On 23 July 2026, the Department of Finance released draft legislative proposals to implement various previously announced tax measures. Included in these legislative proposals are updated proposed amendments to the hybrid mismatch rules that were originally announced on 29 January 2026, commonly referred to as the second package of hybrid mismatch rules (the January 2026 proposals). The second package addresses mismatches arising from the hybridity of an entity (reverse hybrid arrangements, disregarded payment arrangements and hybrid payer arrangements) as well as imported mismatches.

For a summary of the other proposals included in the general package of draft income tax legislative proposals, see EY Global Tax Alert, Canada Dept. of Finance releases draft legislative proposals for Budget 2025 and other previously announced measures, dated 29 July 2026.

Interested parties are invited to provide comments on the proposed amendments by 4 September 2026.

This Tax Alert summarizes certain key amendments in the 23 July 2026 proposals (the July 2026 proposals).

Background

On 29 April 2022, the Department of Finance released the first package of legislative proposals to address certain so-called "hybrid mismatch arrangements." The initial hybrid mismatch rules addressed only deduction/non-inclusion mismatches (D/NI Mismatches) arising under three types of hybrid arrangements: hybrid financial instruments arrangements, hybrid transfer arrangements and substitute payment arrangements. The first package of the rules, which generally apply after 30 June 2022, largely implemented the recommendations of Chapters 1 and 2 of the report under Action 2 of the Organisation for Economic Co-operation and Development/Group of 20 (OECD/G20) Base Erosion and Profit Shifting project, titled Neutralising the Effects of Hybrid Mismatch Arrangements (BEPS Action 2 Report).

The January 2026 proposals were generally intended to implement the balance of the recommendations in Chapters 3, 4 and 6 to 8 of the BEPS Action 2 Report — namely, mismatches arising from the hybridity of an entity (reverse hybrid arrangements, disregarded payment arrangements and hybrid payer arrangements) as well as imported mismatches. These proposals also made certain technical amendments to the existing hybrid mismatch rules. The proposed measures were generally to apply to payments arising on or after 1 July 2026. For more information on the January 2026 proposals, see EY Global Tax Alert, Canada's Department of Finance releases proposed hybrid mismatch arrangement rules, dated 25 February 2026.

The latest revisions in the July 2026 proposals continue to generally apply to payments arising on or after 1 July 2026, although the priority order changes for the thin capitalization rules, as described below, apply to payments arising on or after 23 July 2026.

Amendments to the second package of hybrid mismatch rules

"Ordinary income" deeming rules and definition

The July 2026 proposals introduce proposed deeming rules in new subsections 18.4(16.1) to (16.4) of the Income Tax Act to support the operation of the dual inclusion income and investor dual inclusion income rules. Broadly, these provisions are intended to ensure that amounts that are economically taxed within a hybrid structure can qualify as ordinary income for purposes of the dual inclusion income framework, notwithstanding that a payment may be disregarded under the tax laws of a relevant jurisdiction. These amendments were recommended by the Canadian Bar Association-Chartered Professional Accountants (CBA-CPA) Joint Committee on Taxation.

Proposed subsection 18.4(16.1) applies in the case of a so-called "inclusion/non-deduction" scenario. If an investor in a hybrid entity makes a payment to the hybrid entity that is ordinary income of the hybrid entity, but no deduction is available to the investor in respect of the payment because it is disregarded under the tax laws of the country in which the investor is a resident, an amount in respect of the payment may be deemed to be ordinary income of the investor. The rule generally applies only if the investor would otherwise have been entitled to a deduction if the payment had not been disregarded.

Proposed subsection 18.4(16.2) extends this concept to certain "hybrid-to-hybrid" payments. If two hybrid entities resident in the same jurisdiction have a common investor, a payment between the hybrid entities that is disregarded in the investor jurisdiction, and that is funded out of ordinary income of the payer hybrid entity, may be deemed to be ordinary income of the investor if it is ordinary income of the recipient hybrid entity in its country of residence. The rule generally applies only if the amount would have been ordinary income of the investor had the payment not been disregarded.

Proposed subsections 18.4(16.3) and (16.4) provide "no double counting" rules. If deemed ordinary income under proposed subsection 18.4(16.2) contributes to dual inclusion income or investor dual inclusion income that is used to reduce a hybrid mismatch amount or an investor hybrid payer mismatch amount, or to support a deduction under paragraph 20(1)(zz) or (aaa), the underlying ordinary income from which the payment was funded is deemed not to be ordinary income of the payer hybrid entity to the same extent. These provisions are intended to prevent the same economic income from generating dual inclusion income more than once.

In addition, the explanatory notes for the proposed definition of "ordinary income" now specify that ordinary income refers to a gross amount of income (i.e., revenue) rather than "an amount of income or profits," as was previously indicated. Also, to qualify as ordinary income, this income cannot effectively be sheltered from tax. Guidance and an example were also added with respect to calculating ordinary income when a tax credit is applied to reduce the entity's tax liability (i.e., without reducing its income) or an incentive reduces taxable income.

New ordering rule for thin capitalization

Amendments are proposed to the thin capitalization rules so that those rules apply in priority to the hybrid mismatch rules. Specifically, section 18.4, which includes the primary operative rule of the hybrid mismatch rules, would be disregarded in determining the amount of interest otherwise deductible for purposes of the thin capitalization rules in subsection 18(4). This amendment, along with the corresponding changes to subsection 18.4(3) and other relevant provisions, ensures that the thin capitalization rules apply in priority to the hybrid mismatch rules.

The amendments also preserve the application of subsection 214(16), which deems disallowed interest under the thin capitalization rules to be treated as a dividend and not interest for purposes of Part XIII withholding tax. This is important because the parallel rule in subsection 214(18), which applies to the hybrid mismatch rules, is proposed to be amended to carve out the new categories of hybrid mismatches introduced in the second package of hybrid mismatch rules, as discussed below. This ensures that interest will be subject to restriction (and deemed dividend treatment) under the thin capitalization rules first, even if it would otherwise be denied under the hybrid mismatch rules.

Restrictions to the deemed dividend rule in subsection 214(18)

The July 2026 proposals narrow the scope of application of the deemed dividend rule in subsection 214(18) compared to the January 2026 proposals. Under the current rules, interest that is denied as a deduction under subsection 18.4(4) in respect of hybrid financial instruments arrangements, hybrid transfer arrangements and substitute payment arrangements is generally deemed to be a dividend, rather than interest, for Part XIII withholding tax purposes. The January 2026 proposals extended the scope of the deemed dividend rule to amounts that arose under the new types of hybrid mismatches (other than a hybrid payer arrangement). The explanatory notes to the first set of the hybrid mismatch rules acknowledged that the imposition of withholding tax in the hybrid context was a departure from the recommendations in the BEPS Action 2 Report. The CBA-CPA Joint Committee on Taxation noted that the extension of the withholding tax rule to hybrid arrangements that cannot be viewed as equity substitutes was difficult to justify from a tax policy perspective.

The July 2026 proposals provide that this deeming rule will not apply if the deduction denial arises under a reverse hybrid arrangement, disregarded payment arrangement, hybrid payer arrangement or imported hybrid arrangement. The reference to an amount that is included under the secondary rule in proposed subsection 12.7(4) was also removed. As a result, the deemed dividend rule in subsection 214(18) applies to interest that is denied under the primary rule in respect of the existing categories of hybrid mismatches in the current rules and interest that is denied under the newer categories of hybrid mismatch arrangements should generally retain its character as interest for Part XIII purposes, notwithstanding the denial of the corresponding deduction. The explanatory notes indicate that this carve-out reflects the view that these newer hybrid mismatch arrangements are not inherently substitutes for equity financing.

Relationship test for reverse hybrid arrangements

In general, the reverse hybrid arrangement rules target deductible payments made to a reverse hybrid entity that give rise to a D/NI Mismatch, and where the mismatch would not arise if the payment were made directly to each entity that held a direct equity interest in the reverse hybrid entity (the hypothetical payment) and such hypothetical payment would also not give rise to a hybrid financial instrument mismatch, hybrid transfer mismatch or substitute payment mismatch amount.

One of the conditions in proposed subsection 18.4(15.1) is amended to effectively narrow the scope of the reverse hybrid arrangement rules. Specifically, under the January 2026 proposals, the rules applied if either the payer of the payment did not deal at arm's length with the reverse hybrid entity (the relationship test), or the payment arose under a structured arrangement (as defined in subsection 18.4(1)). The relationship test is expanded in the July 2026 proposals to consider not only the relationship between the payer and the reverse hybrid entity, but also the relationship with any equity holder of the reverse hybrid entity that is resident in a jurisdiction that treats the reverse hybrid entity as fiscally opaque in respect of the payment (the relevant equity holder).

This amendment is intended to ensure that the relationship test is met only in circumstances in which the payer, the reverse hybrid entity and the relevant equity holder do not deal at arm's length with one another. As a result, the scope of the reverse hybrid arrangement rules may be narrower than under the January 2026 proposals.

Revised double deduction mismatch rule for hybrid payer mismatches

The hybrid payer mismatch rules target double deduction outcomes arising from payments made by a hybrid payer. Under the January 2026 proposals, the amount of the double deduction mismatch in proposed subsection 18.4(7.2) was determined solely by reference to the amount that would otherwise be deductible in Canada. The amendment to subsection 18.4(7.2) in the July 2026 proposals changes this approach by defining the double deduction mismatch as the lesser of:

• The Canadian deduction in respect of the payment
• The amount otherwise deductible in the relevant foreign jurisdiction in the absence of any foreign hybrid payer mismatch rule

In addition, if the difference between the Canadian and the foreign deductions is due to a difference in valuation, newly proposed subsection 18.4(7.3) clarifies that the foreign deduction is to be determined using the same valuation applied in determining the Canadian deduction.

Other changes

Definition of "foreign hybrid payer mismatch rule"

The explanatory notes to the proposed definition of foreign hybrid payer mismatch rulewere modified to clarify that a rule enacted by a foreign country can meet this definition even if such foreign law predates the publication of the BEPS Action 2 Report. In addition, the Department of Finance notes that the definition requires the foreign rule to have an effect that is "substantially similar" to a provision of section 12.7 or 18.4 intended to implement Chapter 6 or 7 of the BEPS Action 2 Report, and the effect need not be identical to such a provision. Although not expressly stated, the revised explanatory notes seem to be alluding to the United States (US) dual consolidated loss rules, which predate the BEPS Action 2 Report and arguably have an effect that is substantially similar to the Canadian rules.

Resident in a country

The explanatory notes for the meaning of "resident" in proposed subsection 18.4(19.2) were expanded to clarify that an entity should be considered resident in a country where it is subject to comprehensive taxation (i.e., treated as resident). Furthermore, an entity that is found to be a nonresident of a country as a result of the application of a tax treaty tie-breaker rule will not be considered resident of that country for the purposes of sections 12.7 and 18.4. Proposed subsection 18.4(19.2) simply defines "resident" as meaning resident in a country for income tax purposes under the laws of that country, and therefore the revised explanatory notes clarify that residency refers to being subject to comprehensive taxation in a jurisdiction, unless a treaty residency tie-breaker rule applies.

Definition of "hybrid entity"

The explanatory notes to the proposed definition of hybrid entity in subsection 18.4(1) were modified to remove the term "fiscally opaque" and refer instead to an "entity that is tax resident in one country," to match the text of the proposed legislation. Also, the Department of Finance clarified that the hybrid entity definition is not intended to target entities that are resident in a first country and have a portion of their income taxed in a second country because of the application of a controlled foreign company tax regime, such as the Canadian Foreign Accrual Property Income regime.

Next steps

As previously noted, the consultation period ends on 4 September 2026; accordingly, the Department of Finance could make additional amendments to the legislative proposals in the next few months. EY Canada will be monitoring any further developments to these rules as they make their way through the legislative process.