Canada’s Phase 2 hybrid mismatch rules — Here is what to do before July 1, 2026.

Starting July 1, 2026, the Phase 2 amendments to Canada’s hybrid mismatch arrangement rules in s. 18.4 of the Income Tax Act (the “HMA Rules”) will deny deductions on a far broader set of payments than Phase 1 reached. If your structure includes a Canadian unlimited liability company (“ULC”) or a partnership that is treated as a corporation for US tax purposes, deductions in the structure may be denied.  In the case of denied interest deductions, the interest will also be subject to Canadian withholding tax at 25% (subject to potential treaty relief).

Phase 2 targets entity-level hybridity, most commonly a corporation for Canadian tax purposes that is fiscally transparent for foreign tax purposes (a hybrid), such as a Canadian ULC with U.S. tax residents in the ownership chain, or a partnership that is fiscally transparent for Canadian tax purposes and a corporation for foreign tax purposes (a reverse hybrid). There is no grandfathering and no transitional period. Phase 2 also introduces imported hybrid mismatch arrangement rules, which are beyond the scope of this Insight.

Where do things stand?

As of late May 2026, Phase 2 remains in draft form, but the July 1, 2026 effective date has not been pushed. Taxpayers should plan on the basis that Phase 2 will be enacted substantially as drafted, with retroactive effect to July 1, 2026.

What do the HMA Rules target?

The HMA Rules address cross-border tax arbitrage that arises through hybridity: situations where, because of the inherent nature of an entity or instrument, the same entity (or the same instrument) is characterized differently under the tax law of two countries. The mismatch is typically a deduction in Canada with no corresponding income inclusion in Canada or in any foreign jurisdiction (a “D/NI”) or two deductions for one payment (a “DD”). Phase 1 of the HMA Rules, enacted in Bill C-59 (which received Royal Assent June 20, 2024) and effective for payments arising on or after July 1, 2022, addresses instrument-level hybridity. Phase 2 will add entity-level hybridity and imported mismatches.

Phase 2

Phase 2 targets two outcomes:

  • One-sided deductions (D/NI). A Canadian taxpayer claims a deduction without a corresponding income inclusion in Canada or in any foreign jurisdiction. Typical case: a ULC pays interest to its U.S. parent, and the payment is disregarded under U.S. tax law because the ULC is treated as a disregarded entity (a Disregarded Payment Arrangement); or a payment by a Canadian taxpayer to a partnership that is treated as a corporation under one or more of its foreign owners’ home country’s tax law (a Reverse Hybrid Arrangement).
  • Two-sided deductions (DD). The same payment is deducted in Canada and in a foreign jurisdiction. Typical case: a ULC whose payments are also deducted in the U.S. because the ULC is fiscally transparent for U.S. tax purposes (a Hybrid Payer Arrangement).

For Phase 2 to engage, the payer and recipient must be non-arm’s-length, and the mismatch must be attributable, in whole or in part, to the hybridity. Phase 2 also reaches an Imported Hybrid Arrangement: a deductible payment by a Canadian taxpayer linked through a non-arm’s-length chain to a hybrid mismatch arising entirely between foreign parties offshore. The HMA Rules also reach arm’s-length parties whose arrangement qualifies as a “structured arrangement”, a defined term targeting arrangements designed to produce a hybrid mismatch, but this Insight is limited to the non-arm’s-length context.

Current anti-hybrid rules in Canada-U.S. Tax Treaty are layered on top

The HMA Rules apply only to deductible payments. Equity-like distributions on which no deduction is claimed are outside the HMA Rules and remain subject to Canada’s domestic Part XIII 25% withholding tax, with treaty relief available where applicable. To date, Canada has negotiated an anti-hybrid rule in only one of its tax treaties – the Canada–U.S. Tax Treaty – which may deny treaty relief on both deductible and non-deductible payments made by a hybrid entity to a U.S. tax resident. The anti-hybrid rule in that treaty operates in addition to, not in lieu of, the HMA Rules.

Consequences of the HMA Rules

Where the payer is a Canadian taxpayer, the HMA Rules deny the deduction. Where the denied amount was interest, the HMA Rules re-characterize it as a deemed dividend, attracting Part XIII withholding tax at 25% (subject to treaty rates, but treaty access may itself be limited where the payer is a hybrid entity or the recipient is a hybrid entity), so a Canadian outbound interest payment caught by the HMA Rules loses its deduction and attracts Canadian withholding tax, two distinct adverse outcomes from one payment. For mismatches under a Disregarded Payment Arrangement (D/NI) or a Hybrid Payer Arrangement (DD), the denial applies only to the extent the mismatch amount exceeds the hybrid payer’s (e.g., the ULC’s) “dual inclusion income”, the hybrid payer’s income that is taxed both in Canada (in the hybrid payer’s hands) and in the foreign jurisdiction (in the investor’s hands, because the foreign jurisdiction treats the hybrid payer as fiscally transparent). The offset reflects that where the same underlying income is being taxed in both jurisdictions, the matching deduction is not creating an asymmetric tax benefit. Where Canada is the recipient of a foreign hybrid payment, the HMA Rules require an income inclusion as a backstop, but only to the extent the foreign payer jurisdiction has not already neutralized the mismatch by denying a deduction.

What to do now?

Four steps before July 1:

  1. Identify exposure. If your structure includes a Canadian ULC with a U.S. direct or indirect owner, or a Canadian partnership that is treated as a corporation under the tax law of one or more of its foreign partners’ home jurisdictions, Phase 2 may apply to one or more of your deductible payments.
  2. Review payments. Review every deductible payment by a Canadian taxpayer to a non-resident – interest, royalties, management or services fees, rent, and flag arrangements where any party in the chain is a hybrid or reverse hybrid entity, or where the chain is linked to an offshore hybrid mismatch.
  3. Engage Canadian and foreign tax advisers. Classifying a flagged arrangement as a D/NI, a DD, or neither requires understanding the foreign tax consequence of the payment, whether the recipient jurisdiction includes the amount in income, whether the same payment also generates a deduction in the foreign jurisdiction, and whether any foreign anti-hybrid rule has already neutralized the mismatch. For groups with foreign-to-foreign payment chains, the imported-arrangement limb adds a documentation burden of tracing offshore non-arm’s-length payment flows.
  4. Restructure before July 1. Where the current arrangement will not survive, the structural fixes need to be in place before July 1. A check-the-box election is the most direct tool that can be used to address Phase 2 by eliminating the hybridity. Other options include alternative financing routes that bypass the hybrid entity or repatriation of payment streams to a non-hybrid structure. There is no relief mechanism for payments caught on the wrong side of July 1 absent a structural change. Any proposed change, including a check-the-box election, also requires consideration of the U.S. tax consequences of the proposed solution.

Conclusion


Phase 2 of the HMA Rules arrives on July 1, 2026, with no grandfathering, no transitional relief, and no mechanism to unwind a payment that falls on the wrong side of the effective date. For any group with deductible cross-border payments that include a Canadian ULC or a reverse hybrid, the exposure is real and the window to address it is short. The solution requires Canadian tax advisers who understand the HMA Rules working alongside foreign advisers who can assess the US tax consequences to determine whether the HMA rules are invoked and whether the fix has any negative US tax consequences, The four steps outlined above are the minimum steps that should be taken.

Speak with a lawyer from our Tax Group before July 1 to determine if your structure may be affected  and – where needed – implement a structural fix before the deadline.