Back-to-Back Royalty and Character Substitution Rules

Editor’s note: Revised draft legislation issued on October 19, 2016, as this issue was going to press, is not reflected in this article. The main change from the July 29, 2016 draft legislation described below is to restrict the application of these rules to situations where either (1) the non-resident third party to the transaction is not dealing at arm’s length with the Canadian payer, or (2) one of the main purposes of the arrangement is to reduce part XIII tax.

The back-to-back royalty rules (subsections 212(3.9) and (3.91)) and royalty character substitution rules (subsections 212(3.92) and (3.93)) released in draft form on July 29, 2016 are effective as of January 1, 2017. Before that date, a Canadian payer of rent, a royalty, or a similar payment (referred to herein as a “royalty”) to non-residents should examine the governing contracts to see whether part XIII withholding tax obligations (under paragraph 212(1)(d)) are created by these rules.

The back-to-back royalty rules are intended to prevent the avoidance or reduction of part XIII royalty withholding through the interposition of a non-resident intermediary between the Canadian payer of the royalty and the non-resident payee. In such arrangements, the non-resident intermediary is located in a more favourable jurisdiction than the non-resident payee; in particular, the payee might be located in a jurisdiction with which Canada does not have a tax treaty or in which the treaty withholding rate is higher than it is in other countries. For example, there can be an exemption from withholding only under certain treaties for the rights to use patented information, information concerning scientific experiments, and computer software. The royalty character substitution rules ensure that the back-to-back rules apply regardless of whether or not the interposed arrangements are in the form of a licence, share issuance, or loan.

As currently drafted, the proposed rules apply even when the parties are dealing at arm’s length. They can also apply to commercial transactions in which there is no withholding tax avoidance purpose. There is little grandfathering; the rules apply to all royalty payments made after 2016.

In practice, after 2016 all payments of royalties to non-residents should be viewed as being subject to withholding tax at the domestic rate of 25 percent unless comfort to the contrary can be obtained. In certain cases, for example, the proposed rules could apply to royalty payments made by a Canadian for a licence of software from a non-resident licensor where the software had previously been purchased from a third-party non-resident seller and either (1) the licensor funded the purchase with a loan or share subscription, or (2) the purchase price included an earnout provision tied to the royalty revenues.

Where the rules apply, the licensor will be disregarded and the Canadian licensee will be treated for part XIII purposes as though it had instead paid the royalty to the lender, shareholder, or third-party seller, as the case may be. The Canadian licensee will then be required to remit withholding tax at the rates applicable to those parties instead of at the rate applicable to the licensor.

In instances where the Canadian licensee deals at arm’s length with the licensor, the licensee will not be in a position to know how and on what terms the software was acquired. Therefore, it will be prudent for all Canadian licensees entering into royalty agreements to request a representation from the licensor that the proposed rules do not apply. Parties to such agreements should determine how the risk of non-compliance with part XIII obligations (tax, penalties, and interest) should be allocated among them.

Depending on the bargaining power between the parties, such representations may be difficult to obtain—the licensor may not be willing to assume any Canadian compliance risk—and the Canadian payer may have to bear the burden of the additional 25 percent withholding.

The CBA-CPA Joint Committee on Taxation made submissions to Finance detailing these concerns on July 25, 2016, just prior to the release of the rules, and again on September 27, 2016 as part of the usual commenting process. It is hoped that revised rules will address the uncertainty and business risk noted above.

Laura Gheorghiu
Gowling WLG LLP, Montreal

Canadian Tax Focus
Volume 6, Number 4, November 2016
©2016, Canadian Tax Foundation