Bankruptcy and Tax Debts

Bankruptcy is a process to relieve honest, but unfortunate, debtors of their debts. Usually, at the end of the process, the bankrupt is released from the obligation to repay the debts they had when the bankruptcy was filed.

One of the largest causes of personal and corporate insolvencies in Canada is tax debts.

Options under the Bankruptcy and Insolvency Act

If you or your company are insolvent, you have two options under the Bankruptcy and Insolvency Act (BIA): file for bankruptcy or make a “proposal” to your creditors.

Option 1: Bankruptcy

If you file a bankruptcy, your assets (with some exceptions) are turned over the bankruptcy trustee, who distributes them to your creditors. Secured creditors are given first priority, then, possibly, the government under “Crown prerogative” and, finally, you unsecured creditors are paid. At the end of the bankruptcy process, the debtor will apply for a discharge and receive an automatic discharge, conditional discharge (in a tax-driven bankruptcy, conditions of discharge might be additional payments to CRA, that the debtor will meet future tax obligations, etc.) or the discharge will be refused (debtor is responsible for all pre- bankruptcy debts).

Option 2: Consumer Proposal

An insolvent person or company can also file a consumer proposal. Proposals are made to avoid filing bankruptcy. A proposal is an offer to your creditors to pay a percentage of what you owe (usually over a period of time). Your creditors will vote on your proposal. If it is accepted, you’ll meet the terms of your proposal and your debts will be extinguished. If the proposal is not accepted, you can make another more attractive proposal or file for bankruptcy. If you owe more than $250,000 and make a proposal, which is not accepted, you are automatically deemed bankrupt when the proposal fails.

Proposals are attractive because they are often quicker than a bankruptcy and do not require that an individual or company file for bankruptcy, which has negative connotations and can affect your future credit worthiness.

Both a bankruptcy and proposal stop any collection action against you. If the proposal fails, collection action can resume. If your bankruptcy discharge is refused or the bankruptcy is annulled for some reason, your creditors can resume collecting on your pre-bankruptcy debts.

Personal Tax-Driven Bankruptcies

Taxes are increasingly the cause of personal and corporate bankruptcies. Parliament has created special rules for “tax-driven bankruptcies.” Section 172.1 concerns “tax-driven bankruptcies,” which is when a bankrupt has $200,000 or more of personal income tax debt and whose personal income tax debt represents 75 percent or more of the bankrupt’s total unsecured claims. This section increases the time until a bankrupt is eligible to make a discharge application. This section also requires that the circumstances of the bankrupt’s tax debt be considered at the discharge hearing.

The CRA usually opposes automatic discharges and seeks conditional discharges (conditions usually include payments over time, all outstanding tax returns are filed, and that future tax obligations are met).

For first-time bankrupts, bankruptcy courts usually discharge bankrupts for 10 percent or less of the pre-interest tax debt. If it appears to the court and the CRA that an individual is using the BIA as a debt-clearing tool and/or has filed multiple bankruptcies, that individual will find discharge applications increasingly difficult and will be subjected to increasingly onerous discharge conditions.

GST/HST and Payroll Debts

When a business fails to remit GST/HST and payroll source deductions, the CRA insist that they are an involuntary creditor. Provisions in the Income Tax Act and Excise Tax Act deem these amounts held in “trust” for the government and create a super-priority whereby CRA ranks ahead of other unsecured creditors, even, in some cases, creditors who have secured their interest. On bankruptcy, GST/HST is not considered to be held in trust. On the other hand, payroll source deductions are considered to be held in trust on bankruptcy.

It is possible to bankrupt or make a proposal for GST/HST and payroll debts. However, the CRA may insist that a condition to the bankrupt’s discharge is to repay a portion of the GST/HST and/or payroll arrears.

Other Issues for Bankruptcy and Tax

If a taxpayer has appealed or objected to their tax debts and files for bankruptcy before the appeal or objection is concluded, the bankruptcy trustee can reject the tax debt as unquantifiable, which would prevent the CRA from participating in the creditors’ meeting and participating in asset distribution. This is significant because the CRA can be a difficult creditor (see “Tax-Driven Bankruptcies” above).

While an individual is bankrupt, only the trustee bankruptcy trustee can object or appeal a tax assessment or reassessment. A tax refund paid while an individual is bankrupt is paid to the trustee, who distributes the refund to the creditors.

If a taxpayer has a tax debt and, in certain circumstances, transfers property to a related party, the CRA may assess that related party for the amount of the taxpayer’s debt or the property (up to the value of the tax debt). If the taxpayer files for bankruptcy or makes a proposal, that would not prevent the CRA from assessing the related party.

For personal and corporate income tax, the CRA is an ordinary, unsecured creditor. However, because of the powerful collection tools at the CRA’s disposal, the CRA can register liens on assets and will be treated as secured creditors for those claims in a bankruptcy.

If you have a significant amount of tax arrears and have questions regarding the options available to you, please contact one of our tax lawyers for a free consultation.