Arrangements to use a ULC to generate an interest deduction in Canada and the US, or a non-inclusion in the US, need to be examined under the hybrid mismatch rules

In considering the application of the hybrid mismatch arrangements to cross-border arrangements involving the generation of an interest deduction to a Canadian unlimited liability company (ULC), one should be mindful of the currently-drafted rules in Bill C-59 (the “first package”) and a potential “second package” to implement other proposals contained in the (BEPS) OECD Action 2 Report.

In Example 1, a US C corporation (“US Parent”) wholly owns a Canadian ULC (“Cansub”) that is disregarded in the U.S. and to which it made an interest-bearing loan. The interest payments are deductible in Canada by Cansub.

Although there is a deduction in Canada but no recognition of income in the United States, resulting in a deduction/non-inclusion (D/NI) mismatch, this structure may not represent a hybrid financial instrument under the first package given inter alia that the D/NI mismatch arises primarily because of the difference between the countries in their tax treatment of Cansub (as opaque or disregarded) and not because of a difference in the tax treatment of the financial instrument as such and that the OECD Action 2 Report states that “[a] payment cannot be attributed to the terms of the instrument where the mismatch is solely attributable to the status of the taxpayer or the circumstances in which the instrument is held.”

Regarding the second package, the BEPS Action 2 Report relevantly provides that no mismatch will arise to the extent that the payer’s deduction is set off against “dual-inclusion income,” being an item included in income under the laws of both the payer and payee jurisdictions. Interest expense might be disallowed in Canada to the extent that Cansub was in a net loss position. A deeming rule might be introduced to deem the interest payment to be a dividend paid to US Parent, which would be subjected to a 25% withholding tax rate based on the anti-hybrid rule in Art. IV(7)(b) of the Treaty.

In a variation of Example 1, the loan to Cansub is made by a US C-corp. subsidiary of US Parent (US Sub) out of its own funds rather than by US Parent.

As in Example 1, it is arguable that the first package will not apply.

Respecting the second potential package, although Cansub would be a “hybrid payer” (its interest payments are deductible in Canada and also generate a duplicate deduction for the US investor, viz., US Parent, in the US), the BEPS “deductible payments rule” does not apply if a deduction can be offset against an amount that will be included in income in both jurisdictions, so that if the interest expense can be offset against income of Cansub (which is taxed in both jurisdictions), the rule may not apply – but may apply if Cansub is in a loss position.

Example 3 is the same as Example 2, except that Cansub receives the loan from a third party rather than US Parent. There is a double interest deduction: by Cansub in Canada; and by US Parent in the US.

If this was not a structured arrangement (which would entail it being reasonably considered that a portion of the economic benefit arising from the D/NI mismatch is reflected in the pricing of the transaction giving rise to a D/NI mismatch, or the transaction or series was otherwise designed to give rise to the D/NI mismatch), then it would not be considered a hybrid financial instrument arrangement and would not be caught by the first package.

Regarding the potential second package, there is a BEPS scoping rule, which denies a deduction in the payer jurisdiction (Canada) only where the parties are in the same control group or are part of a structured arrangement – so that if this loan is not a structured arrangement, the interest deduction may not be disallowed in Canada.

Neal Armstrong. Summary of Simon Townsend and Silvia Wang, “Can the Hybrid Mismatch Rules Affect Canadian ULCs?”, International Tax Highlights, Vol. 3, No. 1, February 2024, p. 5 under s. 18.4(10).