The Supreme Court of Canada determines the right of financial
institutions to effect set-off in reimbursement of a loan despite
the enhanced deemed trust in favor of Revenue Canada or Revenue
In a decision released today, the Supreme Court of Canada
settled the ongoing controversy concerning the liability of a
financial institution to the tax authorities when it repays its
loans by way of set-off against its own term deposit at a time when
the borrower is also indebted to the tax authorities for payroll
The Federal and Quebec Provincial Tax Authorities have a first
ranking deemed trust in all the property of a tax debtor for an
amount equal to the amounts deducted from employee salaries, which
arises upon failure of the employer to remit same to the tax
authorities. That deemed trust takes priority over all security
interests held by a financial institution and, as such, would have
priority over the pledge of a term deposit from a third party. The
question was whether the same would apply if the term deposit was
an amount due from the same entity to whom the loan was owed.
In this case, a credit union had repaid its loan of $200,000 by
setting off against a term deposit that it had issued to the
borrower, thereby effecting set-off at the date of bankruptcy of
the borrower by way of simple accounting entries. Revenue Canada
had been successful in convincing the Federal Court of Appeal that
such an operation triggered the personal liability of the credit
union which was deemed to have illegally acquired the term deposit
of the tax debtor, while this term deposit was deemed to be owned
by the Crown pursuant to the deemed trust. The tax authorities had
made their claim many months after the set-off and after the
bankruptcy of the borrower, after finding that an amount of $26,000
in source deductions had not been remitted. Having thought to have
made a "no risk" loan, the credit union had no knowledge
or control of the affairs of its borrower.
Despite the very small amount involved, the Supreme Court held
the matter under reserve for more than fifteen months. This case
required the Court to interpret its own 2002 decision rendered in
First Vancouver Finance v. Minister of National Revenue.
In that case, property was held to have been released from the
deemed trust for source deductions upon being transferred to a
third party purchaser who had provided contemporaneous
corresponding value to the debtor. From then on, Revenue Canada had
adopted the position that only a sale for value in favour of a
third party without knowledge satisfied the conditions for the
release of the property from the trust. This interpretation
resulted in potential liability to the Crown for any creditor who
receives a simple payment from a tax debtor for a past debt,
without a corresponding contemporaneous return of value.
Summary of the Supreme Court of Canada's Decision
In Caisse Populaire Desjardins de L'Est de Drummond v.
Her Majesty the Queen in Right of Canada, the Supreme Court of
Canada maintained the decision rendered by the Federal Court of
Appeal in favour of the tax authorities. For the majority, the
right of set-off and the pledge of the term deposit constitute a
"security interest" within the meaning of the deemed
trust. Therefore, the rights of the tax authorities have priority
over the rights of the financial institution. However, the Court
mentioned that a simple set-off between a credit to a bank account
and a loan would not constitute a security interest.
The Supreme Court of Canada's ruling, as Honourable Justice
Deschamps mentions on behalf of the minority, may have important
consequences on numerous financial instruments and derivative
products that use the set-off or "netting" mechanism.
Also, the question remains open on the rights of the tax
authorities to trace payments made by the tax debtor from moneys
subject to the deemed trust. The Court gave no indication if the
tax authorities can continue to pursue these payments made by the
tax debtor in the hands of the creditor who received such
A detailed paper on this subject, published in the Annual Review
of Insolvency Law 2008 is also available on the Fraser Milner
Casgrain LLP website. Please click on this link to read the article.
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.
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