Introduction
Background
Hybrid mismatch rules may apply to cross-border arrangements
Affected taxpayers
Affected arrangements
Anti-avoidance rule
Comment
Canadian multinationals that have inbound or outbound structures should review the proposed hybrid mismatch arrangement rules recently released by the Department of Finance (Finance). This complex draft tax legislation is intended to neutralise tax benefits associated with hybrid cross-border arrangements that otherwise result in mismatches in the tax treatment of entities or financial instruments across jurisdictions. Generally, these mismatches can result in more than one deduction or a deduction without a corresponding income inclusion for a single economic expense. Finance's draft legislation addresses the treatment of payments under "hybrid financial instrument arrangements", "hybrid transfer arrangements" and "substitute payment arrangements", and also includes new rules to restrict the deduction from taxable income of certain dividends received from foreign affiliates. These proposed hybrid mismatch arrangement rules will generally apply to payments that arise on or after 1 July 2022, including payments under arrangements entered into before that date.
Finance released these draft measures on 29 April 2022 for public consultation, and will accept feedback from stakeholders until 30 June 2022. Finance also notes that it intends to release a second package of hybrid mismatch legislation later, which may address payments under other types of arrangements and would apply no earlier than 2023.
Finance announced that it would introduce hybrid mismatch arrangement rules in the 2021 federal budget to implement the recommendations in the Action 2 Report of the Organisation for Economic Cooperation and Development (OECD)/Group of 20 Base Erosion and Profit Shifting (BEPS) project on neutralising the effects of hybrid mismatch arrangements. This report addresses the following main two forms of hybrid mismatches defined in the BEPS Action 2 Report:
- the deduction or non-inclusion mismatches that may generally arise where a country allows a deduction for a cross-border payment, the receipt of which is not fully included in ordinary income in the other country (where "ordinary income" generally means income that is subject to income tax at the recipient's full tax rate and is not effectively sheltered from tax); and
- the double deduction mismatches that arise where a tax deduction is available in two or more countries in respect of a single economic expense.
According to Finance, the objective of these hybrid mismatch proposals is to eliminate hybrid mismatches and align Canada's tax treatment of mismatches with other countries by restricting the amount deductible by a taxpayer for Canadian income tax purposes in respect of a payment under a hybrid mismatch arrangement, or by including an amount in income of a taxpayer for Canadian income tax purposes who receives such a payment. In the 2021 budget, Finance announced it would release these proposed rules in two separate legislative packages. Amendments implementing other recommendations of the BEPS Action 2 Report are expected to be introduced later (eg, legislation to address double deduction mismatches).
Hybrid mismatch rules may apply to cross-border arrangements
Canadian multinational taxpayers that have entered into certain cross-border arrangements that result in mismatches may be subject to the draft hybrid mismatch legislation. In its explanatory notes, Finance advises that this draft legislation is intended to neutralize hybrid mismatches by either restricting a deduction for Canadian income tax purposes in respect of the payment (under a primary operative rule) or by including an amount in the Canadian income of a recipient of the payment to the extent that the mismatch is not otherwise neutralized by a foreign country (under a secondary operative rule). Additionally, where a Canadian-resident corporation has paid or credited interest that it cannot deduct because of the hybrid mismatch rules, that interest is treated as a deemed dividend for the purposes of Part XIII of the Income Tax Act.
Further, where a foreign income tax deduction is available in respect of a dividend received by a Canadian corporation from a foreign affiliate or certain other entities, a taxpayer's deduction for dividends received from the foreign affiliate surplus is generally restricted to the extent that the foreign income tax deduction is available.
According to Finance, the hybrid mismatch rules must be interpreted consistently with the BEPS Action 2 Report as potentially amended, unless the context otherwise requires (eg, where the hybrid mismatch rules depart from recommendations in the report).
Canadian taxpayers may be subject to these proposed rules for cross-border payments under hybrid financial instrument arrangements, hybrid transfer arrangements and substitute payment arrangements that give rise to a deduction or non-inclusion mismatch, provided that the relevant parties satisfy a relationship test (ie, specified entities), or the payment arises under a structured arrangement.
For purposes of these rules, "payment" is defined broadly and includes any amount or benefit that an entity has an obligation, including any future or contingent obligation, to pay, credit or confer. For two entities to be considered "specified entities", one party must have a 25% equity interest in the other or another entity must have a 25% equity interest in both. A structured arrangement is generally defined as an arrangement that has pricing that reflects the deduction or non-inclusion mismatch, or is otherwise designed to produce a deduction or non-inclusion mismatch. However, the rules may not apply to certain structured arrangements where it is reasonable to conclude that a taxpayer was unaware of the mismatch and derives no benefit from it.
The proposed hybrid mismatch arrangement rules may apply to a payment that gives rise to a deduction or non-inclusion mismatch under certain arrangements. Specifically, this package of draft legislation addresses payments under hybrid financial instrument arrangements, hybrid transfer arrangements and substitute payment arrangements. Finance notes that mismatches may generally occur under these arrangements where the total amount deductible in respect of the payment for Canadian income tax purposes exceeds the total amount included in respect of the payment in taxable income for Canadian and foreign income tax purposes, or if the total amount deductible for foreign income tax purposes exceeds the total amount included for Canadian and foreign income tax purposes.
Additionally, the hybrid mismatch rules may apply to certain deduction/non-inclusion mismatches that arise because of an income tax deduction under foreign law for a notional interest expense in respect of a debt.
Hybrid financial instrument arrangement
A mismatch may occur in a hybrid financial instrument arrangement where a payment under a financial instrument (broadly defined as a "debt", an "equity interest", or "any other arrangement that gives rise to an equity of financing return") results in a deduction or non-inclusion mismatch, and the mismatch arises because of differences in income tax treatment under the laws of different countries that are attributable to the terms or conditions of the financial instrument or related transactions. The consequences under these proposals only apply to the extent that the deduction or non-inclusion mismatch results from the hybridity of the arrangement.
Hybrid transfer arrangement
A hybrid mismatch may also occur where a payment under an arrangement for the transfer of a financial instrument gives rise to a deduction or non-inclusion mismatch, and the mismatch arises because the tax laws of different countries treat different entities as owning returns under the transferred financial instrument.
Substitute payment arrangement
A mismatch may also occur under a substitute payment arrangement where a payment under or in connection with the transfer of a financial instrument functions as a substitute for returns under the instrument and gives rise to a deduction or non-inclusion mismatch that would otherwise undermine the integrity of the rules on hybrid financial instrument arrangements and hybrid transfer arrangements. These rules only apply to the extent that the deduction or non-inclusion mismatch results from the portion of the payment that is a substitute.
The proposed legislation includes an anti-avoidance rule that may apply to situations that meet the essential characteristics of a hybrid mismatch arrangement in substance, even though one or more of the defined technical requirements of the hybrid mismatch rules is not met. The anti-avoidance rule generally applies where one of the main purposes of a transaction, or series of transactions, is to avoid the application of the proposed hybrid mismatch rules or to limit the consequences of those rules, and certain other conditions are met.
Although Finance's proposed hybrid mismatch rules generally follow the recommendations in the BEPS Action 2 Report, there are certain key differences including:
- changes to incorporate Canadian income tax concepts to define the requisite relationships between the parties to arrangements that are within the scope of these rules;
- a modified causal (or "hybridity") test in the context of the hybrid transfer arrangement rules;
- an additional deduction where the rules otherwise restrict a deduction for a payment, and the taxpayer demonstrates that an amount has actually been included in income for foreign tax purposes for the payment;
- rules that apply where a foreign country allows an income tax deduction for a notional interest expense for a debt that results in a deduction or non-inclusion mismatch; and
- changes to treat interest paid or credited by a corporation resident in Canada that is not deductible because of the hybrid mismatch rules as a deemed dividend for the purposes of Part XIII of the Income Tax Act.
The OECD BEPS Action 2 Report and related commentary also includes several examples that may be useful in better understanding the rules.
For further information on this topic please contact Sabrina Wong, Byron Scott Beswick or Allison Blackler at KPMG Law by telephone (+1 416 777 8000) or email ([email protected], [email protected] or [email protected]). The KPMG Law website can be accessed at www.kpmg.com.