The recent decision by the Federal Court of Appeal (FCA) in Canada v Callidus Capital Corporation has turned on its head the commonly understood ordering of priorities amongst secured creditors and the Canada Revenue Agency’s (CRA) “deemed trust” claims in and out of bankruptcy proceedings. Callidus Capital Corp., as secured creditor, was found by the FCA to be personally liable for a borrower’s unpaid “deemed trust” impressed Harmonized Sales Tax (HST), to the extent of proceeds of a sale it received from a borrower prior to the date of bankruptcy of the borrower — a result that, up to the date of the decision, would not have been the prevailing view amongst insolvency practitioners in Canada.
This article will briefly review this decision and discuss its potential impact on lenders, borrowers and insolvency practitioners.
Background: The Callidus Decision
Cheese Factory Road Holdings Inc. carried on business as an Ontario-based real estate investment company. Between 2010 and 2013, Cheese Factory collected, but failed to remit to the CRA, the HST payable in the amount of approximately $177,300 plus interest (the “HST obligation”).
Callidus became the senior secured lender to Cheese Factory in December 2011. Callidus also entered into a forbearance agreement with Cheese Factory wherein, inter alia, Cheese Factory agreed to market certain of its real estate holdings for sale and to deliver the net sales proceeds to Callidus to partially repay the amounts owed to Callidus under the credit facilities.
During the period of the forbearance, Callidus received the sum of approximately $590,956 (the “proceeds”). Callidus applied the proceeds to partially reduce the outstanding indebtedness and obligations owed to it by Cheese Factory.
On or about April 2, 2012, CRA, by way of a letter to Callidus, claimed an amount of $90,844.33 on the basis of the “deemed trust” mechanism of the Excise Tax Act (ETA). CRA did not issue a Requirement to Pay to Callidus.
On Nov. 7, 2013, Cheese Factory made an assignment in bankruptcy pursuant to the Bankruptcy and Insolvency Act (BIA). On Nov. 25, 2013, the Crown, acting for the CRA, commenced an action against Callidus for the HST obligation on the basis that Callidus was deemed to be holding the proceeds in trust for the Crown and was required to remit the proceeds to the Crown in priority to its security interest. The Crown was relying on section 222(3) of the ETA.
Callidus argued that the deemed trust was no longer operative and ceased to apply after Cheese Factory became bankrupt. Prior to 1992, the bankruptcy legislation granted Federal Crown claims priority over other unsecured claims. The 1992 BIA amendments levelled the playing field by making Crown claims ordinary unsecured claims.
The Crown was of the view that Cheese Factory’s bankruptcy did not affect Callidus’s preexisting personal liability for having received the proceeds prior to the occurrence of the bankruptcy at a time when the HST obligation existed. The parties sought a determination from the Court as to whether the Crown could pursue an action against Callidus independent of any subsequent bankruptcy proceeding. The question put before the Court was, “Does the bankruptcy of a tax debtor and subsection 222(1.1) of the render the deemed trust under section 222 of the ETA ineffective as against a secured creditor who received, prior to bankruptcy, proceeds from the assets of the tax debtor that were deemed to be held in trust for the Plaintiff?”
The motion judge hearing the matter held that upon bankruptcy, the deemed trust was ineffective as against the secured creditor, and that any obligation to disgorge the proceeds was extinguished. The Crown appealed this decision.
The Federal Court of Appeal allowed the appeal and held that while the ETA releases the deemed trust upon bankruptcy, which the Crown conceded, it did not extinguish the personal liability of the secured creditor that received the proceeds from the assets of the tax debtor at a time (i.e., prior to the bankruptcy) when the deemed trust was still in effect. The Court indicated that an independent action can be pursued on the basis that section 222(3) of the ETA extends the trust to the tax debtor’s property and requires the proceeds to be paid to the Crown in priority to all secured interests.
Callidus has sought leave to appeal to the Supreme Court of Canada (SCC), but no decision has yet been made as to whether the SCC will hear it.
Impact of the Callidus Decision
The Callidus decision has caused considerable consternation for lenders and insolvency practitioners and is causing these parties to consider its impact on their businesses, in particular how to deal with demands from CRA for “deemed trust” amounts above and beyond what was considered the norm prior to the FCA decision.
On Lenders and Borrowers
The Callidus decision will have a significant impact on how lenders and borrowers contract business with each other and may lead to a tightening of credit available to borrowers or at the very least an increase in monitoring and reporting and the associated cost of doing so. For example, lenders may consider creating a new and specific reserve against the borrowing base for the GST/HST component of the borrower’s accounts receivables, regardless of whether HST arrears exist, in order to protect against a future unexpected exposure. Lenders may also become more diligent in monitoring their borrowers’ financial affairs by requiring borrowers to consent to the lender’s obtaining information from CRA. And lenders may consider it prudent to investigate a borrower’s dealings with CRA prior to entering into or negotiating the terms of a forbearance agreement, or prior to enforcing security. This information may reveal that a borrower is delinquent in its tax filings (and thereby potentially subject to notional tax assessments) or in arrears (including penalties and interest) of HST or source deduction remittances. These types of obligations may promote CRA to take legal action, including issuing enhanced garnishment notices, which may adversely impact the position of the borrower and the secured creditor.
Over the last few years, Canada has seen a decline in the number of corporate bankruptcy filings and greater reliance on private workouts. Borrowers are frequently entering into forbearance agreements as part of an exit plan. Distressed borrowers have been fortunate to have access to an ample supply of capital. The incumbent lender, who is often paid from the positive cash flows generated from operations and/or a refinancing, may now become concerned when being asked to fully release a borrower from its obligations until it satisfies itself that the borrower is compliant in meeting its various tax obligations.
After the commencement of a receivership, CRA routinely carries out an audit of a debtor’s books and records for the purpose of establishing its pre-receivership claims. Lenders have previously taken comfort from an ability to later promote a bankruptcy, if necessary, principally to reverse the priority of the HST-deemed trust and eliminate potential personal exposure to the Crown. Out of an abundance of caution, some lenders are now applying for a bankruptcy order prior to enforcing their security as a means of eliminating this potential exposure. This inevitably will result in an increase in the costs associated with enforcing security.
For Insolvency Practitioners
Insolvency practitioners understandably are concerned about the impact of the Callidus decision on their practices. The ETA states that “the receiver shall be deemed to be an agent of the person and any supply made or received and any act performed by the receiver in respect of the relevant assets of the receiver shall be deemed to have been made, received or performed, as the case may be, by the receiver as agent on behalf of the person.”
The ETA also requires the practitioner to obtain a clearance certificate before distributing. CRA does not generally issue clearance certificates to receivers.
Given the Callidus decision, what should a practitioner do to safeguard itself when distributing funds to creditors in situations other than a bankruptcy?
Prior to making a distribution, receivers should request that CRA conduct an audit for the purposes of establishing their pre-filing claims. The receiver should then follow up with CRA to have it prove its claim, and identify the extent to which these claims constitute a deemed trust.
Although the audit gives some protection to the practitioner, there are situations where CRA, on receipt of new information, raises an HST deemed trust claim after carrying out its audit, and after the practitioner has distributed the funds in its hands. Previously, the receiver would consider promoting a bankruptcy as a means of reversing CRA’s deemed trust priority for unpaid GST/HST. Given the Callidus decision, the subsequent bankruptcy does not reverse CRA’s priority that existed at the time of the distribution, which potentially exposes the receiver to liability.
Private and Court-Appointed Receivers
Receiverships are commonly used by secured creditors as a means of liquidating the assets they hold as collateral vis-à-vis a private or court-appointed receiver. A privately appointed receiver is appointed by the lender pursuant to the specific provisions in the security agreement.
Alternatively, a secured creditor may apply to the Court for the appointment of a receiver. A Court-appointed receiver derives its power and authority from the Court. While the Court-appointed receivership has additional costs, one of the benefits of having the Court supervise the receivership process is to have the receiver seek the Court’s approval for its acts and decisions, including its distribution to creditors. A Court-appointed receiver may consider conducting a claims bar process before distributing funds to creditors, with the process being on notice to CRA. This process may safeguard the practitioner from personal liability.
It is not always practical to seek the appointment of a Court-appointed receiver. A privately appointed receiver could seek indemnity from the appointing creditor. Conversely, the receiver may also consider entering into a reimbursement agreement with those creditors benefiting from a distribution, to safeguard against personal liability in this post-Callidus world.
As leave to appeal to the SCC is pending, this story may not yet be over. In the meantime, though, lenders and insolvency practitioners will have to act with more caution until the issue is resolved by the SCC.
 Canada v. Callidus Capital Corporation, 2017 FCA 162.
 Callidus also collected gross rents in the amount of approximately $780,387, which was applied to reduce Cheese Factory’s indebtedness to Callidus.
 The HST a business collects from its customers is considered a deemed trust amount. This deemed trust arises out of operation of law. To protect these amounts CRA has various powerful collection tools, including:
- Deemed Trust: 222(1) of the ETA explicitly provides that GST or HST collected is deemed held in trust for the Crown and is not the property of the tax debtor;
- Extension of the deemed trust: The deemed trust mechanism also applies to third parties and for all purposes. Subsection 222(3) of the ETA is an extension of the deemed trust: If the collected GST and/or HST are not paid, the equivalent funds or property of the tax debtor are deemed to be property of the Crown, despite any security interest;
- Deemed Trust letters: CRA may issue a secured creditor a deemed trust letter that details the deemed trust debt owed to CRA and warns the creditor that failing to pay the amount of the deemed trust may result in legal proceedings; and
- Requirement to Pay: CRA may issue a Requirement to Pay pursuant to section 317 of the ETA. The Requirement to Pay instructs the third party to send the money to the CRA instead of the “tax debtor.”
 Canada v. Callidus Capital Corporation, 2017 FCA 162.
 Justice Pelletier, writing in dissent, held that that Federal Court correctly answered the question that was put to it.
 Excise Tax Act R.S.C., 1985, c. E-15, Section 266(2)(a).
 Idem, Section 270.