The Joint Committee learns that the Part XIII tax applies under s. 214(18) to avoid abuse of the thin cap rules, and that Finance interprets “ordinary income” in a non-BEPS way

The Joint Committee learned in discussions that Finance considers an amount will not be included in “ordinary income” for purposes of draft s. 18.4(1) to the extent that a foreign tax credit or similar foreign tax credit relief is provided for taxes paid on that amount in another country. (The concept of “ordinary income” is crucial to avoiding double taxation under the hybrid mismatch rules, e.g., subsequent ordinary income may permit recovering under the s. 20(1)(zz) carryforward rule from an expense denial resulting due toa deduction/ non-inclusion mismatch.) However, because such foreign tax relief generally applies to that income rather than revenue, revenue amounts that benefit from such tax relief will be excluded from ordinary income only to the extent that they exceed deductible expenses.

This Finance interpretive would render it difficult to distinguish between revenue amounts that are sheltered by expenses and other revenue amounts representing the net income that are sheltered before foreign tax credits or s. 104(6) deductions.

Accordingly, the Joint Committee recommends that the “ordinary income” definition should not exclude amounts that are subject to double taxation relief, particularly relief that is applied on net income, such as foreign tax credits or similar foreign tax relief granted by a country in respect of taxes paid on an amount of income in another country or s. 104(6) deductions in respect of trust distributions.

However, if such amounts instead are to be excluded from ordinary income, the definition of ordinary income should be redrafted (or Explanatory Notes be added) to specify that where a revenue amount is excluded from ordinary income due to foreign tax credits or s. 104(6) deductions, only an amount equal to the net income is so excluded.

Guidance should also be provided to address the computation of ordinary income in scenarios involving different rules for computing Canadian and foreign taxable income, timing differences, and circular calculations.

As an example of such computational difficulties, consider a corporation resident in a foreign country (Foreignco) wholly owning a Canadian resident ULC (disregarded in the foreign jurisdiction) - but which has a minority ownership interest in a Canadian resident corporation (Canco), which is not so disregarded. The Canadian and foreign tax rates are 25% and 20%, respectively.

ULC has $300 of revenue in a taxation year, consisting of a $100 dividend from Canco, for which it receives a s. 112(1) deduction, and $200 from other sources; and pays a $100 third-party expense. Although the $100 expenses is deductible in both jurisdictions, Foreignco has $200 rather than (as for Canco) $100 of income because it does not haver a dividend-received deduction for the Canco dividend. The foreign tax liability of$40 is reduced to $15 by a foreign tax credit for the Canadian tax of ULC.

In this example it is unclear whether the revenue is sheltered by the foreign tax credit, given the differences in tax rates—$100 (based on the Canadian tax rate) or $125 (based on the foreign tax rate).

It also is unclear what specific revenue amounts are sheltered by the foreign tax credit, since the foreign tax system does not distinguish between the $100 dividend and the $200 of other revenue.

To illustrate difficulties that arise in connection with computing the amount of the carryforward of unused dual inclusion income for future deduction under s. 20(1)(zz), given that the determination of dual inclusion income is affected by tax relief provided on net income under the Finance interpretation, consider the following example.

Foreignco again owns (disregarded) ULC, but this time with both the Canadian and foreign tax rates being 25%.

In 2027, ULC has no revenue and one $100 expense payment. For foreign tax purposes, Foreignco has a $100 loss and for Canadian purposes, ULC has a $100 double deduction mismatch and no dual inclusion income, so that s. 18.4(15.6) applies to deny the $100 deduction.

In 2028, ULC has $200 of revenue and no expenses. This revenue is included in ULC's and Foreignco's income for Canadian and foreign tax purposes, respectively, with Foreignco receiving an FTC for the Canadian tax.

In this example, the amount of ULC's dual inclusion income is unclear. In order to determine whether the $200 revenue amount is ordinary income, it must be determined whether this amount is effectively sheltered from tax, which is unclear.

Under one approach, ULC would start with $200 of dual inclusion income in 2028. It would claim a $100 deduction under s. 20(1)(zz) and would have $100 of hypothetical net income subject to $25 of Canadian tax, producing an FTC that shelters $100 of Foreignco's income. Dual inclusion income would therefore be recomputed as $100 on the basis that $100 of revenue is sheltered by the FTC. This would still leave sufficient dual inclusion income to claim a $100 deduction under s. 20(1)(zz), so that ULC's net income would still be $100.

Another interpretive approach would have ULC with $200 net income in 2028 before applying the hybrid mismatch rules and paying $50 Canadian tax thereon. Foreignco would receive a foreign tax credit for that $50 of tax, which would shelter all its taxable income. As the entire $200 revenue amount would be effectively sheltered from tax, there would be no dual inclusion income, so that no s. 20(1)(zz) deduction would be available. However, ULC would have $200 actual net income and would pay $50 Canadian tax. The actual foreign tax credit would be $50, so that no recomputation of dual inclusion income would be necessary.

This would seem an inappropriate result since ULC would pay $50 tax even though its combined net income for 2027 and 2028 was only $100.

The Joint Committee was requested to make further submissions on the interaction between the draft proposals and the U.S. dual consolidated loss (DCL) rules. It discussed four scenarios and compared, for each, the alternative under which the U.S. DCL rules were not considered substantially similar and thus not a foreign hybrid payer mismatch rule as defined in draft s. 18.4(1), and the alternative where they were so considered.

Scenario 2 involved a U.S. corporation (USco) owning a disregarded Canadian ULC that makes a deductible payment of $100, with ULC having a dual inclusion income of $60. The Committee concluded that:

• Where the U.S. DCL rules were not considered substantially similar, then, regardless of whether a domestic use election was made in the U.S., it appeared that both the Canadian hybrid payer arrangement rule and the U.S. DCL rules could apply, effectively resulting in a double non-deduction outcome for the portion of the payment that exceeded the dual inclusion income.
• Whereas, if the U.S. DCL rules were considered substantially similar, there was optionality as to whether to take the deduction in excess of dual inclusion income in Canada or in the U.S. (but not both.)

Scenario 3 involved Canco owning a US LP that was a corporation for U.S. tax purposes, with US LP making a deductible payment of $100 and having no dual inclusion income.

• In the scenario where the U.S. DCL rules were not considered substantially similar, there was optionality as to whether to take the deduction in Canada or the U.S.
• Whereas, if the U.S. DCL rules were considered substantially similar, there was no optionality, and a domestic use election was required to avoid a double non-deduction outcome.

Based on the language in draft ss. 18.4(7.1) and (7.2), where any portion of a payment is deductible for both Canadian and foreign tax purposes, the deduction component is deemed to be equal to the amount that is deductible for Canadian tax purposes, even if the amount that is deductible for foreign tax purposes is less than this amount.

There is a concern that this rule could result in the denial of a deduction in excess of the amount necessary to neutralize the hybrid mismatch.

Suppose, for example, that Canco is the sole limited partner of a partnership (P1) that is treated as a corporation for local purposes in Country P. P1 incurs $100 of interest expense and earns $20 of income. For Canadian purposes, Canco, as the sole limited partner, is allocated $100 of interest expense and $20 of income, resulting in a net deduction in Canada of $80. For Country P tax purposes, only $90 of interest expense is deductible, and the full $20 of income is still recognized, resulting in a net deduction in Country P of $70.

Under ss. 18.4(7.1) and (7.2), the deduction component of the double deduction mismatch would be deemed equal to the Canadian deduction of $100, notwithstanding that only $90 is deductible for Country P tax purposes. From a policy standpoint, the deduction component of the double deduction mismatch should be limited to the lesser of the amounts in proposed ss. 18.4(7.1)(a) and (b), i.e., the lesser of the Canadian deduction and the foreign deduction. In this example, Canco should have a net deduction of $10 (i.e., $100 less $70 less DII of $20).

The Joint Committee learned from discussions with Finance that the proposed application of Part XIII tax to certain interest expenses that are denied under the anti-hybrid rules is intended to preserve the integrity of the existing thin capitalization rules. In particular, there was a concern that taxpayers might intentionally structure debt to be offside the thin capitalization rules, thereby giving rise to Part XIII tax on interest pursuant to s. 214(16) that would fall within the scope of the anti-hybrid rules, so as to avoid the application of the Part XIII tax.

To address this primary concern, the most efficient approach would be an ordering rule to ensure that the thin capitalization rules apply first. After doing this, it would then be appropriate to repeal the s. 214(18) rule in its entirety.

Neal Armstrong. Summaries of Joint Committee, “Submission on Hybrid Mismatch Arrangements - Technical Comments and Recommendations,” 5 June 2026 Joint Committee Submission under s. 18.4(1) – ordinary income, foreign hybrid payer mismatch rule, s. 18.4(7.2) and s. 214(18).