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 Quebec.
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 source deductions.
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 payments.
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.