Hybrid Mismatch Rules: Tax Insights from the Second Round of Finance Proposals

The Department of Finance (Canada) (“Finance”) recently released its second round of proposals related to hybrid mismatch arrangements (the “Round 2 Proposals”). These new rules, which build upon a first round of proposals originally introduced in 2022 (the “Round 1 Proposals”), are complex and could have broad implications.

This post is the first in a series of updates that the Stikeman Elliott Tax Group will be providing on the Round 2 Proposals. These updates should be of general interest to multinational enterprises and other taxpayers with cross-border structures involving entities that are treated differently for tax purposes in different jurisdictions.

Background and Round 1 Proposals

On January 29, 2026, Finance released Round 2 Proposals, which follow from the Round 1 Proposals that were introduced in 2022 and enacted in 2024. The Round 1 Proposals and the Round 2 Proposals collectively represent the “Hybrid Mismatch Rules.”

The Hybrid Mismatch Rules are intended to implement the recommendations contained in the report titled Final Report on Neutralising the Effects of Hybrid Mismatch Arrangements published under Action 2 of the OECD/G20’s Base Erosion and Profit Shifting Project (the “BEPS Action 2 Report”).^[1] Broadly, the BEPS Action 2 Report sought to address arrangements that utilize mismatches in the tax treatment of a hybrid entity (an entity with differential tax treatment across jurisdictions) or a hybrid instrument (an instrument that typically is treated as debt in one jurisdiction and equity in another) to achieve non-taxation or tax deferral outcomes.^[2] Such hybrid mismatch arrangements can result in either a deduction/non-inclusion (“D/NI”) mismatch or a double deduction (“DD”) mismatch. D/NI mismatches occur when one jurisdiction allows a deduction in respect of a cross-border payment while the recipient of the payment is not required to fully include the amount in their income.^[3] DD mismatches occur when two jurisdictions grant a deduction in respect of the same payment.

The Round 1 Proposals focused on hybrid instruments driving D/NI mismatches and implemented chapters 1 and 2 of the BEPS Action 2 Report. The Round 1 Proposals introduced two operative rules to the Income Tax Act (Canada) (the “ITA”) to neutralize the effects of hybrid arrangements. The primary rule contained in ITA subsection 18.4(4) denies the payer’s deduction to the extent of a hybrid mismatch amount (the “Primary Rule”), while the secondary rule contained in ITA subsection 12.7(3) requires an income inclusion for the recipient where the mismatch is not neutralized at source (the “Secondary Rule”).^[4] The Secondary Rule is a “defensive rule” that applies only insofar as the mismatch is not otherwise neutralized by a foreign rule.^[5]

Round 2 Proposals

The Round 2 Proposals extend the Round 1 Proposals beyond hybrid instruments to include deduction denials or income inclusions for scenarios involving hybrid entities (the “Hybrid Arrangements”). Four categories of Hybrid Arrangements are targeted by the Round 2 Proposals: reverse hybrids, disregarded payments, hybrid payer arrangements, and imported mismatches. The Round 2 Proposals are intended to be effective for payments arising on or after July 1, 2026 and implement chapters 3-4, and 6-8 of the BEPS Action 2 Report.

Reverse Hybrids

A “reverse hybrid entity” is defined in respect of a payment as an entity that is “fiscally transparent” in one country but is “fiscally opaque” in a country in which an equity interest holder is resident, such that neither country treats the payment as income or profits of a resident of that country.^[6]

For example, a partnership formed in country A may be viewed by the income tax laws of country A as a partnership (and therefore taxed as a flow-through vehicle) but may be viewed under the laws of country B, where one of its investors is resident, as a corporation.

Common examples include a Cayman Island partnership (which is treated as a flow-through in the Cayman Islands but may be treated as a corporation for U.S. income tax purposes), or a U.S. limited liability company (which may be treated as a partnership in the U.S., but as a corporation in many foreign jurisdictions). These types of entities may create D/NI mismatches when the payer deducts an amount and there is no corresponding income inclusion. This results in income escaping taxation on a net basis because of the different tax treatments in two jurisdictions.

Under proposed ITA subsection 18.4(15.1), a payment will be within the scope of the reverse hybrid arrangements rule if the following conditions are met:

1. The payment is made to an entity that is a reverse hybrid entity in respect of the payment.
2. The payer and the reverse hybrid do not deal at arm’s length, or the payment arises under or in connection with a “structured arrangement” (generally, an arrangement where it can reasonably be considered that the economic benefits of a mismatch are priced into the arrangement, or that the arrangement is otherwise intentionally designed to produce a mismatch).
3. The payment gives rise to a D/NI mismatch.
4. The amount of the D/NI mismatch exceeds the amount that, had the actual payment been made proportionately to the investors in the reverse hybrid entity, would be a D/NI amount that would not have been caught by a hybrid mismatch rule.

This final condition essentially compares the tax treatment of the actual payment to the treatment of a hypothetical payment received by the owners of the reverse hybrid entity, and is meant to test whether the D/NI mismatch results from the hybrid treatment of the reverse hybrid entity rather than some other cause. The mere existence of a mismatch is therefore not sufficient for the reverse hybrid rule to apply; the rule applies only if a payment to a reverse hybrid produces a different tax outcome than would occur if the payment were made directly to the investor of the reverse hybrid.

Where the four conditions described above are satisfied, a payment under a reverse hybrid arrangement could result in a deduction denial under the Primary Rule and, where the denied deduction is in respect of interest, withholding tax under Part XIII of the ITA.

Disregarded Payments

For the purposes of determining the existence of a disregarded payment arrangement, the definition of “hybrid entity” is relevant. Under the Round 2 Proposals, a “hybrid entity” is a tax resident entity that is treated as fiscally opaque in one country while being treated as fiscally transparent in a second country such that a portion of its income, profits, expenses or losses are treated, under the laws of the latter country, as those of a resident of the latter country for income tax purposes.^[7]

For example, a corporation incorporated in country C may be viewed by the income tax laws of country C as a corporation resident in country C but may be viewed under the laws of country D, where one of its investors is resident, as an extension of the investor with no separate existence for income tax purposes.

A common example is an unlimited liability company (“ULC”) incorporated under the laws of Alberta, British Columbia, Nova Scotia or Prince Edward Island. Although ULCs are treated as corporations for Canadian tax purposes, the U.S. often treats them as fiscally transparent and may thus disregard them altogether when testing payments.

Proposed ITA subsection 18.4(15.3) provides four conditions for determining whether a payment arises within the scope of a disregarded payment arrangement:

1. The payer must be a hybrid entity.
2. The payer and the recipient do not deal at arm’s length, or the payment arises under or in connection with a “structured arrangement”.
3. The payment gives rise to a D/NI mismatch.
4. It can reasonably be considered that the D/NI mismatch arises in whole or in part because the payment is disregarded in the recipient’s jurisdiction (ignoring other causes of the mismatch, including the recipient’s tax-exempt status or specific statutory income tax exemptions permitted under foreign law).

Where these conditions are satisfied, the D/NI mismatch can result in either the Primary Rule or the Secondary Rule applying, depending on whether the payer or the recipient is a Canadian resident. These tax consequences can be mitigated in certain circumstances. Generally, if the hybrid entity earns income that is taxed in both jurisdictions, that income (referred to as “dual inclusion income” (“DII”) or “investor dual inclusion income” (“IDII”) in the Round 2 Proposals) can be used to offset the mismatch, reducing or eliminating the deduction denial or income inclusion (as the case may be). Unused DII or IDII can be carried forward to future years.

Hybrid Payer Arrangements

A “hybrid payer” is a hybrid entity, an entity resident in two countries, or an entity resident in one country and subject to tax in another country by virtue of carrying on business through a permanent establishment in that other country. The intent of the new rule pertaining to hybrid payer arrangements is to prevent a DD mismatch for the same payment (i.e., where the entity’s treatment allows for the same deduction to be made in multiple jurisdictions).^[8]

For example, a corporation incorporated in country E may have a permanent establishment (i.e., a branch) in country F, with the result that the same underlying payment might be deductible in both countries.

Proposed ITA subsection 18.4(7.1) provides certain conditions for determining whether a payment produces a DD mismatch:

1. The payer must be a hybrid payer.
2. For a hybrid entity resident in Canada:
   • The hybrid entity 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 equivalent foreign hybrid payer mismatch rule has neutralized the mismatch in respect of at least one investor.
3. For a multinational entity resident outside Canada:
   • No equivalent foreign hybrid payer mismatch rule has neutralized the mismatch in the entity's home jurisdiction.
4. The payment gives rise to a DD mismatch.

The rules includes special ordering provisions to determine which country has priority to deny the deduction. Generally, the country of residence of the "parent" (the investor in the hybrid payer) has priority. In other words, Canada will deny the deduction only if the investor's home country has not already applied its own hybrid mismatch rules to neutralize the mismatch.

If the conditions noted above are met, Canada will either deny a deduction under the Primary Rule in the case of hybrid entities or multinational entities, or, in the case of partnerships, will require Canadian partners to include an “investor hybrid mismatch amount” in their income under a modified Secondary Rule. In both cases, the impact of the rules can be mitigated to the extent of any DII or IDII, as the case may be, subject to no double counting for any DII or IDII applied under the disregarded payments regime.

Imported Hybrid Mismatches

The fourth, and perhaps most complicated and wide-reaching of the new Hybrid Mismatch Rules, are the rules pertaining to “imported hybrid mismatches.”

These new rules are intended to capture payments that create a D/NI or DD mismatch between foreign countries that have not been fully neutralized by a foreign hybrid mismatch rule and where there is a sufficient nexus to a deductible payment made by a Canadian resident.^[9]

No offshore mismatch exists if the mismatch has been substantially neutralized by foreign rules. However, where a Canadian deduction is tied through a chain of payments to an offshore mismatch, then a portion of the Canadian deduction is denied. The stated objective of these rules is to stop Canadian deductions from financing untaxed or doubly deducted amounts elsewhere in the chain.

SE Tax Blog Series – Hybrid Mismatch Rules

Both broad and complex, the Round 2 Proposals introduce several important changes to the Hybrid Mismatch Rules that will be of interest to taxpayers or practitioners who frequently deal with cross-border tax structures. Even where a structure or arrangement was not intended to result in a D/NI or DD mismatch, these such arrangements may need to be reviewed to avoid unintended tax consequences flowing from the new rules.

[1] Explanatory Notes to the Legislative Proposals Relating to the Income Tax Act - Hybrid Mismatch Arrangements, April 2022, p. 3.

[2] OECD, Neutralising the Effects of Hybrid Mismatch Arrangements, Action 2 - 2015 Final Report (EN), pp. 11-13.

[3] Explanatory Notes to the Legislative Proposals Relating to the Income Tax Act - Hybrid Mismatch Arrangements, April 2022, p. 3.

[4] Explanatory Notes to the Legislative Proposals Relating to the Income Tax Act - Hybrid Mismatch Arrangements, April 2022, p. 4.

[5] Explanatory Notes to the Legislative Proposals Relating to the Income Tax Act - Hybrid Mismatch Arrangements, April 2022, p. 4.

[6] Explanatory Notes to Legislative Proposals Relating to the Income Tax Act and Regulations, February 2026, p. 96.

[7] Explanatory Notes to Legislative Proposals Relating to the Income Tax Act and Regulations, February 2026, pp. 92-93.

[8] Explanatory Notes to Legislative Proposals Relating to the Income Tax Act and Regulations, February 2026, pp. 88, 109.

[9] Explanatory Notes to Legislative Proposals Relating to the Income Tax Act and Regulations, February 2026, pp. 114-115.

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