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Canada: Revised draft legislation introduces arm’s length exception to back-to-back rents and royalties rules

The Canadian Department of Finance has addressed certain industry concerns on the broader application of the proposals to extend the back-to-back (BTB) loan rules to rents and royalties.

Sabrina Wong

The 2016 Canadian federal budget proposed to significantly extend the scope of the BTB loan rules to apply to rents, royalties or similar payments and to "character substitution" transactions.

Initial draft legislation to implement these proposals was released for public comment by the Department of Finance on July 29 2016 (the July draft legislation). Following feedback, revised draft legislation was released on October 21 2016 (the October draft legislation), which addresses certain concerns with the potential application of the rent/royalty BTB rules and the related "character substitution" rules to bona fide arm's length commercial transactions.

The July draft legislation

The rent/royalty BTB rules contained in the July draft legislation would apply where there is a sufficient connection between the rents or royalties paid by a Canadian resident to an intermediary resident in a treaty country (the immediate licensor) and rents or royalties paid by the intermediary to a non-resident (the ultimate licensor), and if the ultimate licensor would have been subject to higher Canadian withholding tax than the immediate licensor if it had received the rents or royalties directly from Canada.

One way in which a sufficient connection would exist is where it can reasonably be concluded that the rent/royalty arrangement between the Canadian resident and the immediate licensor was entered into or permitted to remain in effect, either because the rent/royalty arrangement between the immediate licensor and the ultimate licensor was entered into or permitted to remain in effect.

If the rent/royalty BTB rules apply, the Canadian resident would be deemed to make a fictional rent/royalty payment to the ultimate licensor. The fictional payment would be subject to Canadian withholding tax at a rate equal to the difference between the rate that would apply to a payment made directly to the ultimate licensor and the treaty-reduced rate that actually applied to the payment made to the immediate licensor.

Because of the breadth of the sufficient connection test and because the ultimate licensor can be a person that deals at arm's length with (and can be unknown to) the Canadian resident, the rent/royalty BTB rules as drafted in the July draft legislation could potentially apply to bona fide arm's length sub-lease or sub-license arrangements where there is no intention to avoid or reduce Canadian withholding tax.

Similar issues exist under the related "character substitution" rules contained in the July draft legislation. For example, the "character substitution" rules could potentially apply to certain cross-border lease or royalty securitisation transactions.

The October draft legislation

The October draft legislation provides that where the ultimate licensor deals at arm's length with the Canadian resident, the rules would not apply if it cannot reasonably be concluded that one of the main purposes of the rent/royalty arrangement between the immediate licensor and the ultimate licensor was to reduce or avoid the Canadian withholding tax payable in respect of the amount paid by the Canadian resident or to avoid the application of the rent/royalty BTB rules.

A similar exception to the related "character substitution" rules is also proposed.

The explanatory notes in the October draft legislation indicate that this exception is intended to ensure that the rent/royalty BTB rules do not apply to ordinary, arm's length commercial transactions that do not have as one of their main purposes the reduction or avoidance of Canadian withholding tax that would otherwise be payable, or the avoidance of the BTB rules themselves.

While the new exception should go a long way towards addressing the potential application of the rules to a number of ordinary arm's length commercial transactions, it should be noted the facts and circumstances of each case will still need to be examined in order to determine whether or not "one of the main purposes" test is met.

Sabrina Wong (, Toronto
Blake, Cassels & Graydon LLP
Tel: +1 416 863 2645

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