In 2013, Canada enacted the restrictive covenant rules
(rules) in response to court decisions that found that payments
received for entering into a non-competition agreement (NCA)
were not income from a source and therefore not taxable in
Canada. Under the rules, receipt of a payment for a
'restrictive covenant' is generally included in income or
subject to Canadian withholding tax when made to a
non-resident. Tax practitioners have voiced concerns that the
rules are too broad and potentially apply to payments made in
contexts other than NCAs. The Canada Revenue Agency (CRA)
adopted a broad interpretation of the rules when it recently
applied them to a cross-border upfront fee in the context of a
distribution agreement (see Canada: Of royalties, restrictive
covenants and the revenue, July 12 2018).
The rules were recently applied for the first time by the
Tax Court of Canada in Pangaea One Acquisition
Holdings, in which the court also adopted a relatively
broad interpretation of the rules. Pangaea, a Luxembourg
company, owned shares of a Canadian company (target) together
with two Canadian shareholders and had a veto right on any
transfer of target's shares. Pangaea entered into an agreement
(agreement) with one of the Canadian shareholders (payer) under
which Pangaea agreed to execute a share purchase agreement in
consideration for a lump-sum payment payable by payer
(payment). The agreement provided that the payer would withhold
and remit Canadian withholding tax (25%), which the payer did.
Pangaea then applied for a refund of the withholding under
Article VII of the Canada-Luxembourg Income Tax Convention
(treaty). The CRA refused the refund request on the basis that
the payment constituted a restrictive covenant payment under
the rules and thus did not benefit from treaty relief.
The court confirmed that under the rules, an agreement, an
undertaking or a waiver of an advantage or right constitutes a
restrictive covenant if it affects, or is intended to affect,
the acquisition or provision of property or services, but
agreements or undertakings that dispose of a taxpayer's
property are specifically excluded from the rules' purview
(exception). The court determined that Pangaea implicitly
agreed to waive its right to block the transaction when it
agreed to enter into the share purchase agreement. The
agreement was found to have an 'obvious nexus' with the
disposition of target's shares and therefore affected the
disposition of such shares. The court concluded that the
exception did not apply as there was no evidence of a
conveyance or disposition of Pangaea's veto right –
Pangaea simply refrained from exercising its right.
In discussing the exception, the court did not address
whether a veto right constitutes 'property'. Arguably, the
broad definition of property (a right of any kind whatever)
under the Income Tax Act (Canada) could encompass such a right.
Moreover, although the case states that Pangaea applied for the
refund based on the treaty, the court's decision did not
discuss whether treaty relief was available.
The court's reasoning suggests that Pangaea could have
claimed the exception if it had structured the agreement as a
transfer of its veto right with clear evidence of a deed of
transfer or assignment. This decision represents a worrisome
development as to how broadly the rules can be interpreted and
is a reminder that careful tax planning is needed when
negotiating cross-border transactions.
The decision is still under appeal.
Jean Marc Gagnon (email@example.com) and Julia Qian Wang (firstname.lastname@example.org)
Blake, Cassels & Graydon
Tel: +1 514 982 5025 and +1 514 982 4052