of entry into force of the 
relevant treaty provision or the establishment of the structure 
in question, whichever is later.
    Finally, there may be cases in which a resident of a 
Contracting State may apply for discretionary relief to the 
competent authority of his State of residence. This would 
arise, for example, if the benefit it is claiming is provided 
by the residence country, and not by the source country. So, 
for example, if a company that is a resident of the United 
States would like to claim the benefit of the re-sourcing rule 
of paragraph 3 of Article 23 (Relief from Double Taxation), but 
it does not meet any of the objective tests of paragraphs 2 
through 4, it may apply to the U.S. competent authority for 
discretionary relief.
Paragraph 8
    Paragraph 8 defines several key terms for purposes of 
Article 22. Each of the defined terms is discussed above in the 
context in which it is used.

                ARTICLE 23 (RELIEF FROM DOUBLE TAXATION)

    This Article describes the manner in which each Contracting 
State undertakes to relieve double taxation. The United States 
uses the foreign tax credit method under its internal law, and 
by treaty.
Paragraph 1
    Paragraph 1 provides that Hungary will provide relief from 
double taxation through a mixture of the credit and exemption 
methods.
    Subparagraph 1(a) states the general rule that Hungary will 
exempt income derived by a resident of Hungary if the income 
may be taxed in the United States in accordance with the 
Convention. Subparagraph 1(c), however, permits Hungary to 
include the income corresponding to the U.S. tax in the 
Hungarian resident's tax base in calculating the Hungarian tax 
on the remaining income of the resident. This rule provides for 
``exemption with progression.'' Under subparagraph 1(b), 
Hungary provides for a tax credit rather than an exemption with 
respect to limited classes of income. If the income may be 
taxed by the United States under the provisions of Article 10 
(Dividends) or Article 11 (Interest), Hungary will relieve 
double taxation by allowing a credit against Hungarian tax in 
an amount equal to the tax paid in the United States on such 
income, but limited to the amount of Hungarian tax attributable 
to such income. In the case of income that is exempted from 
U.S. tax under the provisions of the Convention, or is subject 
to reduced U.S. under the provisions of paragraph 2 of Article 
10 or paragraph 2 of Article 11, subparagraph 1(d) provides 
that Hungary is not required to grant an exemption.
Paragraph 2
    The United States agrees, in paragraph 2, to allow to its 
citizens and residents a credit against U.S. tax for income 
taxes paid or accrued to Hungary. Paragraph 2 also provides 
that Hungary's covered taxes are income taxes for U.S. 
purposes. This provision is based on the Treasury Department's 
review of Hungary's laws.
    Subparagraph (b) provides for a deemed-paid credit, 
consistent with section 902 of the Code, to a U.S. corporation 
in respect of dividends received from a corporation resident in 
Hungary of which the U.S. corporation owns at least 10 percent 
of the voting stock. This credit is for the tax paid by the 
corporation to Hungary on the profits out of which the 
dividends are considered paid.
    The credits allowed under paragraph 2 are allowed in 
accordance with the provisions and subject to the limitations 
of U.S. law, as that law may be amended over time, so long as 
the general principle of the Article, that is, the allowance of 
a credit, is retained. Thus, although the Convention provides 
for a foreign tax credit, the terms of the credit are 
determined by the provisions, at the time a credit is given, of 
the U.S. statutory credit.
    Therefore, the U.S. credit under the Convention is subject 
to the various limitations of U.S. law (see, e.g., Code 
sections 901-909). For example, the credit against U.S. tax 
generally is limited to the amount of U.S. tax due with respect 
to net foreign source income within the relevant foreign tax 
credit limitation category (see Code section 904(a) and (d)), 
and the dollar amount of the credit is determined in accordance 
with U.S. currency translation rules (see, e.g., Code section 
986). Similarly, U.S. law applies to determine carryover 
periods for excess credits and other inter-year adjustments.
Paragraph 3
    Paragraph 3 provides a re-sourcing rule for gross income 
covered by paragraph 2. Paragraph 3 is intended to ensure that 
a U.S. resident can obtain an appropriate amount of U.S. 
foreign tax credit for income taxes paid to Hungary when the 
Convention assigns to Hungary primary taxing rights over an 
item of gross income.
    Accordingly, if the Convention allows Hungary to tax an 
item of gross income (as defined under U.S. law) derived by a 
resident of the United States, the United States will treat 
that item of gross income as gross income from sources within 
Hungary for U.S. foreign tax credit purposes. The foreign tax 
credit limitation generally applies separately to re-sourced 
income. Furthermore, the paragraph 3 re-sourcing rule applies 
to gross income, not net income. Accordingly, U.S. expense 
allocation and apportionment rules, (see, e.g., Treas. Reg. 
section 1.861-9), continue to apply to income resourced under 
paragraph 3.
Paragraph 4
    Paragraph 4 provides special rules for the tax treatment in 
both States of certain types of income derived from U.S. 
sources by U.S. citizens who are residents of Hungary. Since 
U.S. citizens, regardless of residence, are subject to United 
States tax at ordinary progressive rates on their worldwide 
income, the U.S. tax on the U.S. source income of a U.S. 
citizen resident in Hungary may exceed the U.S. tax that may be 
imposed under the Convention on an item of U.S. source income 
derived by a resident of Hungary who is not a U.S. citizen. The 
provisions of paragraph 4 ensure that Hungary does not bear the 
cost of U.S. taxation of its citizens who are residents of 
Hungary.
    Subparagraph 4(a) provides, with respect to items of income 
from sources within the United States, special credit rules for 
Hungary. These rules apply to items of U.S.-source income that 
would be either exempt from U.S. tax or subject to reduced 
rates of U.S. tax under the provisions of the Convention if 
they had been received by a resident of Hungary who is not a 
U.S. citizen. The tax credit provided by Hungary under 
subparagraph 4(a) with respect to such items need not exceed 
the U.S. tax that may be imposed under the Convention, other 
than tax imposed solely by reason of the U.S. citizenship of 
the taxpayer under the provisions of the saving clause of 
paragraph 4 of Article 1 (General Scope).
    For example, if a U.S. citizen resident in Hungary receives 
portfolio dividends from sources within the United States, the 
foreign tax credit granted by Hungary would be limited to 15 
percent of the dividend--the U.S. tax that may be imposed under 
subparagraph (b) of paragraph 2 of Article 10 (Dividends)--even 
if the shareholder is subject to U.S. net income tax because of 
his U.S. citizenship. With respect to royalty or interest 
income, the other Contracting State would allow no foreign tax 
credit, because its residents are exempt from U.S. tax on these 
classes of income under the provisions of Articles 11 
(Interest) and 12 (Royalties).
    Subparagraph 4(b) eliminates the potential for double 
taxation that can arise because subparagraph 4(a) provides that 
Hungary need not provide full relief for the U.S. tax imposed 
on its citizens resident in Hungary. Subparagraph 4(b) provides 
that the United States will credit the income tax paid or 
accrued to Hungary, after the application of subparagraph 4(a). 
It further provides that in allowing the credit, the United 
States will not reduce its tax below the amount that is taken 
into account in Hungary in applying subparagraph 4(a).
    Since the income described in subparagraph 4(a) generally 
will be U.S. source income, special rules are required to re-
source some of the income to Hungary in order for the United 
States to be able to credit the tax paid to Hungary. This re-
sourcing is provided for in subparagraph 4(c), which deems the 
items of income referred to in subparagraph 4(a) to be from 
foreign sources to the extent necessary to avoid double 
taxation under paragraph 4(b). Clause (iii) of subparagraph 
3(c) of Article 25 (Mutual Agreement Procedure) provides a 
mechanism by which the competent authorities can resolve any 
disputes regarding whether income is from sources within the 
United States.
    The following two examples illustrate the application of 
paragraph 4 in the case of U.S.-source portfolio dividend 
received by a U.S. citizen resident in Hungary. In both 
examples, the U.S. rate of tax on residents of Hungary, under 
paragraph 2 of Article 10 (Dividends) of the Convention, is 15 
percent. In both examples, the U.S. income tax rate on the U.S. 
citizen is 35 percent. In example 1, the rate of income tax 
imposed in Hungary on its resident (the U.S. citizen) is 25 
percent (below the U.S. rate), and in example 2, the rate 
imposed on its resident is 40 percent above the U.S. rate).


------------------------------------------------------------------------
                                                 Example 1    Example 2
------------------------------------------------------------------------
Subparagraph (a)

  U.S. dividend declared......................      $100.00      $100.00
  Notional U.S. withholding tax (Article              15.00        15.00
   10(2)(b))..................................
  Taxable income in Hungary...................       100.00       100.00
  Hungarian tax before credit.................        25.00        40.00
  Less: tax credit for notional U.S.                  15.00        15.00
   withholding tax............................
  Net post-credit tax paid to Hungary.........        10.00        25.00
========================================================================
Subparagraphs (b) and (c)

  U.S. pre-tax income.........................      $100.00      $100.00
  U.S. pre-credit citizenship tax.............        35.00        35.00
  Notional U.S. withholding tax...............        15.00        15.00
  U.S. tax eligible to be offset by credit....        20.00        20.00
  Tax paid to Hungary.........................        10.00        25.00
  Income re-sourced from U.S. to foreign              28.57        57.14
   source (see below).........................
  U.S. pre-credit tax on re-sourced income....        10.00        20.00
  U.S. credit for tax paid to Hungary.........        10.00        20.00
  Net post-credit U.S. tax....................        10.00         0.00
  Total U.S. tax..............................        25.00        15.00
------------------------------------------------------------------------

    In both examples, in the application of subparagraph 4(a), 
Hungary credits a 15 percent U.S. tax against its residence tax 
on the U.S. citizen. In the first example, the net tax paid to 
Hungary after the foreign tax credit is $10.00; in the second 
example, it is $25.00. In the application of subparagraphs (b) 
and (c), from the U.S. tax due before credit of $35.00, the 
United States subtracts the amount of the U.S. source tax of 
$15.00, against which no U.S. foreign tax credit is allowed. 
This subtraction ensures that the United States collects the 
tax that it is due under the Convention as the State of source.
    In both examples, given the 35 percent U.S. tax rate, the 
maximum amount of U.S. tax against which credit for the tax 
paid to Hungary may be claimed is $20 ($35 U.S. tax minus $15 
U.S. withholding tax). Initially, all of the income in both 
examples was from sources within the United States. For a U.S. 
foreign tax credit to be allowed for the full amount of the tax 
paid to Hungary, an appropriate amount of the income must be 
re-sourced to Hungary under subparagraph (c).
    The amount that must be re-sourced depends on the amount of 
tax for which the U.S. citizen is claiming a U.S. foreign tax 
credit. In example 1, the tax paid to Hungary was $10. For this 
amount to be creditable against U.S. tax, $28.57 ($10 tax 
divided by 35 percent U.S. tax rate) must be re-sourced to 
Hungary. When the tax is credited against the $10 of U.S. tax 
on this re-sourced income, there is a net U.S. tax of $10 due 
after credit ($20 U.S. tax eligible to be offset by credit, 
minus $10 tax paid to Hungary). Thus, in example 1, there is a 
total of $25 in U.S. tax ($15 U.S. withholding tax plus $10 
residual U.S. tax).
    In example 2, the tax paid to Hungary was $25, but, because 
the United States subtracts the U.S. withholding tax of $15 
from the total U.S. tax of $35, only $20 of U.S. taxes may be 
offset by taxes paid to Hungary. Accordingly, the amount that 
must be re-sourced to Hungary is limited to the amount 
necessary to ensure a U.S. foreign tax credit for $20 of tax 
paid to Hungary, or $57.14 ($20 tax paid to the other 
Contracting State divided by 35 percent U.S. tax rate). When 
the tax paid to Hungary is credited against the U.S. tax on 
this re-sourced income, there is no residual U.S. tax ($20 U.S. 
tax minus $25 tax paid to Hungary, subject to the U.S. limit of 
$20). Thus, in example 2, there is a total of $15 in U.S. tax 
($15 U.S. withholding tax plus $0 residual U.S. tax). Because 
the tax paid to Hungary was $25 and the U.S. tax eligible to be 
offset by credit was $20, there is $5 of excess foreign tax 
credit available for carryover.
Relationship to other Articles
    By virtue of subparagraph 5(a) of Article 1 (General 
Scope), Article 23 is not subject to the saving clause of 
paragraph 4 of Article 1. Thus, the United States will allow a 
credit to its citizens and residents in accordance with the 
Article, even if such credit were to provide a benefit not 
available under the Code (such as the re-sourcing provided by 
paragraph 3 and subparagraph 4(c)).

                    ARTICLE 24 (NON-DISCRIMINATION)

     This Article ensures that nationals of a Contracting 
State, in the case of paragraph 1, and residents of a 
Contracting State, in the case of paragraphs 2 through 5, will 
not be subject, directly or indirectly, to discriminatory 
taxation in the other Contracting State. Not all differences in 
tax treatment, either as between nationals of the two States, 
or between residents of the two States, are violations of the 
prohibition against discrimination. Rather, the 
nondiscrimination obligations of this Article apply only if the 
nationals or residents of the two States are comparably 
situated.
    Each of the relevant paragraphs of the Article provides 
that two persons that are comparably situated must be treated 
similarly. Although the actual words differ from paragraph to 
paragraph (e.g., paragraph 1 refers to two nationals ``in the 
same circumstances,'' paragraph 2 refers to two enterprises 
``carrying on the same activities'' and paragraph 4 refers to 
two enterprises that are ``similar''), the common underlying 
premise is that if the difference in treatment is directly 
related to a tax-relevant difference in the situations of the 
domestic and foreign persons being compared, that difference is 
not to be treated as discriminatory (i.e., if one person is 
taxable in a Contracting State on worldwide income and the 
other is not, or tax may be collectible from one person at a 
later stage, but not from the other, distinctions in treatment 
would be justified under paragraph 1). Other examples of such 
factors that can lead to nondiscriminatory differences in 
treatment are noted in the discussions of each paragraph.
    The operative paragraphs of the Article also use different 
language to identify the kinds of differences in taxation 
treatment that will be considered discriminatory. For example, 
paragraphs 1 and 4 speak of ``any taxation or any requirement 
connected therewith that is other or more burdensome,'' while 
paragraph 2 specifies that a tax ``shall not be less favorably 
levied.'' Regardless of these differences in language, only 
differences in tax treatment that materially disadvantage the 
foreign person relative to the domestic person are properly the 
subject of the Article.
Paragraph 1
    Paragraph 1 provides that a national of one Contracting 
State may not be subject to taxation or connected requirements 
in the other Contracting State that are other or more 
burdensome than the taxes and connected requirements imposed 
upon a national of that other State in the same circumstances.
    The term ``national'' in relation to a Contracting State is 
defined in subparagraph 1(j) of Article 3 (General 
Definitions). The term includes both individuals and juridical 
persons.
    A national of a Contracting State is afforded protection 
under this paragraph even if the national is not a resident of 
either Contracting State. Thus, a U.S. citizen who is resident 
in a third country is entitled, under this paragraph, to the 
same treatment in Hungary as a national of Hungary who is in 
similar circumstances (i.e., presumably one who is resident in 
a third State).
    Paragraph 1 provides that, as noted above, whether or not 
the two persons are both taxable on worldwide income is 
particularly relevant to determining whether they are ``in the 
same circumstances.'' United States citizens who are not 
residents of the United States but who are, nevertheless, 
subject to United States tax on their worldwide income are not 
in the same circumstances with respect to United States 
taxation as citizens of Hungary who are not United States 
residents. Thus, for example, Article 24 would not entitle a 
national of Hungary resident in a third country to taxation at 
graduated rates on U.S. source dividends or other investment 
income that applies to a U.S. citizen resident in the same 
third country.
Paragraph 2
    Paragraph 2 provides that a Contracting State may not tax a 
permanent establishment of an enterprise of the other 
Contracting State less favorably than an enterprise of that 
first-mentioned State that is carrying on the same activities.
    The fact that a U.S. permanent establishment of an 
enterprise of Hungary is subject to U.S. tax only on income 
that is attributable to the permanent establishment, while a 
U.S. corporation engaged in the same activities is taxable on 
its worldwide income is not, in itself, a sufficient difference 
to provide different treatment for the permanent establishment. 
There are cases, however, where the two enterprises would not 
be similarly situated and differences in treatment may be 
warranted. For instance, it would not be a violation of the 
non-discrimination protection of paragraph 2 to require the 
foreign enterprise to provide information in a reasonable 
manner that may be different from the information requirements 
imposed on a resident enterprise, because information may not 
be as readily available to the Internal Revenue Service from a 
foreign as from a domestic enterprise. Similarly, it would not 
be a violation of paragraph 2 to impose penalties on persons 
who fail to comply with such a requirement (see, e.g., sections 
874(a) and 882(c)(2)). Further, a determination that income and 
expenses have been attributed or allocated to a permanent 
establishment in conformity with the principles of Article 7 
(Business Profits) implies that the attribution or allocation 
was not discriminatory. Section 1446 of the Code imposes on any 
partnership with income that is effectively connected with a 
U.S. trade or business the obligation to withhold tax on 
amounts allocable to a foreign partner. In the context of the 
Convention, this obligation applies with respect to a share of 
the partnership income of a partner resident in Hungary, and 
attributable to a U.S. permanent establishment. There is no 
similar obligation with respect to the distributive shares of 
U.S. resident partners. It is understood, however, that this 
distinction is not a form of discrimination within the meaning 
of paragraph 2 of the Article. No distinction is made between 
U.S. and non-U.S. partnerships, since the law requires that 
partnerships of both U.S. and non-U.S. domicile withhold tax in 
respect of the partnership shares of non-U.S. partners. 
Furthermore, in distinguishing between U.S. and non-U.S. 
partners, the requirement to withhold on the non-U.S. but not 
the U.S. partner's share is not discriminatory taxation, but, 
like other withholding on nonresident aliens, is merely a 
reasonable method for the collection of tax from persons who 
are not continually present in the United States, and as to 
whom it otherwise may be difficult for the United States to 
enforce its tax jurisdiction. If tax has been over-withheld, 
the partner can, as in other cases of over-withholding, file 
for a refund.
Paragraph 3
    Paragraph 3 makes clear that the provisions of paragraphs 1 
and 2 do not obligate a Contracting State to grant to a 
resident of the other Contracting State any tax allowances, 
reliefs, etc., that it grants to its own residents on account 
of their civil status or family responsibilities. Thus, if a 
sole proprietor who is a resident of Hungary has a permanent 
establishment in the United States, in assessing income tax on 
the profits attributable to the permanent establishment, the 
United States is not obligated to allow to the resident of 
Hungary the personal allowances for himself and his family that 
he would be permitted to take if the permanent establishment 
were a sole proprietorship owned and operated by a U.S. 
resident, despite the fact that the individual income tax rates 
would apply.
Paragraph 4
    Paragraph 4 prohibits discrimination in the allowance of 
deductions. When an enterprise of a Contracting State pays 
interest, royalties or other disbursements to a resident of the 
other Contracting State, the first-mentioned Contracting State 
must allow a deduction for those payments in computing the 
taxable profits of the enterprise as if the payment had been 
made under the same conditions to a resident of the first-
mentioned Contracting State. Paragraph 4, however, does not 
require a Contracting State to give nonresidents more favorable 
treatment than it gives to its own residents. Consequently, a 
Contracting State does not have to allow nonresidents a 
deduction for items that are not deductible under its domestic 
law (for example, expenses of a capital nature).
    The term ``other disbursements'' is understood to include a 
reasonable allocation of executive and general administrative 
expenses, research and development expenses and other expenses 
incurred for the benefit of a group of related persons that 
includes the person incurring the expense.
    An exception to the rule of paragraph 4 is provided for 
cases where the provisions of paragraph 1 of Article 9 
(Associated Enterprises), paragraph 5 of Article 11 (Interest) 
or paragraph 4 of Article 12 (Royalties) apply. All of these 
provisions permit the denial of deductions in certain 
circumstances in respect of transactions between related 
persons. Neither State is forced to apply the non-
discrimination principle in such cases. The exception with 
respect to paragraph 5 of Article 11 would include the denial 
or deferral of certain interest deductions under Code section 
163(j).
    Paragraph 4 also provides that any debts of an enterprise 
of a Contracting State to a resident of the other Contracting 
State are deductible in the first-mentioned Contracting State 
for purposes of computing the capital tax of the enterprise 
under the same conditions as if the debt had been contracted to 
a resident of the first-mentioned Contracting State. Even 
though, for general purposes, the Convention covers only income 
taxes, under paragraph 7 of this Article, the nondiscrimination 
provisions apply to all taxes levied in both Contracting 
States, at all levels of government. Thus, this provision may 
be relevant for both States. The other Contracting State may 
have capital taxes and in the United States such taxes 
frequently are imposed by local governments.
Paragraph 5
    Paragraph 5 requires that a Contracting State not impose 
other or more burdensome taxation or connected requirements on 
an enterprise of that State that is wholly or partly owned or 
controlled, directly or indirectly, by one or more residents of 
the other Contracting State than the taxation or connected 
requirements that it imposes on other similar enterprises of 
that first-mentioned Contracting State. For this purpose it is 
understood that ``similar'' refers to similar activities or 
ownership of the enterprise.
    This rule, like all non-discrimination provisions, does not 
prohibit differing treatment of entities that are in differing 
circumstances. Rather, a protected enterprise is only required 
to be treated in the same manner as other enterprises that, 
from the point of view of the application of the tax law, are 
in substantially similar circumstances both in law and in fact. 
The taxation of a distributing corporation under section 367(e) 
on an applicable distribution to foreign shareholders does not 
violate paragraph 5 of the Article because a foreign-owned 
corporation is not similar to a domestically-owned corporation 
that is accorded non-recognition treatment under sections 337 
and 355.
    For the reasons given above in connection with the 
discussion of paragraph 2 of the Article, it is also understood 
that the provision in section 1446 of the Code for withholding 
of tax on non-U.S. partners does not violate paragraph 5 of the 
Article.
    It is further understood that the ineligibility of a U.S. 
corporation with nonresident alien shareholders to make an 
election to be an ``S'' corporation does not violate paragraph 
5 of the Article. If a corporation elects to be an S 
corporation, it is generally not subject to income tax and the 
shareholders take into account their pro rata shares of the 
corporation's items of income, loss, deduction or credit. (The 
purpose of the provision is to allow an individual or small 
group of individuals the protections of conducting business in 
corporate form while paying taxes at individual rates as if the 
business were conducted directly.) A nonresident alien does not 
pay U.S. tax on a net basis, and, thus, does not generally take 
into account items of loss, deduction or credit. Thus, the S 
corporation provisions do not exclude corporations with 
nonresident alien shareholders because such shareholders are 
foreign, but only because they are not net-basis taxpayers. 
Similarly, the provisions exclude corporations with other types 
of shareholders where the purpose of the provisions cannot be 
fulfilled or their mechanics implemented. For example, 
corporations with corporate shareholders are excluded because 
the purpose of the provision to permit individuals to conduct a 
business in corporate form at individual tax rates would not be 
furthered by their inclusion.
    Finally, it is understood that paragraph 5 does not require 
a Contracting State to allow foreign corporations to join in 
filing a consolidated return with a domestic corporation or to 
allow similar benefits between domestic and foreign 
enterprises.
Paragraph 6
    Paragraph 6 confirms that no provision of the Article will 
prevent either Contracting State from imposing the branch 
profits tax described in paragraph 8 of Article 10 (Dividends).
Paragraph 7
    As noted above, notwithstanding the specification of taxes 
covered by the Convention in Article 2 (Taxes Covered) for 
general purposes, for purposes of providing nondiscrimination 
protection this Article applies to taxes of every kind and 
description imposed by a Contracting State or a political 
subdivision or local authority thereof. Customs duties are not 
considered to be taxes for this purpose.
Relationship to Other Articles
    The saving clause of paragraph 4 of Article 1 (General 
Scope) does not apply to this Article by virtue of the 
exceptions in paragraph 5(a) of Article 1. Thus, for example, a 
U.S. citizen who is a resident of Hungary may claim benefits in 
the United States under this Article.
    Nationals of a Contracting State may claim the benefits of 
paragraph 1 regardless of whether they are entitled to benefits 
under Article 22 (Limitation on Benefits), because that 
paragraph applies to nationals and not residents. They may not 
claim the benefits of the other paragraphs of this Article with 
respect to an item of income unless they are generally entitled 
to treaty benefits with respect to that income under a 
provision of Article 22.

                ARTICLE 25 (MUTUAL AGREEMENT PROCEDURE)

    This Article provides the mechanism for taxpayers to bring 
to the attention of competent authorities issues and problems 
that may arise under the Convention. It also provides the 
authority for cooperation between the competent authorities of 
the Contracting States to resolve disputes and clarify issues 
that may arise under the Convention and to resolve cases of 
double taxation not provided for in the Convention. The 
competent authorities of the two Contracting States are 
identified in paragraph 1(g) of Article 3 (General 
Definitions).
Paragraph 1
    This paragraph provides that where a resident of a 
Contracting State considers that the actions of one or both 
Contracting States will result in taxation that is not in 
accordance with the Convention he may present his case to the 
competent authority of the Contracting State of which he is a 
resident, or, if his case comes under paragraph 1 of Article 24 
(Non-Discrimination), to that of the Contracting State of which 
he is a national.
    Although the most common cases brought under this paragraph 
will involve economic double taxation arising from transfer 
pricing adjustments, the scope of this paragraph is not limited 
to such cases. For example, a taxpayer could request assistance 
from the competent authority if one Contracting State 
determines that the taxpayer has received deferred compensation 
taxable at source under Article 14 (Income from Employment), 
while the taxpayer believes that such income should be treated 
as a pension that is taxable only in his country of residence 
pursuant to Article 17 (Pensions and Income From Social 
Security).
    It is not necessary for a person requesting assistance 
first to have exhausted the remedies provided under the 
national laws of the Contracting States before presenting a 
case to the competent authorities, nor does the fact that the 
statute of limitations may have passed for seeking a refund 
preclude bringing a case to the competent authority. Unlike the 
OECD Model, no time limit is provided within which a case must 
be brought.
Paragraph 2
    Paragraph 2 sets out the framework within which the 
competent authorities will deal with cases brought by taxpayers 
under paragraph 1. It provides that, if the competent authority 
of the Contracting State to which the case is presented judges 
the case to have merit, and cannot reach a unilateral solution, 
it shall seek an agreement with the competent authority of the 
other Contracting State pursuant to which taxation not in 
accordance with the Convention will be avoided.
    Any agreement is to be implemented even if such 
implementation otherwise would be barred by the statute of 
limitations or by some other procedural limitation, such as a 
closing agreement, provided that the competent authority of the 
other State has received notice that such a case exists from 
the competent authority of the Contracting State to which the 
case was presented within six years of the end of the taxable 
year to which the case relates . Paragraph 2 does not prevent 
the application of domestic-law procedural limitations that 
give effect to the agreement (e.g., a domestic-law requirement 
that the taxpayer file a return reflecting the agreement within 
one year of the date of the agreement).
     Where the taxpayer has entered a closing agreement (or 
other written settlement) with the United States before 
bringing a case to the competent authorities, the U.S. 
competent authority will endeavor only to obtain a correlative 
adjustment from Hungary. See Rev. Proc. 2006-54, 2006-49 I.R.B. 
1035, 7.05. Because, as specified in paragraph 2 of Article 1 
(General Scope), the Convention cannot operate to increase a 
taxpayer's liability, temporal or other procedural limitations 
can be overridden only for the purpose of making refunds and 
not to impose additional tax.
Paragraph 3
    Paragraph 3 authorizes the competent authorities to resolve 
difficulties or doubts that may arise as to the application or 
interpretation of the Convention. The competent authorities 
may, for example, agree to the same allocation of income, 
deductions, credits or allowances between an enterprise in one 
Contracting State and its permanent establishment in the other 
or between related persons. These allocations are to be made in 
accordance with the arm's length principle underlying Article 7 
(Business Profits) and Article 9 (Associated Enterprises). 
Agreements reached may also include agreement on a methodology 
for determining an appropriate transfer price, on an acceptable 
range of results under that methodology, or on a common 
treatment of a taxpayer's cost sharing arrangement.
    The competent authorities also may agree to settle a 
variety of conflicting applications of the Convention. They may 
agree to settle conflicts regarding the characterization of 
particular items of income, the characterization of persons, 
the application of source rules to particular items of income, 
the meaning of a term, or the timing of an item of income.
    The competent authorities also may agree as to advance 
pricing arrangements. They also may agree as to the application 
of the provisions of domestic law regarding penalties, fines, 
and interest in a manner consistent with the purposes of the 
Convention.
    The examples above are not exhaustive, and the competent 
authorities may reach agreement on other issues if necessary to 
avoid double taxation. For example, the competent authorities 
may seek agreement on a uniform set of standards for the use of 
exchange rates. Agreements reached by the competent authorities 
under paragraph 3 need not conform to the internal law 
provisions of either Contracting State.
    Finally, paragraph 3 authorizes the competent authorities 
to consult for the purpose of eliminating double taxation in 
cases not provided for in the Convention and to resolve any 
difficulties or doubts arising as to the interpretation or 
application of the Convention. This provision is intended to 
permit the competent authorities to implement the treaty in 
particular cases in a manner that is consistent with its 
expressed general purposes. It permits the competent 
authorities to deal with cases that are within the spirit of 
the provisions but that are not specifically covered. An 
example of such a case might be double taxation arising from a 
transfer pricing adjustment between two permanent 
establishments of a third-country resident, one in the United 
States and one in Hungary. Since no resident of a Contracting 
State is involved in the case, the Convention does not apply, 
but the competent authorities nevertheless may use the 
authority of this Article to prevent the double taxation of 
income.
Paragraph 4
    Paragraph 4 authorizes the competent authorities to 
increase any dollar amounts referred to in the Convention to 
reflect economic and monetary developments. This refers only to 
Article 16 (Entertainers and Sportsmen); Article 19 (Students 
and Trainees) separately instructs the competent authorities to 
adjust the exemption amount for students and trainees in 
accordance with specified guidelines. The rule under paragraph 
4 is intended to operate as follows: if, for example, after the 
Convention has been in force for some time, inflation rates 
have been such as to make the $20,000 exemption threshold for 
entertainers unrealistically low in terms of the original 
objectives intended in setting the threshold, the competent 
authorities may agree to a higher threshold without the need 
for formal amendment to the treaty and ratification by the 
Contracting States. This authority can be exercised, however, 
only to the extent necessary to restore those original 
objectives. This provision can be applied only to the benefit 
of taxpayers (i.e., only to increase thresholds, not to reduce 
them).
Paragraph 5
    Paragraph 5 provides that the competent authorities may 
communicate with each other for the purpose of reaching an 
agreement, including through a joint commission consisting of 
themselves or their representatives. This makes clear that the 
competent authorities of the two Contracting States may 
communicate without going through diplomatic channels. Such 
communication may be in various forms, including, where 
appropriate, through face-to-face meetings of representatives 
of the competent authorities.
Treaty termination in relation to competent authority dispute 
        resolution
    A case may be raised by a taxpayer after the Convention has 
been terminated with respect to a year for which a treaty was 
in force. In such a case the ability of the competent 
authorities to act is limited. They may not exchange 
confidential information, nor may they reach a solution that 
varies from that specified in its law.
Triangular competent authority solutions
    International tax cases may involve more than two taxing 
jurisdictions (e.g., transactions among a parent corporation 
resident in country A and its subsidiaries resident in 
countries B and C). As long as there is a complete network of 
treaties among the three countries, it should be possible, 
under the full combination of bilateral authorities, for the 
competent authorities of the three States to work together on a 
three-sided solution. Although country A may not be able to 
give information received under Article 26 (Exchange of 
Information) from country B to the authorities of country C, if 
the competent authorities of the three countries are working 
together, it should not be a problem for them to arrange for 
the authorities of country B to give the necessary information 
directly to the tax authorities of country C, as well as to 
those of country A. Each bilateral part of the trilateral 
solution must, of course, not exceed the scope of the authority 
of the competent authorities under the relevant bilateral 
treaty.
Relationship to Other Articles
    This Article is not subject to the saving clause of 
paragraph 4 of Article 1 (General Scope) by virtue of the 
exceptions in subparagraph 5(a) of that Article. Thus, rules, 
definitions, procedures, etc. that are agreed upon by the 
competent authorities under this Article may be applied by the 
United States with respect to its citizens and residents even 
if they differ from the comparable Code provisions. Similarly, 
as indicated above, U.S. law may be overridden to provide 
refunds of tax to a U.S. citizen or resident under this 
Article. A person may seek relief under Article 25 regardless 
of whether he is generally entitled to benefits under Article 
22 (Limitation on Benefits). As in all other cases, the 
competent authority is vested with the discretion to decide 
whether the claim for relief is justified.

                  ARTICLE 26 (EXCHANGE OF INFORMATION)

    This Article provides for the exchange of information and 
administrative assistance between the competent authorities of 
the Contracting States.
Paragraph 1
    The obligation to obtain and provide information to the 
other Contracting State is set out in Paragraph 1. The 
information to be exchanged is that which is foreseeably 
relevant for carrying out the provisions of the Convention or 
the domestic laws of the United States or of Hungary concerning 
taxes of every kind applied at the national level. This 
language incorporates the standard of the OECD Model. The 
parties intend for the phrase ``is foreseeably relevant'' to be 
interpreted to permit the exchange of information that ``may be 
relevant'' for purposes of 26 U.S.C. Section 7602, which 
authorizes the IRS to examine ``any books, papers, records, or 
other data which may be relevant or material.'' (emphasis 
added) In United States v. Arthur Young & Co., 465 U.S. 805, 
814 (1984), the Supreme Court stated that the language ``may 
be'' reflects Congress's express intention to allow the IRS to 
obtain ``items of even potential relevance to an ongoing 
investigation, without reference to its admissibility.'' 
(emphasis in original) However, the language ``may be'' would 
not support a request in which a Contracting State simply asked 
for information regarding all bank accounts maintained by 
residents of that Contracting State in the other Contracting 
State. Thus, the language of paragraph 1 is intended to provide 
for exchange of information in tax matters to the widest extent 
possible, while clarifying that Contracting States are not at 
liberty to engage in ``fishing expeditions'' or otherwise to 
request information that is unlikely to be relevant to the tax 
affairs of a given taxpayer.
    Exchange of information with respect to each State's 
domestic law is authorized to the extent that taxation under 
domestic law is not contrary to the Convention. Thus, for 
example, information may be exchanged with respect to a covered 
tax, even if the transaction to which the information relates 
is a purely domestic transaction in the requesting State and, 
therefore, the exchange is not made to carry out the 
Convention. An example of such a case is provided in paragraph 
8(b) of the OECD Commentary: a company resident in one 
Contracting State and a company resident in the other 
Contracting State transact business between themselves through 
a third-country resident company. Neither Contracting State has 
a treaty with the third State. To enforce their internal laws 
with respect to transactions of their residents with the third-
country company (since there is no relevant treaty in force), 
the Contracting States may exchange information regarding the 
prices that their residents paid in their transactions with the 
third-country resident.
    Paragraph 1 clarifies that information may be exchanged 
that relates to the assessment or collection of, the 
enforcement or prosecution in respect of, or the determination 
of appeals in relation to, the taxes covered by the Convention. 
Thus, the competent authorities may request and provide 
information for cases under examination or criminal 
investigation, in collection, on appeals, or under prosecution.
    The taxes covered by the Convention for purposes of this 
Article constitute a broader category of taxes than those 
referred to in Article 2 (Taxes Covered). Exchange of 
information is authorized with respect to taxes of every kind 
imposed by a Contracting State at the national level. 
Accordingly, information may be exchanged with respect to U.S. 
estate and gift taxes, excise taxes or, with respect to 
Hungary, value added taxes.
    Information exchange is not restricted by paragraph 1 of 
Article 1 (General Scope). Accordingly, information may be 
requested and provided under this article with respect to 
persons who are not residents of either Contracting State. For 
example, if a third-country resident has a permanent 
establishment in Hungary, and that permanent establishment 
engages in transactions with a U.S. enterprise, the United 
States could request information with respect to that permanent 
establishment, even though the third-country resident is not a 
resident of either Contracting State. Similarly, if a third-
country resident maintains a bank account in Hungary, and the 
Internal Revenue Service has reason to believe that funds in 
that account should have been reported for U.S. tax purposes 
but have not been so reported, information can be requested 
from Hungary with respect to that person's account, even though 
that person is not the taxpayer under examination.
    Although the term ``United States'' does not encompass U.S. 
possessions for most purposes of the Convention, Section 7651 
of the Code authorizes the Internal Revenue Service to utilize 
the provisions of the Internal Revenue Code to obtain 
information from the U.S. possessions pursuant to a proper 
request made under Article 26. If necessary to obtain requested 
information, the Internal Revenue Service could issue and 
enforce an administrative summons to the taxpayer, a tax 
authority (or a government agency in a U.S. possession), or a 
third party located in a U.S. possession.
Paragraph 2
    Paragraph 2 provides assurances that any information 
exchanged will be treated as secret, subject to the same 
disclosure constraints as information obtained under the laws 
of the requesting State. Information received may be disclosed 
only to persons, including courts and administrative bodies, 
concerned with the assessment, collection, or administration 
of, the enforcement or prosecution in respect of, or the 
determination of the of appeals in relation to, the taxes 
covered by the Convention. The information must be used by 
these persons in connection with the specified functions. 
Information may also be disclosed to legislative bodies, such 
as the tax-writing committees of Congress and the Government 
Accountability Office, engaged in the oversight of the 
preceding activities. Information received by these bodies must 
be for use in the performance of their role in overseeing the 
administration of U.S. tax laws. Information received may be 
disclosed in public court proceedings or in judicial decisions.
Paragraph 3
    Paragraph 3 provides that the obligations undertaken in 
paragraphs 1 to exchange information do not require a 
Contracting State to carry out administrative measures that are 
at variance with the laws or administrative practice of either 
State. Nor is a Contracting State required to supply 
information not obtainable under the laws or administrative 
practice of either State, or to disclose trade secrets or other 
information, the disclosure of which would be contrary to 
public policy.
    Thus, a requesting State may be denied information from the 
other State if the information would be obtained pursuant to 
procedures or measures that are broader than those available in 
the requesting State. However, the statute of limitations of 
the Contracting State making the request for information should 
govern a request for information. Thus, the Contracting State 
of which the request is made should attempt to obtain the 
information even if its own statute of limitations has passed. 
In many cases, relevant information will still exist in the 
business records of the taxpayer or a third party, even though 
it is no longer required to be kept for domestic tax purposes.
    While paragraph 3 states conditions under which a 
Contracting State is not obligated to comply with a request 
from the other Contracting State for information, the requested 
State is not precluded from providing such information, and 
may, at its discretion, do so subject to the limitations of its 
internal law.
Paragraph 4
    Paragraph 4 provides that when information is requested by 
a Contracting State in accordance with this Article, the other 
Contracting State is obligated to obtain the requested 
information as if the tax in question were the tax of the 
requested State, even if that State has no direct tax interest 
in the case to which the request relates. In the absence of 
such a paragraph, some taxpayers have argued that subparagraph 
3(a) prevents a Contracting State from requesting information 
from a bank or fiduciary that the Contracting State does not 
need for its own tax purposes. This paragraph clarifies that 
paragraph 3 does not impose such a restriction and that a 
Contracting State is not limited to providing only the 
information that it already has in its own files.
Paragraph 5
    Paragraph 5 provides that a Contracting State may not 
decline to provide information because that information is held 
by financial institutions, nominees or persons acting in an 
agency or fiduciary capacity. Thus, paragraph 5 would 
effectively prevent a Contracting State from relying on 
paragraph 3 to argue that its domestic bank secrecy laws (or 
similar legislation relating to disclosure of financial 
information by financial institutions or intermediaries) 
override its obligation to provide information under paragraph 
1. This paragraph also requires the disclosure of information 
regarding the beneficial owner of an interest in a person, such 
as the identity of a beneficial owner of bearer shares.
Paragraph 6
    Paragraph 6 provides that the requesting State may specify 
the form in which information is to be provided (e.g., 
depositions of witnesses and authenticated copies of original 
documents). The intention is to ensure that the information may 
be introduced as evidence in the judicial proceedings of the 
requesting State. The requested State should, if possible, 
provide the information in the form requested to the same 
extent that it can obtain information in that form under its 
own laws and administrative practices with respect to its own 
taxes.

              ARTICLE 27 (MEMBERS OF DIPLOMATIC MISSIONS 
                          AND CONSULAR POSTS)

    This Article confirms that any fiscal privileges to which 
diplomatic or consular officials are entitled under general 
provisions of international law or under special agreements 
will apply notwithstanding any provisions to the contrary in 
the Convention. The agreements referred to include any 
bilateral agreements, such as consular conventions, that affect 
the taxation of diplomats and consular officials and any 
multilateral agreements dealing with these issues, such as the 
Vienna Convention on Diplomatic Relations and the Vienna 
Convention on Consular Relations. The U.S. generally adheres to 
the latter because its terms are consistent with customary 
international law.
    The Article does not independently provide any benefits to 
diplomatic agents and consular officers. Article 19 (Government 
Service) does so, as do Code section 893 and a number of 
bilateral and multilateral agreements. In the event that there 
is a conflict between the Convention and international law or 
such other treaties, under which the diplomatic agent or 
consular official is entitled to greater benefits under the 
latter, the latter laws or agreements shall have precedence. 
Conversely, if the Convention confers a greater benefit than 
another agreement, the affected person could claim the benefit 
of the tax treaty.
    Pursuant to subparagraph 5(b) of Article 1 (General Scope), 
the saving clause of paragraph 4 of Article 1 does not apply to 
override any benefits of this Article available to an 
individual who is neither a citizen of the United States nor 
has immigrant status in the United States.

                     ARTICLE 28 (ENTRY INTO FORCE)

    This Article contains the rules for bringing the Convention 
into force and giving effect to its provisions.
Paragraph 1
    Paragraph 1 provides for the ratification of the Convention 
by both Contracting States according to their constitutional 
and statutory requirements. Instruments of ratification shall 
be exchanged as soon as possible.
    In the United States, the process leading to ratification 
and entry into force is as follows: Once a treaty has been 
signed by authorized representatives of the two Contracting 
States, the Department of State sends the treaty to the 
President who formally transmits it to the Senate for its 
advice and consent to ratification, which requires approval by 
two-thirds of the Senators present and voting. Prior to this 
vote, however, it generally has been the practice for the 
Senate Committee on Foreign Relations to hold hearings on the 
treaty and make a recommendation regarding its approval to the 
full Senate. Both Government and private sector witnesses may 
testify at these hearings. After the Senate gives its advice 
and consent to ratification of the treaty, an instrument of 
ratification is drafted for the President's signature. The 
President's signature and countersignature by the Secretary of 
State complete the process in the United States.
Paragraph 2
    Paragraph 2 provides that the Convention will enter into 
force upon the exchange of instruments of ratification. The 
date on which a treaty enters into force is not necessarily the 
date on which its provisions take effect. Paragraph 2, 
therefore, also contains rules that determine when the 
provisions of the treaty will have effect.
    Under paragraph 2(a), the Convention will have effect with 
respect to taxes withheld at source (principally dividends, 
interest and royalties) for amounts paid or credited on or 
after the first day of the second month following the date on 
which the Convention enters into force. For example, if 
instruments of ratification are exchanged on April 25 of a 
given year, the withholding rates specified in paragraph 2 of 
Article 10 (Dividends) would be applicable to any dividends 
paid or credited on or after June 1 of that year. This rule 
allows the benefits of the withholding reductions to be put 
into effect as soon as possible, without waiting until the 
following year. The delay of one to two months is required to 
allow sufficient time for withholding agents to be informed 
about the change in withholding rates. If for some reason a 
withholding agent withholds at a higher rate than that provided 
by the Convention (perhaps because it was not able to re-
program its computers before the payment is made), a beneficial 
owner of the income that is a resident of the other Contracting 
State may make a claim for refund pursuant to section 1464 of 
the Code.
    For all other taxes, paragraph 2(b) specifies that the 
Convention will have effect for any taxable period beginning on 
or after January 1 of the year following entry into force.
Paragraph 3
    Paragraph 3 provides an exception to the general rule of 
paragraph 2. Under paragraph 3, if the prior income tax 
convention between the United States and Hungary would have 
afforded greater relief from tax than this Convention, that 
prior convention shall, at the election of any person that was 
entitled to benefits under the prior convention, continue to 
have effect in its entirety with respect to such person's taxes 
until December 31, 2010.
    Thus, if the Convention would otherwise have effect with 
respect to a taxpayer prior to December 31, 2010, the taxpayer 
may elect to extend the benefits of the prior convention until 
December 31, 2010. During the period in which the election is 
in effect, the provisions of the prior convention will continue 
to apply only insofar as they applied before the entry into 
force of the Convention. If the grace period is elected, all of 
the provisions of the prior convention must be applied during 
the grace period. The taxpayer may not apply certain, more 
favorable provisions of the prior convention and, at the same 
time, apply other, more favorable provisions of this 
Convention. The taxpayer must choose one convention in its 
entirety or the other.
    The prior convention shall terminate on the last date on 
which it has effect with respect to any tax in accordance with 
the provisions of Article 28.
Paragraph 4
    Paragraph 4 provides that an individual who was entitled to 
benefits under Article 18 (Students and Trainees) or Article 17 
(Teachers) of the prior convention at the time of the entry 
into force of this Convention is ``grandfathered,'' and will 
continue to be entitled to the benefits available under the 
prior convention until such time as that individual would cease 
to be entitled to benefits if the prior convention remained in 
force.

                        ARTICLE 29 (TERMINATION)

    The Convention is to remain in effect indefinitely, unless 
terminated by one of the Contracting States in accordance with 
the provisions of Article 29. The Convention may be terminated 
by either State, provided that at least six months' prior 
notice has been given through diplomatic channels. Once notice 
of termination is given, the provisions of the Convention with 
respect to withholding at source will cease to have effect for 
amounts paid or credited on or after the first day of January 
next following the expiration of six month notice period. For 
other taxes, the Convention will cease to have effect as of 
taxable periods beginning on or after the the first day of 
January next following the expiration of this six month period.
    Article 29 relates only to unilateral termination of the 
Convention by a Contracting State. Nothing in that Article 
should be construed as preventing the Contracting States from 
concluding a new bilateral agreement, subject to ratification, 
that supersedes, amends or terminates provisions of the 
Convention without the six-month notification period.
    Customary international law observed by the United States 
and other countries, as reflected in the Vienna Convention on 
Treaties, allows termination by one Contracting State at any 
time in the event of a ``material breach'' of the agreement by 
the other Contracting State.

                                  
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