Article 12.1 and 12.2

12.1 Introduction

The article on royalties accords to both Canada and the U.S. the right to each Contracting State to tax its residents on royalty income received by those residents. The article generally limits the taxation by the source country to maximum rate of 10 percent, unless one of the exemptions applies.

12.2 Overview of the Canadian Domestic Taxation of Royalties

Article XII of the Treaty deals with the cross-border tax treatment of royalty payments. In terms of payments made by Canadian residents to U.S. residents, the first matter to consider is whether the payment falls within the scope of rent or royalties, or similar payments, under Canadian domestic tax principles.

If a payment does fall within the scope of paragraph 212(1)(d), then the payment will be subject to the part XIII withholding tax regime as modified by the Treaty. The Treaty is a “relieving” process that will apply if the recipient of the payment is a resident of the United States for purposes of the Treaty. In particular, Article XII of the Treaty will reduce the 25 percent tax rate imposed by Part XIII to a rate of either 10 percent or , in certain cases, to nil.

12.2.1 Rent and Royalties Paid to a Non-Resident

As a general rule, pursuant to Part XIII of the Act, every non-resident person is liable to pay an income tax of 25 percent on every amount that a person resident in Canada pays, credits, or is deemed to pay or credit, to the non-resident person as, on account or in lieu of payment of, or in satisfaction of, payments rent, royalty or similar payments.

The payments of rents and royalties would be distinguished from the outright sale of property. What constitutes a sale is a mixed question of law and fact. As a general observation, in the course of a sale an owner disposes of all her legal rights in the property and does not retain any interest therein. Where a property remains vested in the owner or encumbered by a reversionary interest or any other property rights in the favour of the owner, the payment, including a lump-sum payment, may be considered to be rent or royalty.

12.2.1 (a) Definition of Rent and Royalties

The terms “rent” or “royalties” are ot expressly defined in the Act and regards should be had to the meaning given to these terms under Canadian law.

12.2.1 (b) Similar Payments Treated as Rent and Royalties

Even when a particular payment does not meet the broad legal definition of “rent” or “royalty”’ such a payment may still be subject to the Part XIII withholding tax as a payment similar to rent or royalty.

12.2.1 [c] Payments For the Use of Property Not Subject to the Part XIII Tax

The following payments made to a non-resident in respect of the use of property are not subject to the Part XIII withholding tax:

• A royalty or similar payment on or in respect of a copyright in respect of the production or reproduction of any literary, dramatic, musical or artistic work.
• A payment in respect of a short-term use by a railway company or a common carrier of property that is railway rolling stock.
• A payment made under bona fide cost sharing arrangements under which the person making the payment shares on a reasonable basis with one or more non-resident persons research and development expenses in exchange for an interest or a right in any property resulting from such arrangements.
• A rental payment for the use of or the right to use outside Canada any tangible or corporeal property.
• Any payment of rent or royalties made to an arm’s length person, but only to the extent that the particular amount is deductible in computing the payor’s Canadian income tax liability in respect of a business carried on in foreign country.
• A payment made to an arm’s length person for the use of, or the right to use, an aircraft, attached equipment, aircraft spare parts, and certain navigational equipment.
• Payment for a right in, or to the use of, a motion picture film, a film, videotape or other means other than the payments for the use of reproduction.

12.2.1 (d) Payments under Mixed Contracts

The taxpayer may be contractually obliged to make a payment under a “mixed contract” or “package fee” that encompass compensation for services, use of property, and other items supplied to the payor by the taxpayer.

12.2.1 [e] Sale of Property

Generally, from a tax perspective it may be more advantageous for a non-resident owner and a Canadian acquirer of the property to treat the transfer of property as a sale rather than as a lease or rental arrangement.

12.2.1 (f) Rents and Royalties Received in the Course of Carrying on Business in Canada

Pursuant to the Act, payments enumerated in Part XIII of the Act, including amounts paid in respect of rents, royalties or similar payments, are subject to the Part XIII withholding tax unless an amount can reasonably be attributed to a business carried on by the non-resident through a permanent establishment in Canada.

Whether a taxpayer has received such payments in the course of her carrying on business in Canada is a question of fact, the determination of which may depend on many factors, such as the level of activities, number or personal employed by the taxpayer, and amount of time extended by the taxpayer to manage a particular property.

12.2.1 (g) Election to Treat Certain Rents as Business Income

Where a non-resident receives income in the form of rent on real property or timber royalties, which are otherwise subject to the Part XIII tax, the non-resident may elect under subsection 216(1) to pay income tax on the net income from these particular sources.

12.2.1 (h) Options to Acquire Property

A payment for an option to acquire property enumerated in paragraph 212(1)(d) and subsection 212(5) does not constitute a payment for the use of property and therefore should not attract the Part XIII withholding tax.

12.2.1 (i) Motion Pictures

In addition to the rents and royalties imposed under paragraph 212(1)(d) subsection 212(5) imposes a 25 per cent withholding tax in respect of any amount that a person resident in Canada pays to a non-resident for a right in, or to the use of, a motion picture film or video product that has been or is to be used or reproduced in Canada (other than used solely in connection with and as part of a news program produced in Canada).

All other payments for a right to the use of a motion picture film, videotape or other means of reproduction are not subject to the Part XIII withholding tax. Thus, payments to a non-resident for the use of a motion film outside Canada should not be subject to the Part XIII withholding tax.

12.2.1 (j) Withholding Obligations and Reporting Requirements

If a non-resident made an election under subsection 216(1) and desires to receive a refund in respect of taxes withhold under Part Xiii on rental payments, an individual may file Form T1; a non-resident corporation should file Form T2; and an estate should file Form T3 to claim a refund.

12.2.1 (k) Non-arm’s Length Payments

Canadian transfer pricing rules apply to all payments by a Canadian resident to a non-arm’s length non-resident. Very generally, the transfer pricing provisions in the Act are based on the premise that non-arm’s length parties should conduct their transactions under terms and conditions that would have prevailed if the parties had been dealing at arm’s length with each other.

The valuation of transactions involving a transfer of intangible properties presents a significant challenge due to the volatility of fair market value of such properties and special scrutiny given by the tax authorities to such transactions.

The transactions between the non-arm’s length persons may also be scrutinized by the CRA for potential violation of the GAAR.

12.2.1 (l) Taxation of Royalties, Rents and Similar income Received by a Canadian Resident

The payments in respect of rents and royalties generally constitute income from property. As such, the Canadian resident should include in her income the amounts of rent and royalties on account of ordinary income.

To more updates contact The Accounting and Tax.

References:

Advisor’s Guide to Canada – U.S. Tax Treaty

By:  Vitaly Timokhov, Raymond Montero, David Kerzner

Published by: Thomson Carswell