Bankruptcy May not Always Clear a Tax Debt
Even if you go bankrupt, or your corporation, or someone close to you (a “non-arm’s length party”), you can still be held liable in the future for a Canada Revenue Agency (“CRA”) tax debt you believed bankruptcy had erased. This is pursuant to the Federal Court of Appeal decision in Canada v. Heavyside, 1996 FCA 3932 (CanLII). As outlined below, there are many circumstances where bankruptcy will not erase a tax debt and it is important, before you consider bankruptcy, to be aware of the risks of potential future liability and ways to protect yourself.
Bankruptcy and Third-Party Liability
You may find yourself in debt to CRA and very stressed. If you search the internet you will find businesses falsely claiming that CRA tax debt cannot be lowered and the only option is bankruptcy. Also, at least one is known to funnel clients, that hired them initially to dispute their tax debt/assessment, into their bankruptcy division as a deliberate method of maximizing profit.
As outlined in detail below, CRA can assess a taxpayer for a non-arm’s length person’s tax debt, even if the original debtor has gone bankrupt. Under certain provisions of the Income Tax Act, RSC 1985, c 1 (5th Supp)and Excise Tax Act, RSC 1985, c E-15 (GST/HST), a person can be held liable for the tax debt of another, including a Director of a corporation and even if the corporation has gone bankrupt for the same tax debt. Or, for example, a wife can be held liable for her husband’s tax debt even if he has gone bankrupt for that debt. In short, a section 160, 224, 325 or Director Liability assessment is not erased by the bankruptcy of the original tax debtor.
Accordingly, in order to properly address your tax debt a tax expert should review the facts of your situation and advise you on the many intricacies and potential traps resulting from the interaction between the relevant components of bankruptcy, corporate and tax law. Here is a list of potential issues to consider:
1. Protection from personal liability for a corporation’s tax debt – Director Liability.
2. Protection from third-party liability for a taxpayer’s (e.g. individual, corporation) tax debt.
3. How exposed are you to third-party liability even if the original tax debtor has gone bankrupt?
4. If the issue is the tax debt of a corporation, what can be done to ensure you are not held personally liable, even if the corporation goes bankrupt.
5. Are you eligible for Taxpayer Relief?
6. Even if bankruptcy turns out to be the only option, what can be done to protect non-arm’s length parties (e.g. wife, husband, director, shareholder) from future liability for the bankrupt’s tax debt.
As you can see, the issue of CRA tax debt can become complicated and is full of traps. It may be wise to go bankrupt in a situation but it should only be done after addressing the issues of present or future risk of liability for the exact same tax debt.
Furthermore, if CRA audits and assesses you or your business for an inflated/incorrect amount based on factual assumptions it is important to provide your rebuttal rather than just immediately trying to move to bankruptcy. If the auditor refers your file to CRA investigations for review, that review should include the taxpayer’s facts establishing the lack of a basis for the auditor’s assessment.
Analysis - The Bankruptcy Process may not relieve you of a CRA Tax Debt
In simple terms, to go bankrupt involves being guided by a Bankruptcy/Insolvency Trustee through an undertaking of appeasing creditors and a court as much as possible to receive a discharge from the bankruptcy process. Under normal circumstances, once that is complete liability for the debt has been extinguished.
There are unique requirements to discharging a CRA tax debt. For instance, you must be insolvent, or unable to pay off your debts. You will have to file all outstanding tax returns and you will not receive any potential tax refunds. CRA takes a hardline when it comes to tax debt so depending on the amount at issue, you may have to appear before a judge for a ruling on your discharge from the bankruptcy, which you may never receive. And even if you or your corporation is discharged, you or those close to you may be held liable in the future for the same tax debt.
Director Liability, Sections 160 & 325 & 224
A director of a corporation can be held “joint and severally liable” for the unpaid tax arrears of a corporation. Therefore, you may have a business and be directed to the bankruptcy process only to later be pursued personally by the CRA for the tax debt of the business.
Another risk is a 3rd-party or derivative assessment under section 160 of the Income Tax Act and section 325 of the Excise Tax Act. Under both legislative provisions, a non-arm’s length taxpayer can be held liable for the debt of another person, which includes a corporation. This is a very common issue in the practice of tax law.
For example, if you have a tax debt with CRA and decide to transfer a property (for nil or less than fair-market value consideration) to your husband/wife in an attempt to prevent CRA from liening the property, CRA can then assess your significant other for your tax debt. Most importantly, the assessment is valid even if you have been discharged from bankruptcy for that exact tax debt. The same outcome occurs if a corporation transfers property for less than fair-market value consideration to a non-arm’s length party, e.g. director, shareholder, family member. If a related party has been assessed under sections 160 or 325, they are now liable for the debt, even if the corporation has completed the bankruptcy process.
Canada v. Heavyside, 1996 FCA 3932 (CanLII)
This unfortunate result is law pursuant to the Federal Court of Appeal in Canada v. Heavyside, 1996 FCA 3932 (CanLII). In their decision, the Federal Court of Appeal overturned the Tax Court of Canada’s opposite ruling and held that a section 160 tax debt was not extinguished on account of the bankruptcy of the original debtor. According to the court, the liability of the original debtor was extinguished, not the debt. Therefore, the “joint and several” liability of the section 160 assessment recipient endured.
In Heavyside, the husband transferred 50% of his property interest to his wife in 1989, for less than fair-market value consideration, while he had an outstanding tax debt to CRA. In 1993, the husband began the bankruptcy process and was discharged in 1994. Pursuant to section 160 of the Income Tax Act, the CRA assessed the wife for the husband’s tax debt.
The Federal Court of Appeal disagreed with the Tax Court
The Tax Court of Canada favoured the taxpayer and concluded that a section 160 assessment was only valid as long as the husband was liable for the debt. According to the Tax Court, because the husband extinguished the debt through bankruptcy the wife could not be held liable for it as it no longer existed. The Federal Court of Appeal did not agree and ruled in favour of the CRA, stating:
[t]here is no doubt that the husband’s discharge from bankruptcy relieves him from paying the Minister the amount due by him under section 160 of the Income Tax Act; this is made clear by subsection 178(2) of the Bankruptcy Act…[But to] allow the [wife] to escape her tax liability in the present case because of her husband’s discharge from bankruptcy would be to allow what Parliament precisely sought to prevent by the adoption of section 160.
According to the appeals court, the wife’s section 160 liability and the husband’s underlying liability are distinct and separate, therefore:
[the wife] was personally liable, in her 1989 taxation year, for income tax in respect of the gains from the disposition of the property transferred and her liability being joint and several with that of her husband, it had a life of its own and survived the eventual extinguishment through bankruptcy, in 1994, of her husband’s own tax liability. The fact that she was assessed only in 1994 and only after her husband’s discharge is irrelevant as far as her own liability is concerned.
The husband was relieved from having to pay CRA the tax debt due to his bankruptcy. However, the court held that his discharge from bankruptcy did not extinguish the debt, stating, “it is personal to the husband and does not affect the liability of the [wife] who is jointly bound…”.
A Section 160/325 Liability Survives the Bankruptcy and Discharge of the Principal Tax Debtor
In Wannan v. Canada, 2003 FCA 423 (CanLII), the Federal Court of Appeal affirmed the decision in Heavyside (at the time of this article more recently applied in Légaré v. The Queen, 2019 TCC 106 (CanLII)), stating:
Heavyside can be taken as authority for at least three propositions. (1) Liability under section 160 of the Income Tax Act arises upon a transfer of property in circumstances that meet the statutory conditions, not on the date on which the liability is assessed. (2) A section 160 liability survives the bankruptcy of the principal tax debtor. (3) A section 160 liability survives the bankruptcy discharge of the principal tax debtor. The statutory basis of the third proposition is that although subsection 178(2) of the Bankruptcy and Insolvency Act provides that a discharge relieves the bankrupt person from liability for a debt proved in the bankruptcy, section 179 of that Act prevents the discharge from giving the same relief to a person who, at the date of the bankruptcy, was jointly liable for the debt.
Requirements to Pay, Section 224 Assessments and Bankruptcy
CRA also has the power to garnish pursuant to section 224 of the Income Tax Act. According to subsection 224(1), “[w]here the Minister has knowledge or suspects that a person is, or will be within one year, liable to make a payment to another person who is liable to make a payment under this Act” CRA can assess that other person for the tax debt up to the amount owed to the original tax debtor. This liability is not extinguished by the bankruptcy of the original tax debtor.
In practice, this means that if a person has a tax debt and CRA is aware that you are legally liable to make a payment to that tax debtor, CRA has the power to seek payment directly from you. CRA will initially seek payment with a Requirement to Pay. If you ignore the Requirement to Pay you will likely receive an assessment for the tax debt.
3087-8847 Quebec Inc. v. The Queen
For example, in the Tax Court of Canada case of 3087-8847 Quebec Inc. v. The Queen, 2007 TCC 302 (CanLII), the corporation/appellant received a Requirement to Pay on account of an individual’s tax debt and the corporation being legally liable to pay that individual. In this case, one assessment was related to a debt the corporation owed the individual.
A key issue was whether the bankruptcy of the individual resulted in the debt being extinguished and therefore the corporation’s liability being erased. According to the Tax Court it was not. Referring to the decision in Heavyside, the Tax Court held that the bankruptcy, as in the case of Heavyside, did not mean that a “third party’s derivative obligation was extinguished when the tax debtor’s obligation was extinguished.”
Are your Best Interests being Considered?
Director liability and other 3rd party assessments are legal matters and can be complicated. A bankruptcy component certainly does not make it less so. All derivative forms of assessment for a tax debt occur pursuant to specific conditions outlined in the respective legislation. The underlying liability per this legislation must be addressed before considering bankruptcy or the process may be useless.
If you are considering bankruptcy to clear a CRA tax debt it is key that you first obtain advice regarding your possible options and potential pitfalls. It may be possible to dispute and lower the tax debt, including removing large financial penalties. A Taxpayer Relief application may also be an option to lower the debt. You will also be advised on the continuing risk of CRA enforcement action even if you seek bankruptcy, as well as possible ways to avoid future liability.
Ultimately, do not assume your bankruptcy clears the tax debt forever. You may go through the process only to be pursued later by the CRA for the debt you believed had been resolved. The facts of your situation need to be reviewed to ensure you can avoid personal and/or extended liability.
SpenceDrake Tax Law
Canada v. Heavyside, 25 RFL (4th) 334, [1997] 2 CTC 1, 43 CBR (3d) 128, AZ-50069864, 51 DTC 5026
Wannan v. Canada, 312 NR 247, [2004] 1 CTC 326, 1 CBR (5th) 117, [2003] FCJ No 1693 (QL), 57 DTC 5715
3087-8847 Quebec Inc. v. The Queen, [2007] 5 CTC 2313, [2007] FCJ No 203 (QL), [2007] TCJ No 203 (QL), [2007] DTC 1064