Finance releases revised second package of hybrid mismatch rules

On July 23, 2026, the Department of Finance released revised draft legislation and explanatory notes for the second package of Canada's hybrid mismatch rules (the July Proposals). They revise the draft legislation released on January 29, 2026 (the January Proposals) following stakeholder consultations. Finance is accepting comments until September 4, 2026.

As discussed in our earlier update, the January Proposals formed part of Canada's implementation of the OECD's BEPS Action 2 recommendations. They expanded the regime beyond hybrid financial instrument arrangements to cover reverse hybrid arrangements, disregarded payment arrangements, hybrid payer arrangements, and imported mismatch arrangements. The July Proposals retain this framework but make several important refinements and clarifications.

Key developments

Interaction with the thin capitalization rules

The July Proposals generally require Canada's thin capitalization rules to apply before the hybrid mismatch rules. This ordering addresses concerns about the consequences of applying the hybrid mismatch rules first. Consequential amendments apply the new ordering rule consistently across the regime.

Narrowing of deemed dividend consequences

The January Proposals extended deemed dividend treatment to additional hybrid mismatches under the second package. The July Proposals largely reverse this approach. Deemed dividend treatment generally remains limited to certain hybrid financial instrument arrangements under the first package. Finance considers the newer mismatches less likely to substitute for equity.

Changes to the hybrid payer rules

Finance revised the hybrid payer rules for double deductions. The amendments change how mismatches are measured by comparing Canadian and foreign deductions. They also add rules for valuation and dual inclusion income. Further rules prevent ordinary income from being counted more than once. These changes better align the rules with their policy objectives.

Refinements to the reverse hybrid rules

The July Proposals broaden certain aspects of the reverse hybrid rules. The revised relationship test captures more circumstances involving investors in reverse hybrid entities. The core framework remains unchanged, but the rules may apply more broadly when entity classification differences create targeted mismatches.

Additional interpretive guidance

The updated explanatory notes clarify several concepts, including the meaning of a foreign hybrid payer mismatch rule, the concept of residence, the definition of ordinary income, and the meaning of hybrid entities. They also address stakeholder questions about foreign hybrid mismatch rules, treaty residence, and when an entity qualifies as a hybrid entity.

Takeaway

The July Proposals preserve the January Proposals' core structure but respond to several stakeholder concerns. Finance has not proposed a general delay to the July 1, 2026 effective date. Multinational groups involving branches, fiscally transparent entities or other hybrid arrangements should continue assessing the rules and monitoring the consultation process.