International Tax Review is part of the Delinian Group, Delinian Limited, 8 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 00954730
Copyright © Delinian Limited and its affiliated companies 2023

Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement

Beware of Canadian withholding tax and the breadth of the restrictive covenant rules

AdobeStock_130972011_beware

Under Canadian 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.

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.

more across site & bottom lb ros

More from across our site

An intense period of lobbying and persuasion is under way as the UN secretary-general’s report on the future of international tax cooperation begins to take shape. Ralph Cunningham reports.
Fresh details of the European Commission’s state aid case against Amazon emerge, while a pension fund is suing Amgen over its tax dispute with the Internal Revenue Service.
The OECD’s rules may be impossible for businesses to manage, according to tax experts from companies including Shell.
The UK government is now committed to replacing the ‘super-deduction’ with a 100% capital allowances regime to offset the impact of the corporate tax rise to 25%.
Corporate tax is set to rise in the UK for the first time in decades, but the headline rate remains historically low despite what many observers think.
President Joe Biden’s nominee is set to be confirmed as IRS commissioner for a five-year term.
British companies are waiting to hear the details of what will replace the 130% ‘super-deduction’ next week, while Spain considers stopping a major infrastructure company moving to the Netherlands.
President Joe Biden wants to raise corporate tax and impose a higher stock buyback tax on US businesses, but his budget proposal faces insurmountable obstacles in Congress, writes Ralph Cunningham.
EY is still negotiating the terms of the plan to split its audit and consulting functions, but the future of tax services is reportedly a sticking point.
Country-by-country reporting is the best option for safe harbour provisions under the global anti-base erosion rules, according to tax directors at companies including Standard Chartered Bank and Pernod Ricard.