24 May 2011 External T.I. 2007-0246981E5 - Subsection 212(1)

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: Determination of the extent to which payments for rights to manufacture and sell trademarked product by Canadian resident to non-resident person will be subject to tax under paragraph 212(1)(d) where payments are calculated (subject to a minimum amount payable) as a percentage of sales of the product and sales are made to customers inside and outside of Canada.

Position: Full amount of payment is subject to tax under Part XIII of the Act.

Reasons: The amounts will constitute royalties within the meaning of paragraph 212(1)(d) and therefore it is not necessary to allocate usage of the rights in Canada for the purposes of subparagraph 212(1)(d)(i).

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									2007-024698
									J. MacGillivray
									(613) 957-2103
May 24, 2011

Dear Sir:

Re: Technical Interpretation Request - Subsection 212(1)

We are writing in response to your letter in which you requested our comments on the interpretation of subsection 212(1) of the Income Tax Act (Canada) R.S.C. 1985, c.1 (5th Supplement) (the "Act") in the context of the hypothetical situation described below.

You have asked us to consider a scenario in which a person who is not resident in Canada for the purposes of the Act (the "Non-Resident") grants the right to manufacture and sell a trademarked product to a person who is a resident of Canada (the "Resident"). The Resident manufactures the product in Canada and sells the product wholesale to customers throughout the world. In consideration for the grant of such rights, the Resident agrees to pay the Non-Resident the greater of an amount equal to a percentage of amounts invoiced to customers from sales of the product and a pre-determined fixed minimum amount.

You have asked to what extent subsection 212(1) would apply to require the Resident to withhold tax under Part XIII of the Act on payments made to the Non-Resident under the aforementioned arrangement. In this regard, you have suggested that a portion of the payment made based on sales of the product to customers situated outside of Canada is arguably not subject to tax pursuant to paragraph 212(1)(d) because the product will be sold and used outside of Canada.

Our Comments

Please note that it is not this Directorate's practice to comment on transactions involving specific taxpayers other than in the form of an advance income tax ruling. For more information about how to obtain a ruling, please refer to Information Circular 70-6R5, "Advance Income Tax Ruling", dated May 17, 2002. This Information Circular can be accessed on the Canada Revenue Agency's website, http://www.cra-arc.gc.ca. We are, however, prepared to provide the following general comments, which we trust will be of some assistance.

Subparagraph 212(1)(d)(i) of the Act states the following:

212. (1) Tax - Every non-resident person shall pay an income tax of 25% on every amount that a person resident in Canada pays or credits, or is deemed by Part I to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of,

(d) rent, royalty or similar payment, including, but not so as to restrict the generality of the foregoing, any payment

(i) for the use of or for the right to use in Canada any property, invention, trade-name, patent, trade-mark, design or model, plan, secret formula, process or other thing whatever...

The provision specifically provides that any payment made to a non-resident person by a person resident in Canada for the use of or for the right to use any property, invention, trade-name, patent, trade-mark, design or model, plan, secret formula, process or other thing whatever will be subject to tax under Part XIII of the Act. However, if an amount paid to a non-resident person constitutes a rent, royalty or similar payment, the amount need not fall within the wording of subparagraph (i) in order to attract withholding tax.

The terms "rent" and "royalty" are not defined in the Act. 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. 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 following definition of a royalty as stated in Vauban Productions v. The Queen [1975] CTC 511 (FCTD); 75 DTC 5371:

The term "royalties" normally refers to a share in the profits or a share or percentage of a profit based on user 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, [1999] 1 CTC 2512 (TCC); 98 DTC 2129, 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."

In the circumstances you have described above, it is our view that a payment made by the Resident to the Non-Resident would constitute a payment of a royalty for the purposes of paragraph 212(1)(d). The payments in question are clearly in consideration for obtaining the rights to manufacture and sell the product and are based on a share of the profits that the Resident will realize from using such rights. Although the arrangement specifies that there is a minimum amount payable to the Non-Resident regardless of the level of sales of product by the Resident, it is our view that the payment will possess the requisite element of contingency since the amount payable by the Resident will not be ascertainable until the end of the period in which the level of the Resident's sales of the product are calculated. Until that time, it will not be certain whether the amount payable to the Non-Resident will be the minimum amount or the greater amount based on the percentage of sales by the Resident. Furthermore, while the commercial description of an amount as a "royalty" is not determinative of its characterization for the purposes of the Act, we note that, as a matter of commercial practice, it is not uncommon for amounts referred to as royalties to provide for a minimum payment obligation. The following court decisions provide illustrations of such royalty arrangements: Shaw v. Shaw, 2006 CanLII 13776 (ONSC), Erck Eckrohrkessel GmbH v. CET Energy Systems Inc. 1995 CanLII 1592 (BCCA), 1994 CanLII 3000 (BCSC), and Mechanical Pin Resetter Co. Ltd. v. Canadian Acme Screw & Gear, Ltd. [1971] S.C.R. 628.

Having concluded that the amounts in question will be royalties for the purposes of paragraph 212(1)(d), it is not necessary to consider the extent to which the rights granted to the Resident are used outside of Canada for the purposes of subparagraph 212(1)(d)(i). Without taking into account the potential application of an income tax treaty, the full amount of the payments to the Non-Resident will be subject to tax under Part XIII unless one of the exclusions in subparagraphs 212(1)(d)(vi) to (xi) applies to the payments. In this regard, we note that subparagraph 212(1)(d)(x) may be relevant in the above circumstances, which exempts any payment made to a person with whom a payer deals at arm's length, to the extent the amount is deductible in computing the income of the payer under Part I of the Act from a business carried on by the payer in a country other than Canada. However, where a taxpayer resident in Canada manufactures a product in Canada and sells the product on a worldwide basis, we would not agree that the taxpayer would be considered to carry on business outside of Canada for the purposes of subparagraph 212(1)(d)(x) solely because a portion of the sales of the product are made to customers who are not situated in Canada.

Our comments are provided in accordance with the practice outlined in paragraph 22 of Information Circular IC-70-6R5.

Yours truly,

for Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch