Beneficial Ownership Test For Tax Treaty Benefit Entitlement

November 2012 | William J. Fowlis, Regan A. O’Neil

In Velcro
Canada Inc. v. Her Majesty the Queen
 (2012 TCC 57), the Tax Court of Canada (the “TCC”) applied
the test of beneficial ownership as established by the Federal Court of Appeal
in Prévost Car Inc. v. Canada (2009 FCA 57) for purposes of determining tax treaty benefit entitlement in
respect of royalty payments instead of dividends, as was the case in Prévost.  The TCC also considered in the Velcro case the concepts of agency,
nominees and conduits.

Factual
Background

In 1987, Velcro Canada Inc. (“VCI”) entered
into a licensing agreement with Velcro Industries BV (“VIBV”) for the use of
Velcro brand fastener technology in Canada (the “First License Agreement”).
From 1987 to October 1995, VCI paid royalties to VIBV.  During that period, VIBV was a resident of
the Netherlands and VCI withheld Canadian taxes from royalty payments at
applicable rates in accordance with the Canada-Netherlands
Tax Convention
(the “Tax Treaty”).

The Velcro group of companies was reorganized
on October 26, 1995 and as a consequence VIBV became a resident of the
Netherlands Antilles. On October 27, 1995, VIBV entered into an assignment
agreement with Velcro Holdings BV (“VHBV”), a resident of the Netherlands, and
assigned its rights and obligations in connection with the First License
Agreement to VHBV (the “First Assignment Agreement”).  As a result of this assignment, VCI was
required starting on October 27, 1995 to pay royalties to VHBV under to the
First License agreement but subject to the First Assignment Agreement.

VCI continued to withhold Canadian taxes from
royalty payments to VHBV at applicable rates in accordance with the Tax Treaty
but ceased to make such withholdings after 1998 when the withholding tax rate
was reduced from 10% to 0% under the Tax Treaty.  Canada and the Netherlands Antilles do not
have a tax treaty such that, if the royalty payments had been made to VIBV
instead of VHBV, the Canadian withholding tax rate on such payments would have
been 25%.

VIBV and VCI entered into a new license
agreement on October 1, 2003, which superseded the First License Agreement (the
“Second License Agreement”). On the same day, the Second License Agreement was
assigned by VIBV to VHBV (the “Second Assignment Agreement”).  There was no change in the flow of royalty
payments by VCI to VHBV for the use of VIBV’s intellectual property under the
Second Assignment Agreement.  The terms
and conditions of the Second License Agreement and Second Assignment Agreement
were similar to the First License Agreement and First Assignment Agreement.

These license agreements allowed VCI to use
VIBV’s intellectual property in the manufacturing and selling of fastening
products in exchange for royalty payments while VIBV maintained ownership of
the intellectual property. In particular, VCI was granted the right to
manufacture, sell, and distribute the licensed products and the right to use
the licensed trademark in relation thereto.

Under the assignment agreements, VHBV was
assigned the right to grant licenses for VIBV’s intellectual property to VCI in
exchange for royalty payments to VIBV and by operation of the assignment
agreements VHBV became licensor of this intellectual property to VCI.  The amount of royalty payments by VHBV to
VIBV under the assignment agreements was equal to 90% of the royalties received
under any licensing agreement from VCI and were payable within 30 days of
receiving royalty payments from VCI.

TCC Analysis
and Decision

The issue considered in this case was
whether the beneficial owner of the royalties paid by VCI was VIBV (a resident
of the Netherlands Antilles at the relevant time) or VHBV (a resident of the
Netherlands at the relevant time). The consequence of a determination that VIBV
was the beneficial owner of VCI’s royalty payments under the assignment
agreements is that VCI would have been liable for Canadian withholding tax at
the rate of 25% rather than 10% until it was reduced to 0% if the beneficial
owner was VHBV.

The main arguments of the Minister were
that VHBV did not beneficially own the royalties, VHBV was an agent or a
conduit, and that VHBV did not exercise the “incidences of ownership” in
respect of the royalties as required under the beneficial ownership test
established in Prévost. The position
of VCI was that VHBV was the beneficial owner of the royalties paid by VCI in
accordance with this test and that there was no evidence of an agency or
nominee relationship or that VHBV was acting as a conduit in respect of VIBV
and the royalties paid by VCI.

The argument put forth by the Minister that
VHBV was acting as an agent for VIBV was rejected by the TCC.  The crux of the TCC’s reasoning for why an
agency relationship was not present was that VHBV did not have the capacity to
affect the legal position of VIBV. The fundamental element of their
relationship, as governed by the assignment agreements, was that in
consideration of VHBV licensing certain of VIBV’s intellectual property, a fee
equal to 90% of the royalties received in respect of the licensing was to be
paid by VHBV to VIBV.

The TCC also considered whether or not VHBV
was acting as a conduit or nominee vis-à-vis VIBV.  The TCC referred to the dictionary
definitions of the terms “nominee” and “conduit”.  The term “nominee” means a person designated
to act in place of another, usually in a limited way while the term “conduit”
means a person or organization. . . through which anything is
conveyed.  The TCC found no evidence that
VHBV acted in any sort of limited way. 
Rather, the TCC found that VHBV acted on its own account at all times
subject to the assignment agreements. 
Evidence considered by the TCC in support of this position included the
fact that VHBV comingled the royalty payments received from VCI with its own
funds, VHBV transferred funds received as royalty payments to other accounts in
different currencies, and VHBV had no legal right to specific funds.

Turning to the principal issue of the case,
being the determination of beneficial ownership under the Prévost test, the Court articulated the test to be applied as
follows:

. . .
there are really four elements in considering the attribution of beneficial
ownership and those are: 
(a) possession; (b) use; (c) risk; and
(d) control.  The question therefore
is, did VHBV have possession, use, risk and control of the royalties from
VCI . . .

In applying this test, the TCC also showed
the same reluctance as the Federal Court of Appeal in Prévost in piercing the corporate veil and stated in this regard
that the “ the Court is not likely to pierce the corporate veil unless the
corporation has no discretion with regard to the use and application of the
funds.”

With respect to each of the four factors,
the TCC found as follows:

1. Possession: The TCC identified various ways in which
VHBV exercised dominion over the royalties received from VCI, which included,
in particular:

 (i) 
VHBV had exclusive possession
over the accounts into which the royalties were deposited;

  
(ii) 
the funds were sometimes
converted into different currencies and any interest earned thereon was for the
account of VHBV;

 (iii) 
VHBV did not require
instruction or permission in any particular application of the royalties;

  
(iv) 
the royalty payments were
co-mingled with the general funds of VHBV; and

  
(v) 
the amount of the royalty
payments by VCI to VHBV was different from the amount of the royalty payments
by VHBV to VIBV such that the royalties did not simply go in the bank account
and come out in an automated fashion.

2. Use:     Only 90% of the royalties received from VCI
were to be paid to VIBV and VHBV made use of the royalties received from VCI
for its operational and business needs including payment of expenses and
repayment of loans.

3. Risk:    The royalties received by VHBV from VCI were
available to its creditors and therefore were at risk of seizure like any other
assets of VHBV. The royalties received by VHBV from VCI were also subject to
currency risk to the extent they were converted to other currencies. There were
no indemnification provisions in any of the agreements which would have reduced
VHBV’s risks and exposure in relation to the royalty payments.

 4. Control: VIBV could enforce its
contractual right to payment under the assignment agreements but otherwise had
no control over the royalties received by VHBV from VCI.  Other elements of control were outlined in
the other factors.

Accordingly, the TCC concluded that VHBV
was the beneficial owner of the royalty payments made by VCI and therefore
entitled to the reduced withholding tax rate applicable to royalty payments
under the Tax Treaty.

It will be interesting to see how the
findings in the Velcro and Prévost cases will have an impact on
CRA’s assessing practices with respect to treaty shopping and whether CRA will
try to combat treaty shopping through other means such as negotiating
limitation on benefits and other anti-abuse provisions in tax treaties.

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