Tax Insights: Finance releases second package of hybrid mismatch rules

Isssue 2026-07

In brief

What happened? 

On January 29, 2026, the Department of Finance (Finance) released draft legislation to implement various 2025 federal budget, 2024 Fall Economic Statement and other measures. The release includes the initial draft of legislation to implement the second package¹ of the hybrid mismatch rules (Second Package) that were announced in the 2021 federal budget.

Why is it relevant?

The hybrid mismatch rules are generally intended to eliminate the tax benefits arising from hybrid mismatch arrangements by implementing into the Income Tax Act (Act)² the relevant recommendations of the Organisation for Economic Co‑operation and Development (OECD) BEPS Action Plan (Action 2 Report).³ The first package (First Package) of hybrid mismatch rules generally focused on arrangements involving hybrid treatments of financial instruments that give rise to deduction/non‑inclusion (D/NI) mismatches (including mismatches involving hybrid transfers of financial instruments and substitute payments relating to these instruments). The Second Package is generally focused on hybrid treatments of entities that give rise to either a D/NI mismatch or a double deduction (DD) mismatch.

The rules in the Second Package are proposed to apply in respect of payments arising after June 30, 2026. There is no grandfathering for existing arrangements.

Action(s) to consider

Taxpayers should review the proposed new rules and determine whether they could apply to their existing arrangements. If they do apply, taxpayers should consider restructuring those arrangements before the rules are proposed to take effect on July 1, 2026.

Finance is inviting comments by February 27, 2026, in respect of all draft tax legislation released on January 29, 2026.

In detail

Overview

Hybrid mismatch arrangements

“Hybrid mismatch” is a term used to describe tax arbitrage that is based on hybridity (i.e. the differing treatment of arrangements or entities under the tax laws of two countries). Many cross-border tax planning arrangements around the world have sought to use hybrid mismatches to obtain additional deductions (e.g. for interest and other financing payments). In some cases, this planning achieves:

• a deduction under the tax laws of one country without a full corresponding income inclusion under the tax laws of the other country – this is referred to as a D/NI mismatch, or
• two deductions for the same payment (i.e. a deduction is taken when computing the tax base in two different countries) – this is referred to as a DD mismatch 

To neutralize the tax arbitrage created by hybrid arrangements, an ordering is required to determine which country will pick up the tax, and to ensure there is no double taxation. As such, the hybrid mismatch rules typically contain:

• a primary rule, which generally allows a denial of the deduction to the country under whose laws the deduction is otherwise granted, and 
• a secondary rule, which in most cases allows the country that is otherwise not taxing the receipt of the payment to tax the mismatched amount if the other country is not applying the primary rule  

Hybridity generally arises from the differing tax treatment of:

• the instrument underlying the payment (e.g. treated as debt in one country and equity in another country), or 
• the entities involved in the payment (e.g. treated as separate entities in one country and transparent in another country)

Second Package rules

The proposed rules in the Second Package:

• adopt the basic structure of the rules enacted under the First Package, and 
• mainly add new bases for determining whether an expense denial (under the primary rule in subsection 18.4(4)) or income inclusion (under the secondary rule in subsection 12.7(3)) is warranted to neutralize a perceived mismatch 

These new bases for mismatches can generally be grouped into the following categories:

• reverse hybrid arrangements
• disregarded payment arrangements
• hybrid payer arrangements
• imported hybrid arrangements

The first and second categories target certain D/NI mismatches while the third targets certain DD mismatches. The fourth category is a supporting rule – it targets certain arrangements that effectively import the benefit of a hybrid mismatch into Canada.

Historical background

The 2021 federal budget announced two significant measures with potentially far-reaching implications on the cross-border arrangements of multinational enterprises: the excessive interest and financing expense limitation (EIFEL) and hybrid mismatches. Both measures emanated from the OECD’s BEPS initiative: EIFEL from the Action 4 Report and hybrid mismatches from the Action 2 Report.

While EIFEL has been largely addressed, subject to some outstanding tweaks, a large subset of the hybrid mismatches initiative remained outstanding, which has now mostly been addressed by the Second Package of hybrid mismatch rules. The Second Package is proposed to apply “in respect of payments arising on or after July 1, 2026” – this is consistent with the 2021 federal budget, which had stated that the Second Package would apply “no earlier than 2023.” 

Similar to EIFEL, the Second Package is proposed to apply to arrangements put in place before their effective time. In other words, there is no grandfathering for transactions and arrangements put in place before July 2026. In contrast, the EIFEL rules had a longer transition time from the release of the initial draft legislation (on February 4, 2022) to their effective date (taxation years beginning after September 2023), allowing more time for restructuring.

Second package

General structure of the new rules

The Second Package adds a significant amount of complexity to what is already a complex set of rules. However, the basic framework of the existing hybrid mismatch rules has been maintained. Specifically, the primary “deduction denial” rule in subsection 18.4(4) has been expanded to include additional arrangements in its scope. 

The secondary “income inclusion” rule in subsection 12.7(3) is subject only to very limited amendments. However, in the context of the new “hybrid payer arrangement” rules, a separate rule is being added in subsection 12.7(4) to effect an income inclusion for a partner in lieu of an expense denial to the partnership itself. This new rule is a “primary” rule. 

Consequential amendments are also made to the Part XIII withholding tax deemed dividend rule, the remedial deduction rules (for amounts that are included in foreign income in a future year, thus resolving the mismatch), and the Part XIII withholding tax refund rules relating to remedial deductions. There are no proposed amendments to the existing foreign affiliate dividend deduction rules.

Some new terminology

The rules in the Second Package apply to certain arrangements involving payments made by “hybrid payers” or payments received by “reverse hybrid entities.” These defined terms (and a few related terms) are key to understanding the new arrangements being targeted, especially since some may seem counterintuitive.

Hybrid payer

A “hybrid payer” is a “payer” that is a hybrid entity, a multinational entity or a dual resident; each of these terms is defined in the Second Package.

Hybrid entity

A “hybrid entity” is defined as a particular entity (which includes a corporation, partnership and trust) that is resident in a country (Country A), but any portion of its income, expenses, profits or losses are treated as those of a second entity under the tax laws of another country (Country B) in which the second entity is resident. This typically occurs when the second entity directly or indirectly holds an equity interest in the hybrid entity, and the hybrid entity is viewed as transparent under the tax laws of Country B. That second entity is generally defined as an “investor” in the hybrid entity. For these purposes, and all purposes of the hybrid mismatch rules, the residence of an entity in a particular country is to be determined based on whether the entity is resident in that country for income tax purposes under the laws of that country.

This definition would capture a partnership organized under the laws of a US state that is treated as a corporation under US tax law but is considered a partnership under Canadian principles and has at least one Canadian partner. It would also capture an unlimited liability company formed under the laws of a Canadian province that is owned by a US corporation and treated as transparent under US tax law.

Multinational entity

A “multinational entity” is defined as an entity that is resident in one country and subject to tax in another country, because it carries on business through a permanent establishment in that other country. This is somewhat counterintuitive in that it looks only to the legal entity itself in determining multinational status (i.e. it does not look to the group of entities of which the entity may be a part). 

Dual resident

A “dual resident” is defined as an entity that is resident in two different countries. 

Reverse hybrid entity

Unlike other definitions in the Second Package, which define an entity in absolute terms, a reverse hybrid entity is defined in respect of a “payment received by the entity.” The definition “reverse hybrid entity” (RHE) in respect of a payment will apply when:

• the income relating to the payment is not subject to tax in a particular country, because the particular country considers the income to belong to one or more other entities, and 
• at least one entity that directly or indirectly holds an equity interest in the RHE is not subject to tax on the income in their country of residence, because the tax law of that country treats the payment as being income of the RHE 

The RHE definition would typically apply when an entity is viewed as transparent under the tax laws of the country where it is formed, but is viewed as a separate entity under the tax laws of the country where its owner is resident. For example, this definition captures a situation when a payment is received by a US limited liability company (LLC) that is held by a Canadian corporation and the LLC is treated as either a disregarded entity or a partnership under US tax law, but is treated as a non-resident corporation for Canadian tax purposes. In these circumstances, a payment received by the LLC would not be taxed in the United States and could also avoid Canadian taxation if the income does not create foreign accrual property income (FAPI).

This definition would also appear to apply when payments are received by a partnership formed in Canada (or another country that treats it as fiscally transparent), whose partners are US residents and for which an election is made under US tax law to treat the partnership as a corporation. 

Some payments that are subject to this definition would already be subject to anti-avoidance rules under certain tax treaties, which result in higher withholding taxes. However, the hybrid mismatch rules do not take into account increased withholding taxes when determining whether a mismatch has been partly or fully resolved.

New targeted arrangements

Reverse hybrid arrangements

A payment will be in the scope of the reverse hybrid arrangements rule if:

• the payment is made to an entity that is a RHE in respect of the payment
• the payer does not deal at arm’s length with the RHE, or the payment is made under a structured arrangement
• the payment gives rise to a D/NI mismatch, and
• the amount of the D/NI mismatch exceeds the amount that would, if the payment were instead received by the direct owners of the RHE, be a D/NI mismatch that would not be denied under one of the hybrid mismatch rules from the First Package

The final condition essentially compares the tax treatment of the actual payment to the treatment of a hypothetical payment received by the owners of the RHE. This condition is meant to test whether the D/NI mismatch results from the hybrid treatment of the RHE (instead of some other cause). 

When these conditions are met, a deduction for the payment would be denied (under subsection 18.4(4)) to the extent of the excess amount so determined. Unlike most other hybrid mismatch rules, there is no secondary rule (i.e. this rule only applies when the excess amount erodes the Canadian tax base).⁴  As this rule could apply to payments made by a Canadian corporation to certain partnerships, it may be necessary to determine whether the two parties do not deal at arm’s length. This could be a difficult exercise, because there is a lack of relevant statutory rules under the Act and the determination would usually be made using factual arm’s length principles.

Disregarded payment arrangements

A payment will be in the scope of the disregarded payment arrangements rule if:

• the payer is a hybrid entity
• the payer does not deal at arm’s length with the recipient, or the payment is made under a structured arrangement
• the payment gives rise to a D/NI mismatch, and
• it can reasonably be considered that the D/NI mismatch: 
  • arises in whole or in part because the payment is disregarded under the laws of the country of residence of the recipient, or
  • would arise in whole or in part because the above condition would be satisfied if all other conditions for the D/NI mismatch were disregarded

The awkward wording of the last condition is meant to ensure that one cannot escape this rule by arguing that other conditions could also have contributed to the D/NI mismatch.

When a payment meets these conditions, either of the following will occur:

• if the payer is a Canadian resident, a deduction for that payment will be denied under subsection 18.4(4)
• if the recipient is a Canadian resident, an amount will be included in income under subsection 12.7(3) 

However, there would be no income inclusion if the other country applies its primary rule to deny a deduction for the payment. As this rule could apply to partnership payers, it may also be necessary to apply factual arm’s length principles.

Hybrid payer arrangements

A payment will be in the scope of the hybrid payer arrangements rule if the following conditions are met:

• the payer is a hybrid payer
• if the hybrid payer is a hybrid entity resident in Canada:
  • either the payer does not deal at arm’s length with an investor in the hybrid entity or the payment is made under a structured arrangement, and
  • no foreign hybrid payer mismatch rule applies to at least one investor in the hybrid entity
• if the hybrid payer is a multinational entity resident in a country other than Canada, no foreign hybrid payer mismatch rule applies to the multinational entity
• the payment gives rise to a DD mismatch 

The conditions relating to foreign hybrid payer mismatch rules establish, in certain circumstances, special ordering rules for determining which of the two relevant countries will have priority to apply its hybrid mismatch rules. This is achieved by the second and third conditions described above, which apply only to certain types of hybrid payers. Under these special ordering rules, priority is given to the country of residence of the “parent” of the hybrid payer. Thus, if the hybrid payer is a hybrid entity resident in Canada, Canada will resolve the mismatch by denying a deduction under subsection 18.4(4) only if the mismatch is not resolved by the country of residence of the investor/parent of the hybrid payer. 

Similarly, if the hybrid payer is a multinational entity resident in another country, that other country will have priority. In both cases, if the other country does not resolve the mismatch, then subsection 18.4(4) will apply to deny the deduction taken against the Canadian tax base. When neither of these specific ordering rules apply (i.e. when the hybrid payer is a dual resident), then Canada will apply subsection 18.4(4), regardless of whether the other country has applied its mismatch rules.

Note that a person will generally be an “investor” in a Canadian-resident hybrid entity only if any portion of the hybrid entity’s income is treated as their income under the tax laws of their country of residence (based on the “investor” definition discussed above under “Hybrid entity”). 

On the topic of income inclusion, there is one other unique feature of the hybrid payer arrangement rules: if the hybrid payer is a hybrid entity that is a partnership (e.g. a partnership that is treated as a corporation for US tax purposes, but has Canadian-resident partners), then instead of denying a deduction under the primary rule in subsection 18.4(4), there will be an income inclusion for the Canadian partners under a special rule in subsection 12.7(4). Thus, unlike the other rules in section 12.7, this is not a secondary rule. Other than that special rule, the hybrid payer arrangement rules do not contemplate an income inclusion under section 12.7.

Imported hybrid arrangements

Imported hybrid arrangements are different from the other arrangements, because they target hybrid mismatch arrangements that indirectly affect the Canadian tax base, instead of arrangements in which Canadian taxpayers are direct participants. This makes the design of these rules among the most complex in the hybrid mismatch rules. The detailed conditions for the application of these rules are beyond the scope of this publication. 

In general terms, there must be an “offshore mismatch” (essentially a hybrid mismatch arrangement involving parties in different foreign countries), and the benefit of this mismatch must be effectively “imported” into Canada (meaning that a Canadian taxpayer makes a deductible payment either directly to the participant in the offshore mismatch, or indirectly through a series of linked payments). Essentially, the payment made by the Canadian taxpayer is included in the foreign recipient’s income, but is offset against a deduction generated by the offshore mismatch, such that the recipient of the payment is not fully taxed on the income.   

Accordingly, the imported hybrid mismatch rules do not have a secondary rule that can give rise to an income inclusion under subsection 12.7(3) – they can only deny a deduction under subsection 18.4(4).

More to come?

Although the 2021 federal budget referred only to two planned legislative packages to address hybrid mismatches, it is unclear whether the Second Package is the final package, because there appear to be some gaps between what is addressed in these two packages and the recommendations in the Action 2 Report. For example, the Action 2 Report included recommendations to address several different types of hybrid mismatches involving branches. While some of the branch mismatches are dealt with in the Second Package, others do not appear to be addressed by the proposed legislation. Finance may have decided that those issues are not sufficiently relevant in the Canadian context, or Finance may be using its scarce resources to address hybrid mismatch issues in order of significance and may release additional legislation to address these other mismatches in the future. 

Foreign tax credit generator rules

The foreign tax credit generator (FTCG) rules have long been problematic when working with hybrid arrangements. These rules were Finance’s first attempt at addressing certain hybrid mismatch arrangements. When they apply, the FTCG rules can permanently deny foreign tax credits (and equivalent deductions for underlying foreign taxes paid by foreign affiliates). Unfortunately, only minimal attempts have been made over the years to introduce exceptions for sympathetic circumstances. This may be because Finance was waiting to complete its hybrid mismatch initiative and then repeal the FTCG rules. Finance may not yet be willing to repeal the FTCG rules, particularly if it believes more work is needed to complete the hybrid mismatch initiative. However, given the slow progress of the initiative to date, it would seem appropriate for Finance to immediately address some of the more problematic fact patterns under the FTCG rules.

Integration with EIFEL and the thin capitalization rules

As both EIFEL and the hybrid mismatch rules could operate to deny all or part of an amount of interest and financing expenses, the order of application of these rules must be taken into account. Consistent with the existing expense denial rule in subsection 18.4(4), the rules in the Second Package will generally⁵ apply in priority to EIFEL. As such, any amounts denied under subsection 18.4(4) will not be taken into account for EIFEL (including in the determination of the EIFEL denial ratio). For more information on EIFEL, see our Tax Insights “Bill C-59: Excessive interest and financing expenses limitation (EIFEL) regime” (September 16, 2025 update). Similarly, subsection 18.4(4) generally⁵ has priority over the thin capitalization rules.

Federal Bill C-15

Although the legislation for the First Package was enacted in Bill C-59 (royal assent: June 20, 2024; Statutes of Canada 2024, chapter 15), some tweaks to that legislation are before Parliament in Bill C-15 (currently being studied by the House of Commons and Senate finance committees). Those tweaks narrow the scope of an earlier measure, involving a FAPI inclusion for dividends between foreign affiliates for which a deduction is granted in the payer’s jurisdiction. These amendments apply in respect of dividends received after June 2024, which is the same timing as the initial rule.

The takeaway

Although well integrated with the existing hybrid mismatch rules, the rules in the Second Package add a significant amount of complexity to an already complex regime. Taxpayers should carefully review these rules to determine whether they apply to their existing arrangements. In some cases, taxpayers may need to refer to the explanatory notes⁶ and the Action 2 Report for additional guidance.

As with the rules in the First Package, taxpayers must have a sound understanding of the foreign tax treatment of their arrangements when applying the proposed rules in the Second Package to those arrangements. Since the rules in the Second Package are proposed to take effect on July 1, 2026, taxpayers must act quickly to assess the impact of these rules on their financing arrangements and consider whether restructuring is warranted.