The new back-to-back royalty rules may require a Canadian taxpayer to determine an arm’s length licensor’s structure and whether it was tax motivated

A key departure in the proposed back-to-back loan rules from the existing rules is that funding provided by an ultimate funder who is entitled to a lower withholding tax rate than the intermediary is incorporated into the calculation of the amount of deemed interest under the rule, thereby potentially reducing the deemed interest paid to other ultimate funders who are subject to higher withholding tax rates. This is illustrated by an example in the article below.

The new back-to-back royalty rules can apply where one or more "ultimate licensors" indirectly lease or license property to a Canadian taxpayer by way of a chain of "relevant royalty arrangements" involving one or more intermediaries. Similarly to the back-to-back loan rules, there is a connection test which considers causal connections between incoming royalty arrangements received by an intermediary and outgoing royalty arrangements provided by the intermediary. When the licensor under an incoming royalty arrangement deals at arm's length with the taxpayer, the connection test will be satisfied only if one of the main purposes of this arrangement is to reduce or avoid withholding tax, or to avoid the back-to-back royalty rules.

This additional condition was added in the October proposals and, according to the Explanatory Notes, is intended to prevent the rules from applying to ordinary, arm's length commercial transactions that are structured without any main tax purposes. However, it may be difficult to rely on this condition in practice because a Canadian taxpayer is not likely to have sufficient information to determine an arm's length licensor's tax motivations.

Neal Armstrong. Summaries of PWC, “Bill C-29 significantly expands back-to-back rules,” Tax Insights PWC International Tax Services, Issue 2016-53, 16 November 2016 under s. 212(3.4), s. 212(3.92)(b)(ii) and s. 212(3.91).