Canada: A Cautionary Tale : Now You See It, Now You Don't!

Last Updated: October 3 2017
Article by Natasha De Cicco and Daniel T Richer

In Canada v Callidus Capital Corporation,[1] the Federal Court of Appeal has concluded that the bankruptcy of a tax debtor after a secured creditor has already received proceeds from the sale of the tax debtor's assets does not reverse the deemed trust for GST/HST on the proceeds in the hands of the secured creditor.  This decision may have significant implications for the secured creditor community as secured creditors who receive sale proceeds may be personally liable to CRA for the tax debtor's unremitted GST/HST notwithstanding the tax debtor's bankruptcy.

1. The Deemed Trust for Unremitted GST/HST

Subsection 222(1) of the Excise Tax Act (Canada)[2] creates a deemed trust in favour of the Crown for collected but unremitted goods and services tax/harmonized sales tax ("GST/HST").  The deemed trust attaches to all of the property of the tax debtor (which would include proceeds of such property) and ranks ahead of the claims of secured creditors, except a "prescribed security interest".[3]  Subsection 222(3) of the ETA extends the trust to apply to property of the tax debtor (which would include proceeds of such property) held by a secured creditor.  Subsection 222(3) provides that (i) such property is deemed to be held by the secured creditor in trust for the Crown, (ii) the property is beneficially owned by the Crown despite any security interest the secured creditor may have in the property and (iii) "the proceeds of such property shall be paid to the Receiver General in priority to all security interests."  Subsection 222(1.1) of the ETA provides that the deemed trust created under subsection 222(1) of the ETA does not apply at or after the debtor becomes a bankrupt within the meaning of the Bankruptcy and Insolvency Act (Canada).[4]  In effect, subsection 222(1.1), together with subsections 67(2) and (3) of the BIA, extinguish and "reverse" the priority of a deemed trust for collected but unremitted GST/HST upon the bankruptcy of a tax debtor.

While the ETA together with the BIA provide that this deemed trust is extinguished and loses its priority upon the tax debtor's bankruptcy, the caselaw has been unclear as to whether a debtor's bankruptcy after a secured creditor receives proceeds is sufficient to extinguish the deemed trust or not.  Where assets of a tax debtor in financial difficulty are sold outside an insolvency proceeding or in a receivership, secured creditors have been known to defer receiving any proceeds until the tax debtor is bankrupt, either voluntarily or involuntarily.  While the jurisprudence has confirmed that the use of the insolvency statutes to reverse the priority of a deemed trust is a proper use of the statute,[5] this process has its disadvantages.  Notably, it adds to the costs and expenses incurred by the secured creditor, which could have a significant impact on net recoveries, and delays distributions. 

2. The Federal Court of Canada Decision

For a brief moment, it appeared that the Courts had provided some clarity on the issue.  In Her Majesty the Queen in Right of Canada v. Callidus Capital Corporation,[6] Justice McVeigh of the Federal Court of Canada held that upon the bankruptcy of a tax debtor, the deemed trust under subsection 222(1) of the ETA for collected but unremitted GST/HST is rendered ineffective against a secured creditor.  In this case, the Court found that the subsequent bankruptcy of the tax debtor extinguished the deemed trust on the proceeds distributed to the secured creditor prior to the tax debtor's bankruptcy.

The tax debtor owed CRA approximately $178,000 for collected but unremitted GST/HST.  From December 2011 to July 2014, the secured creditor received proceeds from the sale of property owned by the tax debtor.  The proceeds were used to repay the obligations owed by the tax debtor to the secured creditor.  In April 2012, CRA, by way of letter, claimed over $90,000 from the secured creditor on the basis of the deemed trust provisions under the ETA.  In November 2013, at the request of the secured creditor, the tax debtor made an assignment in bankruptcy under the BIA.  Also in November 2013, and shortly after the tax debtor made an assignment in bankruptcy, CRA commenced proceedings against the secured creditor and claimed approximately $178,000, plus interest, from the secured creditor on the basis of the deemed trust provisions under the ETA.

The question of law before the Federal Court of Canada was:

Does the bankruptcy of a tax debtor and subsection 222(1.1) of the ETA render the deemed trust under section 222 of the ETA ineffective against a secured creditor who received, prior to the bankruptcy, proceeds from the assets of the tax debtor that were deemed to be held in trust.[7]

One of the arguments made by the Crown was that the deemed trust under subsection 222(3) of the ETA is a personal and independent liability imposed on secured creditors who do not pay to the Crown proceeds that are "imprinted" with a deemed trust.[8]  The Crown argued that the word "shall" in subsection 222(3) of the ETA did not allow for any discretion and as such, a secured creditor who fails to comply with the obligation to pay is personally liable for such amounts and the Crown has an independent cause of action against the secured creditor.[9]

Justice McVeigh of the Federal Court of Canada answered the question of law in the affirmative and held that a plain reading of the legislation and an examination of the relevant jurisprudence establish that, upon the bankruptcy of the tax debtor, the deemed trust under subsection 222(1) of the ETA was rendered ineffective against the secured creditor for collected but unremitted GST/HST.[10]  Justice McVeigh was particularly focused on subsection 222(1.1) of the ETA, which provides that the deemed trust under subsection 222(1) of the ETA is extinguished upon the bankruptcy of the tax debtor.  Justice McVeigh was not swayed by the Crown's arguments, which she characterized as the Crown's attempt to re-characterize the agreed upon question of law put before the Court. 

3. The Federal Court of Appeal Decision

The Crown appealed and the Federal Court of Appeal allowed the appeal.[11]  Justice Rennie, for the majority of the Federal Court of Appeal, was of the view that the reasoning in Canada (Procureure generale) vs. Banque Nationale du Canada,[12] which dealt with the deemed trust for unremitted source deductions under subsection 227(4.1) of the Income Tax Act (Canada),[13] was dispositive and held that "[s]ecured creditors who do not comply with the obligation to pay proceeds derived from deemed trust assets are personally liable to the Crown, which has a separate cause of action against them, irrespective of the subsequent bankruptcy of the debtor."[14]

In reaching his decision, Justice Rennie held that the mechanism in subsection 222(3) of the ETA, which deems any trust property held by a secured creditor to be held in trust for the Crown and that the proceeds of such property shall [emphasis added] be paid to the Receiver General in priority to all security interests, renders a secured creditor who receives funds out of the deemed trust personally liable for the amount owed to the Crown under an independent cause of action.[15]  Furthermore, while Justice Rennie confirmed that subsection 222(1.1) of the ETA releases a tax debtor's assets from the deemed trust, it doesn't extinguish the pre-existing liability of a secured creditor who received proceeds from the deemed trust.[16]  According to Justice Rennie, "[t]he personal liability [of the secured creditor] is fully engaged, the debt is due and can be pursued by the Crown in a cause of action independent of any subsequent bankruptcy proceedings."[17]

4. Conclusions

The Federal Court of Appeal's decision is significant for insolvency practitioners and secured creditors for a number of reasons.  The decision not only clarifies that the subsequent bankruptcy of a tax debtor does not extinguish or reverse the priority of a deemed trust for GST/HST on proceeds that were received by a secured creditor prior to the bankruptcy of the tax debtor, it establishes that a secured creditor who receives such proceeds is personally liable to the Crown.  Furthermore, the decision provides that the Crown has an independent cause of action against the secured creditor to recover amounts for unremitted GST/HST.  By implication, the creation of a new cause of action provides CRA with a collection mechanism to pursue secured creditors for amounts owing for collected but unremitted GST/HST under section 222(3) of the ETA.  This collection mechanism is in addition to and arguably broadens the current mechanisms available to CRA, notably requirements to pay and garnishments under the ETA.

The secured creditor has until the end of September, 2017 to apply for leave to appeal to the Supreme Court of Canada so this may not be the final word on these issues.  In the interim, secured creditors should be mindful of these developments, the risks associated with accepting sale proceeds that may be impressed with a deemed trust for unremitted GST/HST and the options available to mitigate those risks.

Footnotes

[1] Canada v Callidus Capital Corporation, 2017 FCA 162.

[2] Excise Tax Act, RSC 1985, c E-15 ("ETA").

[3] Subsection 222(4) of the ETA provides that for the purposes of subsections 222(1) and 222(3) of the ETA, a security interest does not include a "prescribed security interest", which is defined by regulation as a mortgage or a hypothec registered on real property before the time the deemed trust is deemed to arise under subsection 222(1) of the ETA.  See the Security Interest (GST/HST) Regulations, SOR/2011-55 (Excise Tax Act).

[4] Bankruptcy and Insolvency Act, RSC 1985, c B-3 ("BIA").

[5] Re Ivaco, 12 CBR (5th) 213; [2005] OJ No 3337 (Ont SCJ [Commercial List]) at para 11, aff'd 83 OR (3d) 108; 25 CBR (5th) 176.

[6] Her Majesty the Queen in Right of Canada v Callidus Capital Corporation, 2015 FC 977.

[7] Ibid at para 2.

[8] Ibid at para 11.

[9] Ibid at para 13.

[10] Ibid at para 20.

[11] Supra note 1.

[12] Canada (Attorney General) v National Bank of Canada, 2004 FCA 92; 3 CBR (5th) 1.

[13] Income Tax Act, RSC 1985, c 1 (5th Supp).

[14] Supra note 1 at para 23.

[15] Ibid at para 25.

[16] Ibid at para 26.

[17] Ibid.

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