Section 18.4

Recommended exclusion of ss. 12.7 and 18.4 from the foreign affiliate context (under “3. Application to Foreign Affiliates”)

• Where, for example, a FAPI-earning controlled foreign affiliate has issued a financial instrument that is treated as debt from a Canadian perspective and as equity from a foreign tax perspective, it seems inappropriate to deny a deduction in computing such FAPI through an extension to such context of the proposed hybrid mismatch rules, given that if this instrument had instead been treated as equity from a Canadian perspective, such that there would not have been any deduction in computing FAPI for the “interest” payments, the existence of the instrument would have in any event resulted in a reduction of the Canadian taxpayer’s participating percentage in respect of the affiliate, and thus a corresponding reduction of attributed FAPI.
• It is recommended that s. 95(2)(f.11)(ii)(A) be expanded to exclude the application of ss. 12.7 and 18.4 in computing a foreign affiliate’s income from property, income from a business other than an active business and income from a non qualifying business.

Hybrid payer mismatch where an investor in a hybrid entity makes a disregarded payment to that entity (pp. 7-9)

• Where an investor in a hybrid entity makes a payment to that entity, which is disregarded under the tax laws of the investor’s country, although the payment is included in the hybrid entity’s ordinary income, it would not be dual inclusion income (because both the expense and revenue relating to the payment are disregarded under the investor country’s tax laws).
• The payment thus produces an “inclusion / no-deduction” outcome (essentially the reverse of the “deduction / non-inclusion” mismatches targeted by the disregarded payment arrangement rules).
• To illustrate: Two US companies (“USCo 1” and “USCo 2”) are members of a consolidated group for U.S. tax purposes, with USCo 1 wholly-owning USCo 2, and USCo 2 wholly-owning a fiscally-transparent Canadian ULC (“Can ULC”)
• Can ULC receives, as its only source of income, payments from members of the U.S. group for the performance of its services (assume $100, in compliance with s. 247 - in this example, paid by USCo 2) and makes payments to arm’s length third parties for general expenses such as costs of its R&D services (assume $90, for a net profit of $10).
• S. 18.4(15.5) would be satisfied in respect of the R&D payment, as ULC is a Canadian-resident hybrid entity, and is therefore a hybrid payer, and USCo 2 is an investor not dealing at arm’s length with Can ULC (and assume that no foreign hybrid payer mismatch rule applies, in respect of the payment in computing the relevant foreign income or profits, for a foreign taxation year, of this investor).
• The R&D payment gives rise to a double deduction mismatch of $90, since an amount is deductible in respect of the $90 payment in computing the income of both Can ULC and USCo 2.
• Regarding the service fee is paid by USCo 2 to Can ULC, USCo 2 does not have “ordinary income” respecting this payment (no amount is included in computing its (US) income or profits for the year) because the payment from Can ULC is disregarded, so that the payment is not dual inclusion income.
• Consequently, the amount of the hybrid payer mismatch under s. 18.4(15.6) would be $90.

Potential additional Canadian tax where partially-owned hybrid entity (pp. 10-11)

• Where a Canadian-resident hybrid entity has multiple owners but with only some of them located in countries viewing that Canadian-resident entity as fiscally transparent, the “double deduction mismatch” respecting the payment by that entity equals the full amount of the payment, rather than the portion thereof that reflects the relevant investors’ share of the hybrid entity’s income.
• However, the amounts included as “dual inclusion income” may be limited to the portion of the revenue amounts that are included in the relevant investors' share of the hybrid entity’s income.
• S. 18.4(7.2) should be revised so that, if a payment gives rise to a double deduction mismatch, the amount of the double deduction is equal to the lesser of the amounts described in ss. 18.4(7.1)(a) and 18.4(7.1)(b).

Potential double taxation through considering there to be a mismatch where the amount is deductible (but not actually deducted) in the foreign jurisdiction (under “6. Proposed Subsection 18.4(6): Application to Deductible Amounts)

Variable “C” of proposed paragraph 18.4(6)(b) determines whether a payment gives rise to a deduction/non-inclusion mismatch by reference to whether the payment would be, or would reasonably be expected to be, in the absence of any foreign expense restriction rule, deductible in computing foreign income. It appears the test of “deductible” as opposed to a test of “deducted” could give rise to double taxation due to the application of proposed section 12.7 where there is in fact no deduction taken in the foreign jurisdiction. This issue is particularly relevant for the notional interest expense rule in proposed subsection 18.4(9), which does not require an actual payment. ...

We recommend that the test of “deductible” be changed to a test of “deducted”, at the very least, in proposed subsection 18.4(9).

Example 1 (p. 5)

• 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.

Example 1: non-application of hybrid financial instrument rules (pp. 5-6)

• 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 hybrid mismatch arrangement (HMA) rules in Bill C-59 ( 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 (that is, regarded/disregarded), 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.”

Example 1: potential application of second package (p. 6)

• The portion of the BEPS Action 2 Report that might be included in a second package of amendments (the “second package”) provides (in Chapter 3) 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.
• Under the second package, 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.

Example 2 (p. 6)

• In a variation of Example 1, the loan to Cansub (again, a disregarded ULC subsidiary of US Parent ) is made by a US C-corp. subsidiary of US Parent (US Sub) out of its own funds rather than by US Parent. (See 2010-0376751E5.)

Example 2: non-application of first package (p. 6)

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

Example 2: potential application of second package (p. 7)

• Respecting the second package, under Chapter 6 of the Action 2 Report, 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 Chapter 6 “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 (p. 7)

• 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.

Example 3: non-application of first package (p. 7)

• If it 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.

Example 3: non-application of second package (p. 7)

• Chapter 6, which is relevant to the application of the second package, includes, in its overview, a 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, chapter 6 may not apply, and the interest deduction may not be disallowed in Canada.

Triggering of reverse hybrid status by an arm’s length investor (pp. 16-17)

• As a general matter, a reverse hybrid entity is transparent in a jurisdiction and is opaque to at least one of its investors. Furthermore, either the payer of the payment and the reverse hybrid entity do not deal with each other at arm's length, or the actual payment arises under or in connection with the structured arrangement.
• In contrast with the Action 2 Report, which recommends that a reverse hybrid arrangement exists only where all of the investor, the reverse hybrid, and the payer are members of the same control group, as currently drafted, no account is taken of the relationship between the reverse hybrid entity and the entity (the investor) holding a direct or indirect equity interest in the reverse hybrid entity.
• It is anomalous that a reverse hybrid arrangement can be triggered by the tax treatment of the actual payment by an arm’s length investor in the reverse hybrid entity.
• This would arise where a US LLC or UK LLP that is transparent for local tax purposes, and that issues a membership interest to even one investor who treats the LLC or LLP as an opaque entity under the tax laws of that investor's jurisdiction of residence.