How Secure is a Lender's Secured Interest?

29 June 2020

Consider a scenario where a lender provides a borrower with a loan and secures that loan against the borrower's home. Unbeknownst to the lender, the borrower has outstanding GST remittance obligations. When the borrower sells the home, who gets the sale proceeds? That question lies at the heart of a recent Federal Court of Appeal ("FCA") decision.[1] The FCA held that the sale proceeds, paid to the lender in that case ("Lender"), to satisfy a secured line of credit and mortgage loan, were deemed to be held in trust for the Crown. In doing so, the FCA affirmed the lower court's decision and clarified the boundaries of the Crown's priority over secured creditors.



The Lender had extended a line of credit and a mortgage loan to two debtors in 2010. Before one of the debtors became a customer of the Lender, he had an outstanding GST remittance obligation of $67,854. The debtors sold their home in 2011 and repaid the line of credit and mortgage loan. In 2013, the Canada Revenue Agency ("CRA") asserted a deemed trust claim pursuant to section 222 of the Excise Tax Act and asked the Lender to transfer a portion of the sale proceeds to the CRA to satisfy the GST remittance obligation.

Subsection 222(1) of the Excise Tax Act deems an amount collected for GST/HST to be held in trust for the Crown, despite any security interest in the amount. If the amount collected is not remitted to the Receiver General, subsection 222(3) extends the statutory trust to property held by the debtor's secured creditors where, but for the security interest, the property would belong to the debtor. Subsection 222(3) also mandates that property held in the deemed trust be paid to the Crown in priority to all security interests.

There are three situations where the CRA could lose its priority in relation to other creditors. The first is where the debtor becomes bankrupt. In that context, the priority scheme in the Bankruptcy and Insolvency Act would prevail. This exception stems from the opening words in subsection 222(3) of the Excise Tax Act, which expressly subordinates its application to the Bankruptcy and Insolvency Act. The second situation is where the other creditors have a "prescribed security interest". A "prescribed security interest" is defined in the Security Interest (GST/HST) Regulations and includes a secured interest that is registered prior to the emergence of the statutory deemed trust. Thirdly, the deemed trust would also cease to apply to property sold to a bona fide purchaser for value.[2]

The Lender made the following arguments:

  1. It was a bona fide purchaser for value and the Federal Court had erred in finding that secured creditors cannot avail themselves of the bona fide purchase for value defence.
  2. The Federal Court had erred in finding that the statutory deemed trust does not require a triggering event, such as bankruptcy or a proceeding to recover unpaid taxes. The Lender argued that a deemed trust is akin to a floating charge, in that a triggering event is required for the deemed trust to crystalize over the debtor's assets.
  3. The Federal Court had erred by failing to consider that the Lender's security interests were not created in the context of providing financing to the debtor's business.

The FCA denied the Lender's ability to use the bona fide purchaser defence, stating that it would be irrational for Parliament to make the defence available if it intended to ensure that GST collected by the tax debtor was recovered in priority to all debts.

With respect to the Lender's second argument, the FCA considered the evolution of section 222 and found that triggering events, such as receivership or bankruptcy, were removed from the current version of the provision. The FCA also did not agree that a deemed trust was akin to a floating charge, which requires a triggering event to crystallize over a debtor's assets. While the FCA agreed with the Lender that Justice Iacobucci had analogized a deemed trust with a floating charge in First Vancouver Finance v MNR,[3] it found that his analogy was intended to describe a tax debtor's ability to sell property subject to a deemed trust, rather than to equate deemed trusts with floating charges for all purposes. The FCA concluded that the statutory deemed trust was not akin to a floating charge in the context before the court, did not require a triggering event and operated from the time GST was collected but not remitted to the Receiver General.

The FCA did not accept the Lender's argument that the Federal Court should have differentiated tax debtors who carry on a business from those who transact in their personal capacity. The Lender had argued that a secured creditor cannot have knowledge of a borrower's business obligations in situations where the secured creditor provides financing that is unrelated to the borrower's business. The FCA noted that the Lender had not cited any authority to substantiate its position and that subsection 222(1) clearly stated that "every person who collects an amount as or on account of [GST/HST]" is obligated to remit the amount to the Receiver General.

The Lender and the intervener, the Canadian Bankers Association, also raised a number of policy concerns with the FCA's interpretation of section 222 of the Excise Tax Act:

  • Secured creditors would be reluctant to credit borrowers for amounts repaid without continuously confirming tax compliance with the CRA.
  • Secured creditors would be placed in the anomalous position of being held personally liable for borrowers' GST remittance obligation.
  • Secured creditors would be incentivized to pursue liquidation or bankruptcy proceedings over restructuring alternatives that could preserve the borrower's business.

The FCA did not give these concerns weight as, in its view, Parliament had made a policy decision to prioritize the public treasury over the interests of secured creditors. Secured creditors could manage the risks posed by Parliament's decision by identifying high-risk borrowers and requiring those borrowers to either provide evidence of tax compliance or allow secured creditors to verify their compliance directly with the CRA.

Takeaways

In light of the FCA's decision, secured creditors may wish to:

  • Review their lending practices and risk management procedures.
  • Require enhanced disclosure from business owners seeking personal loans or mortgages, to ensure the financing arrangement fits within the definition of a "prescribed security interest".
  • Require evidence of continuing compliance with remittance obligations during the term of the loan or mortgage, as well as a comfort letter from the CRA prior to discharging their security interest.

Where borrowers are at risk of defaulting on their remittance obligations, secured creditors should carefully weigh the risks and benefits of restructuring the loan versus pursuing bankruptcy proceedings.


[1] Toronto-Dominion Bank v Canada, 2020 FCA 80.

[2] First Vancouver Finance v MNR, 2002 SCC 49.

[3] Ibid.


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