The Treatment of Personal Income Taxes In A Personal Bankruptcy

By Mary Plahouras, CFE, LL.M.

The approach taken by the Canada Revenue Agency (CRA) regarding the collection of personal income tax debt is straightforward: upon issuance of a Notice of Assessment or Reassessment to the taxpayer, all taxes assessed and determined to be owing, are to be paid in full, pursuant to the Income Tax Act (ITA).

When bankruptcy occurs, the taxation year is split into twoperiods: (1) pre-bankruptcy period; and, (2) post-bankruptcy period. The taxation year of a bankrupt comes to anend on the day before the date of bankruptcy (pre-bankruptcy period) and a newtaxation year begins on the date of bankruptcy and ends on December 31stof that year (post-bankruptcy period). Forinstance, if the date of bankruptcy is April 3, 2019, the taxation year of thebankrupt comes to an end on April 2, 2019 and a new taxation year begins on April3, 2019 and ends on December 31, 2019.

The significance of the pre and post-bankruptcy period hasconsequences for the dischargeability of the tax debt. A pre-bankruptcy tax debt is dischargeable inbankruptcy. A post-bankruptcy tax debtis not dischargeable in bankruptcy. Notwithstanding the bankruptcy, the bankruptremains liable to the CRA for payment of the post-bankruptcy tax debt.

Prior-Bankruptcy Personal Income TaxReturn

Pursuant to section 22 of the Bankruptcy and Insolvency Act (BIA), the Licensed Insolvency Trustee(LIT) is not liable to make any return that the bankrupt was required to makemore than one year prior to the commencement of the calendar year, or thefiscal year, of the bankrupt, in which the bankrupt became bankrupt. For instance, if the year of the bankruptcyis 2019, the LIT is required to file the bankrupt’s 2018 tax return with theCRA. Notwithstanding the LIT’s obligation to file the one-year prior-bankruptcytax return, the bankrupt has an obligation under ITA to file all outstandingtax returns.

If there is a prior-bankruptcy refund, the CRA can claim aset-off to the prior-bankruptcy refund where there is: (1) one or more prioryear tax liability owing to the CRA; or, (2) an enforcement maintenanceregistered with the CRA, such as a maintenance order by Family ResponsibilityOffice for child support. In absence ofany prior-bankruptcy tax liability or enforcement maintenance registered, theCRA will send the prior-bankruptcy refund to the LIT for the general benefit ofthe bankrupt’s creditors. If there is atax liability owing to the CRA arising from prior year(s) tax assessment(s), thetax liability is a claim provable in the bankruptcy and dischargeable. The bankrupt will not be liable to the CRA for payment of the prior-bankruptcy taxliability.

Notwithstanding section 22 of the BIA, where the LITdetermines that there may be significant refunds for the bankruptcy estate, theLIT may opt to file all the outstanding prior year tax returns for which thebankrupt has not filed in order to capture any income tax refunds or GST/HSTtax credits that may become available to the bankruptcy estate.

Pre-Bankruptcy Personal Income TaxReturn

If the year of the bankruptcy is 2019, then,in the year 2020, the LIT has anobligation to file the 2019 pre-bankruptcy tax return with the CRA. If there is a pre-bankruptcy refund, the CRA canclaim a set-off to the refund where there is: (1) prior year(s) tax liabilityowing to the CRA; or, (2) an enforcement maintenance registered with the CRA.

If there is no prior-bankruptcy or pre-bankruptcy taxliability or enforcement maintenance registered, the CRA will send thepre-bankruptcy refund to the LIT for the general benefit of the bankrupt’screditors. If there is a tax liabilityowing to the CRA arising from the pre-bankruptcy return, the tax liability is aclaim provable in the bankruptcy and dischargeable. The bankrupt will not be liable to the CRA for payment of the pre-bankruptcy taxliability.

Post- Bankruptcy Personal Income TaxReturn

If the year of the bankruptcy is 2019, then, in the year2020, the bankrupt has an obligationto file the 2019 post-bankruptcy tax return with the CRA. Notwithstanding that the LIT is not obligatedto file the post-bankruptcy tax return with the CRA, as a matter of practice, theLIT will typically file the return on behalf of the bankrupt.

If there is a post-bankruptcy refund, the CRA can claim aset-off to the refund where there is an enforcement maintenance registered withthe CRA. If there is no post-bankruptcytax liability or enforcement maintenance registered, the CRA will send the post-bankruptcyrefund to the LIT for the general benefit of the bankrupt’s creditors.

If there is a tax liability owing to the CRA arising fromthe post-bankruptcy tax return, the tax liability is not a claim by thebankruptcy estate. The CRA will send theNotice of Assessment or Reassessment to the bankrupt. The bankrupt will be liable to the CRA forpayment of the post-bankruptcy tax liability.

High-TaxDebtor Status *

Section 172.1 of the BIA deals with high-tax debtors. It is aimed at ensuring that bankrupts with:

(1) personal income tax debt of $200,000.00 or more; and, whose:

(2) personal income tax debt represents 75% or more of thetotal unsecured proven claims;

do not become eligible for an automatic discharge frombankruptcy. The matter of the bankrupt’sapplication for discharge will be brought by the LIT before the court for ahearing. The bankrupt will be requiredto attend the hearing. The types ofdischarge orders that the court may impose and the factors that the court willtake into consideration in deciding the bankrupt’s discharge application differfrom that of a bankruptcy where the bankrupt is not a high-tax debtor.

To avoid the necessity for a court hearing and the consequences that may flow therefrom, a high-tax debtor would be well advised to consider a proposal to creditors under the BIA as opposed to an assignment in bankruptcy.

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* GST/HST payable is not included in thecalculation of high-tax debtor. 

* Taxes on additional income arising from a shareholder loan, draw or dividend, is included in the calculation of high-tax debtor.

A link to the original article, first published on MNP Ltd’s blog, can be found HERE.