In a decision widely welcomed by lenders, the Supreme Court of Canada has ruled that the bankruptcy of a tax debtor, although subsequent to the repayment of the secured creditor’s debt, terminated secured creditors’ personal liability for deemed trust claims under s. 222 of the Excise Tax Act.
In a decision widely welcomed by lenders, the Supreme Court of Canada has ruled that the bankruptcy of a tax debtor, although subsequent to the repayment of the secured creditor’s debt, terminated secured creditors’ personal liability for deemed trust claims under s. 222 of the Excise Tax Act.
The deemed trust allows the Crown to claim a tax debtor’s unremitted sales tax arrears against a creditor that obtains proceeds from the debtor’s assets. But ss. 222(1.1) also provides that the deemed trust does not apply “at or after the time a person becomes a bankrupt.”
“The issue in Callidus Capital Corp. v. Canada was whether a secured creditor whose repayments include sums for GST and HST that have been collected but not remitted under the ETA remains liable for these amounts in a subsequent bankruptcy,” says Alan Kenigsberg, a tax partner in Osler, Hoskin & Harcourt LLP’s Toronto office, who was not involved in the case.
Callidus was a secured creditor of Cheese Factory Road Holdings Inc. Cheese Factory collected sales taxes and paid them to Callidus. When Cheese Factory went bankrupt, the Crown sought recovery of the taxes.
In July 2017, a majority in the Federal Court of Appeal ruled that the deemed trust survived the debtor’s bankruptcy, meaning that creditors would remain personally liable for any outstanding sales tax included in amounts they received from enforcing security notwithstanding the subsequent bankruptcy.
In his 2-1 majority ruling, Justice Donald Rennie reasoned that while ss. 222(1.1) released a tax debtor’s assets from the deemed trust on bankruptcy, it did not extinguish the pre-existing liability of a secured creditor who received proceeds from the deemed trust. As Rennie saw it, a secured creditor should not be allowed to subvert the deemed trust by forcing a debtor into bankruptcy. A creditor, he wrote, should not be able to “choose the time of bankruptcy and liquidate the deemed trust assets so as to satisfy their interests at the expense of the Crown.”
Here, although Cheese Factory had filed a voluntary assignment into bankruptcy, it had done so at Callidus’ request.
In dissent, however, Justice Denis Pelletier concluded that ss. 221(1.1) retroactively extinguished the deemed trust when a bankruptcy occurred. Although it was true that creditors might time bankruptcy petitions to their advantage at the expense of the Crown, the legislation should be “interpreted on the assumption that the Crown only collects amounts which it is owed and not more”. The upshot, in Pelletier’s view, was that the bankruptcy released Callidus from liability for Cheese Factory’s unremitted sales tax obligations.
The majority ruling in the FCA, however, rang alarm bells in the business community.
“The majority’s decision was contrary to the way most secured creditors and bankruptcy lawyers believed things worked,” Kenigsberg said. “Most of the jurisprudence had concluded that the Crown becomes an unsecured creditor following a bankruptcy, so that secured creditors have preference over the Crown as they do over any other unsecured creditor.”
The decision also portended practical consequences.
“Had it stood up, the FCA decision [had it not been overturned by the Supreme Court] might have discouraged secured creditors from trying to work things out with debtors in jeopardy rather than forcing them into bankruptcy earlier than they otherwise might for fear that the CRA might swoop in,” says Kenigsberg. “The way people do business, then, would have changed — and not in a good way — because the ruling upped the risk factor for secured creditors by increasing the possibility of disgorgement to the Crown.”
All the more so because the Canada Revenue Agency isn’t required to give creditors notice of a debtor’s sales tax arrears. And because there are similar deemed trust provisions for other types of tax debts, the majority’s reasoning assumed even greater precedential importance.
“The majority decision had implications for secured creditors generally, especially financial institutions who frequently confront these situations in our economy,” says Jocelyn Perreault, in McCarthy Tétrault LLP’s Montreal office, who represented the Canadian Bankers’ Association, which was an intervener in the case at the SCC.
“It’s an issue with which I’ve been dealing for more than 10 years.”
The SCC’s unanimous but short judgment reversed the majority decision and adopted the reasons of the dissenting judge.
But the reversal doesn’t leave the business community entirely in the clear, as secured creditors’ position prior to bankruptcy remains uncertain.
“As a result, as it is not necessary to do so to resolve this appeal, this Court is not commenting, one way or the other, on the scope of the deemed trust or any liability under s. 222 of the ETA prior to bankruptcy,” stated Justice Clément Gascon, writing for a unanimous high court bench.
