Avoiding Canadian Tax when Licensing Software into Canada

By Patrick Westaway

When software companies license or “sell” into Canada from abroad, there is often some leeway in how they allocate their fees between the license itself and related services. How that allocation is made results in very different tax consequences and so should be taken into account in the early planning stages.

In short, license fees, aka royalties, for the use of software are exempt from Canadian tax under certain tax treaties. So, for example, royalties are not subject to Canadian tax when paid to the U.S., the U.K., France, Germany or the Netherlands. Royalties are, however, subject to Canadian tax when paid to India or Barbados. In each case, the relevant treaty provision speaks to a recipient that is both resident in the particular jurisdiction and which beneficially owns the royalties such that one cannot simply route the royalties through shell companies to access an exemption.

In contrast, fees for services are subject to 15% withholding. This imposes an administrative burden on the Canadian customers and a cash flow burden on the service provider, who must then wait until the following year to either claim a Canadian refund if (a) another treaty exemption applies and (b) it files a Canadian tax return or, alternatively, claim foreign tax credits in the home jurisdiction.

For the purposes of this discussion, fees for services includes fees for all services, which includes configuration and set up as well as subsequent technical support. Some software companies charge a fee for these services while others do not, making it up on the license. Certainly, such decisions are driven by various factors, not the least of which are the practices of competitors. In a given market, a lower implementation cost or lower royalty could be determinative in landing the customer. Any number of real world elements factor in, and for each scenario, different tax solutions apply. That said, the simplest and most effective tax strategy is more often than not a simple fee reallocation.

As a final remark, it should be noted that transfer pricing considerations would not apply to arm’s length transactions, such as with customers. Transfer pricing rules apply to cross-border transactions to ensure that a given jurisdiction is not cheated of tax revenues by under- or over-charging between related parties. In such cases, jurisdictions typically have the statutory authority to tax parties based on what they should have charged rather than on what they actually did charge. Where, however, the parties are unrelated, such as contemplated above, parties are free to negotiate fees as their interests dictate without fear of interference from the tax authorities.