2014-0539631I7 Restrictive Covenants-Part XIII (Luxembourg)

Principal Issues: Whether the Convention Between the Government of Canada and the Government of the Grand Duchy of Luxembourg provides for a reduction of the rate imposed under Part XIII of the Act, for a payment made to a resident of Luxembourg, in respect of a "restrictive covenant" as defined by subsection 56.4(1) of the Act.

Position: No

Reasons: In our view, provided that the payment meets the definition of “restrictive covenant” as defined under subsection 56.4(1) of the Act, the income would be subject to Part XIII tax under paragraph 212(1)(i) of the Act. The Convention Between the Government of Canada and the Government of the Grand Duchy of Luxembourg indicates in Article 21 that “other income” is taxable only in Luxembourg unless that income is derived from sources within Canada, in which case, the payment may also be taxed in Canada. The income, in this fact pattern, is derived from a source in Canada and is therefore subject to Part XIII tax at a rate of 25% with no relief available under the Treaty.

Author: Storr, Keely
Section: Subsection 56.4(1) "restrictive covenant" and paragraph 212(1)(i) of the Act; Articles 7 and 21 of the Convention between the Government of Canada and the Government of the Grand Duchy of Luxembourg

                                                                                                                                November 20, 2014

HEADQUARTERS                                                                                                  HEADQUARTERS
Compliance Programs Branch                                                                                Income Tax Rulings Directorate
Specialty Audit Division                                                                                          International Division
Attention:  Claudio DiRienzo                                                                                   K. Storr
                                                                                                                               (613) 957-8284

                                                                                                                               2014-053963

Restrictive Covenant Payment to a Resident of Luxembourg

We are writing in response to your email dated July 11, 2014, in which you have asked for our opinion with respect to the application of Part XIII of the Income Tax Act (Act) to a payment in respect of a “restrictive covenant” made to a resident of Luxembourg.
In our view, provided that the payment from XXXXXXXXXX (CanCo) to XXXXXXXXXX (LuxCo) meets the definition of “restrictive covenant” under subsection 56.4(1) of the Act, the payment would be subject to Part XIII tax under paragraph 212(1)(i) of the Act at a rate of 25%. The Convention Between the Government of Canada and the Government of the Grand Duchy of Luxembourg (Treaty) indicates in Article 21 that other income is taxable only in Luxembourg unless the other income is derived from sources within Canada, in which case, the payment may also be taxed in Canada. In the current fact pattern, the income is derived from a source in Canada and the payment is therefore subject to Part XIII tax at a rate of 25%, with no relief available under the Treaty.
Facts:
Based on the information you submitted, our understanding of the basic facts is as follows:
*     LuxCo is a resident of Luxembourg for purposes of the Treaty;
*     CanCo is a resident of Canada for tax purposes;
*     CanCo and LuxCo held shares of XXXXXXXXXX (SubCo);
*     The shares of SubCo held by CanCo and LuxCo are sold to XXXXXXXXXX (BuyCo) pursuant to a share purchase agreement (SPA);
*     The shares of SubCo which were held by LuxCo were considered to be a capital investment, according to LuxCo’s representative (Representative);
*     CanCo and LuxCo also entered into a second agreement, referred to as the “Letter Agreement”, which provided that CanCo would pay LuxCo a certain amount dependent on certain “post-closing cash savings”;
*     A payment in satisfaction of the Letter Agreement was made to LuxCo by CanCo and CanCo withheld 25% of the payment on the premise that the payment met the definition of a “restrictive covenant” as defined in subsection 56.4(1) of the Act;
*     LuxCo does not have a permanent establishment in Canada, as per the Representative; and
*     LuxCo is requesting a refund of the amounts withheld based on Article 7 or Article 21of the Treaty.
Issue:
The issue is whether the Treaty provides for a reduction of the rate imposed under Part XIII of the Act, for a payment in respect of a "restrictive covenant" as defined by subsection 56.4(1) of the Act, made by CanCo to LuxCo.

Taxpayer’s Position:

LuxCo is requesting a refund of the withholding taxes which, the Representative maintains, were incorrectly remitted, on their behalf, by CanCo. The remittance to the Canada Revenue Agency (CRA) by CanCo was on the basis that the payment made to LuxCo was in respect of a “restrictive covenant”, as defined in subsection 56.4(1) of the Act and therefore subject to withholdings pursuant to paragraph 212(1)(i) of the Act.

The Representative is requesting the refund on the basis that the payment qualifies for relief by application of the Treaty. Their position is that the payment is exempt from Canadian tax by application of paragraph 1 of Article 7 of the Treaty as the payment amount constitutes profits of LuxCo, and LuxCo does not have a permanent establishment situated in Canada through which it carries on a business. Alternatively, if Article 7 of the Treaty does not apply, the Representative asserts that the payment is other income and qualifies for exemption from Canadian tax, under paragraph 1 of Article 21 of the Treaty because it is not derived from sources within Canada.

Compliance Programs Branch – Specialty Audit Division Position:

Your view is that the payment of an amount in respect of a “restrictive covenant” does not represent business income and cannot be considered to be profits from a business as purported by the Representative. Therefore, the provisions of Article 7 of the Treaty, regarding business profits and the requirement therein for LuxCo to have a permanent establishment in Canada in order for it to be taxable in Canada, are not applicable. In addition, since it appears that the payment, as per the Letter Agreement, was made by CanCo, a Canadian resident company, the payment was derived from sources in Canada. Therefore, the provisions of Article 21 of the Treaty do not provide LuxCo any reduction in withholding rates under Part XIII of the Act.

Our Comments:
The definition of a “restrictive covenant”, found in subsection 56.4(1) of the Act, is very broad and can apply to many types of agreements. Provided that the payment under the Letter Agreement made from CanCo to LuxCo qualifies as a payment in respect of a “restrictive covenant”, it would be subject to a 25% withholding tax rate as per paragraph 212(1)(i) of the Act. The Representative argues that since the first sentence of paragraph 1 of Article 7 of the Treaty uses the term “profits” rather than the term “business profits” it applies to all profits, and not only business profits, of the enterprise. However, it is our view that Article 7 of the Treaty applies to only “Business Profits”.
For Article 7 of the Treaty to apply so as to deny Canada the right to tax the amount, as the Representative suggests, the restrictive covenant payment must constitute profits of an enterprise of a contracting state. The word “enterprise” is not specifically defined in the Treaty, however, it is defined in paragraph 1(c) of Article 3 of the OECD Model and the OECD Model provides that the term “enterprise” applies to the “carrying on of any business”. Therefore, it is our view that the reference to “profits of an enterprise” in this situation means profits from carrying on a business.
The Representative has not provided any explanation or rationale that would suggest that the payment in respect of a “restrictive covenant” is income from a business carried on by Luxco. Moreover, the Representative has indicated that the shares of SubCo were held by LuxCo on account of capital, so we have no reason to believe the payment in respect of a “restrictive covenant” constitutes income from a business.
If the payment in respect of a “restrictive covenant” does not form part of the profits of LuxCo from carrying on a business, then Article 7 of the Treaty would not apply, and Canada would not be precluded by Article 7 from taxing the payment under Part XIII.
Article 21 of the Treaty applies to any income not addressed in the other articles of the Treaty. This article provides that other income of a resident of Luxembourg, wherever arising, shall be taxable only in Luxembourg, except if that income is derived from sources within Canada, then it may also be taxed in Canada.
Based on the limited information provided, it is our view that the income of LuxCo in respect of the restrictive covenant is derived from sources within Canada for the purpose of Article 21.  Our view is grounded on the following considerations.  Firstly, the person who made the payment to Luxco under the Letter Agreement (i.e. CanCo) is a resident of Canada.  Secondly, the Letter Agreement is in respect of a sale of shares of a Subco which is a corporation resident in Canada.   Thirdly, the Letter Agreement and the SPA are both governed by the laws of XXXXXXXXXX.
In summary, the payment in respect of a “restrictive covenant” from CanCo to LuxCo is subject to Part XIII tax at a rate of 25% with no relief available by application of the Treaty.
We trust our comments will be of assistance.
Yours truly,

Olli Laurikainen, CPA, CA
For Director
International Division
Income tax Rulings Directorate

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