12 December 2014 Internal T.I. 2014-0524751I7 F - Redevances perçues d'avance -- translation

Principal Issues: 1. Does the payment qualify as a royalty prepayment ? 2. Should the payment be included into income as per paragraph 12(1)(a) or subsection 9(1) ?

Position: 1. Question of fact. 2. Both provisions (whether 12(1)(a) or 9(1)) could apply.

Reasons: 1. The payment is not determined based on future sales or other contingency, which does not seem consistent with the definition of "royalty" as enunciated by the courts. 2. Since the taxpayer did not want to claim a deduction under paragraph 20(1)(m), it was not necessary to establish whether a provision took precedence over the other.

December 12, 2014

Audit Directorate                   	Income Tax Rulings Directorate
Large Business Audits                   	Business and Employment
XXXXXXXXXX  	 				  Income Division
							N. Deslandes, CPA, CGA, D.Fisc.
Attention:      XXXXXXXXXX
Large Case Auditor                   	2014-052475

Prepaid royalty income

This memo is in response to your email received on December 6, 2013, in which you requested our opinion respecting the tax treatment of prepaid royalty income in a context such as that described below.

Legislation

Unless otherwise indicated, all legislative references herein refer to the provisions of the Income Tax Act, R.S.C . 1985 (5th Supplement), c.1, as amended (hereinafter the "Act").

Similarly, unless otherwise stated, the terms and expressions which are defined in the Act have the meanings so assigned to them.

Designation of parties and abbreviations

For the purposes of this interpretation, names and corporate names and certain terms are replaced by the following names, corporate names and abbreviations:

XXXXXXXXXX 								Corporation A
XXXXXXXXXX								Corporation B
XXXXXXXXXX								Corporation C
XXXXXXXXXX 								Corporation D
XXXXXXXXXX								Corporation E
XXXXXXXXXX								Corporation F
XXXXXXXXXX								Corporation G
Canada Revenue Agency   					CRA
XXXXXXXXXX								Product A
Generally Accepted Accounting Principles  		GAAP
Payment, within the meaning of Fact No 8 below		Payment 

Facts

Based on the documentation you provided, we noted the following:

1. Corporation A is a Canadian corporation controlled by Corporation E, a XXXXXXXXXX corporation.

2. In XXXXXXXXXX, Corporation A granted a licence to Corporation D, a XXXXXXXXXX corporation, to manufactures and sells Product A throughout the world in return for a royalty and an advance payment of XXXXXXXXXX Canadian dollars. In XXXXXXXXXX, this license was amended to exclude the XXXXXXXXXX market.

3. The royalty referred to in the preceding paragraph corresponds to XXXXXXXXXX% of the worldwide net sales (excluding the XXXXXXXXXXX market) made by Corporation D and is governed, inter alia, by the following terms and conditions:

a) Within XXXXXXXXXXX days following the end of each quarter, Corporation D shall file and remit to Corporation A a detailed statement of the sales of Product A booked for that quarter;

b) Corporation D shall pay the royalties due within a period of XXXXXXXXXX days following the delivery of this statement. However, Corporation D is still entitled to remit the sums thus due before the expiry of this period.

4. In XXXXXXXXXX, Corporation A effected a transfer of assets, including the licence described above, to Corporation B, which was now the owner of the licence and consequently the recipient of the royalties arising therefrom.

5. On XXXXXXXXXX, Corporation B amalgamated with another group corporation, Corporation F and the new Corporation resulting from the amalgamation was named Corporation G. The tax consequences resulting from this amalgamation were as follows:

a) By virtue of paragraph 87(2)(a) of the Act, property owned by the predecessor corporation immediately before the amalgamation, including the licence held by Corporation B, became the property of Corporation G following the amalgamation. Consequently, Corporation G was now the recipient of the royalties described above.

b) At the time of the amalgamation, XXXXXXXXXX, Corporation F had the following tax attributes: a non-capital loss balance of $XXXXXXXXXX and a cumulative eligible capital amount of $XXXXXXXXXX. These attributes were also transferred to Corporation G.

c) As a result of the amalgamation, Corporation B and Corporation F were deemed to have a taxation year ending on XXXXXXXXXX, while Corporation G was deemed to begin its first taxation year at the time of the amalgamation, being XXXXXXXXXX.

6. On XXXXXXXXXX, Corporation E, the parent XXXXXXXXXX corporation, amalgamated with another XXXXXXXXXX corporation operating in the same field. This amalgamation resulted in a change in control that caused the taxation year of Corporation G to be deemed to end on XXXXXXXXXX.

7. On XXXXXXXXXX, Corporation G had a non-capital loss balance of $XXXXXXXXXX, which could no longer be applied against future income earned by it, as that balance had reached the carry-forward limit (Footnote 1) permitted by paragraph 111(1)(a) of the Act.

8. On the same day, Corporation D made a payment of $XXXXXXXXXX (footnote 2) (hereinafter, the "Payment") to Corporation G. We have summarized, in our words, our understanding of the conditions surrounding the Payment as provided for in the letter of agreement of XXXXXXXXXX between Corporation G and Corporation D:

a) It is agreed that the Payment (footnote 3) is made as an advance on any royalties arising from future sales of Product A.

b) The parties agree that it is reasonable to believe that future sales will occur between the months of XXXXXXXXXX and XXXXXXXXXX. Where applicable, the said amount shall be credited against the royalties to be paid by Corporation D arising from such sales.

c) The letter of agreement also states that the Payment will not, under any circumstances, be refundable by Corporation G, even if future sales do not materialize. The parties agree, however, that such an event is very unlikely.

9. For accounting purposes, Corporation G indicated that the Payment had been amortized over the period XXXXXXXXXX to XXXXXXXXXX in accordance with GAAP. From a tax point of view, the Payment was instead included in income for the fiscal year ending on XXXXXXXXXX.

10. Furthermore, in conversations and e-mail exchanges (Deslandes/XXXXXXXXXX), you indicated that royalties had historically been included in Corporation G's income as business income.

Your questions

11. You have asked us several questions which we summarize as follows:

a) You inquired as to the characterization of the payment that Corporation D made to Corporation G. You asked us whether this payment really constituted "pre-paid royalties" to be included in the income of Corporation G in its taxation year ending on XXXXXXXXXX. This question arises because the parties' binding contract stipulates that the royalties are calculated on the basis of the net sales that are realized, according to the taxpayer estimates, between the months of XXXXXXXXXX and XXXXXXXXXX.

b) In addition, you wished to know if the Payment, to the extent that it constitutes income, must be included in the income of Corporation G under paragraph 12(1)(a) or pursuant to subsection 9(1) of the Act. You also asked us to specify in which taxation year the Payment should be included in the income of Corporation G.

Your position

12. In your view, the Payment constitutes royalty income. In your view, royalty income is generally considered to be property income. You indicated that this was not an amount that Corporation G had received in respect of services that were not rendered or goods not delivered in the course of a business. Therefore, the royalty income was not subject to paragraph 12(1)(a) of the Act.

13. Rather, you indicate that the income inclusion of the Payment should be made in the taxation year which ended XXXXXXXXXX under subsection 9(1) of the Act in order to most accurately reflect the financial position of Corporation G. In your view, the Payment is linked to future royalties calculated on the basis of the net sales of Product A that will in all likelihood occur during its taxation year (footnote 4) ending on XXXXXXXXXX.

The position of the taxpayer/representative

14. The worksheets provided to you by Corporation G (or its agent) indicated that the Corporation considered the Payment to be business income subject to paragraph 12(1)(a) of the Act and that it must be included in the income of Corporation G in its taxation year ending on XXXXXXXXXX. However, representations made by Corporation G to us on XXXXXXXXXX indicated that the Payment should instead be included under subsection 9(1) of the Act. Essentially, it states that the case law (footnote 5) provides that, where a taxpayer has an absolute right in respect of an amount paid to it, that amount constitutes income. Accordingly, the representative submits that the taxpayer correctly included the Payment in its income during the taxation year ending on XXXXXXXXXX, being the year in which the Payment was received.

Our comments

15. We have grouped our comments under two headings. First, the nature of the Payment will be examined. Then, we will review the relevant provisions in this file, namely, subsection 9(1) and paragraph 12(1)(a) of the Act.

Qualification of payment

16. In the situation described, the parties to the agreement seem to agree on the characterization of the payment, i.e. as "pre-paid royalties". However (and as raised by you in your note, it is appropriate to consider whether the Payment, based on its particular features, constituted a royalty.

17. The term "royalty" is not defined in the Act. In this context, it is necessary to rely on the courts which have been called upon to examine the meaning of the term on various occasions. For example, in the Vauban Productions case (footnote 6), the Federal Court, Trial Division, stated:

The term "royalties" normally refers to a share in the profits or a share or percentage of a profit based on use or on the number of units, copies or articles sold, rented or used. When referring to a right, the amount of the royalty is related in some way to the degree of use of that right. This is evident from the various dictionary definitions of the word "royalty" when used in connection with a sum payable. Royalties, which are akin to rental payments, have invariably been considered as income since they are either based on the degree of use of the right or on the duration of the use, while a lump sum payment for the absolute transfer of a right, without regard to the use to be made of it, is of its nature considered a capital payment, although it may of course be taxable as income in the hands of the recipient if it is part of that taxpayer's regular business.
(Our emphasis)

18. Essentially, the case-law highlights that the term "royalty" is generally used in reference to a periodic payment based on use, production or sales.

19. This principle was adopted, in particular, in the Grand Toys case (footnote 7), where the question of whether a lump sum payment had the characteristics of a royalty was examined. In that case, Lamarre-Proulx J found (footnote 8) that the amount in question was not a royalty (but a capital payment) as it was not influenced by any factor, contingency or uncertainty. She indicated that the element of "contingency," which could be translated as a possibility or uncertainty, was the essence of the definition of the term "royalty".

20. In the file under review, we noted that one of the terms of the Payment ensures that it is not refundable under any condition. In our view, this is an important element separating such payment from the future events (i.e, anticipated sales) to which it appears to be linked by its wording. In addition, Corporation G has the right to benefit from the Payment and to use it as it wishes since it is not refundable under any conditions. Thus, even if Corporation D did not sell any Product A in the following year and therefore did not owe any royalty to Corporation G, Corporation G could still retain the Payment. In this case, therefore, the Payment does not appear to be subject to any contingency which, in our opinion, suggests that it does not satsify the essential character of the term "royalty" imparted by the courts.

21. That being said, taking into account the particular facts of this file, we are of the view that the classification of the Payment, i.e. determining whether or not such Payment constitutes a royalty, does not affect its nature, although there are in fact arguments to the effect that the Payment does not satisfy the definition of the term "royalty". In sum, in the situation under consideration, our conclusion is that the transactions and commercial relations between Corporation D and Corporation G ensure that the Payment is integral to the business of Corporation G and that it is business income to it (footnote 9).

Subsection 9(1) versus paragraph 12(1)(a) of the Act

22. Your other questions, which we have consolidated into the same question, inquire as to whether subsection 9(1) or paragraph 12(1)(a) of the Act applies to include the Payment in the business income of Corporation G. If applicable, you would like us to confirm to you in which taxation year the Payment is to be included as income, either that ending on XXXXXXXXXX or that ending in the year following, being XXXXXXXXXX.

23. Both subsection 9(1) and paragraph 12(1)(a) of the Act have the effect of including amounts in the taxpayer's income. However, paragraph 20(1)(m) allows the taxpayer to claim a reserve in respect of the amounts described in paragraph 12(1)(a) of the Act.

Paragraph 12(1)(a) of the Act

24. The question of the application of paragraphs 12(1)(a) and 9(1) to prepaid income was one of the issues of interest discussed at the annual Canadian Tax Foundation Conference in 2003 (footnote 10). The position articulated by the CRA on this subject was as follows:

[A]s a general rule, the inclusion/deduction mechanism provided under paragraphs 12(1)(a), 12(1)(e) and 20(1)(m) should apply to amounts received in a year by a taxpayer in the course of a business in respect of services not rendered or goods not delivered before the end of the year or that for any reason may be regarded as not having been earned in the year or a previous year. This inclusion/deduction mechanism is a specific statutory scheme dealing with the taxation of some types of prepaid income. It normally allows a closer matching of costs and revenues and therefore generally results in a more accurate picture of a taxpayer's profit for a particular period.

25. In the file under review, we are of the view that the Payment could be included under paragraph 12(1)(a) of the Act in the course of Corporation G's business from the standpoint of being viewed by us as prepaid royalties. This paragraph includes amounts paid on account of services not rendered or goods not delivered before the end of the year or that for any other reason may be regarded as not having been earned in the year or a previous year.

26. The Ellis Vision case (footnote 11) dealt in particular with a similar issue. In that case, Ellis Vision granted licences for the broadcast of programs that had not yet been produced or for programs that had been produced but may have already been televised.

27. Ellis Vision was attempting to grant as many international licences as possible. Respecting the tax treatment of the licence fees, its counsel argued that the licence fees received by Ellis Vision were not all, at the time of their receipt, earned income since those amounts were collected incrementally as the contracts were performed. Consequently, the amounts received were to be considered taxable income over the term of the license. For its part, the CRA argued that the wording of paragraph 12(1)(a) did not apply to the facts of this case. Under the licensing agreements, as soon as Ellis Vision had the right to charge or collect amounts provided under the agreements, it was no longer required to provide services or goods.

28. In this scenario, Rip J. provided the following reasoning. He first concluded that the scenario met the parameters of subparagraph 20(1)(m)(iii) and that, if applicable, the amount was described by paragraph 12(1)(a) of the Act. He stated:

[OFFICIAL ENGLISH]
[53] I am also of the view that the right to the production licensed to a broadcaster is a chattel. The French version of subparagraph 20(1)(m)(iii) uses the words "de biens meubles" for "chattels" in the English version. …

[55] Ellis Vision is entitled to deduct an amount as a reserve in accordance with paragraph 20(1)(m). Ellis had transferred the right to use a production in a defined area for a specific term to a licensee. To the extent the licensee pays in advance to enjoy this right, Ellis Vision is entitled to a reasonable reserve in respect of the amount it so received. The amount is described in paragraph 12(1)(a): it is either on account of a service that, in the main, is not rendered before the end of the year or is not earned in the year of receipt or a previous year in the course of Ellis Vision's business, or as an amount for the use of a chattel that was paid in advance. (Footnote 12)
(Our emphasis)

29. In our view, a parallel can be drawn between the situation under consideration and that described in the Ellis Vision case. Just as in that case, the Payment could be considered as an amount paid in advance for the use of chattels (bien meuble). If so, then the Payment would be described by paragraph 12(1)(a) of the Act and, thus, included in the Corporation G's business income in its taxation year ending XXXXXXXXXX.

Section 9 of the Act

30. Section 9 provides that, subject to the other provisions of Part I of the Act, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year. The Act does not define the word "profit". However, the Supreme Court of Canada considered this concept in Canderel Limited (footnote 13) and set out six principles relevant to the computation of profit for the purposes of the Act and summarized as follows:

(1) The determination of profit is a question of law.

(2) The profit of a business for a taxation year is to be determined by setting against the revenues from the business for that year the expenses incurred in earning said income: Minister of National Revenue v. Irwin, [[1964] R.C.S. 675], Associated Investors, [[1967] 2 R.C. 96].

(3) In seeking to ascertain profit, the goal is to obtain an accurate picture of the taxpayer's profit for the given year.

(4) In ascertaining profit, the taxpayer is free to adopt any method which is not inconsistent with:

a) the provisions of the Income Tax Act;
b) established case law principles or "rules of law"; and
c) well-accepted business principles.

(5) Well-accepted business principles, which include but are not limited to the formal codification found in G.A.A.P., are not rules of law but interpretative aids. To the extent that they may influence the calculation of income, they will do so only on a case-by-case basis, depending on the facts of the taxpayer's financial situation.

(6) On reassessment, once the taxpayer has shown that he has provided an accurate picture of income for the year, which is consistent with the Act, the case law, and well-accepted business principles, the onus shifts to the Minister to show either that the figure provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture (footnote 14).

31. It follows that the manner in which a transaction is recorded according to well-accepted business principles, including GAAP, is not determinative of its treatment in tax law. Thus, accounting methods do not in themselves establish rules of income tax law but they are tools of interpretation that could influence the computation of income in specific cases depending on the particular facts of the taxpayer's situation. According to this case, the taxpayer may adopt any method that is not inconsistent with the provisions of the Act and the principles derived from jurisprudence or established rules of law.

32. In the situation you have presented to us, the profit component under review is revenue. In this regard, the courts have provided extensive guidance. Thus, Justice Létourneau in The Queen v. La Capitale, Compagnie d'assurance générale (footnote 15) stated that for the purposes of section 9 of the Act, the concept of "income" included both amounts received and amounts receivable. In addition, in IKEA Limited v. Canada (footnote16), Iacobucci J. stated that:

The ultimate effect of this principle is clear: amounts received or realized by a taxpayer, free of conditions or restrictions upon their use, are taxable in the year realized, subject to any contrary provision of the Act or other rule of law.

33. This is called the realization principle. In our view, given that the Payment received by Corporation G does not contain any condition or limitation as to its use, an argument could be made that the Payment could also come within subsection 9(1) of the Act. As a result, Corporation G would include the Payment in its income upon receipt. In other words, on the basis of the above reasoning, the Payment would be added to Corporation G's income during its taxation year ending XXXXXXXXXX.

Conclusion

34. In summary, we are of the view that the tax treatment of the Payment by the taxpayer gives an accurate picture of the income of Corporation G that is consistent with the Act, jurisprudence and business principles. As we have indicated, we are of the view there are still arguments for the payment to be included in income either under paragraph 12(1)(a) or under subsection 9(1) of the Act. We will not resolve the issue of which of these two provisions prevails because Corporation G does not wish to benefit from a deduction under paragraph 20(1)(m) of the Act.

35. In addition, according to the stated principles in Canderel (footnote 17) and Ikea (footnote 18), it would be for the Minister to show either that the amount provided does not represent an accurate picture, or that another method of computation would provide a more accurate picture. As a result of our review, we have not identified a methodology that would give a more accurate picture of the taxpayer's profit. In the circumstances, we recommend that you accept the tax treatment proposed by the taxpayer.

36. We have not considered the application of the General Anti-Avoidance Rule (GAAR) in this case since the decision of whether or not to apply the GAAR rests with the Tax Planning Division of the Compliance Programs Branch.

We trust that our comments will be of assistance.

Michel Lambert, CPA, CA, M. Fisc.
Manager
Business and Employment Income Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Due to our systems requirements, the footnotes contained in the original document are reproduced below:

1 Prior to March 22, 2004, the Act allowed for a carry-forward over a period of 7 years rather than 20 years, which is the current limit.
2 Payment is in Canadian currency.
3 The payment is referred to as "an advance royalty payment" in the letter of understanding of XXXXXXXXXX.
4 Specifically, these sales are expected to occur between XXXXXXXXXX and XXXXXXXXXX.
5 See, among others, Ikea Limited v. Canada, [1998] 1 S.C.R. 196.
6 Vauban Productions v. The Queen, 75 DTC 5371, affirmed by the Federal Court of Appeal, 79 DTC 5186, quoted in particular in Hasbro Canada Inc. v. The Queen, 98 DTC 2129; See also Angoss International Ltd. V. The Queen, 99 D.T.C. 567.
7 Grand Toys Ltd. V. M.N.R., 90 DTC 1059; [1990] 1 CTC 2165
8 Specifically, Lamarre-Proulx J stated: « Counsel for the Respondent referred me to the case of Vauban Productions v. The Queen, 75 DTC 5371, where Mr. Justice Addy discusses the meaning of royalties at p. 5372 "The term royalties normally refers to a share in the profits or a share or percentage of a profit based on use or on the number of units, copies or articles sold rented or used." Counsel relies on the expression "a share in the profits". He says that contrary to what is expressed in the case of The Queen v. Saint John Shipbuilding and Dry Dock Co. Ltd., 80 DTC 6272 at 6276: "here there was no limit as to time with respect to use or the right to use. Nor were the payments proportionate to or in any way related to use or extent of use or to revenues or profits therefrom or to a period of use" the Respondent's basic contention is that the expression "in no way related to revenue or profit" is not a means of defence that the Appellant can invoke in the present case. It is the Respondent's contention that the payments in issue are clearly related to revenue or profit and therefore are royalties. I cannot agree with this proposition. The profits referred to in the two cases cited are the payor's profits, not the payee's profits. In the case at bar, the payments were the payee's profits and were in no way related to the Appellant's profits nor were they related to the Appellant's gross sales of the units. Whether the Appellant sold all the units or none of them, whether it made profits or not, did not influence the amount of money paid. There was no element of contingency in the payments in question and an element of contingency is the essence of a royalty payment. »
9 XXXXXXXXXX.
10 The French version of this position can be found in Income Tax Technical News No. 30.
11 Ellis Vision Incorporated v. The Queen, 2003 TCC 912.
12 Rip J explained that he doubted that Ellis could reasonably foresee that it would have to assume any obligation whatsoever, for example, to protect the licensee against the unauthorized use of production during the period of validity of the licence or to take measures to prevent any infringement of copyright. To the extent that in the calculation of the reserve these obligations have been taken into account, the amount of the reserve should be reduced.
13 Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147
14 Id., para. 53.
15 98 DTC 6215 (FCA)
16 Supra note 5, para. 37
17 Supra note 13
18 Supra note 5