Hybrid mismatch rules could impact cross-border debt forgiveness

First published by the Canadian Tax Foundation in (2024) 14:2 Canadian Tax Focus / Focus sur la fiscalité canadienne.

Subsection 12.7(2), which is part of a budget bill currently before Parliament (C-59), could create an income inclusion for a Canadian debtor if the debt is forgiven by a lender that is not resident in Canada. Since the normal debt-forgiveness rules in section 80 could also be applicable, there may be a question as to which set of rules has priority; alternatively, both sets of rules could apply, creating a type of double taxation (if subsection 248(28) does not prevent this).

Suppose Parentco, a US corporation, loans funds to its wholly owned Canadian subsidiary, Canco. On or after July 1, 2022 (the general effective date of the new rules), Parentco forgives the debt.

Subsection 12.7(3) will create an income inclusion for Canco if, according to subsection 12.7(2), a payment arises under a hybrid mismatch arrangement and there is a foreign deduction component of that arrangement. Paragraphs (a) to (d) of subsection 18.4(10) provide the conditions that must be satisfied for this income inclusion to occur.

Paragraph 18.4(10)(a) requires that Canco be the recipient of a payment, which is defined under subsection 18.4(1) to include any amount or benefit that an entity has an obligation to pay, credit, or confer. Debt forgiveness seems to be caught under this rule if the jurisprudence under section 15 can be applied in this context. Del Grande (E.) v. Canada ([1993] 1 CTC 2096 (TCC)) held, in the context of subsection 15(1), that the “word ‘confer’ implies the bestowal of bounty or largesse to the economic benefit of the conferee and a corresponding economic detriment of the corporation.” Also, it had been accepted that a taxable benefit would arise in a shareholder’s hands on the value of a loan forgiven (Merriman v. MNR, 86 DTC 1056 (TCC)) before subsection 15(1.2) was enacted to deal specifically with valuing the benefit.

Paragraph (a) also requires that the payment arise under, or in connection with, a financial instrument (the first prong of the definition of “hybrid mismatch arrangement” in subsection 18.4(1)). This condition is met because debt is a financial instrument by virtue of the definition of the latter in subsection 18.4(1).

Paragraph 18.4(10)(b) is satisfied in this case because of the relationship between Parentco and Canco.

Paragraph 18.4(10)(c) requires that (1) Parentco is allowed a deduction in its taxing jurisdiction for the debt forgiveness, and (2) Canco does not have an equivalent inclusion in computing its income for the purposes of part I (see the definition of “Canadian ordinary income” in subsection 18.4(1)). Regarding the Parentco side of this condition, Parentco may avail itself of a bad debt deduction under Internal Revenue Code section 166, regardless of any formal forgiveness of the debt, if certain criteria are met (that is, complete worthlessness of the debt). On the Canco side of this condition, section 80 may apply in this example, but it could not result in an inclusion that would match the deduction provided to Parentco: section 80 provides first for a reduction in various tax attributes (subsections 80(3) to (12)) and, at most, calls for an inclusion of 50 percent of the amount of debt forgiveness (subsection 80(13)).

Paragraph 18.4(10)(d), the final condition for the application of subsection 12.7(2), is a potential escape hatch. It requires that the mismatch of a deduction with no inclusion, required by paragraph (c), must be attributable to the terms and conditions of the particular transaction or financial instrument, such as might occur if one jurisdiction views a particular financial instrument as equity while the other jurisdiction views it as debt. The US tax rules have a complex system of classifying certain instruments based on all the facts and circumstances. This classification can differ from Canadian reporting. The answer to whether the debt forgiveness meets this condition will likely require a case-by-case analysis and may turn on how broadly Canadian courts interpret this requirement—that is, whether a different tax outcome in the two jurisdictions is sufficient to trigger the rules.