Recently the Supreme Court of Canada, by its decision in Caisse Populaire Desjardins de l’Est de Drummond v. Canada, created a cause for concern for all creditors in Canada. In a surprising 5 to 2 decision, which has the effect of classifying a right of set-off/compensation as a security interest, priority was taken away from a creditor and handed over to federal tax authorities for unremitted source deductions. This applied independently of whether those deductions had occurred before or after the creation of a "security interest" in favour of a creditor.

It is therefore essential that creditors understand the following. Although the purpose of a right of set-off/compensation is to extinguish debts and in that regard is considered as a personal right under civil law and common law, it has been broadly interpreted by the Supreme Court as constitutive of a real right. As a result of this, a right of set-off/compensation was found to create a "security interest" within the meaning of the Income Tax Act (“ITA”), which in turn was subject to a deemed trust in favour of the Crown for unremitted employment insurance premiums and income taxes deducted at the source. This important decision also makes secured creditors liable to tax authorities for interest from the secured creditor effected the set-off/compensation to the date of payment of the amount set-off to the tax authorities.

In the judgment rendered by Justice Rothstein, the majority considered whether a right of set-off/compensation created a security interest within the meaning of s. 224(1.3) of the ITA. While agreeing upon a business line of credit, the parties entered into a Term Savings Agreement whereby a right of set-off/compensation was created in favour of Caisse Populaire Desjardins should the employer default on his line of credit. It was found that the existence of a security interest within the meaning of the ITA depends on multiple factors, the most important of which is the intention of the parties. In search of this intention, Justice Rothstein considered the following 5 factors: (1) the five year term of the Agreement, (2) the required maintenance and retention of the deposit (3) the agreement not to transfer or negotiate the deposit, (4) the fact that the deposit could only be used as security for the creditor, (5) the use of the word "security" in the agreement. These factors led the court to find an intention to create a security interest by conferring on Caisse Populaire Desjardins an interest in the tax debtor’s property. Without these conditions, the debtor could have taken possession of the deposit at any time, leaving the creditor without a guaranteed source for repayment. While in this case the right of set-off/compensation was merely a method of realizing the security, the Supreme Court found it to be the root of the parties’ intention to create a security interest, more particularly a movable hypothec over a non-negotiable claim published by the physical delivery of the property. The creditor’s hypothec therefore made his right subject to the deemed trust. In short, an agreement which provides for set-off/compensation and which also conforms to the statutory definition of a “security interest” will not be exempted from the purview of this definition merely because it is not specifically listed as an example of the types of security documents contemplated by s. 224(1.3) ITA. Therefore, where property subject to a right of set-off/compensation secures repayment of an indebtedness, a security interest exists.

In light of this decision, it has become increasingly difficult to effectively protect the interests of creditors against the federal tax authorities for unremitted source deductions. Increased monitoring of remittances by lenders may be necessary to control this risk.