Lenders, Are your Investments Safe?

Introduction

In certain circumstances, the Income Tax Act[1] and the Excise Tax Act[2] provide Canada Revenue Agency (“CRA”) with powerful tools, enabling it to collect unremitted source deductions and HST from a debtor, and even from the pocket of a secured creditor who may have been unaware of the debtor’s tax-related debts.

Notwithstanding that a prospective borrower may appear to be financially stable, have no outstanding security registered against it, and possesses assets against which security for the repayment of a loan may be registered, it is not a given that a loan provided to such debtor is without risk. A prospective lender must look deeper if it wishes to ensure that its investment is risk-protected. As such, it is essential for lenders to know about deemed trusts and their implications, particularly since they can drastically affect their ability to recover their investments.

What is a deemed trust?

 A trust, by definition, is property held by a party (i.e., the trustee) for the benefit of another party, commonly referred to as a beneficiary. In many cases, a trust is formed intentionally. A deemed trust, on the other hand, is a creature of statute, whereby a trust is created, by operation of law, in the event that certain circumstances arise.

Formation of a deemed trust for the benefit of CRA  

A deemed trust is formed when a taxpayer fails to remit source deductions or HST/GST payable that it is otherwise obligated to collect and remit to CRA. In such event, the unremitted amount is deemed to be held in trust by the taxpayer for the benefit of CRA. The rights inherent in the deemed trust attach to the assets of the respective taxpayer, which operates similarly to a secured debt held by CRA, bearing priority over all other secured or unsecured debts payable by the taxpayer.

How might a deemed trust cause problems for secured and unsecured creditors?

In the matter of Toronto Dominion Bank v Canada,[3] a taxpayer operated a landscaping business. In 2007 and 2008, the taxpayer collected but failed to remit GST/HST in the amount of $67,854. Accordingly, CRA enjoyed a deemed trust in respect of the taxpayer’s assets, in the amount of the unpaid sum. In 2010, the Toronto-Dominion Bank (“TD”) extended loans to the said taxpayer which were secured by mortgages against its real property. At the time at which it registered its security, TD was not aware of the unremitted amount owing to CRA. In 2011, the taxpayer sold the said real property. Following payment of the loans by the taxpayer from the sale proceeds, TD discharged the respective mortgages. Later, CRA asserted a deemed trust claim against TD and demanded payment from the proceeds received by TD from the taxpayer.

The court, in that instance, ruled that the respective deemed trust took priority over all other security interests, including that of TD’s, notwithstanding that TD was a secured creditor. The courts have affirmed that “secured creditors and the property over which they assert their security interests are subject to deemed trusts.”[4]

In practice, this means that even if a loan is repaid by a debtor to a lender, the repaid sum is not safe from a claim by CRA. CRA may seek to be made whole by the lender, in addition to by the debtor.

Prudent due diligence:

In order to avoid a scenario in which a lender becomes subject to a deemed trust, lenders should engage in the following forms of due diligence:

• Require that a prospective borrower provide a comfort letter from CRA, which confirms whether the borrower’s tax accounts are in good standing.
• Require a prospective borrower to provide evidence that its tax accounts are in good standing.
• Subject to certain exceptions, a voluntary mortgage registered against real property prior to the time at which a deemed trust debt arose will have priority over the deemed trust. This is referred to in the law as a “prescribed security interest”. Subject to the completion of the due diligence best practices mentioned above, the registration of a mortgage may protect against the possibility of a deemed trust impacting the security of a lender’s investment.

Conclusion:

Given the potential impact that a deemed trust may have upon the security of an investment made by a lender, it is important that caution and due diligence be exercised by such lender, which includes examining and confirming that a prospective borrower’s tax accounts are in good standing and taking such further steps as may be advised by the lender’s legal advisor.