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 a lump sum upfront payment for exclusive distributorship rights and/or subsequent supply payments made for the product itself are subject to Canadian withholding tax under the Act and if yes, whether they are exempt from the Canadian withholding tax under the Canada-XXXXXXXXXX Income Tax Convention.
Position: Unless any portion of any payment is allocated to the use of a trade-mark or a patent, the payments are either not subject to the Canadian withholding tax under the Act or exempt under the Canada-XXXXXXXXXX Income Tax Convention.
Reasons: In our view, to the extent the lump sum payment is subject to Canadian withholding tax under subparagraph 212(1)(d)(i) or 212(1)(d)(iv), or paragraph 212(1)(i) of the Act, it should be exempt under Article VII of the Canada-XXXXXXXXXX Income Tax Convention as a business profit from a business that is not carried on through a permanent establishment in Canada, unless any portion of that payment is allocated to the use of a trade-mark or a patent. The subsequent supply payments are, in our view, payments on account of the purchase price and are not subject to the Canadian withholding tax under the Act.
August 16, 2017
XXXXXXXXXX Income Tax Rulings
Specialty Audit Division Directorate
Compliance Programs Branch Ina Eroff
112 Kent, Place de Ville, TWR B 416-952-0959
Ottawa, Ontario, K1A 0L5
Re: Exclusive Distributorship Rights
This is in reply to your emails of April 13, 2017 and May 2, 2017 regarding the Part XIII withholding tax obligations of XXXXXXXXXX (“Canco”). Unless otherwise stated, all statutory references herein are to the Income Tax Act (the “Act”).
We understand the facts to be as described below:
- Canco is a corporation organized and existing under the laws of the province of XXXXXXXXXX. Canco is the distributor of certain XXXXXXXXXX.
- XXXXXXXXXX (“NRco”) is a corporation organized and existing under the laws of XXXXXXXXXX and is a resident of XXXXXXXXXX under Article IV of the XXXXXXXXXX (the “Treaty”). NRco has no permanent establishment in Canada as defined in Article V of the Treaty.
- NRco is the manufacturer of XXXXXXXXXX (the “Product”). The Product is patented in XXXXXXXXXX.
- Canco and NRco deal with each other at arm’s length.
- On XXXXXXXXXX, Canco and NRco entered into a distribution agreement (the “Distribution Agreement”), pursuant to which NRco granted to Canco a right to promote, market and distribute the Product in Canada under the trade-mark XXXXXXXXXX, registered in Canada in the name of NRco or its affiliate. All governmental registrations required to distribute the Product in Canada were transferred from NRco’s affiliate to Canco under the Distribution Agreement. However, Canco expressly acknowledged in the Distribution Agreement that ownership of the registration dossier and corresponding data remains with NRco and would be transferred back to NRco upon the termination of the Distribution Agreement. The rights to distribute the Product are granted on an exclusive basis (except for the right reserved by NRco to co-promote the Product in Canada). The right to distribute relates to a specific presentation (XXXXXXXXXX) and only for the specified purpose of XXXXXXXXXX. Rights granted under the Distribution Agreement include rights on new XXXXXXXXXX of the Product in case NRco decides to launch them in Canada.
- In compensation for the rights granted under the Distribution Agreement, Canco paid to NRco, as a non-refundable down-payment, the net amount of XXXXXXXXXX (the “Upfront Payment”) – XXXXXXXXXX paid upon signing of the Distribution Agreement and XXXXXXXXXX paid upon receipt of all governmental approvals by Canco required to distribute the Product in Canada.
- NRco’s total compensation in respect of supplies of the Product (the “Supply Payments”) is the greater of (i) XXXXXXXXXX% of the gross amount charged, billed or invoiced by Canco for the sale of the Product, at the applicable approved ex factory price (less an amount up to XXXXXXXXXX% of the gross sales covering any discounts) and (ii) XXXXXXXXXX per unit of the Product supplied to Canco (the “Minimum Payment”). The obligation is satisfied by Canco initially paying the Minimum Payment at the time of the supply and subsequently adjusting the price at the end of each calendar quarter based on actual sales.
- NRco granted to Canco free of charge an exclusive license to use the trade-mark for the commercialization of the Product in Canada under the Distribution Agreement.
- Under the Distribution Agreement, Canco is required to maintain a minimum level of promotional activity and establish a marketing plan, including a pricing strategy, which has to be approved by NRco. Promotional activities have to be approved by NRco. If the minimum promotional commitment is not achieved and the failure is not remedied within specified time, NRco has the right to terminate the Distribution Agreement. Notwithstanding the foregoing, Canco has full discretion over all pricing decisions regarding the distribution price of the Product in Canada.
- The Distribution Agreement establishes sales targets. In case the agreed sales targets are not met, and the failure to meet the targets is not remedied within specified time, NRco has the right to terminate the Distribution Agreement.
- Canco undertakes to indicate the logo and company name of NRco on all packaging and promotional materials.
- During the time of the Distribution Agreement, Canco cannot acquire the Product from third parties, unless the party is designated by NRco, and cannot sell, promote, develop, manufacture or make in Canada a XXXXXXXXXX product that is in competition with the Product.
- Canco undertakes not to make any studies to develop new XXXXXXXXXX or any other development related to the Product, both patentable or not, without prior approval by NRco, it being in any event understood and agreed that the ownership of the result of any such development shall be vested in NRco. The Distribution Agreement specifies that nothing derogates from any ownership rights or control of NRco of all information related to the Product, both patentable or not, including any inventions, discoveries and improvements.
Whether the Upfront Payment and the Supply Payments are subject to Canadian withholding tax under the Act and if so, whether they are exempted from such withholding tax under the Treaty.
The Upfront Payment and/or the Supply Payments may be subject to Canadian withholding tax under paragraph 212(1)(d) if they are “royalties” within the meaning of the Act. If the Upfront Payment and/or the Supply Payments are not royalties, they may still be subject, in whole or in part, to Part XIII tax under the Act to the extent they satisfy the requirements in any of subparagraphs 212(1)(d)(i) to (v) or paragraph 212(1)(i). If the Upfront Payment and/or the Supply Payments are subject to Canadian withholding tax under the Act, they may be exempted from such Canadian tax under the Treaty if they are not “royalties” within the meaning of paragraph 4 of Article XII of the Treaty.
In our view, the Upfront Payment is not a “royalty” within the meaning of paragraph 212(1)(d) on the basis that it is a lump sum payment that does not depend on Canco’s profit or the degree of exercise by it of its exclusive distributorship right. The term “royalty” is not defined in the Act. In general, a royalty represents a payment made to the owner of property for the right to use the property. On a number of occasions, the courts have considered whether certain amounts constitute royalties for the purposes of paragraph 212(1)(d) and, in doing so, have applied the definition of a royalty articulated in Vauban Productions v. The Queen, 75 D.T.C. 5371 (F.C.-T.D.), affirmed in 79 D.T.C. 5186 (F.C.A.):
The term “royalties” normally refers to a share in the profits or a share or percentage of a profit based on user (sic) 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.
In light of the relationship between the quantum of a royalty and the degree of use of the underlying rights, it has been held that contingency is an essential element of a royalty. In Hasbro Canada Inc. v. The Queen, 98 D.T.C. 2129 (T.C.C.), it was stated that a royalty payment is 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.” This contingency is not present in the case of the Upfront Payment.
In our view, to the extent the Upfront Payment is paid for the exclusive distribution right, it may be subject to Canadian withholding tax pursuant to subparagraph 212(1)(d)(i), which applies to a payment for the use of “any property …or other thing whatever”. In particular, an exclusive distribution right is a “property” for the purposes of the Act because the definition of “property” in subsection 248(1) includes “a right of any kind”. However, the decision in R. v. Farmparts Distributing Ltd., 80 D.T.C. 6157 (F.C.A.) casts doubt on whether an exclusive right to distribute is within the scope of subparagraph 212(1)(d)(i).
In Farmparts Distributing, the Court considered the nature of upfront lump sum payments made by a Canadian resident to an American resident for an exclusive right to purchase and resell within certain Canadian provinces “Wonder Matic” pipe bending machines, for the concept or technique of merchandising replacement muffler systems using this “Wonder Matic” machine and for certain uses of the “Wonder Muffler” trade name and logos. The “Wonder Matic” machines themselves had to be purchased separately for an additional cost. The Canadian resident would then repackage the “Wonder Matic” machine by adding components such as inventory of exhaust pipes and other parts necessary to complete the installation of muffler systems and re-sell the package to its sub-distributors.
The Court concluded in Farmparts Distributing that the lump sum one-time payments for the exclusive right paid irrespective of the extent of use by the taxpayer of the product and unrelated to the profits made by the taxpayer as the result of any use of the product were not royalties. The Court further considered whether any of subparagraphs 212(1)(d)(i) to (v) could nevertheless apply to the payments. The Court stated that an exclusive right to buy and sell could, “under no circumstances, be said to constitute the use or the right to use” the product and was outside the scope of subparagraph 212(1)(d)(i). However, the Court concluded that it was open to the Minister of National Revenue to allocate a portion of the payments to the use of or the right to use the trade name and to the use of or the right to use a “plan” or a “process”.
While Farmparts Distributing creates uncertainty as to whether a payment for an exclusive distribution right is subject to subparagraph 212(1)(d)(i), to the extent any portion of the Upfront Payment could be allocated to the use of the patent or the trade-mark, such portion of the Upfront Payment would be subject to Canadian withholding tax. Under the Distribution Agreement, NRco grants to Canco free of charge an exclusive license to use the trade-mark for the commercialization of the Product in Canada. This agreement would have to be challenged if any portion of the Upfront Payment is allocated to the trade-mark. In that respect, the dictum in Grand Toys Ltd. v. Minister of National Revenue, 90 D.T.C. 1059 (T.C.C.) appears relevant.
In Grand Toys, the taxpayer entered into an agreement with a Hong Kong company for the exclusive right to distribute and sell in Canada certain dolls, using their names, characters, symbols, designs, likeliness and visual representation. While a portion of the payment made by the taxpayer to the Hong Kong company was labeled “royalty”, the Court concluded that the word “royalty” did not accurately describe the nature of the payment and concluded further that the payment was not made for the use of any properties listed in subparagraph 212(1)(d)(i) on the basis that the dolls were not manufactured by the taxpayer using the intellectual property, but merely acquired for resale in Canada. While we do not have an expertise in valuation, the conclusion of the Court in Grand Toys seems reasonable and equally applicable to the Upfront Payment on the basis that nothing is manufactured by Canco using the patent, the trade-mark or the trade name. The Distribution Agreement does not contemplate an extensive use of the trade-mark, but only limited use in connection with the distribution, promotion and advertising of the product granted under the gratuitous license to use the trade-mark for the commercialization of the Product in Canada. Thus, while it is open to you to allocate a portion of the Upfront Payment to the use of various intellectual property, we are not inclined to recommend challenging the Distribution Agreement.
Alternatively, the Upfront Payment may, in whole or in part, be subject to Canadian withholding tax under subparagraph 212(1)(d)(iv) as a payment made pursuant to an agreement under which NRco agrees not to use or not to permit any other person to use any property listed in subparagraph 212(1)(d)(i). In our view, subparagraph 212(1)(d)(iv) 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). Since there is no restriction on the use of the Product itself, “any thing referred to in subparagraph (i)” to which subparagraph 212(1)(d)(iv) may apply would be the trade-mark, the patent, or the right to distribute. As discussed above, the decision in Farmparts Distributing casts doubt on whether the exclusive distribution right is within the scope of subparagraph 212(1)(d)(i).
To the extent neither subparagraph 212(1)(d)(i) nor subparagraph 212(1)(d)(iv) applies to the Upfront Payment, in our view, paragraph 212(1)(i) is broad enough to apply to it on the basis that the Upfront Payment is an amount that would, if NRco had been resident in Canada throughout the taxation year in which the amount was received, be required by subsection 56.4(2) to be included in computing NRco’s income for the taxation year. Subsection 56.4(2) includes in a taxpayer’s income an amount in respect of a restrictive covenant. The definition of a “restrictive covenant” in subsection 56.4(1) is broad and contemplates all undertakings or waivers that affect or are intended to affect the acquisition or provision of property. In our view, the undertakings of NRco under the Distribution Agreement would satisfy the definition of a “restrictive covenant”.
To the extent the Upfront Payment is subject to Part XIII tax under subparagraphs 212(1)(d)(i), 212(1)(d)(iv) or paragraph 212(1)(i), the Upfront Payment should be exempt from Canadian withholding tax under Article VII of the Treaty on the basis that it is a business profit to NRco that is not earned through a permanent establishment in Canada, unless you conclude that a portion of the Upfront Payment has to be allocated to the use of the trade-mark or the patent. In our view, the Upfront Payment does not constitute “royalties” as that term is defined in Article XII of the Treaty. The term “royalties” in Article XII of the Treaty is defined to include “payments of any kind received as a consideration for the use of, or the right to use, any copyright, patent, trade mark, design or model, plan, secret formula or process…” A substantially similar definition of the term “royalties” is found in Article 12 of the Model Convention with Respect to Taxes on Income and on Capital (the “Model Tax Convention”) by the Organization for Economic Cooperation and Development (“OECD”). Paragraph 10.1 of the OECD commentary (the “OECD Commentary”) on Article 12 of the Model Tax Convention states that payments made in consideration for obtaining the exclusive distribution rights of a product in a given territory do not constitute royalties within the meaning of the Model Tax Convention as they are not made in consideration for the use of, or the right to use, an element of property included in the definition. We are in agreement with this portion of the OECD Commentary. The OECD Commentary further states that in the context of the exclusive distributorship, the distributor does not pay for the right to use the trade name or trade-mark under which the products are sold, but merely obtains the exclusive right to sell the product bought from the manufacturer.
In respect of the Supply Payments, in our view, they are not royalties and are not otherwise subject to the Canadian withholding tax under subsection 212(1). Based on the facts presented to us, in our view, these payments represent a purchase price for the product rather than payments for the use of various intellectual property associated with the products.
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Olli Laurikainen, CPA, CA
For Division Director
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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