István Csővári

Software developer companies fall under a very favourable corporate income taxation in Hungary. Moreover, their income is local business tax exempt. Surprisingly, however, most of such companies are not aware of their beneficial status, losing billions of forints as a consequence.

According to a rule effective for more than ten years, if a company sells or utilises an intellectual property then 50% of the received royalty is deductible from the corporate income tax base. This regime can be easily exploited by software developing companies, reducing their effective corporate income tax rate to 5-6% as a result. This benefit was supplemented by another incentive, introduced in 2012, which exempted the capital gain realised on the sale of an intellectual property from corporate taxation, provided that the IP was reported to the tax authority and it was held in the books for at least one year. It is also to be noted that neither the royalty income, nor the capital gain on the sale of intellectual property fall under local business taxation.

Why the special treatment?

The reason for the special status of IP income does not derive from an intention of the Government to aid this sector. The beneficial regime was introduced after 2005, when Hungary – under the pressure of the European Union – was obliged to shut down its offshore regime. The off-shore regime provided a 3% effective corporate income tax rate to companies established in Hungary but operating outside. The aim of the royalty regime was to prevent offshore companies from leaving the country by giving them a reasonable alternative. While, based on EU principles this beneficial regime equally applies to general domestic companies, such companies are not aware of this rule.

The devil is in the details

Taxpayers who plan to apply the royalty deduction, need to pay attention. Only such income qualifies as royalty which derives from the sale of the software or the right to use the software. It is important to know that software development under a service contract does not mean that the entire consideration qualifies as royalty. Based on the consistent practice of the Hungarian tax authority the consideration should be split into a royalty part and a service fee part. Only the royalty part entitles companies for the tax advantage, while the service fee part does not.

Detailed legal analysis is required to determine what portion of the consideration is royalty income in such cases. In some instances this will necessitate obtaining a ruling from the authorities. In practice, depending on the business and legal structure of the software development, even a 80/20 allocation can be reached, in the favour of the royalty, i.e. only 20% of the income is taxable under general rules and the beneficial treatment can be applied to the remaining 80%. This can result in a 6% effective tax rate under the HUF 500 million income threshold and complete exemption from local business tax for the qualifying part of the consideration.

Available only to software developers?

While software developers can make a benefit of this favourable tax regime easily, companies operating in other fields may also exploit the rules. Both the royalty incentive and the tax exempt sale of intellectual properties may be utilised by technology companies; innovative firms developing products or business solutions not reaching the level of patent; architects and designers; film, TV programme and advertisement producers; database creators; as well as artists and entertainers. These companies may apply the beneficial tax regime if they sell the ownership or the right of use of their product.

It needs to be emphasised that sale or utilisation of know-how also falls under the above regime. Know-how is present in almost every enterprise at some level, mainly in not materialized from. For instance, franchisers may mitigate their corporate income tax base, as they license know-how to their franchise partners.

Furthermore, not only the original creator of the product can apply the royalty benefit. If the utilisation right is sold by the developer through a chain of distributors, such intermediaries may also benefit from the 50% tax reduction.