Finance releases proposed hybrid mismatch arrangement rules
Taxpayers who engage in cross-border payments or those who use hybrid instruments in their cross-border transactions, e.g., financial instruments that might be treated as debt in one country and equity in another country, will need to grapple with recently released hybrid mismatch arrangement rules.
Further to the government’s announcement in the 2021 Federal Budget, the Department of Finance released the first set of draft legislative proposals to address cross-border tax avoidance arrangements known as hybrid mismatch arrangements (HMAs) on April 29, 2022.
These proposals are the first of the two proposed rules to be implemented into the Income Tax Act (the Act) and are based on the recommendations of the Organisation for Economic Co-operation and Development (OECD) BEPS Action Plan (Action 2 Report) to eliminate the tax benefits arising from HMAs.
HMAs are cross-border tax avoidance structures that exploit differences in the income tax treatment of business entities or financial instruments under the laws of two or more countries to produce mismatches in tax results. The draft legislation identifies limited circumstances in which a hybrid mismatch amount may arise and provides operative rules to create an income inclusion or deny a deduction associated with a hybrid mismatch amount. The limited circumstances addressed in the draft legislation primarily relate to hybrid financial instruments. Key details of the draft legislation include the following:
- Operative rule 1: a denial of a deduction for an entity in Canada to the extent there is a non-inclusion of a receipt in a foreign jurisdiction
- Operative rule 2: an income inclusion to the extent the payment is deductible in computing the foreign income of a non-resident payer, but would otherwise not result in taxable income to the Canadian recipient
- Dividend received from a foreign affiliate: a denial of the dividend deduction under section 113 of the Act for a dividend received from a foreign affiliate to the extent there is a foreign deduction for the payment. The dividend deduction limitation proposed rules and the Operative rule 2 are not intended to apply to the same payment.
The application of the proposed rules is limited to taxpayers not dealing at arm’s length, taxpayers who have a specified percentage of equity interest in one another, or to taxpayers where the pricing of a payment reflects the hybrid mismatch. Where the pricing of a payment reflects the hybrid mismatch, taxpayers may avail themselves of an exception where it is reasonable to assume the taxpayer was not aware of the mismatch and derives no benefit from it.
More draft legislation to come
Finance is accepting feedback on the draft proposal for the first package before June 30, 2022. These proposed measures would apply to payments arising on or after July 1, 2022 — only one day after the deadline for public feedback. The second legislative package, which is unreleased, would apply no earlier than 2023.