3 August 1994 External T.I. 9108855 - WITHHOLDING TAX COMPUTER SOFTWARE ROYALTIES

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.

Principal Issues: Whether payment in respect of copyright in respect of production and reproduction

Position TAKEN: Substance of transactions was the acquisition of copies for a fee. Therefore payment was not in respect of copyright in respect of production and reproduction.

Reasons FOR POSITION TAKEN: Substance over form of arrangement.

910885
XXXXXXXXXX O. Laurikainen

Attention: XXXXXXXXXX

August 3, 1994

Dear Sirs:

Re: Computer Software Payments to a Non-resident

This is in reply to your letter concerning the above subject matter. We apologise for the delay in replying.

Unless as otherwise stated all references to statute are to the Income Tax Act S.C. 1970-71-72,c.63 as amended consolidated to June 10, 1993 (the "Act").

You inquired whether payments made by a Canadian subsidiary ("Canco") to its United States parent (USco) qualifies for the exemption from Part XIII withholding tax set out in subparagraph 212(1)(d)(vi) of the Act. You provide the following hypothetical fact situation:

1) Pursuant to a license agreement between USco and Canco, Canco has obtained from USco the right to produce or reproduce computer software. Canco pays USco a royalty for this right based on the number copies of software made.

2) Canco has entered into a services agreement with USco, under which Canco has subcontracted to USco the physical reproduction of the software. USco acts as a contract manufacturer for Canco in respect of the physical reproduction of the software and bills Canco at cost plus a small mark up. USco will ship the software either to Canco for its inventory or to the Canadian customers of Canco.

In our view the substance of the above arrangement would appear to be one whereby Canco is acquiring copies of the software manufactured by USco for a fee equal to the royalty referred to in paragraph 1 above plus the charge for paid for each copy referred to in paragraph 2 above. Accordingly, it is our view that neither amount would be in respect of copyright in respect production or reproduction of the software by Canco and such amounts would not benefit from the exemption from Part XIII withholding tax set out in subparagraph 212(1)(d)(vi) of the Act. Details of actual facts and agreements would have to be examined to determine the withholding tax consequences of such an arrangement.

We would draw your attention to the following positions reached by the Department as result of a recent study of computer software arrangements:

(a) It is the Department's view that a payment to a non-resident for the use of, or the right to use, a custom computer software program for a period of indefinite duration is a payment for the use of or the right to use, a secret formula or process and is subject to tax under subparagraph 212(1)(d)(i). It is our understanding that Canada has no bilateral agreements presently in force wherein such payments are exempted from tax. In this respect we note that the Department of Finance announced as part of the 1993 Budget that it intends to negotiate on a bilateral basis exemptions from this tax. The Protocol to the Income Tax Convention between Canada and the Netherlands contains such an exemption. When that Protocol enters into force, its provisions will have effect for taxes withheld at source with respect to amounts paid on after the first day of January 1993.

(b) The Department will treat a transaction whereby a non-resident grants a resident of Canada the right to use packaged or shrink-wrap computer software as a sale of tangible goods. Furthermore, the Department takes the view that Part XIII of the Act does not apply to the proceeds received by a non-resident from a resident of Canada in respect of such transaction. Shrink-wrap software may generally be distinguished from custom software through examination of the license agreement. Shrink-wrap software is normally associated with a general license agreement which does not name the licensee or the fee to be paid for the software. Such fee would normally be set out separately on an invoice. Custom software on the other hand is generally licensed pursuant to an agreement which specifies the licensee and the fee to be paid (lump sum or otherwise) for the use of the software.

(c) It would be necessary to review the relevant agreements to make a determination whether a payment is for the right to distribute. In the Department's experience where such a determination has been made, the payment to a non-resident for the right to distribute computer software is generally taxable under paragraph 212(1)(d). However, where such payment is made to a resident of country with which Canada has an income tax convention, the provisions of the convention must be examined to determine whether such payment is exempted from tax in Canada. In this respect it is the Department's view that such payments made to a resident of the United States would not fall under the definition of "royalties" in Article XII of the Canada-U.S. Income Tax Convention (1980) (the "Convention") and would therefore be exempted from tax in Canada under Article VII of the Convention unless the related income is attributable to a permanent establishment (as defined in Article V of the Convention) the United States resident has in Canada.

It should be noted that a distributor of computer software may act as agent for the non-resident. The relevant agreements must be examined to determine whether this is the case. Where a distributor is acting as agent for a non-resident and such agent is not deemed to be a permanent establishment of the non-resident, a payment made to the agent will be treated under Part XIII of the Act as if had been made to the non-resident. If the amount paid is one to which withholding tax applies (e.g. a payment for the use of, or the right to use custom computer software) and it has been paid to the agent without the appropriate Part XIII withholding being made then the agent is required to withhold.

Yours truly,

for Director
Reorganizations and Foreign Division
Rulings Directorate
Policy and Legislation Branch