Canada expands hybrid mismatch arrangement rules for cross-border payments

Businesses with cross-border operations should pay close attention to the latest proposed updates to Canada’s hybrid mismatch arrangement (HMA) framework.

The Department of Finance’s draft legislative proposals released on Jan. 29, 2026 contains the second package of new HMA rules. These measures—in conjunction with the initial package that was enacted in 2024—will complete Canada’s implementation of recommendations from the Organization for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) Action 2 report.

These measures are meant to prevent businesses with international presences from exploiting differences in countries’ tax systems to achieve mismatched tax outcomes, such as double deductions, on cross-border payments.

The new proposals apply to payments arising on or after July 1, 2026—including payments under arrangements entered into before that date. 

As a result, businesses should review their cross-border arrangements, payments and structures to assess exposure. Restructuring ahead of the proposed effective date, in coordination with appropriate advisors, is another critical consideration.

Expanding the hybrid mismatch framework

The latest draft legislation extends Canada’s existing framework to account for hybrid mismatches arising from hybrid entities. It also amends key definitions such as hybrid mismatch arrangement and hybrid mismatch amount to incorporate new categories of mismatches.

The core mechanism of the primary and secondary rules enacted in 2024 remains unchanged. The primary rule generally denies a deduction where the payment is not taxed in the payee country, while the secondary rule requires the payment be brought into income if there is a deduction in a foreign jurisdiction for a non-taxable payment received in Canada.

The proposals also introduce concepts like dual inclusion income and investor dual inclusion income. They function as mitigating factors to prevent double taxation where cross-border structures with flow-through elements recognize receipts twice.

Reverse hybrid arrangements

A reverse hybrid arrangement may apply to cross-border structuring where an entity is treated as taxable for its investor and flow-through for tax purposes in the jurisdiction where it is established.

A partnership formed in one country may be treated as a flow-through for tax purposes there, but viewed as a corporation in a different country where one of its investors resides.

A payment would generally fall under the reverse hybrid rules if:

• It is made to a reverse hybrid entity.
• The parties are not at arm’s length, or the payment is part of a structured arrangement where it can reasonably be considered that the economic benefits of a mismatch are priced into the arrangement or that the arrangement is otherwise intentionally designed to produce a mismatch.
• The payment produces a deduction/non-inclusion (D/NI) mismatch.
• The mismatch exceeds what would occur if the payment were made directly to the investors.

Where these conditions are satisfied, a D/NI mismatch can result in the application of either the primary or secondary rule. This typically depends on whether a deduction component of the payment is in Canada or a foreign country. Interest payments may also be subject to Part XIII withholding tax under the Income Tax Act as if they were dividends.

Disregarded payment arrangements

The definition of a hybrid entity is key to determining whether a payment falls within a disregarded payment arrangement.

A hybrid entity is an entity that is taxable in its home jurisdiction but is treated as fiscally transparent in the jurisdiction of one or more of its investors. Disregarded payment arrangements may apply where a payment is not recognized by a payee and the payment is deductible for the payor. 

A corporation incorporated in one country may be taxed as a corporation there but could be treated as fiscally transparent in a different country where one of its investors resides; this effectively disregards the entity for income tax purposes.

A common instance of this is an unlimited liability company (ULC) in Alberta, British Columbia and Nova Scotia. Canada taxes these ULCs as corporations, but the U.S. often treats them as transparent and disregards them in cross-border payment analysis.

The proposed legislation lists four conditions for a payment to qualify as a disregarded payment:

• The payer must be a hybrid entity.
• The payer and recipient do not deal at arm’s length or the payment arises under a structured arrangement.
• The payment produces a D/NI mismatch.
• The mismatch arises, at least in part, because the payment is disregarded in the recipient’s jurisdiction—ignoring other causes of the mismatch.

Where these conditions are satisfied, a D/NI mismatch can result in the application of either the primary or secondary rule. This typically depends on whether a deduction component of the payment is in Canada or a foreign country.

Similar to the reverse hybrid arrangement, the denial of an interest deduction may cause the payment to be treated as a dividend subject to withholding tax.

Hybrid payer arrangements

The proposed rules generally target double deduction mismatches arising because a payer is treated as opaque in the jurisdiction where the entity is established and transparent for its parent or investors.

Since this is similar to disregarded payment arrangements, structures that fall into either category may need to account for both frameworks when making a payment that causes mismatches in cross-border tax outcomes. 

A payment would fall into a hybrid payer arrangement only if all of the following conditions are met:

• The payer must be a hybrid payer.
• For hybrid entities resident in Canada, the entity is not at arm’s length with an investor—or the payment arises from a structured arrangement—and no foreign hybrid payer mismatch rules applies in computing foreign income of at least one investor entity.
• For multinational entities resident outside of Canada, no rules equivalent to Canada’s hybrid mismatch rules apply to the payment.
• The payment gives rise to a double deduction mismatch

Without dual-inclusion income, the payment that forms part of a double deduction may not be deductible under the primary operating rule.

Imported hybrid arrangement

Canada’s imported hybrid mismatch rules typically require a hybrid mismatch amount that occurs outside of the country where neither the payer nor the payee are Canadian taxpayers.

Once that is determined, the rules consider whether a sufficient link exists between a deductible payment made by a Canadian entity and the deducting entity. If so, the rules will consider that the mismatch has been imported to Canada.

The purpose of this framework is to prevent entities from engaging in tax planning that avoids the application of other hybrid mismatch arrangement rules by leveraging foreign jurisdictions that have not implemented a framework in alignment with OECD’s Action 2 report.

For example, if an offshore mismatch in taxation is not addressed abroad, Canada may deny a related domestic deduction.