Super Priority of Revenue Canada

The majority of the income tax collected by Revenue Canada is obtained through source deduction as opposed to direct payments of tax from self-employed persons. Therefore, Revenue Canada has a very strong interest in insuring that it has a first priority over taxes which have been deducted by a business from the wages of its employees but which have not been remitted to Revenue Canada. Source deductions are amounts deducted from an employee's wages on account of the employee's income tax, Canada Pension Plan contributions, and Employment Insurance contributions.

Secured Creditors will generally petition a debtor into bankruptcy if the debtor owes significant amounts to Revenue Canada. This is because certain priorities in favour of Revenue Canada are lost upon a bankruptcy. Section 86 (1) of the Bankruptcy and Insolvency Act specifically provides that subject to certain exceptions all claims of the Crown which includes Revenue Canada, rank as unsecured claims. As you know, the claims of all secured creditors are satisfied first on a bankruptcy. If any assets of the debtor remain after satisfaction of the secured claims, unsecured creditors are paid on a pro rata basis.

Recent amendments to the Income Tax Act have provided for two methods by which Revenue Canada can obtain priority over secured creditors in a bankruptcy.

These two methods are through the Enhanced Requirement to Pay and through the deemed Trust.

The Enhanced Requirement to Pay is essentially a statutory garnishment available only to Revenue Canada. The Income Tax Act provides that where the Minister of Finance suspects that a person is or will become within one year's time liable to make a payment to a tax debtor or to a secured creditor who has a right to receive the payment that would, absent the security interest in favour of the secured creditor, be payable to the tax debtor, then the Minister may in writing require the person to pay the amount to Revenue Canada. However, in order for this provision of the Income Tax Act to become applicable, the Minister must have actually issued the notice to the person to pay all amounts which he or she owes to the tax debtor to Revenue Canada. Nonetheless, once the Minister issues the notice, it is effective and binding on the person who receives it. No court application is required to invoke this particular provision of the Income Tax Act. It is automatically available to Revenue Canada. This provision in the Income Tax Act states that it specifically overrides every other provision in the Income Tax Act, and the Bankruptcy and Insolvency Act. Therefore, this Enhanced Requirement to Pay effectively gives Revenue Canada priority over all secured creditors with respect to the accounts of a tax debtor. The Enhanced Requirement to Pay applies to all amounts owing with respect to the Income Tax Act, Employment Insurance premiums, and Canada Pension Plan premiums. In addition, the Enhanced Requirement to Pay applies to penalties and interest owing to Revenue Canada.

The Enhanced Requirement to Pay only gives Revenue Canada priority over funds which are actually owed to the tax debtor. In addition, Revenue Canada will have to determine the identity of all persons owing money to the tax debtor so that Revenue Canada may issue the notice of Enhanced Requirement to Pay to that person. If Revenue Canada fails to issue the Notice then it does not obtain any priority over the accounts receivable of the tax debtor.

The provision providing for the Enhanced Requirement to Pay has been reviewed by the Supreme Court of Canada. In Her Majesty the Queen v. Province of Alberta Treasury Branches and The T-D Bank, the Supreme Court of Canada concluded that the Enhanced Requirement to Pay gave Revenue Canada a priority over the claim of secured creditors in respect of accounts receivable. Therefore where Revenue Canada is able to identify account debtors of the tax debtor and issues Enhanced Requirement to Pay Notices to them, Revenue Canada will obtain priority over those accounts receivables owing to the tax debtor in priority to all secured creditors.

A decision of the Quebec Court of Appeal called into question the use of this statutory garnishment procedure under the Enhanced Requirement to Pay for collecting unpaid employer Employment Insurance premiums and Canada Pension Plan contributions. The Department of Finance issued a press release on March 11, 1999 indicating that amendments will be introduced to clarify the legislation so that it is clear that unpaid employment insurance premiums and Canada Pension Plan contributions may be collected using the Enhanced Requirement to Pay.

The second method contained within the Income Tax Act which gives a super priority to Revenue Canada with respect to source reductions is the Deemed Trust claim. It is a general principle of law that where money is validly owing to a person, and is held by another person separate and apart from that person's assets, the monies are the property of the first person and are not subject to seizure by the creditors of the second person. This general principle of law is not very helpful because people holding money or other property which is in fact owed to another person do not generally keep that money or those assets separate and apart from the person's own assets. Therefore, the Income Tax Act contains a provision which will deem a trust to in fact be in existence.

Secured creditors were excited when the decision of the Supreme Court of Canada was released in early 1997 in Her Majesty, the Queen v. Royal Bank of Canada which is known as the Sparrow Electric Case. Sparrow Electric provided that in the absence of clear language to the contrary the Court would not grant priority to the Deemed Trust. In other words, although a Deemed Trust may be validly created, it would not obtain priority over secured creditors upon bankruptcy. However, the Court made some very interesting comments. It was held that the government could in fact establish a super priority with respect to the Deemed Trust if it chose to do so. Therefore, the Court accepted the fact that the Minister of Finance could legislate the priorities between Revenue Canada and secured creditors. Therefore, the joy of secured creditors caused by the decision in Sparrow Electric was short lived. Not surprisingly, amendments have been made to the Deemed Trust provisions of the Income Tax Act. These new amendments specifically provide that all property which is deemed to be held in trust by a person is property which is beneficially owned by Revenue Canada notwithstanding any security interest in such property and in the proceeds of that property, and the proceeds of such property shall be paid to the Receiver General in priority to all security interests. In effect, these amendment provide for a super priority in favour of Revenue Canada.

There are limitations to this super priority however. The Income Tax Act provides that the super priority will not apply to security interests which are prescribed by regulations to the Income Tax Act. These regulations have not been proclaimed in force to date. However, on March 11, 1999 the Department of Finance issued a news release indicating that draft regulations had been prepared. The press release states that the prescribed security interests which are excluded from the super priority of Revenue Canada are mortgages in land or a building registered before a Deemed Trust arises. However, the security interest in the land mortgage will be limited to the amount of the obligation that is secured by the mortgage after deducting the value of all of the rights of the secured creditor securing the obligation including other collateral securities that guarantee the obligation. In other words secured creditors that enjoy multiple securities must first exhaust their other securities so that the limited security of the Crown may remain intact. The value of the collateral securities is to be calculated as their net realizable value. In addition the secured interest of the secured creditor holding the land mortgage or mortgage over the building is limited to the outstanding amount of the obligation to the secured creditor calculated as of the time of the failure by the tax debtor to remit an amount to Revenue Canada. This means that if the secured creditor makes advances to the tax debtor after a failure by the tax debtor to remit source deductions to Revenue Canada, the secured creditors advances will be excluded in the calculations of the outstanding amount owing pursuant to the security interest and will be subordinated to the Deemed Trust. In addition, the regulations provide that all amounts paid or credited after the failure of the tax debtor to remit source deductions to Revenue Canada on account of the debt to the secured creditor will further reduce the amount owing to the secured creditor. In other words, the secured creditor can not improve its situation by realizing on the collateral securities before the Deemed Trust is invoked. These provisions in the amendment of the super priority apply retroactively from June 14, 1994.

In a bankruptcy proposal, even though a stay may be imposed on Revenue Canada, the entire claim of Revenue Canada must be satisfied in full within six months of the Court's approval of the proposal. The stay will also be terminated if the bankrupt fails to remit current source deductions.

The intent of the current amendments to the Income Tax Act is to provide Revenue Canada with a super priority over secured creditors with respect to unremitted source deductions under the Income Tax Act, The Employment Insurance Act, or The Canada Pension Plan Act. This super priority applies whether or not the tax debtor is bankrupt. Therefore, the ability of a secured creditor to enhance its priority position by petitioning a creditor into bankruptcy has been substantially eroded by the amendments to the Income Tax Act.

The amendments to the Income Tax Act with respect to Revenue Canada's super priority have not been tested by the courts as of yet. However, as indicated the Supreme Court of Canada did hold in Sparrow Electric that it was open to the Minister of Finance to amend the Income Tax Act to give Revenue Canada a super priority over all secured creditors. A secured creditor can also face liability under the Income Tax Act where a tax debtor does not remit source deductions to Revenue Canada. A secured creditor who controls property that belongs or belonged to a tax debtor is jointly and severally liable with the tax debtor to pay each amount payable under the Income Tax Act by the tax debtor to the extent that the secured creditor is in possession or control of the property.

Although the Supreme Court of Canada purported to limit the application of Revenue Canada's super priority, the recent amendments to the Income Tax Act do purport to create an enhanced priority in favour of Revenue Canada over all secured creditors. Although this legislation has not yet been tested by the courts, it appears that the legislation does effectively create a super priority. Therefore, it would appear that it is of little advantage for a secured creditor to petition a tax debtor into bankruptcy if the sole purpose for doing so is to eliminate the claims of Revenue Canada with respect to unremitted source deductions. However, there is still an advantage for petitioning a creditor into bankruptcy if the purpose of doing so is to avoid the priority in favour of Revenue Canada with respect to the tax debtor's unpaid income tax. The super priority of Revenue Canada does not apply to personal or corporate income tax owing by a debtor.

Prepared May 10, 1999 by Mark Taggart, Associate
Commentary is of a general nature and is not intended as legal advice. Specific advice should be sought with respect to each specific case.

© Scarfone Hawkins LLP, 1999
Super Priority of Revenue Canada