20 June 1988 Income Tax Severed Letter RRR2

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.

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

Re: Royalties

This is to comment on whether royalties paid to U. S. residents in consideration of the sale of a capital asset are to be exempt from tax pursuant to Article VIII of the Canada-U. S. Convention or are to be taxed as royalties in accordance with Articles II and XI of the Convention and Article 6(a) of the Protocol.

Background - Meaning of Royalty under Canadian Law

It would appear that the word "royalty" is capable of being applied to a payment of an income or capital nature, provided that the payment is computed with respect to the production derived from the use of assets, to the profits of a business, or to the gains generated by the exercise of certain rights. In other words, whether the occasion for the payment is the use or the disposition of tangible property, of a business, or of rights would seem to be immaterial for the purposes of characterizing a payment as a royalty.

In Wilder v. MNR [[1951] C.T.C. 304] (1952) 1 S.C.R. 123, the taxpayer sold his business in return for the purchaser's undertaking to pay him an 'annuity' during his lifetime of $1,000 per month and other consideration. Paragraph 3(1)(b) of the Income War Tax Act brought into income "...annuities or other annual payments received under the provisions of any contract ...".

The majority decision of the Supreme Court was that the legislative intention was to tax income receipts and not capital payments (in the case at hand, instalments due on the purchase price of the business). In the view of Taschereau and Fauteux J. J., the fact that the so-called annuity payments were made as part of the consideration for the transfer of capital assets conclusively characterized them as capital. Rinfret D. J. seemed to feel that, as instalments of the purchase price, the monthly annuity payments contained some element of interest. Subsection 2(3) permitted the Minister to bring into income as interest the appropriate portion of an amount paid under a contract or arrangement, however the provision had not been invoked because the Minister had assessed on the assumption that the entire annuity payment was of an income nature.

The dissenting judgements of Rand and Kellock J. J. are perhaps more interesting and are probably more convincing expositions of the law.

The basis for their opinions is the principle stated in Jones v. CIR (1920) 1 K.B. 711 by Rowlatt J. according to whom "there is not law of nature or any invariable principle that because it can be said that a certain payment is consideration for the transfer of property it must be looked upon as price in the character of principal." The determination to be made in such cases is whether 1) a capital asset ha been transmuted into an annuity payment (or other income receipt) or 2) whether what is being paid is merely an instalment of the agreed sale price. A subsidiary issue in connection with 2) above, is whether any portion of the instalment payment is on account of interest. Generally, in cases where the number of metered periodic payments is expressly limited or where the payments are to cease when a specified aggregate amount has been paid, the payments will be treated as instalments of the purchase price (capital). Where every likelihood of some reasonable apportionment between capital and interest being made. Where, however, the periodic payments are perpetual (for the life of the taxpayer) the better view would seem to be that they are of an income nature. On this basis Rand and Kellock J. J. found the annuity payments in Wilder to be taxable as income.

Is is difficult to see how the monthly payments in Wilder could be regarded as an instalment of the purchase price inasmuch as they were uncertain as to duration and aggregate amount and, further, it would accordingly be virtually impossible to determine the interest element in each monthly payment. Very likely the majority judges were reluctant to tax an amount as income which they perceived as containing some capital element. They thus refused to adopt the principle that a capital asset could be transmuted into an income amount and their judgement even suggests that whenever a variable periodic payment is received in consideration for the transfer of a capital asset it is to be regarded as consisting entirely of capital.

Though the Wilder case dealt with an 'annuity' the same reasoning would also apply to a payment which the parties have styled a 'royalty'. In other words, both the majority and minority judges in Wilder took the position that it mattered little what the parties had called the payment if according to its true nature and substance it was properly something else. 'Annuities', after all, were specifically brought into charge in Wilder. The differences in judicial attitude turned on opposed views of what the substance of the 'annuity' payments was.

In the earlier case of Spooner, the taxpayer sold land, including minerals, for a cash sum, shares in the purchase company, and a 'royalty' of 10% of all oil produced free of cost. The question was whether the 10% of oil produced, the value of which was paid in cash, was an"annual net profit or gain" within subsection 3(1) of the Income War Tax Act. The Supreme Court of Canada and the Judicial Committee of the Privy Council in England held that the Minister had been unsuccessful in discharging the evidentiary burden of proving that the payments were not of a capital nature. While acknowledging that capital might be expended in the acquisition of a right or entitlement to income, both judicial bodies inclined to the view that as consideration for the transfer of capital property the payment was of a capital nature notwithstanding that the royalties would be payable so long as the land was worked for minerals. The result in Wilder is thus easily reconciled with the decision in Spooner. It should be noted, however, that 'royalties' were not specifically brought into charge in Spooner.

As a result of the Spooner case, the government enacted the predecessor of paragraph 12(1)(g) which brought into charge as income "rents, royalties or other like periodical receipts which depend upon the production or use of any real or personal property, notwithstanding that the same are payable on account of the use or sale of any such property".

This working was subsequently considered in Wain-Town Gas & Oil [[1952] C.T.C. 147] (1952) 2 S.C.R. 377 where the taxpayer assigned to another company its franchise to supply a town with natural gas. The consideration for the assignment was that the respondent was to be paid monthly "by way of royalty" a percentage of the gross sales of gas.

Mr. Justice Locke, who dissented, held that "the word 'royalty' does not describe, or extend to, a payment such as stipulated for in this case, where the payment is made as part of the purchase price of the outright sale of personal property transferred without reservation". the majority judges, Rinfret C.J.C., Kerwin, Tascherau, and Rand, J.J., however all inclined to the view that the payments made, though in consideration for the sale of a capital assets, were within the meaning of the word "royalties". If we accept the results in Spooner and Wilder it would seem to follow that the royalties, being in consideration of the sale, were on account of capital.

This result would seem to be correct inasmuch as a royalty differs from rent as involving a consumption or partial realization of capital property rather than as merely yielding a return in the form of income from property. In mining leases where the soil consists of minerals, the minerals are not just used but are taken away (see Greville - Nugent v. Mackenzie (1900) A. C. 83), and where any profit a prendre is granted in return for a portion of the value of what is taken, the grantor has effectively disposed of an interest in land which is real property. Thus, it may safely be said that a 'royalty' can be a capital sum according to ordinary usage, though it is absolutely clear that it can also be a use payment entirely of an income nature to the recipient.

Canada - U.S. Convention -ART. II, XI, Protocol ART. 6(a)

These characterizations are significant in interpreting the expression 'rents and royalties' as defined in the Protocol to the Canada - U.S. Convention and the word 'royalties' in paragraph 212(1)(d) of the Income tax Act. A problem area implicating these provisions arises where a non-resident disposes of capital property in exchange for a 'royalty'. The question is whether such payments are 'royalties' for the purposes of the Convention to gains from the sale or exchange of capital assets within Article VIII of the Convention. It is apparent that any such payments would be subject to withholding either under paragraph 212(1)(d) of the Act (as 'royalties') or under subparagraph 212(1)(d)(v).

By virtue of Article 6(a) of the Protocol to the Canada-U. S. Convention, royalties are defined as including royalties arising from any interest in real or personal property. It is doubtful that royalties paid in consideration of the sale of capital property are "from an interest" in any such property. In addition, it is well to take stock of the comments of Thurlow J. in the Saint John Shipbuilding case [[1980] C.T.C. 352] 80 DTC 7261. Although the definition is inclusive, Thurlow J. opined as follows:

That definition appears to be intended to expand the scope of what would be covered by the ordinary meaning of rentals and royalties but seems to me that the expansion is not in the meaning of the words but is by reference to the sorts of things in respect of which the rentals and royalties are paid. The expression is to include "rental or royalties" from leasing both real or immovable and personal or movable property (all apparently of a corporeal nature) and is to include as well "rentals or royalties" for the use of or for the privilege of using a list of items of incorporeal property. Nowhere, however, is there any wording which could have the effect of expanding the definition by including payments that do not have the characteristics ordinarily associated with rental or royalties.

Although I would question the judge's interpretation of the effect of the word "include" in the definition, his dictum obviously presents problems in treating part of the consideration for the transfer of a capital asset as a 'royalty' for the purposes of the Convention. In view of the results in Spooner and Wilder, in which it was held that such proceeds or consideration are on capital account, the difficulty is compounded by Thurlow J.'s further comments:

It seems to me as well that the repetition of the expression "rental or royalties" in the definition, which, with defence, appears to me to have an unusual grammatical construction, indicates that the authors had in mind that what was being dealt with was the taxation of income, as opposed to capital and that the expression "rentals or royalties" is used, rather than "any payment", in order to ensure that no payment that would not have the characteristics of "rentals or royalties" would be included.

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