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 two periods: (1) pre-bankruptcy period; and, (2) post-bankruptcy period.  The taxation year of a bankrupt comes to an end on the day before the date of bankruptcy (pre-bankruptcy period) and a new taxation year begins on the date of bankruptcy and ends on December 31st of that year (post-bankruptcy period).  For instance, if the date of bankruptcy is April 3, 2019, the taxation year of the bankrupt comes to an end on April 2, 2019 and a new taxation year begins on April 3, 2019 and ends on December 31, 2019. 

The significance of the pre and post-bankruptcy period has consequences for the dischargeability of the tax debt.  A pre-bankruptcy tax debt is dischargeable in bankruptcy.  A post-bankruptcy tax debt is not dischargeable in bankruptcy. Notwithstanding the bankruptcy, the bankrupt remains liable to the CRA for payment of the post-bankruptcy tax debt.

Prior-Bankruptcy Personal Income Tax Return

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 make more than one year prior to the commencement of the calendar year, or the fiscal year, of the bankrupt, in which the bankrupt became bankrupt.  For instance, if the year of the bankruptcy is 2019, the LIT is required to file the bankrupt’s 2018 tax return with the CRA. Notwithstanding the LIT’s obligation to file the one-year prior-bankruptcy tax return, the bankrupt has an obligation under ITA to file all outstanding tax returns.

If there is a prior-bankruptcy refund, the CRA can claim a set-off to the prior-bankruptcy refund where there is: (1) one or more prior year tax liability owing to the CRA; or, (2) an enforcement maintenance registered with the CRA, such as a maintenance order by Family Responsibility Office for child support.  In absence of any prior-bankruptcy tax liability or enforcement maintenance registered, the CRA will send the prior-bankruptcy refund to the LIT for the general benefit of the bankrupt’s creditors.  If there is a tax liability owing to the CRA arising from prior year(s) tax assessment(s), the tax 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 tax liability.

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

Pre-Bankruptcy Personal Income Tax Return

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

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

Post- Bankruptcy Personal Income Tax Return

If the year of the bankruptcy is 2019, then, in the year 2020, the bankrupt has an obligation to file the 2019 post-bankruptcy tax return with the CRA.  Notwithstanding that the LIT is not obligated to file the post-bankruptcy tax return with the CRA, as a matter of practice, the LIT will typically file the return on behalf of the bankrupt. 

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

If there is a tax liability owing to the CRA arising from the post-bankruptcy tax return, the tax liability is not a claim by the bankruptcy estate.  The CRA will send the Notice of Assessment or Reassessment to the bankrupt.  The bankrupt will be liable to the CRA for payment of the post-bankruptcy tax liability. 

High-Tax Debtor 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 the total unsecured proven claims;

do not become eligible for an automatic discharge from bankruptcy.  The matter of the bankrupt’s application for discharge will be brought by the LIT before the court for a hearing.  The bankrupt will be required to attend the hearing.  The types of discharge orders that the court may impose and the factors that the court will take into consideration in deciding the bankrupt’s discharge application differ from 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 the calculation 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.

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