Canada: Of royalties, restrictive covenants and the revenue

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Canada: Of royalties, restrictive covenants and the revenue

A recent technical interpretation released by the Canada Revenue Agency (CRA) confirms the CRA's position that withholding tax under paragraph 212(1)(d) of the Income Tax Act (Canada) (ITA) does not apply to lump-sum payments made to a non-resident of Canada for exclusive distributorship rights and also serves as a reminder to taxpayers of the breadth of the restrictive covenant provisions in the ITA.

In CRA technical interpretation 2017-0701291I7 (dated August 16 2017), a Canadian-resident corporation (Canco) had entered into a distribution agreement (Distribution Agreement) with a non-resident corporation (NRCo), under which Canco was granted the exclusive right to promote, market and distribute NRCo's products in Canada. In addition to regular supply payments to be made by Canco to NRCo, Canco paid a lump-sum, upfront fee (Upfront Fee) to NRCo upon signing the Distribution Agreement in consideration for the grant of the exclusive distribution rights.

Paragraph 212(1)(d) of the ITA applies a 25% withholding tax to rents, royalties and similar payments made to non-residents of Canada, as well as to certain payments for the right to use property (including intangible property) in Canada, or that are based on the production from or use of property in Canada. The CRA concluded that the Upfront Fee was not a royalty for these purposes or otherwise subject to paragraph 212(1)(d) because (i) the amount of the payment was not contingent on the extent or duration of use, profits or sales or otherwise, and (ii) it was a payment for the right to purchase and sell NRCO's products in Canada, and not for a right to use NRCo's products in Canada. While paragraph 212(1)(d) is a very broad provision, the technical interpretation confirms that lump-sum upfront payments that relate exclusively to distribution rights are outside its ambit.

The CRA nevertheless concluded that the Upfront Fee could be subject to withholding tax under domestic law under paragraph 212(1)(i), which applies to payments made in respect of restrictive covenants granted by non-residents. The definition of 'restrictive covenant' in the ITA is extremely broad and captures any agreement entered into, undertaking made, or waiver of an advantage or right, whether legally enforceable or not, that affects, or is intended to affect, in any matter whatever the acquisition or provision of property or services by a taxpayer or persons not dealing at arm's length with the taxpayer (subject to certain limited exceptions). The CRA implicitly concluded that since the Distribution Agreement affected or was intended to affect the acquisition or provision of property, the Upfront Fee was captured by paragraph 212(1)(i).

The CRA ultimately concluded that the Upfront Fee was not subject to withholding tax due to the application of the business profits provision of the applicable tax treaty, on the basis that the fee constituted business profits that were not earned through a permanent establishment in Canada. However the technical interpretation provides a reminder that, due to the expansive definition of restrictive covenant in the ITA, the CRA may seek to apply paragraph 212(1)(i) to a payment that would not otherwise be subject to Canadian withholding tax.

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