4 December 2012 Internal T.I. 2011-0431871I7 - Part XIII and Procurement Fees

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether fee paid under franchise agreement which allows franchisee to procure products and equipment directly from third-party vendors (instead of the franchisor) is subject to tax under paragraph 212(1)(d).

Position: To the extent the fee represents consideration for items described within subparagraphs 212(1)(d)(i),(ii) and (iv), and does not represent consideration for copyright in subparagraph 212(1)(d)(vi) the fee will, subject to the U.S Treaty, be subject to withholding.

Reasons: Although fee is stated to be in exchange for right to directly procure products and equipment, a closer look at the franchise agreement suggests that the fee is consideration for the various rights granted to the franchisee under the agreement. Due to the structure of the fee, it is not a rent, royalty or similar payment, but portions of the fee allocable as payments described within the meaning of subparagraphs 212(1)(d)(i), (ii) and (iv) will be taxable under Part XII at treaty-reduced rates. Portions of the payment allocable to the right to use computer software and to certain copyright, as well as portions allocable to training services to be provided by the franchisor to the franchisee will be exempt under the U.S. Treaty.

December 4, 2012

HEADQUARTERS
XXXXXXXXXX Tax Services Office Income Tax Rulings Directorate
J. MacGillivray
(613) 957-2103

2011-043187

Procurement License Fee

This is in response to your memorandum of December 16, 2011, in which you have asked for our opinion with respect to the application of Part XIII of the Income Tax Act (Canada) to payments of a "Procurement License Fee" (the "PLF") under the terms of a Master License Agreement dated XXXXXXXXXX (the "Agreement") between XXXXXXXXXX ("USCo") and XXXXXXXXXX ("Canco").

Background

USCo is incorporated under the laws of the State of XXXXXXXXXX. It is a resident of the United States under the Canada-United States Tax Convention (1980) (the "U.S. Treaty") and does not carry on business through a permanent establishment situated in Canada for the purposes of the U.S. Treaty. USCo holds an exclusive license to sublicense franchise rights in Canada for XXXXXXXXXX ("Brand Name") XXXXXXXXXX retail outlets. These rights were granted to USCo by XXXXXXXXXX, a corporation governed under the laws of the State of XXXXXXXXXX. (footnote 1)

Under the Agreement, USCo granted various rights to Canco, which allow Canco to operate Brand Name outlets in Canada, or to sub-franchise such rights to allow sub-franchisees to operate such outlets in Canada, for a period of XXXXXXXXXX years commencing on XXXXXXXXXX (the "Franchise Rights"). Specifically, USCo granted to Canco an exclusive license to (i) use trade-marks in connection with the operation of those outlets in Canada, (ii) to use and to sub-franchise proprietary information, know-how and the franchise system in connection with the operation of those outlets, and (iii) to enter into agreements to permit sub-franchisees to use the aforementioned trademarks, proprietary information, know-how and franchise system in connection with the operation of outlets in Canada. USCo also granted Canco the exclusive right to sell in Canada goods, supplies and products bearing the licensed trade-marks, which are intended to be purchased by customers of Canco (or Canco's sub-franchisees), produced by third parties under specifications provided by USCo or XXXXXXXXXX ("Private Label Merchandise").

In consideration for the grant of the Franchise Rights, Canco agreed to pay USCo a "Master License Fee" of $XXXXXXXXXX and a monthly royalty payment equal to XXXXXXXXXX% of "Net Revenues" (e.g. XXXXXXXXXX% of gross receipts from sales of products, services and Private Label Merchandise net of sales taxes and gross receipts from transfers of inventory between outlets) from all outlets operated by Canco and its franchisees (the "Continuing Royalty Payment"). (footnote 2) Canco also agreed to pay USCo a monthly amount equal to XXXXXXXXXX% of gross receipts from sales of Private Label Merchandise sold outside of outlets.

The Agreement also contemplates that Canco will pay USCo a fee for advertising and promotional support and a handling fee in the event that Canco requests USCo to order equipment, XXXXXXXXXX and signage on Canco's behalf. (footnote 3)

The PLF is an additional amount that Canco must pay to USCo under the Agreement for the right to fully coordinate and oversee the procurement of all Brand Name XXXXXXXXXX and equipment for outlets in Canada (the "Procurement Rights"). The Procurement Rights allow Canco to purchase the XXXXXXXXXX and equipment from the manufacturers and vendors directly. (footnote 4) Absent such permission, it is understood that Canco and its sub-franchisees would be required under the Agreement to order the products and equipment from USCo, which would then purchase the products and services from the vendor or manufacturer and sell the products and equipment to Canco. The price USCo would charge to Canco for the products and equipment would generate a profit. The PLF is intended to compensate USCo for profits it will not realize from selling products and services to Canco.

USCo's representatives advise that USCo has entered into a number of franchise agreements with various franchisees in XXXXXXXXXX. In each case, the relevant agreement obligates USCo to provide to the franchisee a list of approved vendors and suppliers. Under the Agreement, USCo was obligated to provide a list of approved vendors and suppliers to Canco as part of the guidance USCo was required to provide to Canco in connection with the purchasing and selling of approved products and services. (footnote 5) The representatives also advise that, in contrast to the agreements between USCo and its other franchisees, the Agreement allows Canco to oversee the procurement function in exchange for the PLF. This recognizes Canco's ability to independently negotiate favourable pricing terms with vendors and suppliers.

Taxpayer's Submissions

The taxpayer's position is that the payment of the PLF is not subject to withholding under Part XIII of the Act. It is submitted that paragraph 212(1)(d) of the Act does not apply to the PLF and that the PLF does not fall within the definition of a "royalty" in Article XII(4) of the U.S. Treaty.

Rent, Royalty or Similar Payment

The representatives specifically considered whether the PLF is a rent, royalty or similar payment within the meaning of the opening words of paragraph 212(1)(d). Reference was made to paragraph 7 of Interpretation Bulletin IT-303, Know-How and Similar Payments to Non-Residents, which states that:

In general, a rent or royalty represents a payment made to the owner of property for the right to use such property for a given period of time. In most circumstances where a rent or royalty is paid, the owner of the property used by the person paying the rent or royalty retains ownership.

It was submitted that a payment of the PLF should be characterized as a payment for the right to fully coordinate and oversee procurement for the products and equipment, not as a payment for the use of property belonging to USCo. The representatives emphasize that the PLF is separate from the Continuing Royalty Payment made for the use of the Franchise Rights, presumably in support of the position that the PLF should therefore not be considered as a royalty in the sense of being a payment for the use of the Franchise Rights. Therefore, the PLF should not be considered a rent, royalty or similar payment within the meaning of the opening words of paragraph 212(1)(d).

The Tax Court of Canada decision in Entré Computer Centers Inc. v. The Queen, (footnote 6) was also cited as authority for the conclusion that the PLF lacked the characteristics of a rent, royalty or similar payment. In Entré Computers, Dussault T.C.J. held that a payment by a franchisee for the purchase of computer products under a franchise agreement, representing a percentage mark-up over the cost of products purchased by the franchisee, was not a rent, royalty or similar payment under paragraph 212(1)(d). The franchise agreement stated that the mark-up component was "deemed and considered a license fee charged for the license to use" proprietary marks of the franchisor. Despite this nomenclature, it was held that the payment did not constitute a rent, royalty or similar payment for the use of or the right to use those marks. This conclusion was premised, at least in part, on the absence of a link between the mark-up and the actual use of the proprietary marks by the franchisee.

The representatives submit that the PLF lacks any link to the Franchise Rights that would allow it to be considered a royalty paid for the use or the right to use such rights because it is not contingent on the use or sale of those products and equipment purchased from vendors or manufacturers, nor is it contingent on Canco's revenues or profits.

Subparagraphs 212(1)(d)(i) to (v)

The representatives also submit that the PLF does not fall within any of subparagraphs 212(1)(d)(i) to (v). It is conceded that the Procurements Rights would be considered property within the meaning of "property" in s. 248(1). However, it is submitted that case law does not support the application of subparagraph 212(1)(d)(i) to the payment of the PLF. The representatives cite the Federal Court of Appeal decision in The Queen v. Farmparts Distributing Ltd. as authority for this conclusion. (footnote 7) In Farmparts, it was held that a payment to a non-resident for an exclusive right to purchase and resell machinery would not be a payment for property within the meaning of subparagraph 212(1)(d)(i). The court considered the word "property" in subparagraph 212(1)(d)(i) to mean the machinery that was the subject of the exclusivity right, not the exclusivity right itself. The payment, which was a lump-sum amount paid at the outset of the agreement, did not give the payor any right to use specific machinery belonging to the recipient and was therefore not considered to be for the use of the machinery. Similarly, the representatives suggest that the payment of the PLF is not a payment for the use of or the right to use any product or equipment subject to the PLF, but only for the right to coordinate the procurement function and negotiate contracts directly with vendors and manufacturers, which should not be considered property for the purposes of subparagraph 212(1)(d)(i).

With respect to subparagraphs 212(1)(d)(ii) and (iii), the representatives submit that, based on the wording of the Agreement, the PLF is not paid for any information or services described in those subparagraphs, but only for the Procurement Rights. Subparagraph (iv) does not apply because the PLF is not a payment for USCo's agreement not to use or not to permit any other person to use anything referred to in subparagraph 212(1)(d)(i) or information described in subparagraph 212(1)(d)(ii). Finally, it is submitted that the PLF is not dependent on use or production from property in Canada, but is instead dependent upon Canco's procurements of product and equipment, and therefore subparagraph 212(1)(d)(v) should not apply to payments of the PLF.

The U.S. Treaty

The representatives also considered whether the PLF falls within the definition of a royalty in Article XII(4) of the U.S. Treaty. Having characterized the PLF as an amount paid as consideration for the Procurement Rights, it was submitted that the PLF was not a royalty within the meaning of that term in Article XII(4). Therefore, even if it were possible to conclude that payments of the PLF were subject to Part XIII tax under paragraph 212(1)(d), USCo would not be liable to Canadian tax on the PLF payments pursuant to Article XII of the U.S. Treaty.

Our Comments

At the outset, we believe the application of paragraph 212(1)(d) of the Act in these circumstances depends on whether the PLF is characterized as consideration for the Procurement Rights or as additional consideration for the Franchise Rights. If characterized as consideration for the Procurement Rights, it does not appear that the payments of the PLF would fall within the preamble to paragraph 212(1)(d) as a "rent, royalty or similar payment" and we would expect previous case law would discourage arguments that the PLF constitutes an amount described within any of subparagraphs 212(1)(d)(i) to (v). But when the PLF is characterized as consideration for the Franchise Rights, it is our view that certain portions of the PLF should be subject to tax under paragraph 212(1)(d).

We believe characterizing the PLF as additional consideration for the Franchise Rights can be supported by previous court decisions. In Grand Toys Ltd. v. Minister of National Revenue, (footnote 8) the court held that an amount referred to as a "royalty" under a contract was not a rent, royalty or similar payment for the purposes of paragraph 212(1)(d). In reaching this conclusion, the court stated that the following approach should be adopted in order to determine the character of the amount at issue:

As I have said already, to determine the nature of the obligations under an agreement, what an obligation is called may be of some assistance in interpreting the nature of the obligation but it does not mean that because someone has called an obligation something, that this resolves the nature of the obligation. The nature of a contractual obligation is determined by trying to ascertain from a careful review of the agreement, what was the intent of the parties, what was the nature of their undertakings or in other terms what is the agreement about. [emphasis added]

Although the Agreement states that Canco's obligation to pay the PLF to USCo is given in exchange for the Procurement Rights, we believe that Canco's obligation to pay the PLF represents consideration for the grant of the Franchise Rights, which allows the payments of the PLF to be characterized as payments for the right to use the Franchise Rights (i.e., the trademarks, information, know-how, etc. relating to the operation of Brand Name outlets in Canada and the right to distribute Private Label Merchandise).

Section XXXXXXXXXX of the Agreement indicates that USCo will allow Canco to exercise the Procurement Rights. This implies that Canco would not be at liberty to directly procure products and equipment from vendors and manufacturers without USCo's permission and that Canco would breach the terms of the Agreement if it sought to do so. (footnote 9) Although the Agreement does not expressly prohibit direct procurement of products and equipment, the "System Standards", as defined in Section XXXXXXXXXX of the Agreement, which Canco and its subfranchisees must comply with under Section XXXXXXXXXX of the Agreement, would, in the absence of Section XXXXXXXXXX, likely obligate Canco and its subfranchisees to order products and equipment through USCo.

In our view, the obligation to operate in accordance with System Standards is part of the consideration that Canco gave to USCo for the grant of the Franchise Rights. Section XXXXXXXXXX essentially modifies these obligations by releasing Canco from the requirement to order products and equipment through USCo. As a result, it can be argued the PLF is a substitute for the obligation to purchase products and equipment from USCo that would otherwise have been given as consideration for the grant of the Franchise Rights. In our view, this links the PLF to the grant of the Franchise Rights. In addition, we are of the view that the Franchise Rights would not have been granted to Canco unless Canco agreed to deal with USCo with respect to the procurement of products and equipment or, alternatively, provide additional compensation to USCo if Canco wished to control the procurement function directly. In other words, it is our view that if Canco insisted on control over the procurement of products and equipment, USCo's decision to grant the Franchise Rights to Canco depended upon the inclusion of the PLF under the Agreement. Otherwise, it is not clear that the Agreement would have been entered into by the parties. Furthermore, it would seem logical that a franchisee would pay more to acquire the right to operate a franchised business that did not carry an accompanying obligation to purchase inputs from the franchisor than it would pay if it was required to assume that obligation.

When characterizing the PLF payments in the manner described above, it should not be implied that actual purchases of product or services by a franchisee from a franchisor are payments for the use of any rights granted to the franchisee under a franchise agreement. The PLF is a substitute for the obligation to purchase products and equipment that would have otherwise been given as consideration for the Franchise Rights, not the purchases of products and equipment contemplated by that obligation. We believe that the actual purchase of products by a franchisee from its franchisor can be distinguished from representing consideration for the grant of franchise rights because such purchases are distinct transactions between the franchisor and the franchisee.

We do not believe that USCo provides a distinct good or service to Canco in exchange for the payments of the PLF. Therefore, while we realize that the PLF is, from a commercial perspective, a substitute for amounts that USCo would receive from sales of product and equipment to Canco, which themselves would not generally be subject to paragraph 212(1)(d), (footnote 10) it does not necessarily follow that the PLF should be treated in the same manner as the receipts from actual sales between a franchisor and franchisee in applying paragraph 212(1)(d).

Accordingly, we believe that USCo can be considered to have granted the Franchise Rights, in consideration for the Master License Fee, the Continuing Royalty Payment and a number of other obligations of Canco, including the obligation to comply with a less stringent set of System Standards that is supplemented by Canco's obligation to pay the PLF.

Rent, Royalty or Similar Payment

In Vauban Productions Ltd. v. Her Majesty the Queen, (footnote 11) the court defined "royalties" in the following manner:

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.

In Farmparts, the court referred to the definition in Vauban Productions to determine whether the payment in question, having concluded it was not described within subparagraph 212(1)(d)(i), was a royalty for the purposes of paragraph 212(1)(d). It held that the payment in question, a fixed, lump-sum amount, was not a royalty because it was to be made by the payor without regard to the extent of the use of the payor's right to purchase and resell machinery and without reference to the amount of any profits realized by the payor with respect to the use of the machinery.

Subsequently, in Grand Toys, the court held that a payment must be based on the profits (or the share or percentage of profit based on use or sales) of the party paying the royalty amount, not the recipient's, in order to be considered a royalty under paragraph 212(1)(d). In that case, a non-resident granted exclusive rights to distribute and sell merchandise to a Canadian resident under a contract, which also established that the price for each item of merchandise purchased from the non-resident included an amount referred to as a "buying commission and royalty". Although this amount was charged on a per-unit basis, the non-resident was entitled to a minimum amount from the Canadian resident regardless of the number of units actually purchased under the contract. The minimum amount was intended to reflect the gross profit margin that would be realized by the non-resident on sales of a certain number of units of merchandise to the Canadian resident.

In addressing whether the amounts in question were royalties for the purposes of paragraph 212(1)(d), the court, in response to an argument put forth by the Crown, held that the "profits" referred to in the royalty definition from Vauban Productions were the profits of the party paying the amount. The court concluded that the amount could not be a royalty because it was not contingent upon the profits or the sales of use of the merchandise purchased by the Canadian resident and stated:

There was no element of contingency in the payments in question and an element of contingency is the essence of a royalty payment.

The Tax Court of Canada confirmed this point in Hasbro Canada Inc. v. The Queen. (footnote 12) At issue in Hasbro was the characterization of an amount referred to as a buying commission by a Canadian resident to a related non-resident corporation. The non-resident corporation agreed to act as a purchasing agent for the Canadian resident. In exchange for those services, the Canadian resident agreed to pay the non-resident a commission equal to a percentage of the purchases of merchandise made by the Canadian resident with the assistance of the non-resident. The court concluded that the commission payments were not royalties or similar payments within the meaning of the opening words of paragraph 212(1)(d) because they were payments for services rendered by the non-resident and were not contingent upon the use, profit or sales of the merchandise by the Canadian resident. (footnote 13) The court stated:

A royalty or similar payment is therefore one made for the use of property, rights or information whereby the payments for such use are contingent upon the extent or duration of use, profits or sales by the user.

Based on the royalty definition that emerges from these court decisions, we would not view the PLF to be a royalty or similar payment within the meaning of the opening words of paragraph 212(1)(d), regardless of whether the PLF can be characterized as consideration for the Franchise Rights or the Procurement Rights. If the PLF represents consideration for the Franchise Rights, it would not be a royalty because it is not calculated with reference to the profits that Canco earns from the sales to its customers, nor does it appear to be contingent on the degree to which Canco uses the Franchise Rights. If viewed as consideration for the Procurement Rights, one could maintain that the PLF is, in a sense, paid for the use of the Procurement Rights and is contingent on the degree to which Canco makes use of those rights through the purchase of products and equipment. However, the obligation to pay the PLF arises when Canco purchases products and equipment and does not depend on whether Canco ultimately sells products to customers or uses the equipment in the course of its revenue-generating operations.

The decision in Entré Computers, cited above in the representative's submissions, also supports the conclusion that the PLF would not constitute a royalty or similar payment within the meaning of the opening words of paragraph 212(1)(d) since it is not based on the profits Canco earns from the operation of retail outlets. However, we would note that the court held that there was no link between the amounts at issue in Entré Computers and the use of the franchise rights that were granted to the Canadian-resident franchisees in that case. While we accept that the PLF is not a royalty or similar payment due to the basis of its calculation, we still maintain that the PLF can be viewed as consideration for the grant of the Franchise Rights and is thereby linked to those rights.

Subparagraph 212(1)(d)(i)

Included within the Franchise Rights is the right to use the trade-marks associated with the operation of Brand Name outlets. (footnote 14) As consideration for the grant of the Franchise Rights, the portion of any payment of the PLF that can be allocated as consideration for the grant of the right to use the trade-marks (and any property, inventions, trade-names, patents, designs, models, plans, secret formulas, processes that fall within the definitions of "Information", "Know-How", "Program" and "System" under the Agreement) is, in our view, within the express wording of subparagraph 212(1)(d)(i) (footnote 15) and is therefore subject to withholding under Part XIII at a rate of 10% pursuant to Article XII of the U.S. Treaty. (footnote 16) Unlike a royalty, a payment does not have to be correlated to the degree to which a particular property is used in order to fall within subparagraph 212(1)(d)(i), so the fact that the PLF is calculated with reference to the volume of product and equipment purchases, or with reference to the price of such purchases, does not preclude payments of the PLF from falling within the wording of subparagraph 212(1)(d)(i). (footnote 17)

The right to distribute Private Label Merchandise that was granted to Canco is similar to the distribution right at issue in the Farmparts decision, which was found not to be within the meaning of subparagraph 212(1)(d)(i). Accordingly, any portion of the PLF payments allocable to this particular right would not, in our view, be subject to withholding pursuant to subparagraph 212(1)(d)(i).

In our view, subparagraph 212(1)(d)(i) applies to a portion of the PLF payments. Furthermore, as discussed below, it is our view that subparagraphs 212(1)(d)(ii) and (iv) apply to certain portions of the PLF. Other portions of the PLF payments do not appear to fall within the scope of any of subparagraphs 212(1)(d)(i) to (v) or are excluded from paragraph 212(1)(d) by virtue of subparagraph 212(1)(d)(vi). In the Farmparts decision, it was established that where a payment can reasonably be considered to be in part for something taxable and in part for something non-taxable under paragraph 212(1)(d), the Minister has the onus to establish which portion of the payment is subject to the taxing provision relied upon; failure by the Minister to do so will result in the taxpayer not being subject to tax under that particular provision. Therefore, in the present circumstances, the CRA has the duty to establish which portion of the PLF is subject to Part XIII of the Act. Accordingly, in assessing whether subparagraphs 212(1)(d)(i) to (v) are applicable in these circumstances, our comments are expressed in terms of the portions of the PLF that can be allocated to the various rights, information or services which accompanied the grant of the Franchise Rights to Canco.

Subparagraph 212(1)(d)(ii)

Proceeding on the basis that the PLF represents consideration for the grant of the Franchise Rights, (footnote 18) subparagraph 212(1)(d)(ii) will apply to any portion of a PLF payment that is for information concerning industrial, commercial or scientific experience where the total amount payable as consideration for that information is dependent in whole or in part on:

• the use to be made of, or the benefit, to be derived from, that information
• production or sales of goods or services, or
• profits.

As part of the grant of the Franchise Rights, USCo granted Canco the right to use and to subfranchise proprietary information, know-how and the franchise system under Section XXXXXXXXXX of the Agreement. This provision of the Agreement refers to this as a "XXXXXXXXXX." The terms Information, Know-How, Program and System are defined in the Agreement. These terms appear to be duplicative, (footnote 19) or, at the very least, are not mutually exclusive. In any event, these definitions suggest that the following items of information were provided to Canco by USCo as a consequence of the grant of the Franchise Rights:

• site selection criteria (utilized by XXXXXXXXXX in the United States per Section XXXXXXXXXX of the Agreement)
• guidance criteria (detailed in Section XXXXXXXXXX of the Agreement and Section XXXXXXXXXX of the Agreement)
• specifications, procedures and system standards (detailed in Section XXXXXXXXXX of the Agreement) (footnote 20)
• access to an Operations Manual (detailed in Section XXXXXXXXXX of the Agreement) (footnote 21)
• trade secrets (footnote 22)

Also included within the definitions of Information and Program is a reference to "accounting software and materials" and "advertising and promotional materials". (footnote 23) Based on our review of the Agreement, it would not appear that these items would fall within subparagraph 212(1)(d)(ii). To the extent the PLF can be allocated as a payment for the use of or the right to use the accounting software and materials and the advertising and promotional materials, it is our view that the portion of the PLF would fall within subparagraph 212(1)(d)(i) as a payment for the use of or the right to use the software and materials in Canada; however, such portion of the PLF payments would likely be excluded from the application of Part XIII tax under subparagraph 212(1)(d)(vi) or by virtue of Article XII(3) of the U.S. Treaty. (footnote 24)

The definitions also make reference to a "training program and materials". Under the Agreement, USCo has agreed to deliver XXXXXXXXXX to Canco's employees/subfranchisees. In addition, Canco and its subfranchisees are permitted to attend ongoing training programs delivered by USCo. In large part, the training programs will take the form of classroom seminars and meetings. Attendees will be provided with certain training materials, which Canco will use to develop a training program for the operation of Canadian outlets. The delivery of training seminars by USCo would be better viewed as a service that USCo performs for the benefit of Canco. Therefore, the application of paragraph 212(1)(d) to portion of the PLF allocable to the delivery of training seminars by USCo should be assessed under subparagraph 212(1)(d)(iii). However, the training materials provided to Canco, which Canco will use to develop its own training program, could constitute information falling within the wording of subparagraph 212(1)(d)(ii).

A portion of a payment of the PLF that can be allocated to those items of information would be an amount described in subparagraph 212(1)(d)(ii) for two reasons. The first is that the PLF is itself calculated with reference to sales of goods and is therefore described within clause 212(1)(d)(ii)(B). Although Section XXXXXXXXXX of the Agreement refers to sales made to Canco by third-party vendors, the decision in Hasbro supports an argument that the reference to sales of goods or services need not be read as a reference to sales of goods or services of the party that pays for the information. (footnote 25) The second reason supporting the inclusion of this portion of the PLF is that the PLF, taken together with the other consideration given for the Franchise Rights, including the Continuing Royalty Payment, forms part of the consideration given for the information. As part of the consideration for the information (i.e., the Continuing Royalty Payment) is dependent on the use to be made of or the benefit to be derived from the information, the portion of the PLF allocable as consideration for the information component of the Information, Know-How, Program and System would be an amount described within clause 212(1)(d)(i)(A). (footnote 26)

This portion of the PLF would be considered a royalty for the purposes of Article XII of the U.S. Treaty as a payment for information concerning commercial experience. Although Article XII(3) of the U.S. Treaty exempts payments for the use of or the right to use information of this type, the exemption does not apply if the information is provided in connection with a franchise agreement. Accordingly, Part XIII tax can be withheld from this portion of the PLF at a rate of 10% under Article XII(2). (footnote 27)

Subparagraph 212(1)(d)(iii)

Paragraph 20 of IT-303 states:

20. Under this provision any payment for services of an industrial, commercial or scientific character performed by a non-resident person will be subject to tax where the total amount payable as consideration for such services is dependent in whole or in part upon:

(a) the use to be made thereof or the benefit to be derived therefrom;

(b) production or sales of goods or services; or

(c) profits.

As noted above, the Agreement provides that USCo will provide training to Canco's employees. (footnote 28) Since the definitions of Information and Program specifically refer to a training program, it follows that USCo granted Canco the right to attend training programs as part of the grant of the Franchise Rights. (footnote 29) Consequently, the amount of any payment of the PLF allocable to the training programs (other than the portion allocable to training materials to which subparagraph 212(1)(d)(ii) applies) can be considered a payment for services of a commercial character for the purposes of subparagraph 212(1)(d)(iii).

The decision in Hasbro would support an argument that a portion of any payment of the PLF allocable to training programs provided to Canco's employees would be dependent on sales of goods for the purposes of clause 212(1)(d)(iii)(B), even though the sales of products and equipment are by third-party vendors to Canco. (footnote 30) In Hasbro, the court considered whether the reference to production or sales of goods and services in that provision had to be read as a reference to the production or sales of the party to whom the services were provided, but was not convinced it could reach that conclusion, stating:

While I am of the opinion that the use, benefit, production, sales and profits referred to in clauses 212(1)(d)(iii)(A) through (C) were intended to refer primarily to those of the payer, I recognize it is not an unreasonable interpretation that they can sometimes refer to the use, benefit, production, sales or profits of third parties. In the present case, the phrase "dependent … on …sales of goods" could thus, as argued by counsel for the respondent, include payments which are dependent on the sales of goods by third parties, like the sales by the manufacturers to Hasbro.

However, if a payment for services is made for services performed in connection with the sale of property or the negotiation of a contract, the payment will not fall within subparagraph 212(1)(d)(iii) based on the wording of the post-amble of that provision. In Hasbro, the court ultimately concluded that the commission paid to the buying agent was paid for services in connection with the sale of property by the manufacturers who sold merchandise to the Canadian-resident taxpayer and was therefore not subject to Part XIII tax under subparagraph 212(1)(d)(iii).

While the court held that the term "in connection with" should be interpreted broadly in applying subparagraph 212(1)(d)(iii), we would not agree that payments for training services contemplated under the Agreement are excluded from the application of that provision. The Hasbro decision dealt with a payment to a non-resident that was engaged to perform services to assist the taxpayer with purchasing merchandise abroad. Given that the training programs described in Section XXXXXXXXXX of the Agreement are not specifically designed to assist Canco with any particular sale of property or contract negotiation, the training services contemplated under the Agreement can be distinguished from the services provided in Hasbro, and services which have previously been considered by our Directorate to be excluded from the application of subparagraph 212(1)(d)(iii) under the post-amble of that provision. (footnote 31)

In any event, payments for services are not included within the definition of "royalties" in Article XII(4) of the U.S. Treaty, and therefore no amount should be withheld in respect of any portion of a payment of the PLF that can be considered consideration for training services rendered by USCo to Canco's employees. (footnote 32)

Subparagraph 212(1)(d)(iv)

Subparagraph 212(1)(d)(iv) applies to any payment made pursuant to an agreement between a Canadian resident and a non-resident person under which the non-resident person agrees not to use or not to permit any other person to use anything referred to in subparagraph 212(1)(d)(i) or any information referred to in subparagraph 212(1)(d)(ii). In this regard, paragraph 27 of IT-303 states:

27. This provision applies to payments made to a non-resident to ensure that certain property or information will not be used by the payee or his licensee,

(a) in the case of items described in subparagraph 212(1)(d)(i), in Canada, or

(b) in the case of information concerning industrial, commercial or scientific experience, either in Canada or elsewhere.

Previously, we considered the application of this provision to payments made under an agreement under which a Canadian resident was granted the right to reproduce computer software in Canada and distribute the copies to its Canadian customers. (footnote 33) Our interpretation of this provision is that it encompasses payments for the exclusive aspect of the use of, or right to use, in Canada of any item referred to in subparagraph 212(1)(d)(i) or for the exclusive use of information described in subparagraph 212(1)(d)(ii). (footnote 34) Accordingly, subparagraph 212(1)(d)(iv) applies to any portion of the payment of the PLF allocable to the exclusive aspect of the licenses granted to Canco under Section XXXXXXXXXX (i.e., the exclusivity of the use of the Marks, the accounting software and materials, the advertising and promotional material and the exclusive access to the site selection criteria, guidance criteria, specifications, procedures and system standards, the Operations Manual and trade secrets).

Subparagraph 212(1)(d)(v)

Payments made to a non-resident that are dependent on the use of or production from property in Canada, including instalment payments on the sale price of the property (other than an instalment on the sale price of agricultural land) that are dependent on the property's use or on the production from the property, are subject to Part XIII tax pursuant to subparagraph 212(1)(d)(v).

If the PLF is characterized as consideration for the Franchise Rights, it would be difficult to conclude that any portion of the PLF would fit within the wording of this subparagraph because the PLF is dependent upon the volume or the price of the products and equipment purchased by Canco, not the degree to which Canco uses or has production (i.e., sales or profits) from the Franchise Rights.

If characterized as consideration for the Procurement Rights, there is an argument that the whole amount of the PLF is within the wording of subparagraph 212(1)(d)(v). Because the definition of "property" in subsection 248(1) states that property includes a right of any kind whatever, the Procurement Rights would then be "the property" referred to in subparagraph 212(1)(d)(v). One could then conclude that the PLF is dependent upon the use of the property by Canco, since the amount of the PLF is affected by the degree to which Canco purchases products and equipment from third party vendors.

However, this argument is analogous to what was postulated with respect to subparagraph 212(1)(d)(i) if one assumed that the Procurement Rights was "the property" for the purposes of that provision. We anticipate that the same challenges associated with the subparagraph 212(1)(d)(i) argument would apply to this analogous argument. Again, these difficulties can be attributed to the decision of the Federal Court of Appeal in Farmparts. In any event, if the PLF was considered to be within the wording of subparagraph 212(1)(d)(v) as a payment that was dependent on the use of the Procurement Right, the PLF would not constitute a royalty for the purposes of Article XII(4) of the U.S. Treaty, which provides that:

4. The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work (including motion pictures and works on film, videotape or other means of reproduction for use in connection with television), any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, tangible personal property or for information concerning industrial, commercial or scientific experience, and, notwithstanding the provisions of Article XIII (Gains), includes gains from the alienation of any intangible property or rights described in this paragraph to the extent that such gains are contingent on the productivity, use or subsequent disposition of such property or rights.

If the PLF falls within the wording of subparagraph 212(1)(d)(v) because it is a payment dependent on the use of the Procurement Rights, it would not be received by USCo as a consideration for any item referred to in the above definition. There is no copyright, patent, trade mark, design, model, plan, secret formula or process associated with the Procurement Rights. It is merely consideration for permission given to Canco to coordinate and oversee procurement of products and equipment for the Brand Name outlets in Canada. As the Procurement Rights are contractual rights granted to Canco, the Procurement Rights are not tangible personal property to Canco. USCo is not giving Canco any use of or any rights in any tangible personal property; Canco only has permission to acquire that property from third parties.

Conclusions

1. When taking into account the terms and conditions of the Agreement in their entirety, we believe a reasonable argument exists to support the conclusion that Canco's payments of the PLF to USCo represents consideration for the grant of the Franchise Rights. In order for the grant of the Procurement Rights to be of any value to Canco, the Agreement must otherwise implicitly prohibit Canco from directly coordinating the procurement of products and equipment. We believe this obligation would be part of the System Standards that Canco must abide by under the Agreement. In our view, those obligations are consideration for the grant and the continued use of the Franchise Rights. By giving Canco permission to coordinate procurement directly, Canco and USCo modified the consideration Canco gave to USCo for the grant and the continued use of the Franchise Rights by relaxing the obligation to comply with System Standards (with respect to the prohibition on direct procurement) and by adding an obligation to make future payments of the PLF. In our view, this links the payment of the PLF to the Franchise Rights.

2. Based on the royalty definition established under case law, we do not believe the PLF would be a rent, royalty or similar payment under the opening words of paragraph 212(1)(d).

3. Subparagraph 212(1)(d)(i) applies to portions of PLF payments allocable to trade-marks and any property, inventions, trade-names, patents, designs, models, plans, secret formulas, processes that fall within the definitions of "Information", "Know-How", "Program" and "System" under the Agreement and are subject to tax under Part XIII at a rate of 10% pursuant to Article XII of the U.S. Treaty.

4. Subparagraph 212(1)(d)(i) will not apply to portions of the PLF payments allocable to the right to distribute Private Label Merchandise.

5. Paragraph 212(1)(d) will not apply to portions of the PLF allocable to the use of, or the right to use copyright in the computer software or in the accounting and advertising materials described in the definitions of Information, Know-How, Program. Though such portions of the PLF may be described within subparagraph 212(1)(d)(i), subparagraph 212(1)(d)(vi) will exclude such portions from the application of paragraph 212(1)(d).

6. Subparagraph 212(1)(d)(ii) applies to portions of PLF payments allocable to site selection criteria, guidance criteria information and materials provided to Canco as part of the XXXXXXXXXX which are to be used to develop the training program for Canadian outlets. It also applies to portions of PLF payments allocable to information within the definitions of "Information", "Know-How", "Program" and "System" under the Agreement, imparted to Canco through access to specifications, procedures and system standards, the Operations Manual and trade secrets, to the extent subparagraph (i) does not apply to those items. Those payments are subject to tax under Part XIII at a rate of 10% pursuant to Article XII of the U.S. Treaty.

7. Subparagraph 212(1)(d)(iii) would apply to the portions of the PLF payments allocable to the training programs that USCo is obligated to deliver to Canco under the Agreement. However, this represents a payment for services that does not constitute a royalty under Article XII of the U.S. Treaty. As we understand that USCo does not carry on business in Canada through a permanent establishment, this portion of the PLF is not subject to tax in Canada under Part I.

8. Subparagraph 212(1)(d)(iv) applies to any portion of the PLF payments allocable to the exclusivity of the Franchise Rights, including the exclusivity of the use of the accounting software and materials and the advertising programs and materials referenced in the definitions of Information, Know-How and Program in the Agreement. However, to the extent a portion of a PLF payment is allocable to the use of, or the right to use computer software or to any copyright in the accounting or advertising materials, the portion will be exempt from Part XIII tax because of Article XII(3) of the U.S. Treaty.

9. Subparagraph 212(1)(d)(v) does not apply to the PLF payments.

10. Having concluded the PLF is not a rent, royalty or similar payment, or a payment described within subparagraph 212(1)(d)(v), we are unable to conclude that the entire amount of the PLF payments will be subject to withholding under Part XIII of the Act. Only the portions of the PLF payment described in paragraphs 3, 6 and 8 above will be subject to withholding under Part XIII at a rate of 10%. In circumstances where a payment is partly taxable under paragraph 212(1)(d), case law suggests there is an onus on the Minister to specify which portion of the payment is subject to the taxing provision relied upon. If the Minister fails to make this allocation, the taxpayer will not be subject to tax under that particular provision. (footnote 35) In these circumstances, it will be necessary to make a reasonable determination of the portion of the PLF payments that represents consideration for the items subject to Part XIII tax, through a valuation of the various rights provided in the Agreement, and calculate the withholding obligation on that amount.

We trust the foregoing is of assistance. Should you have any questions or wish to discuss this matter further, please contact Jackson MacGillivray at 613-957-2103 or Robert Demeter at 613-948-5274. For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Céline Charbonneau at (613) 952-1361. A copy will be sent to you for delivery to the client.

Yours truly,

Robert Demeter
Section Manager
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Although not indicated in the materials provided, it appears that XXXXXXXXXX and USCo are related to each other for the purposes of the Act.
2 It is acknowledged that Part XIII tax is exigible from the payments of the Master License Fee and the Continuing Royalty Payment.
3 In exchange for receiving advertising and promotional support from USCo, Canco is required to set aside XXXXXXXXXX% of Net Revenues for advertising and marketing purposes, and, after the first year of the Agreement, pay an escalating portion of the amount set aside to USCo, which USCo is obligated to use for marketing/promotional planning and development associated with the Brand Name brand. In the event that Canco requests USCo to order equipment, XXXXXXXXXX and signing for outlets on behalf of Canco, Canco agreed to pay USCo a fixed percentage of the cost of the equipment ordered.
4 The terms relevant to the PLF are found in Section XXXXXXXXXX of the Agreement and XXXXXXXXXX.
5 Section XXXXXXXXXX of the Agreement.
6 97 DTC 846 (TCC); [1997] 1 CTC 2291 [hereinafter Entré Computers].
7 80 DTC 6157 (FCA); [1980] CTC 205 [hereinafter Farmparts].
8 90 DTC 1059 (TCC); [1990] 1 CTC 2165 [hereinafter Grand Toys].
9 If the Agreement would not otherwise prohibit Canco from directly procuring products and equipment, then it is unclear how the PLF would constitute consideration for the right to oversee and coordinate procurement and purchasing. Without such an underlying prohibition, the granting of any right to oversee and coordinate procurement is meaningless and the PLF could be clearly linked to the Franchise Rights.
10 Unless, for example, USCo charged Canco a price for a particular product or piece of equipment based the use of or production from the product or equipment within the meaning of subparagraph 212(1)(d)(v).
11 [1975] CTC 511; 75 DTC 5371 [hereinafter Vauban Productions].
12 [1999] 1 CTC 2512 (TCC); 98 DTC 2129 [hereinafter Hasbro].
13 As discussed below, the court also considered whether the commission payments were described with subparagraphs 212(1)(d)(ii) and (iii).
14 See Section XXXXXXXXXX of the Agreement.
15 See paragraph 10 and 11 of Interpretation Bulletin IT-303, Know-How and Similar Payments to Non-Residents.
16 Assuming USCo is a qualifying person under Article XXIX A(2) of the U.S. Treaty.
17 Alternatively, if the PLF is treated as consideration for the grant of the Procurement Rights, it would be more difficult, in our view, to conclude that PLF payments will fall within subparagraph 212(1)(d)(i). This difficulty can be traced to the decision in Farmparts, where it was held that payments made for, among other things, the right to purchase and sell a certain type of machinery was not a payment for the use of or the right to use property in Canada within the meaning of subparagraph 212(1)(d)(i). Although the court did take note of the definition of "property" in subsection 248(1) to conclude that a payment for the use of a merchandising concept was a payment for the use of property within the meaning of subparagraph 212(1)(d)(i), it was not prepared to conclude that the right to purchase and sell machinery was a property in and of itself under that provision. Instead, the court viewed the machinery to be the property for the purposes of applying subparagraph 212(1)(d)(i) to this aspect of the payment and then proceeded to consider whether the right to purchase and sell the machinery was a right to use the machinery for the purposes of the provision. It concluded that the right to purchase and sell the machinery was not a right to use the machinery.
Although the Procurement Rights are themselves property, given that "property" as defined in subsection 248(1) includes "a right of any kind whatever", and that the PLF is a payment made for the use of that property, we believe there is considerable risk that the courts would construe the property, in relation to the PLF, to be the products and equipment that is contemplated under Section XXXXXXXXXX of the Agreement. If construed in this manner, one could foresee that the court would consider itself bound by the Farmparts decision, and proceed to assess whether the payment for Procurement Rights is a payment for the use of or the right to use the products and equipment. In those circumstances, we expect the courts would conclude that the Procurement Rights do not provide Canco with the use of or the right to use those products and equipment since USCo does not provide Canco with the products or equipment under the Agreement; it is another party that actually supplies Canco with the equipment under the procurement arrangements contemplated in Section XXXXXXXXXX of the Agreement. In other words, the payment of the PLF, in and of itself, does not allow Canco to use any particular item of product or equipment. It should be noted that Farmparts was decided at the level of the Federal Court of Appeal and that the decision has been followed by the courts in a number of subsequent decisions, so the risk that a court would draw an analogy between the rights to purchase and sell machinery in that case to the present circumstances is, in our view, fairly substantial.
18 If viewed as consideration for the Procurement Rights, the PLF would clearly not be a payment for information. In that event, the PLF is being paid in order to gain permission to oversee procurement and purchase products and equipment from third parties.
19 In fact, the term Know-How is defined so as to specifically include Program.
20 Upon further examination, it is possible that these items may be considered to fall within subparagraph 212(1)(d)(i). In this regard, paragraph 11(c) of IT-303 indicates that the CRA considers subparagraph 212(1)(d)(i) to apply to payments for the right to use special procedures, processes or recipes pertaining to a business, whether or not incorporated in a franchise.
21 Ibid.
22 Ibid.
23 The definition of Know-How indirectly incorporates such references because that definition includes the Program.
24 The courts have held that computer software constitutes a literary work for the purposes of subparagraph 212(1)(d)(vi) such that payments to non-residents for rights to reproduce software are exempt from Part XIII tax. See Syspro Software Ltd. v. The Queen, [2003] 4 CTC 3001 (TCC). This is also confirmed by Document E 2011-0399141R3. Article XII(3)(b) of the U.S. Treaty precludes Canada from taxing royalty payments for the use of, or the right to use computer software made to a U.S. resident (assuming of course that the U.S. resident beneficially owns the payment and is eligible to claim treaty benefits under Article XXIX A of the U.S. Treaty).
25 This is elaborated on in the discussion of the application of subparagraph 212(1)(d)(iii).
26 But see paragraph 17 of IT-303, which could be read such that the PLF should be treated separately from the Continuing Royalty Payment in assessing whether it is dependent upon the use to be made of, or the benefit to be derived from the information.
27 Assuming USCo is the beneficial owner of the payment and is eligible to claim treaty benefits under Article XXIX A of the U.S. Treaty.
28 Sections XXXXXXXXXX of the Agreement.
29 If viewed as consideration for the Procurement Rights, the PLF would clearly not be a payment for services since the PLF, on that characterization, would be paid in order to gain permission to oversee procurement and purchase products and equipment from third parties.
30 This is also supported by paragraph 21 of IT-303, which states that, "…taxability [under subparagraph 212(1)(d)(iii)] does not necessarily rest upon the payments being dependent on use, production or profits of the person by whom the payments are made. In certain circumstances the provision will extend to cases where payment is dependent upon the use, production or profits of the recipient of the payments or of third parties."
31 In Document E 2002-0130827, it was concluded that commissions paid to a non-resident insurance agent from the sale of life insurance policies were excluded based on the wording of the post-amble in subparagraph 212(1)(d)(iii).
32 Based on the assumption that USCo does not have a Canadian permanent establishment, any portion of the PLF allocable to training services would not be subject to Canadian income tax under Part I of the Act. The terms of the Agreement seems to imply that USCo would only deliver training programs in the United States, so it would appear doubtful that the training services would even be considered to be activities of USCo that constitute carrying on business in Canada.
33 This was confirmed in Document E 2002-0147545, which dealt with a license to use computer software. Having concluded the payment for the right to use the software, which was a payment for use under subparagraph 212(1)(d)(i), was exempt from Part XIII withholding under subparagraph 212(1)(d)(vi) as a payment in respect of copyright, we stated that any portion of the payment attributable to a licensor's agreement not to reproduce or distribute or permit any other person to reproduce or distribute copies of the software in a particular geographical area specifically assigned to the licensee would be considered in respect of such undertaking and would fall under subparagraph 212(1)(d)(iv). Consequently, that portion of the payment would not be exempt by virtue of subparagraph 212(1)(d)(vi).
34 Arguably, this is also supported by the decision in Grand Toys, which appears to confirm that a payment for exclusivity of use would be subject to the application of subparagraph 212(1)(d)(iv), provided that a payment can be allocated to the exclusive aspect of the use of, or the right to use property.
35 XXXXXXXXXX.