In April, draft legislative proposals to the Income Tax Act to address hybrid mismatch arrangements were released. The Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada, in a submission to Finance Canada, outlines several comments on key areas related to the draft legislative proposals.
The government of Canada defines hybrid mismatch arrangements as “cross-border tax avoidance arrangements that exploit differences in the income tax treatment of business entities or financial instruments between two or more countries.” In its 2021 budget the government committed to bringing forward legislation to address them. The first package was released at the end of April 2022. The joint committee’s most salient comments are summarized below.
Effective date
The Joint Committee notes that while the timeline set out in the 2021 budget allowed for more than six months between the introduction of proposed legislation and its effective date, the proposed legislation was released on April 29, 2022, with an effective date of July 1, 2022. The Joint Committee also notes that the deadline for submissions was one day before the proposed legislation’s effective date. “This reduced comment period may not provide sufficient time for stakeholders to provide meaningful commentary on the proposed legislation, or for affected taxpayers to restructure their affairs to comply with this legislation,” the letter says. (While Parliament has yet to pass the legislation at the time of writing, the draft legislation would apply the new rules to payments made or deemed to be made on or after July 1, 2022.)
Recognition of foreign withholding tax
The draft legislation would result in an absence of deduction for foreign withholding tax paid on a dividend received by a corporation resident in Canada from a foreign affiliate of the corporation. “Given that the reduction of the dividend in the foreign country (which would trigger the application of proposed subsection 113(5)) would generally not reduce withholding tax on the dividend, this result seems inappropriate,” the letter says. Including that in some circumstances this would lead to double taxation. The Joint Committee recommends modifying the proposed subsection 113(5) to allow grossed-up deductions for such withholding tax.
Application to foreign affiliates
The draft proposals are not clear on whether they would apply to transactions involving foreign affiliates of taxpayers resident in Canada. The Joint Committee recommends that “clause 95(2)(f.11)(ii)(A) should be expanded to exclude the application of proposed sections 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 nonqualifying business.” A similar adjustment should be made to the definition of “earnings” in subsection 5907(1) of the Income Tax Regulations.
Definitions of “Canadian ordinary income” and “foreign ordinary income”
There are several concerns over the wording of those definitions, which the letter describes in detail. Broadly speaking, the Joint Committee recommends that they “should be clarified such that inclusions in respect of a particular amount are not reversed as a result of any deductions or other relief that may be applicable as a result of other payments – that is, payments other than the payments that give rise to the included amounts.”
As well, the definition of foreign ordinary income should be made clearer when it comes to tax-exempt entities, those that are located in jurisdictions where they are not taxed, or in jurisdictions that tax them at rates lower than those applied to individuals and other entities.
De minimis rule
The proposed legislation contains one specific de minimis that is problematic because it might lead to double taxation. There are no other, broad de minimis rules in the draft legislation, which is also a concern. The Joint Committee proposes to decrease the cost and administrative burden to both the Canada Revenue Agency and taxpayers by replacing the current de minimis rule with a “broader de minimis exclusion for small hybrid mismatch amounts,” which would more efficiently target arrangements of concern for tax administrations.
Interaction with other rules
As the Joint Committee notes, the proposed hybrid mismatched rules “are a detailed and complex set of rules that can have a fundamental impact on the treatment of certain financial instruments, transactions and other arrangements for Canadian tax purposes.” That’s why it is crucial to give proper consideration to how they can potentially impact other provisions within the Act. The letter identifies a few areas of concern: EIFEL rules that are currently undergoing revisions and about which the Joint Committee has already offered comments, capitalization rules and foreign tax credit generator rules.