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.