The Updated Hybrid Mismatch Rules

On November 30, 2023, the federal government tabled the Fall Economic Statement Implementation Act, 2023 (Bill C-59), which includes updated legislation for the hybrid mismatch rules. These rules address hybrid mismatch arrangements, which are cross-border arrangements that are characterized differently under the tax laws of different countries. The rules in Bill C-59 are the first of two legislative packages that will amend the ITA to implement the recommendations of the action 2 report, which was prepared as part of the OECD/G20 base erosion and profit shifting (BEPS) project. This first legislative package deals with “deduction/non-inclusion” (D/NI) mismatches relating to hybrid financial instruments (including mismatches that involve hybrid transfers of financial instruments and substitute payments relating to these instruments). These rules apply to payments arising after June 30, 2022 (except where otherwise noted). The second legislative package has not yet been released and is expected to address the remaining recommendations from the action 2 report. In this article, we provide a brief overview of the hybrid mismatch rules, summarize Bill C-59’s key updates to those rules, and discuss related policy concerns.

Scope of the Rules

The hybrid mismatch rules generally apply to payments arising under a “hybrid mismatch arrangement” that produces a D/NI mismatch. A D/NI mismatch generally arises where a payment is deductible in Canada or a foreign country but is not included in ordinary income in either country.

The rules address three types of hybrid mismatch arrangements:

• Hybrid financial instrument arrangements. These are arrangements in which financial instruments are treated differently under the tax laws of different countries (for example, as debt in one country and equity in another country).
• Hybrid transfer arrangements. These are arrangements, involving the transfer of a financial instrument, that are treated differently under different countries’ tax laws. (For example, one country treats the arrangement as a sale of the transferred instrument, while another country treats it as a loan that is secured by the transferred instrument.)
• Substitute payment arrangements. In these arrangements, which involve the transfer of a financial instrument, payments are made that substitute for returns on the transferred instrument.

Each type of arrangement is defined through complex tests, which generally involve the following requirements:

• The parties to the arrangement must be connected in a certain way: either they do not deal at arm’s length or they satisfy the “specified entity” test (which generally requires having at least 25 percent common ownership). If the parties are not sufficiently connected, the rules can still apply if the arrangement is a “structured arrangement” (generally, an arrangement that is designed to produce a D/NI mismatch or is priced to reflect the economic benefit of the mismatch).
• The arrangement must include a payment that produces a D/NI mismatch.
• The D/NI mismatch must reasonably be considered to arise because of the hybrid tax treatment of the arrangement (that is, because the tax treatment of the arrangement varies by country).

The substitute payments rule is somewhat different, because its application does not require that a D/NI mismatch arise from the hybrid tax treatment. This rule generally applies to transfer arrangements that produce D/NI mismatches (or similar results) involving substitute payments, which could undermine the integrity of the other hybrid mismatch rules.

The rules also apply to notional interest deductions, which are allowed in some foreign jurisdictions on interest-free (or low-interest) debts. These debts are essentially deemed to be hybrid financial instruments under subsection 18.4(9). Notably, this rule was not included in the action 2 report.

Where a hybrid mismatch arrangement exists, the D/NI mismatch that results from the hybrid tax treatment is called the “hybrid mismatch amount” and is subject to the operative rules, which aim to neutralize the D/NI mismatch.

Operative Rules

Primary Rule

The primary operative rule (found in subsections 18.4(3) and (4)) generally applies to “inbound” arrangements (that is, arrangements in which a Canadian taxpayer makes a payment to a foreign entity under a hybrid mismatch arrangement). This rule denies a deduction for the payment to the extent of the hybrid mismatch amount. Any denied interest deduction is deemed to be a dividend for the purposes of non-resident withholding tax (as set out in subsection 214(18)). This deemed dividend treatment is another departure from the action 2 report. This primary rule takes precedence over any foreign hybrid mismatch rules, which might otherwise include the payment in foreign income.

If a deduction for a payment is denied under the primary rule, an adjustment mechanism (set out in paragraph 20(1)(yy)) allows a deduction to be claimed in the future, to the extent that an amount is subsequently included in foreign ordinary income. This rule provides relief for hybrid mismatch amounts that involve timing differences rather than permanent mismatches.

Secondary Rule

The secondary operative rule (set out in subsections 12.7(2) and (3)) generally applies to “outbound” arrangements (that is, arrangements in which a payment is received by a Canadian taxpayer from a foreign entity under a hybrid mismatch arrangement). Under this rule, an amount equal to the hybrid mismatch amount for the payment is included in the taxpayer’s income. This rule does not apply to a payment that is non-deductible in the foreign country because of a foreign hybrid mismatch rule; the foreign rule therefore takes precedence over the Canadian secondary rule.

Denial of Foreign Affiliate Dividend Deduction

Subsection 113(5) denies a section 113 deduction for a dividend received from a foreign affiliate (FA) to the extent that the dividend is deductible for foreign tax purposes by the dividend payer (or by other entities that directly or indirectly own the dividend payer, or that pick up the dividend payer’s income for foreign tax purposes). Unlike the application of the main operative rules, the application of this rule does not require a hybrid mismatch arrangement. This rule takes precedence, however, over any foreign hybrid mismatch rules that would otherwise deny the foreign tax deduction for the dividend.

Bill C-59: Key Updates to the Hybrid Mismatch Rules

Rules for FAs

The most significant changes in Bill C-59 are new rules addressing how the hybrid mismatch rules apply in the computation of the foreign accrual property income (FAPI) and surplus of FAs:

• The primary rule (subsection 18.4(4)) does not apply in computing the FAPI of an FA.
• The secondary rule (subsection 12.7(3)) can apply in computing the FAPI of an FA, in respect of payments received by the FA (or by a partnership of which the FA is a member). However, this rule does not apply if subparagraph 95(2)(a)(ii) applies to include the income or loss of the FA derived from the payment in its active business income or loss (or if, in the case of notional interest expenses, subparagraph 95(2)(a)(ii) would have applied to an actual interest payment on the debt).
• Dividends received by an FA from another FA (including dividends received through partnerships) are included in the recipient FA’s FAPI, to the extent that subsection 113(5) would have applied had the recipient FA been a Canadian corporation (that is, to the extent that the dividend payment is deductible under foreign tax laws).
• Where one FA receives from another FA a dividend to which subsection 12.7(3) applies, or to which subsection 113(5) would have applied had the recipient been a Canadian corporation, the dividend is not included in the recipient’s surplus balances under the normal rules applicable to interaffiliate dividends (it is included instead, presumably, in “taxable earnings,” as part of the recipient’s FAPI).

These rules apply to payments arising after June 30, 2024.

The new rules for FAs significantly expand the scope of the hybrid mismatch rules. We have some policy concerns regarding the scope and effects of these rules, and these concerns are as follows:

• The exemption for payments covered by subparagraph 95(2)(a)(ii) is welcome. However, the scope of the exemption could be somewhat limited in practice, because many hybrid investments that fund active business operations produce payments (for example, dividends from other FAs) that are not typically covered by subparagraph 95(2)(a)(ii). Furthermore, this exemption does not apply to the new rule targeting deductible interaffiliate dividends.
• Double taxation can arise when the new rules apply to an investment that funds the FAPI-generating activities of another FA. This is because the rules include a payment in the recipient’s FAPI, without providing a deduction from FAPI for the payer. Consider an example in which one FA receives a dividend from a second FA, which earns FAPI. If the dividend is deductible by the second FA under foreign tax laws, the dividend will be included in the first FA’s FAPI, even though no deduction is available from the second FA’s FAPI. This reflects the fact that such arrangements do not receive hybrid tax treatment from a FAPI perspective, because the payer and recipient FAs both compute FAPI under Canadian tax rules.
• The foreign tax credit generator rules (set out in subsections 91(4.1) to (4.7) and in regulations 5907(1.03) to (1.07)) apply in many of the same situations as the hybrid mismatch rules, denying deductions for foreign tax paid in connection with these arrangements (which would otherwise be available under subsection 91(4) to offset FAPI, and under paragraph 113(1)(b) to offset income from taxable surplus dividends). Where the hybrid mismatch rules include a payment in an FA’s FAPI or taxable surplus, the foreign tax credit generator rules will often deny relief for foreign tax on that payment, even where relief would be provided in comparable scenarios involving a Canadian recipient (for example, in a situation where a dividend received by a Canadian corporation from an FA would benefit from the new subsection 113(6) deduction, described below).

Deduction for Foreign Withholding Tax on Subsection 113(5) Dividends

New subsection 113(6) provides a deduction for foreign withholding tax paid by a Canadian corporation on a dividend to which subsection 113(5) applies (the deduction is equal to the non-business income tax paid on the dividend, multiplied by the corporation’s relevant tax factor). This change addresses a concern that double taxation could arise where subsection 113(5) dividends were subject to foreign withholding tax (since foreign tax credits are generally not available for dividends received from FAs).

Notional Interest Expense

The deeming rule in subsection 18.4(9) now applies where any entity, not just the debtor, claims a notional interest deduction on a debt. However, the updated explanatory notes (November 2023) confirm that the deeming rule would not apply to deductions in respect of equity (for example, an allowance for corporate equity regimes).

There is also a change to the effective date: the secondary rule will not apply to notional interest expense computed in respect of a period before January 1, 2023.

Exempt Dealer Compensation Payments

The rule for hybrid transfer arrangements now provides an exemption for dealer compensation payments received in certain circumstances. This exemption will apply to certain dealer compensation payments for underlying dividends on public corporation shares. To qualify for the exemption, these payments must be received by a Canadian registered securities dealer from a controlled FA that carries on a regulated securities-trading business principally with arm’s-length persons (the FA must also have substantial market presence in a foreign country and face competition in that country).

Timing Mismatches

As noted above, when an interest deduction is denied under the primary rule, subsection 214(18) deems the interest to be a dividend for withholding tax purposes. When a deduction is subsequently provided under paragraph 20(1)(yy) (for example, because a timing mismatch is resolved), new subsection 227(6.3) allows the taxpayer to apply for a refund of withholding tax. The refund is based on the difference between the withholding tax applicable to the deemed dividend and the withholding tax that would have applied to an interest payment.

The updated explanatory notes acknowledge that no equivalent to paragraph 20(1)(yy) exists to address timing mismatches under the secondary rule (that is, situations where a payment is included in income under this rule, but the D/NI mismatch resolves in the future). However, the explanatory notes suggest that subsections 12(3) and 248(28) should generally prevent a timing mismatch from producing a double income inclusion. Although these provisions may provide relief in some circumstances, they may not be effective in others (for example, in situations where the future income inclusion arises for a different Canadian taxpayer, or under foreign tax laws).

Other Changes

Bill C-59 also includes the following changes:

• The rule for substitute payment arrangements now requires that at least one of certain parties linked to the arrangement be a non-resident.
• The rules for specified entities now provide that two parties are not specified entities in respect of each other in certain circumstances involving rights granted to secure a debt.
• Taxpayers must file prescribed forms where the hybrid mismatch rules apply. These filing requirements generally apply to payments arising after June 30, 2023. The details of these new forms are not yet available.

Conclusion

The updated hybrid mismatch rules in Bill C-59 address some of the concerns previously raised by the tax community. Other concerns persist, however, and the rules for FAs raise new policy concerns. The hybrid mismatch rules remain complex and have a potentially broad scope. Taxpayers should carefully review these rules to determine whether they apply to the taxpayers’ existing cross-border arrangements. The rules will necessitate that taxpayers take a coordinated global approach so as to properly understand how these cross-border arrangements will be treated in foreign tax systems, including how the rules interact with any foreign hybrid mismatch rules.

Ian Bradley and Seth Lim
PwC Law LLP, Toronto