Canada: Canada Revenue Agency Interprets Anti-Hybrid Rule

Copyright 2009, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Tax, November 2009

The Fifth Protocol to the Canada-U.S. tax treaty (the Treaty) was ratified in December 2008, and for most purposes came into force in 2009. One of the more controversial measures contained in the Protocol is the new "anti-hybrid" rule in Article IV(7) of the Treaty. This unprecedented rule takes effect on January 1, 2010.

The Anti-Hybrid Rule

There are two branches to the anti-hybrid rule.

The first branch deals with "reverse hybrid" entities. These are entities which are fiscally transparent in the source state but not in the state of residence. An example of such an entity is a partnership formed under Canadian law which has elected for U.S. tax purposes to be treated as a foreign corporation. This branch of the rule, found in Article IV(7)(a), applies to an amount paid to or derived by a U.S. person through an entity that is not a U.S. resident, where, by reason of the entity not being treated as fiscally transparent under U.S. law, the treatment of the amount under U.S. law is "not the same" as its treatment would be if that amount had been derived directly by that person. In other words, the rule could potentially apply to an amount derived by a U.S. person through a partnership formed under the laws of Canada where the treatment of the item differs from the hypothetical treatment that would have arisen had the person derived the amount directly rather than through the partnership. If the rule applies, the item of income paid to or derived by the U.S. person is not eligible for Treaty benefits.

The second branch of the rule, and the one arising more commonly in practice in Canada, deals with "hybrid" entities, namely entities that are not fiscally transparent in the source state, but fiscally transparent in the state of residence. An example is a Canadian unlimited liability company (ULC). This branch of the rule, found in Article IV(7)(b), applies to an amount that is paid to or derived by a U.S. person if the person is considered under Canadian law to have received the amount from an entity that is a resident of Canada, where, by reason of the entity being treated as fiscally transparent under U.S. law, the treatment of the amount under U.S. law is "not the same" as its treatment would be if the entity were not treated as fiscally transparent under U.S. law. The rule could potentially apply to an amount paid by a ULC to a U.S. person, but only if the treatment of the item differs from the hypothetical treatment that would have arisen had the ULC not been fiscally transparent for U.S. tax purposes. Where the rule applies, no Treaty benefits are available in respect of the item in question.

It is widely understood that the anti-hybrid rule, and in particular Article IV(7)(b), was drafted in a way that was overbroad and went well beyond the perceived mischief that gave rise to the rule. This has been observed by, among others, the Joint Committee on Taxation of the U.S. Congress, which noted that Article IV(7)(b) was overbroad, especially (though not exclusively) with respect to non-deductible payments such as dividends. Dividends paid by a ULC out of the after-tax earnings of the ULC clearly should not, as a matter of sound tax policy, be subjected to non-treaty rates of dividend withholding tax, and yet this seemed to be the result obtained by mechanically applying the language of Article IV(7)(b).

Meaning of "Same Treatment"

The anti-hybrid rules introduce a notion that is not well understood in Canadian tax law, specifically the concept of comparing the actual U.S. tax treatment of an item in question with its hypothetical U.S. tax treatment under assumed circumstances. This rule begs the obvious question as to what is meant by "treatment", and what criteria are to be applied when comparing actual treatment with hypothetical treatment, and determining whether they are the "same". In the U.S. Treasury Department's Technical Explanation (TE), released in July 2008, it was stated that this determination would be made from a U.S. point of view in accordance with the principles set forth in Code section 894. The TE added that although Canada does not have analogous provisions in its domestic law, "it is anticipated that principles comparable to those described [in section 894] will apply". The Minister of Finance of Canada has stated that Canada agrees with the TE.

On November 25, 2009, the Canada Revenue Agency (the CRA) released a copy of an internal technical interpretation commenting upon the Canadian approach to the question of "same treatment". In short, the CRA stated that three factors will be considered to determine whether the treatment of an amount is the same as its hypothetical treatment: (a) the timing of the recognition or inclusion of the amount; (b) the character of the amount; and (c) the quantum of the amount. Geographic source generally will not be relevant unless it affects the treatment of the amount as an item of income under U.S. tax law. The mere fact that the geographic source of an amount may affect the ability of a U.S. person to claim a foreign tax credit will not be relevant.


In both the technical interpretation noted above and at the "Round Table" session held at the Canadian Tax Foundation Annual Conference on November 24, 2009, the CRA commented on the application of the anti-hybrid rule to some fact patterns. Generally, these comments provide helpful guidance in dealing with the anti-hybrid rule.

Set out below is a description of some of these examples, and the comments made by the CRA.

Example 1: Payment of Dividends by ULC

Suppose the ULC is wholly owned by a U.S. corporation which qualifies for Treaty benefits (USco). Beginning January 1, 2010, any dividend paid by the ULC to USco will be subject to statutory 25% withholding tax. Clearly, this is anomalous from a tax policy perspective.

The following solution was accepted by the CRA at the Round Table: Instead of paying a dividend, the ULC undertakes a two-step transaction. First, the ULC increases its paid-up capital without distributing any cash or other property. This increase in paid-up capital gives rise to a deemed dividend for Canadian tax purposes, but no tax consequence for U.S. tax purposes. Because the U.S. treatment (no consequence) is the same as the hypothetical treatment of that transaction that would have arisen had the ULC not been fiscally transparent, the anti-hybrid rule does not apply. Accordingly, the CRA confirmed that Treaty withholding rates (5%) would apply. Immediately after the foregoing step, but in a clearly separate step, the ULC makes a distribution to USco in the form of a return of the paid-up capital that was just created in the first step. A distribution structured legally as a return of paid-up capital is not subject to Canadian withholding tax, and therefore there is no need to have recourse to the Treaty. This two-step procedure effectively accomplishes a distribution without giving rise to a problem under the anti-hybrid rules.

The CRA commented that while the application of the general anti-avoidance rule (GAAR) depends on all the facts and circumstances, it would "not normally" apply GAAR to this type of planning where the ULC is used by USco to carry on an active branch operation in Canada and the arrangement is used by the ULC to qualify for the reduced Treaty rate of withholding tax on the distribution of the ULC's after-tax earnings to USco. While this is a welcome statement, it obviously leaves some room for the CRA to selectively seek to apply GAAR if it believes the circumstances so warrant. It is critically important to ensure that all necessary corporate law formalities are complied with, including any restrictions on the circumstances in which paid-up capital may be increased under the applicable corporate law. It should also be noted that this planning will not work in a situation where the shares of the ULC are held by a fiscally transparent limited liability company (LLC). In that case, alternative approaches should be considered.

Example 2: Luxembourg Intermediary

The CRA also confirmed that the inter-position of a Luxembourg resident company between USco and the ULC normally will result in any dividends paid to Luxco being eligible for the 5% treaty rate of withholding tax under the Luxembourg-Canada Tax Treaty, provided of course the dividend is "beneficially owned" by Luxco. The CRA indicated that its comments on the application of GAAR in Example 1 would also apply to this example.

Example 3: Payment of Interest to "Grandparent"

In this example, "Grandparent" is a U.S. resident company, entitled to Treaty benefits, which wholly owns USco, which in turn wholly owns the ULC. The ULC pays interest on a debt owing directly to Grandparent. The CRA confirmed that the treatment of the interest is considered to be the same as the hypothetical treatment that would have arisen had the ULC not been fiscally transparent (even in the case where Grandparent and USco elect to file a consolidated group tax return for U.S. tax purposes), and that Treaty benefits are therefore available. However, the CRA cautioned that it may apply GAAR to this type of arrangement where the arrangement results in the creation of a "double deduction" or "double dip" or an internally generated interest deduction in one country without offsetting interest income in the other country.

Example 4: ULC with Two Shareholders

This example, which is contained in the technical interpretation, could be extremely helpful in many circumstances. The example sets out a situation in which USco owns 90% of the shares of the ULC. The other 10% is owned by USsub, a U.S. corporation wholly owned by USco. The ULC pays interest to USco on debt owing to USco. It is clear that the anti-hybrid rule would have applied had USco been the sole owner of the ULC.

This is because the actual treatment of the interest under U.S. tax law (it is disregarded) differs from the hypothetical treatment that would have arisen had the ULC not been fiscally transparent.

However, in this example, the introduction of a second shareholder transforms the ULC from being a disregarded entity for U.S. tax purposes into being a partnership for U.S. tax purposes. This makes a critical difference. The CRA confirmed that the treatment of the interest in the hands of USco is the same as the hypothetical treatment that would have arisen had the ULC not been fiscally transparent. Therefore, the anti-hybrid rule does not apply, and Treaty benefits are available.

This suggests it might be possible to defeat the antihybrid rule through the use of ULCs with multiple owners rather than single owners. One critical caveat, however, is that the CRA clearly pointed out in the technical interpretation that it reserves the right to challenge planning of this nature under GAAR. Based on comments made by senior officials of the CRA at the Round Table (including the comment on the potential application of GAAR to the type of arrangement described in Example 3), it is likely that the CRA will be more prone to challenge such planning where the effect is to create a "double deduction" or "double dip". Conversely, if there is no "double dip", it appears the CRA is less likely to take the position that the planning undermines the object, spirit and purpose of the antihybrid rules, and therefore can be challenged under GAAR.


The above is but a brief summary of some of the recent guidance provided by the CRA on the anti-hybrid rule. As the anti-hybrid rule takes effect on January 1, 2010, it is expected that considerably more authority will develop over time.

We wish to acknowledge the contribution of Sabrina Wong to this publication.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

Events from this Firm
30 Apr 2019, Seminar, Toronto, Canada

We invite you to join us for our semi-annual program exploring recent updates and legal developments in pensions and employee benefits law.

14 May 2019, Seminar, Toronto, Canada

We know that diversity, in all forms, enriches the conversation and decision-making in the boardroom. Blakes strives to be at the forefront of creating opportunities for women to get a seat and, more importantly, a say, at the board table. In order to do just that, in 2017 we launched our Women GCs on Boards program, which supports women GCs who have the potential to be ideal candidates for board positions.

16 May 2019, Other, Toronto, Canada

Blakes invites you to join us for our annual presentation on current Canada-U.S. cross-border tax developments.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of

To Use you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions