Federal Court of Appeal decision exposes secured creditors to significant risk under Section 222 of the Excise Tax Act

On April 29, 2020 the Federal Court of Appeal (the “FCA”) released its decision‎¹‎ with respect to Section 222 of the Excise Tax Act (the “Act”), which creates a deemed trust in favour of the Crown, in priority to all security interests, for unremitted GST.

Background

The tax debtor (the “Debtor”) operated a landscaping business as a sole proprietor and had collected, but failed to remit, goods and services tax (“GST”).  Without knowledge that the Debtor owed the unremitted GST to the Receiver General, the bank (the “Bank”) subsequently advanced personal loans to the Debtor which were secured by property owned by the Debtor.  The Debtor later sold the property to third parties and used the proceeds of that sale to repay the loans owing to the Bank in exchange for a discharge of the Bank’s security against the property sold.  The Canada Revenue Agency, on behalf of the Crown, later asserted a deemed trust claim against the Bank pursuant to Section 222 of the Act for that portion of sales proceeds of the property equal to the amount of the unremitted GST.

At trial, the Federal Court (“FC”) held that the Bank was obligated under Section 222(3) of the Act to remit to the Crown that portion of the sales proceeds which were subject to the deemed trust arising under Section 222 of the Act.

Pursuant to Section 222(1) of the Act, every person who collects GST is deemed to hold the amount in trust for the Crown.  Section 222(3) of the Act extends the deemed trust to the property of the tax debtor held by secured creditors by requiring the amount received by such secured creditors: (i) to be held in trust for the Crown despite any security interest in the property or the proceeds thereof and (ii) to be paid to the Receiver General in priority to all security interests, other than prescribed security interests.

In reaching its decision, the FC found that:

• The amounts paid by the Debtor to the Bank were “proceeds” of the sale of the ‎Debtor’s property and were subject to the deemed trust under Section 222.
• The Debtor was obliged to pay his tax debt from the sales ‎proceeds of the property, but failed to do so. Instead, he used the proceeds ‎to pay the Bank, who was a secured creditor of the Debtor.As such, the Bank had a ‎statutory obligation to pay the Debtor’s tax debt using the proceeds it received from the Debtor.‎
• Third party purchasers can rely on the bona ‎fide purchaser defence in order to acquire a tax debtor’s property free and clear of the Crown’s beneficial interest in that property under Section 222.However, the Bank, as a secured creditor of the Debtor, cannot rely on that defence to counter the statutory obligation imposed by ‎Section 222(3) of the Act as doing so ‎would defeat the purpose of the deemed trust thereby rendering it meaningless.‎
• No triggering event is necessary to bring the deemed trust created by Section 222 into operation.
• Parliament clearly intended to confer a super priority to the Crown for unremitted GST over ‎secured creditors.‎
• Parliament considered the potential challenges posed by the deemed trust on ‎secured creditors and provided a remedy by excluding prescribed ‎security interests from the obligations under Section 222(3).‎

Issues on appeal

The central issue raised on the Bank’s appeal was the correct interpretation of Sections 222(1) and (3) of the Act.  Is a secured creditor who receives proceeds from a tax debtor’s property at a time when the Debtor owes GST to the Crown required to pay a portion of the proceeds equal the tax debt to the Receiver General in priority to all other security interests?  In particular, the Bank raised the following three issues:

1. Did the FC err by finding that the deemed trust does not require a triggering event which causes the trust to crystallize around specified assets?
2. Did the FC err by finding that secured creditors cannot avail themselves of the bona fide purchaser for value defence?
3. Did the FC err by failing to consider that the security interests of the Bank were not created and granted in a transaction providing financing to the Debtor’s business?

Bank’s argument

1. Deemed trust requires a triggering event
   

   
   The Bank argued that the deemed trust under Section 222 of the Act requires a triggering event to crystallize around satisfied assets.  While the Bank acknowledged that the deemed trust provisions grant an absolute priority to the Crown, it argued that the provisions do not amount to a statutory direction to pay at the time GST ought to have been remitted.  Instead, the Bank contended that a triggering event, which it suggested could include bankruptcy, the initiation of proceedings by the Crown for the recovery of unpaid taxes or the exercise of a security interest, is required to crystalize the Crown’s claim to a debtor’s assets by way of the deemed trust.

   The Bank further submitted that inherent in the concept of priority is that priorities are to be assessed at the time competing claims come into conflict. In its view, the right to a priority claim is remedial in nature, meaning it can only arise upon the exercise of enforcement or bankruptcy remedies by creditors.  In other words, the Crown is only able to exercise its priority over a secured creditor’s security interest when there is a competition between claimants and there is a shortfall. In the case at hand, the Bank alleged that it was not a secured creditor of the Debtor at the time the Crown asserted its claim as the debt was repaid and the Bank’s security interest discharged.

2. Bona fide purchaser for value defence

   
   The Bank argued that the FC erred because “Parliament is assumed to know the concept it has implied and only if it has excluded the defence with irresistible clearness is the defence excluded.” The Bank submitted that the bona fide purchaser for value defence is well-established in law and that Parliament had not enacted a change to the common law so as to eliminate this defence to the Crown’s deemed trust claim.
   

3. The Bank’s security interests did not relate to the Debtor’s business

The Bank argued that the FC should have distinguished between the Debtor carrying on business as a sole proprietorship and the Debtor transacting in his personal capacity. The Bank submitted that it had not been unjustly enriched at the expense of the Crown because the Bank had not received proceeds of the Debtor’s business in priority to the Crown. Instead, the proceeds of the property were the Debtor’s personal property and not an asset of the business. In addition, the Bank argued that a secured creditor who does not grant credit to a debtor’s business cannot protect itself or know the obligations of that business.

FCA conclusion

1. Deemed trust requires a triggering event
   
   The FCA held that the deemed trust under Section 222 of the Act does not require a triggering event. Parliament, in response to the decision of the Supreme Court of Canada (the “SCC”) in Royal Bank of Canada v. Sparrow Electric Corp., amended this Section by removing the language from the previous iteration of the legislation which did include reference to the triggering events of “liquidation, assignment, receivership or bankruptcy”. In addition, Parliament further revised Section 222 to clarify that a secured creditor is deemed to hold a debtor’s property in trust at the time that GST is collected but not remitted. Upon reviewing the grammatical and ordinary sense of the language of Section 222, in particular the addition of “whether or not the property is subject to a security interest”, the FCA concluded that Parliament intended to grant priority to the deemed trust in respect of property that is also subject to a security interest, regardless of when the security interest arose in relation to the time the GST was collected. According to the FCA, the purpose of Section 222 is to protect the collection of unremitted GST, and this purpose is effected by granting priority to the deemed trust in respect of property that is also subject to a security interest irrespective of when the security interest arose in relation to the time GST was collected.  Parliament addressed the harshness of this result by excluding prescribed security interests from the effects of Section 222(3).
   
   
2. Bona fide purchaser for value defence

   
   The FCA held that the bona fide purchaser defence is not available to secured creditors.  It referenced the following explanation of the defence, as approved by the SCC, in i Trade Finance Inc. v. Bank of Montréal:

   The effect of the defence is to allow the defendant to hold its legal proprietary rights unencumbered by the pre-existing equitable proprietary rights. In other terms, where the defence operates, the pre-existing equitable proprietary rights are stripped away and lost in the transaction by which the defendant acquires its legal proprietary rights.

   The FCA concluded that it would be irrational for Parliament, in an effort to ensure that collected, unremitted GST is recovered in priority to all debts, intended that secured creditors could rely on the bona fide purchaser defence to undo the Crown’s pre-existing beneficial interest in the property by way of the deemed trust. Upholding the FC’s decision, the FCA found that such a conclusion would eviscerate the deemed trust provisions.

   The FCA also inferred that the exclusion of “purchasers for value” and the inclusion of “secured creditors” in Section 222 is determinative that the bona fide purchaser defence is not available to secured creditors in the context of the deemed trust provisions.
   

3. Bank’s security interests were not created and granted in relation to the Debtors business

The FCA held that there was no merit in the Bank’s arguments that the debt which resulted in its security interest was not related to the Debtor’s business. The Agreed Statement of Facts in the case was silent as to the extent of the Bank’s knowledge of the Debtor’s source of income or what, if anything, the Bank did to inquire as to the Debtor’s compliance with his obligations under the Act. The Bank also did not cite any authority for its proposition.

Summary

Section 222 of the Act exposes secured creditors to significant risk to the extent that debtors have outstanding GST obligations. Some of this risk is mitigated by the fact that the FCA confirmed that prescribed security interests, such as mortgages registered before the deemed trust arises, are exempted from the deemed trust provisions.  That being said, the onus is clearly on a lender to carry out sufficient due diligence at the underwriting stage, during the term of the debt, and as part of the discharge of security process to minimize the risk that unremitted GST poses to its security.