On April 29, 2022, the Department of Finance released the long-awaited Legislative Proposals Relating to the Income Tax Act—Hybrid Mismatch Arrangements, together with explanatory notes (collectively, “the proposals”). The proposals generally target transactions and series of transactions that give rise to a “deduction/non-inclusion mismatch,” as contemplated by proposed subsection 18.4(6). Stakeholders are invited to provide feedback on the proposals by June 30, 2022. However, the proposals would apply to payments arising on or after July 1, 2022, including payments arising from arrangements entered into before that date (that is, the proposals do not provide for any form of grandfathering for existing arrangements). This article provides a broad overview of the proposals.
The proposals relate to the implementation of Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2—2015 Final Report (“the hybrids report”), published by the OECD on October 5, 2015. This relation is specifically stated in proposed subsection 18.4(2), which also provides that, unless the context otherwise requires, the rules “are to be interpreted consistently with that report, as amended from time to time.” This is a very novel approach to Canadian tax legislation; it effectively contemplates a legislative delegation to the OECD, which may be questionable from a Canadian constitutional perspective.
It should be noted that the proposals do not purport to implement all of the chapters of the hybrids report. In keeping with the announcement on this matter in the 2021 federal budget, the proposals are focused only on deduction/non-inclusion outcomes, not double deduction outcomes, and they mainly focus on hybrid financial instruments rather than a broader range of scenarios. At the same time, they depart from the hybrids report in targeting not only actual payments but also certain notional interest deductions in the absence of any payment.
There are three categories of arrangements to which the proposals would apply. In the definition of “hybrid mismatch arrangement” in proposed subsection 18.4(1), these categories are identified as
In all cases, a “payment” must “arise,” but there is a special rule in proposed subsection 18.4(9) that relates to “notional interest expense” on a debt that would be, or could reasonably be expected to be, in the absence of any “foreign expense restriction rule,” deductible in computing the “relevant foreign income or profits for a foreign taxation year” of a debtor. When this rule applies, the debtor is deemed to make a payment under the debt to the creditor in respect of the debt, in an amount equal to the deductible amount, and the creditor is deemed to be a recipient of such payment. The mismatch condition in proposed paragraph 18.4(10)(d) is also deemed to be satisfied.
A hybrid financial instrument arrangement is addressed mainly in proposed subsections 18.4(10) and (11). This category comprises situations where the payment (other than a payment under a substitute payment arrangement) arises under, or in connection with, a financial instrument. For the purposes of these rules, a “financial instrument” is broadly defined to mean a debt, an equity interest, or any right that may reasonably be considered to replicate a right to participate in profits or gain of any entity, or any other arrangement that gives rise to an equity or financing return.
The payment arising from such an arrangement must give rise to a deduction/non-inclusion mismatch, which in general is the key element of the proposed rules. Whether such a mismatch exists is determined under proposed subsection 18.4(6), which has an inbound category and an outbound category. In the inbound category, a payment gives rise to a deduction/non-inclusion mismatch if A exceeds B, where
A is the total of all amounts, each of which would, in the absence of this section, subsection 18(4) and subsection 18.2(2), be deductible in respect of the payment, in computing the income of a taxpayer . . . under [part I] for a taxation year (referred to in this paragraph as the “relevant year”), and
B is the total of all amounts each of which, in respect of the payment,(i) can reasonably be expected to be—and actually is—foreign ordinary income of an entity for a foreign taxation year that begins on or before the day that is 12 months after the end of the relevant year, or
(ii) is Canadian ordinary income of a taxpayer for a taxation year that begins on or before the day that is 12 months after the end of the relevant year.
The outbound category is similar, but inverted, such that a payment gives rise to a deduction/non-inclusion mismatch if C exceeds D, where
C is the total of all amounts, each of which, in the absence of any foreign expense restriction rule, would be—or would reasonably be expected to be—deductible, in respect of the payment, in computing relevant foreign income or profits of an entity for a foreign taxation year (referred to in this paragraph as the “relevant foreign year”), and
D is the total of all amounts, each of which, in respect of the payment,(i) would, in the absence of section 12.7, be Canadian ordinary income of a taxpayer for a taxation year that begins on or before the day that is 12 months after the end of the relevant foreign year, or
(ii) can reasonably be expected to be—and actually is—foreign ordinary income of another entity for a foreign taxation year that begins on or before the day that is 12 months after the end of the relevant foreign year.
The terms “Canadian ordinary income” and “foreign ordinary income” are defined in proposed subsection 18.4(1). Of particular note is the fact that “foreign ordinary income” is subject to a number of downward adjustments, including an adjustment whereby the income is subject to tax at a nil rate (or even a rate that is lower than the highest rate imposed by the relevant foreign country on such income), or is included in income because of a foreign hybrid mismatch rule—the latter reflecting the ordering rule in the hybrids report, which gives priority to a country’s deduction-denial rule (except for a rule that is substantially similar in effect to proposed subsection 113(5)).
The payer of the payment must not deal at arm’s length with, or must be a specified entity in respect of, a recipient of the payment, or the payment must arise under, or in connection with, a structured arrangement (discussed below). A specified entity is defined, essentially, by reference to a relationship that involves an ownership interest representing at least 25 percent of votes or value.
The final set of conditions in proposed subsection 18.4(10) are (1) that it can reasonably be considered that the deduction/non-inclusion mismatch arises in whole or in part because of a difference in the treatment of the financial instrument (or in the treatment of one or more transactions, either alone or together, where the transaction or transactions are part of a transaction or series of transactions that includes the payment or relates to the financial instrument) for tax purposes under the laws of more than one country that is attributable to the terms or conditions of the financial instrument (or transaction or transactions); or (2) that it can reasonably be considered that the deduction/non-inclusion mismatch would arise in whole or in part because of such a difference if any other reason for the deduction/non-inclusion mismatch were disregarded.
A hybrid transfer arrangement is addressed mainly in proposed subsections 18.4(12) and (13). Similar conditions apply in this regard—including, in particular, the condition that the payment under the hybrid transfer arrangement must give rise to a deduction/non-inclusion mismatch under proposed subsection 18.4(6)—although the targeted scenario is a bit different.
A payment is considered to arise under a hybrid transfer arrangement if the payment arises under, or in connection with, a transaction or series of transactions (referred to as the “transfer arrangement”) that includes a disposition, loan, or other transfer by an entity to another entity (the “transferor” and “transferee,” respectively) of all or a portion of a financial instrument (referred to as the “transferred instrument”); or arises under, or in connection with, the transferred instrument.
An additional condition is that it must be reasonable to consider that the deduction/non-inclusion mismatch arises (or would arise, if other reasons for the mismatch were disregarded), in whole or in part, for the reasons specified. If the payment arises as compensation for a particular payment under the transferred instrument, the reasons must be that (1) the tax laws of one country treat all or a portion of the payment as though it has the same character as, or represents, the particular payment, in determining the tax consequences to an entity that is a recipient of the payment but not of the particular payment; and (2) the tax laws of another country treat the payment as a deductible expense of another entity. In any other case, it must be reasonable to consider that the mismatch arises because
A substitute payment arrangement is addressed mainly in proposed subsections 18.4(14) and (15). Again, many of the conditions are similar in spirit to those for the arrangements described above, although they are extensively described in a page and a half of detailed drafting. It should also be noted that this category is not conditional on hybridity as such (that is, the mismatch need not be attributable to a difference in how two countries treat the arrangement—a difference based on the terms and conditions of the arrangement or a financial instrument).
The core descriptive conditions (in simplified form) for this kind of arrangement appear to be that
In brief, this seems to target situations where the amount of the underlying return or distribution from a transferred instrument received by a transferee exceeds the amount of ordinary income resulting from that receipt, or where the transfer would result in an avoidance of an ordinary income inclusion or of a hybrid mismatch arrangement regime.
Proposed subsection 18.4(5) provides an exception to the deduction-denial rule in proposed subsection 18.4(4) and the income-inclusion rule in proposed subsection 12.7(3) for payments under a structured arrangement. A “structured arrangement” is any transaction or series of transactions that meets the following criteria: the transaction or series includes a payment that gives rise to a deduction/non-inclusion mismatch, and it can reasonably be considered, having regard to all the facts and circumstances, including the terms or conditions of the transaction or series, that any economic benefit arising from the deduction/non-inclusion mismatch is reflected in the pricing of the transaction or series, or the transaction or series was otherwise designed to, directly or indirectly, give rise to the deduction/non-inclusion mismatch. The exception applies if, at the time the taxpayer entered into, or acquired an interest in, any part of a transaction that is, or is part of, the structured arrangement, it was not reasonable to expect that the taxpayer, a non-arm’s-length entity, or a specific entity in respect of the taxpayer was aware of the deduction/non-inclusion mismatch, and none of those entities shares in the value of any economic benefit resulting from that mismatch. The explanatory notes suggest that this exception is expected to be available only to the holder of a financial instrument; the issuer, on the other hand, is expected to be “aware” of the structuring and the related tax consequences, such that it (the issuer) would not be able to rely on the exception.
In addition, under a relatively broad anti-avoidance rule in proposed subsection 18.4(20), it is proposed that the tax consequences to a person be determined in order to deny a tax benefit “to the extent necessary to eliminate any deduction/non-inclusion mismatch, or other outcome that is substantially similar to a deduction/non-inclusion mismatch, arising from a payment” if certain conditions are met. Among these conditions is that one of the main purposes of a transaction or series of transactions that includes the payment is to avoid or limit the application of subsection 12.7(3), 18.4(4), or 113(5) in respect of the payment, and that the mismatch be caused by certain specific factors—namely, the payment of a deductible dividend, or a mismatch that results from differences in the income tax treatment of arrangements under the laws of two or more countries that are grounded in the terms or conditions of the arrangement (although the explanatory notes suggest that this requirement, in the context of the anti-avoidance rule, should be interpreted more broadly than the causal test in proposed paragraph 18.4(10)(d)).
The consequences of the application of this regime in respect of the payment are produced under subsection 12.7(3), 18.4(4), or 113(5), depending on the circumstances. Subsection 12.7(3) results in an income inclusion; subsection 18.4(4) results in the denial of an income deduction; and subsection 113(5) results in the denial of a deduction in computing taxable income that would otherwise be available in respect of a dividend received on the shares of a foreign affiliate. In addition, under proposed subsection 214(18), interest paid or credited by a corporation resident in Canada, which is not deductible because of the hybrid mismatch rule in proposed subsection 18.4(4), is deemed to be a dividend, not interest, for the purposes of part XIII of the Act. This rule, in effect, is intended to align the treatment of these interest payments for the purposes of withholding tax under part XIII with the tax treatment for the purposes of part I and the tax treatment under the relevant foreign tax law, and it prevents taxpayers from using hybrid mismatch arrangements as equity substitutes to inappropriately avoid dividend withholding tax.
While it is too soon to have fully digested all of the potential implications of these new rules, taxpayers would be well advised to begin to review their arrangements in light of these developments. As noted above, the proposals would apply in respect of payments arising on or after July 1, 2022.
EY Law LLP, Montreal