Ambiguity of a deduction etc. in computing income “in general” (pp. 3-5)
- The definition of ordinary income, which is crucial to avoiding double taxation under the hybrid mismatch rules, turns on an ambiguous distinction between deductions, credits, exclusions, and exemptions that apply “specifically in respect of all or a portion of [an] amount” that is included in computing the entity’s taxable income “and not in computing the entity's income or profits in general.”
- In the context of foreign tax credits, consider a U.S. corporation (USCo) holding an equity interest in a Canadian unlimited liability company (ULC), such that the ULC is subject to Canadian tax on its income and USCo is subject to U.S. tax on its share of ULC's income, with a foreign tax credit (FTC) provided in the U.S. for the Canadian tax.
- Alternatively, consider a Canadian corporation (Canco) that carries on a business through a permanent establishment in the United Kingdom, on which U.K. tax is levied, and with Canada granting an FTC.
- It should be clarified that an amount included in computing income that is subject to tax in a country will be considered ordinary income, notwithstanding that an FTC is provided for tax paid on that income in another country, i.e., the FTC should be considered tax relief applicable in computing the entity's income or profits “in general.”
- An example in the intercorporate dividend context is where USCo holds an equity interest in a fiscally-transparent Canadian ULC (“Canco 1”) that is fiscally transparent for U.S. tax purposes, with Canco 1 receiving a dividend eligible for the s. 112(1) deduction from a shareholding in Canco 2, which is a separate entity for U.S. tax purposes.
- It is recommended that the ordinary income definition, or the related Explanatory Notes, indicate that a dividend amount will not be excluded from ordinary income merely because the amount is eligible for a deduction under s.112 or 113, or with similar tax relief provided for intercorporate dividends under foreign tax law.
- It should be clarified that an amount of trust income will not be excluded from ordinary income merely because the trust receives a deduction under s. 104(6) for the income’s distribution, i.e., the deduction under s. 104(6) should be considered tax relief that applies in computing the trust's income or profits “in general.”
Inappropriate failure to recognize dual inclusion income where multiple fiscally-transparent entities (pp. 5-6)
- The proposals may relieve taxpayers from the denial of a deduction under s. 18.4(4) (or an inclusion under s. 12.7) to the extent of dual inclusion income.
- However, the entity-by-entity approach to the dual inclusion income definition may result in a mismatch between a deductible payment, and related income that normatively should be treated as dual inclusion income, but is not.
- For example of a U.S. REIT directly holds Canco, which directly holds CanSub (both “qualifying REIT subsidiaries” for Code purposes, and thus disregarded for such purposes).
- When CanSub on-lends the proceeds of a third-party loan to Canco, although the interest paid by CanSub gives rise to a hybrid payer mismatch, CanSub has no dual inclusion income of its own, while CanCo earns dual inclusion income but does not incur expenses giving rise to a double deduction (because the interest paid by Canco to CanSub is disregarded for Code purposes).
- It is suggested (among other possibilities) that the proposals be revised to allow the sharing of excess dual inclusion income among members of a corporate group (as can be done in the UK).
FAPI-type taxes do not qualify the FAPI as dual inclusion income (pp. 6-7)
- Controlled foreign company (“CFC”) taxes would be excluded from the amended “income or profits tax” definition in s.18.4(1)), so that income earned by an entity will not be included in dual inclusion income if it is included in computing the entity’s income for tax purposes in its country of residence, and is also included in CFC income that is subject to tax in an investor’s country.
Application of Pt. XIII tax to hybrid payer situations (pp. 17-18)
- The application of withholding tax under s. 214(18) to hybrid payer situations is an unwarranted and unnecessary extension of the ambit of the Action 2 report.
- The mischief addressed by the rules is unrelated to profit distributions or disguised payments, and is wholly addressed by denying the excess deductions.
Application of Pt. XIII tax to reverse hybrid situations (p. 18)
- Similarly, the application of withholding tax to interest paid under reverse hybrid arrangements seems inappropriate given that the deduction/non-inclusion mismatch arises from the hybrid tax status of the recipient, rather than the hybrid tax treatment of the arrangement (i.e., it is not an arrangement in which payments are treated as interest for Canadian, and dividends for foreign, tax purposes.
- The interest payments do not represent disguised distributions out of the Canadian tax system, as the recipient's status as a reverse hybrid entity generally results from ownership by Canadian residents.
Application of Pt. XIII tax to arm’s-length hybrid payer situations (p. 10)
- Even if withholding tax were to be applied to hybrid payer arrangements, withholding tax should not apply to ordinary arm's length borrowings.
- Although s. 214(18)(b) limits deemed dividend treatment to arm's length non-residents unless the non-resident is a “party” to a structured arrangement, this concept turns in part on being aware of the mismatch in tax outcomes, which will be readily evident whenever, for example, the borrower is a hybrid entity.
- Arm's length lenders will not accept any withholding tax risk that arises simply because the borrower is a hybrid entity, a dual resident, or has a foreign branch.
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.
Inappropriate breadth of definition
- The “structured arrangement” is too broad in relation to the “hybrid payer arrangement” definition.
- An arrangement that gives rise to a double deduction mismatch could be a structured arrangement even where the amount of the hybrid payer mismatch as computed under s. 18.4(15.6) was nil, due to a dual inclusion income completely offsetting the double deduction mismatch.
- For example, any arrangement involving a fiscally-transparent Canadian ULC could be considered a structured arrangement, even where the U.S. investors were dealing at arm’s length with the ULC, on the basis that the ULC is inherently designed to produce a double deduction mismatch (thereby giving rise to withholding tax issues for interest payments made by the Canadian ULC to arm’s length lenders).
- Similarly, a “structured arrangement” does not refer to the reverse hybrid mismatch amount as computed under s. 18.4(15.2) or the disregarded payment mismatch amount as computed under s. 18.4(15.4), but rather refers to all payments that produce deduction/non-inclusion mismatches or double deduction mismatches, regardless of whether those payments produce actual hybrid mismatches.
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.
Application of para. (b) to CFC income (pp. 9-10)
- Assume “XCo”, resident in County X, wholly owns “Canco”, which earns $100 of active business income, and also$10 of passive interest income, and incurs $5 of interest expense.
- Under the laws of Country X, Canco is not fiscally transparent, but under the controlled foreign company (“CFC”) regime in Country X, the passive income and expenses of Canco are included in the taxable income of XCo.
- It seems clear, based on the Action 2 Report, that Canco is not a hybrid entity by virtue of a portion of its income or expenses being included in the taxable income of XCo, unless it is due to Canco being fiscally transparent under the relevant foreign tax law, but this could be clarified.
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).
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