The Supreme Court of Canada's recent decision1 to hold a financial institution responsible for "deemed trust" amounts under the ITA2 has lessons for secured creditors of all types.
On September 18, 2000, the Caisse granted its customer Camvrac a line of credit of up to $227,000, in accordance with which two different contracts were signed, a "Term Savings" agreement under which Camvrac had to give to the Caisse a non-negotiable and non-transferable deposit for a 5-year term. The deposit could be given as security only in favour of the Caisse. Camvrac and the Caisse also entered into a "Security Given Through Savings" agreement, under which they agreed that, to secure repayment of any sum owed to the Caisse, Camvrac would maintain a deposit of $200,000, and in the event of default, there would be compensation by means of set-off between the line of credit and the deposit of $200,000.
On September 25, 2000, Camvrac deposited $200,000 with the Caisse. Two months later Camvrac defaulted on its line of credit. However, the Caisse did not take any steps, and on February 7, 2001, Camvrac made an assignment in bankruptcy. The Caisse made a note to end the line of credit and to realize security on Feb. 21, 2001. Finally, on June 12, 2001 the Crown gave the Caisse notice to pay amounts owing to the Crown for Camvrac's unremitted employment insurance premiums and income tax source deductions from the proceeds of the term deposit the Crown said was subject to a deemed trust.
Under s.227(4.1) of the ITA and s.86(2.1) of the EIA3 a deemed trust is created in favour of the Crown over property of an employer that has deducted income tax or employment insurance premiums, from payments to employees. The deemed trust applies to property of the employer and is extended to property held by any secured creditor of the employer that, but for its security interest, would be property of the employer. The primary issue facing the Supreme Court was whether the Crown was the beneficial owner of Camvrac's term deposit to the extent of the unremitted employment insurance premiums and income tax deducted by Camvrac at source, due to these "deemed trust" provisions.
In order to determine whether the deemed trust provisions applied to the Camvrac term deposit the Court needed to determine whether it was subject to a "security interest". Finding that a uniform definition across provinces was required, the Court determined that subsection 224(1.3) of the ITA was the sole relevant definition of "security interest" for the purposes of the deemed trust rules.
The Court then considered the right to compensation conferred on the Caisse by a contract between the Caisse and Camvrac, and stated that the terms of the contract are of paramount interest since they reflect the mutual intention of the parties. If the substance of the agreement demonstrates that the parties intend an interest in property to secure a debt, then a "security interest" exists within the meaning of s. 224(1.3) ITA. Although the Caisse argued that its contractual right to effect compensation with Camvrac was not a "security interest" within the meaning of s. 224(1.3) ITA, the Court held that both agreements expressly conferred on the Caisse an interest in the property of Camvrac to secure repayment of Camvrac's indebtedness to the Caisse:
It was the five-year term and the maintenance and retention of the $200,000 deposit, as well as Camvrac's agreement not to transfer or negotiate the deposit and that the deposit could only be used as security with the Caisse, that created the Caisse's interest in Camvrac's property for the purposes of s. 224(1.3) ITA.4
It is for these reasons that the majority found in favour of the Crown, and the appeal was dismissed. Under s. 227(4.1) of the ITA and s. 86(2.1) of the EIA, Camvrac's property was impressed with the Crown's deemed trust from the time income tax and employment insurance premiums were deducted at source by Camvrac.
It is important to note that had there not been any encumbrances on Camvrac's deposit of $200,000, the result would likely have been different since it would not have been considered as a security interest.
The majority reasons of Rothstein J. distinguish between a mere right to affect compensation on the one hand, which is not a security interest; and a series of contractual agreements including a right to affect compensation that did create a security interest. In dissent, Deschamps J. noted some potential issues with regard to the use of a right of set-off as a security interest under the deemed trust provisions. In particular, it was noted that financial derivatives frequently provide for termination and close-out netting provisions, including a right of set-off, enforceable against the swap counterparty.
However, it seems relatively clear from Rothstein J.'s argument that security interests are created only where the entire contractual scheme is intended to create a security interest in property, and not merely when a right of set-off is present. Given that a right of set-off within a financial derivative exists to mitigate the complications of large payments related to notional debts being transferred among parties, and not to secure any particular property of a swap counterparty, it appears unlikely that the Desjardins decision will put financial derivatives such as interest swap transactions in danger of the deemed trust regime. Similar reasoning would apply to the standard terms of deposit agreements, as Rothstein J. made clear in his reasons.5
Therefore a mere right of set-off (as might be contained, for example, in an account management agreement) does not itself create a security interest that can give rise to an extended deemed trust. So if a bank has an unsecured personal loan but reserves the right to set off amounts in the deposit account, there is no "security interest" and so no extended deemed trust unless the bank has taken steps to place restrictions on that property (i.e. the deposit account) in order to ensure that the creditor continually remains liable to the bank in order to make the set-off effective. A "security interest" is created by the totality of the agreements in place between lender and borrower, and is not automatically created merely because the bank enjoys a right of set-off between a deposit account and a loan.
Given the decision, however, and given the increased level of use of the deemed trust provisions by CRA in its collections procedures in recent months, it does make sense for creditors to examine their security arrangements and consider whether certain aspects may create a "security interest" for the purposes of these provisions. In practice, any money realized out of "secured" assets, on this definition, at the time a deemed trust is in existence, must be remitted to the CRA to satisfy the amount of the deemed trust. However, all parties (including CRA) may be entirely unaware of the deemed trust existing. If CRA obtains information regarding a security interest after the fact, it will require such property to be paid to satisfy the deemed trust (less, generally, costs of seizure or sale). No safe limitation period exists in respect of such deemed trusts.