The deemed trust that fell away in bankruptcy

The situation

A commercial print-and-packaging company in southwestern Ontario had run for seventeen years, most recently supplying folding-carton work to two regional food processors. A lost renewal and a bank line that would not stretch further left it unable to meet payroll, and the directors made an assignment in bankruptcy rather than continue trading. The licensed insolvency trustee ran a short, controlled sale process for the operating assets — equipment, the customer list, the leasehold — and a buyer's bid of $2,650,000 was accepted. The company's bank held a general security agreement securing $1,900,000.

Compare the non-insolvency version of this same arrears profile, where the identical categories of Crown debt both ranked ahead of the bank. This file has the same numbers in a different process.

The problem

Buyer's counsel had worked a deal like the earlier one and modelled the arrears the same way: both categories impressed with a deemed trust ranking ahead of a secured lender's collateral and the sale proceeds. On that model, the trustee would owe the Crown $568,000 of the $598,000 arrears (everything but the never-collected $30,000) before the bank saw a dollar.

That model is correct outside insolvency. It stops being correct once the company is actually bankrupt — the Bankruptcy and Insolvency Act has its own rules about which Crown deemed trusts survive it, and does not treat the two arrears the same way.

The numbers

Sale proceeds $2,650,000. Secured debt $1,900,000. CRA arrears $598,000 in three parts, as above. Trustee's fees and administration costs are set aside here for clarity — they rank ahead of ordinary unsecured claims under BIA s.136(1) but, like every other preferred claim in that section, only “subject to the rights of secured creditors”.

The rule that decided it

Start with what a bankruptcy does to a Crown deemed trust generally. BIA s.67(1)(a) keeps property held by the bankrupt “in trust for any other person” out of the estate divisible among creditors. Subsection (2) then takes most of that protection back where the trust exists only because a statute deems it to: “notwithstanding any provision in federal or provincial legislation that has the effect of deeming property to be held in trust for Her Majesty, property of a bankrupt shall not be regarded as held in trust for Her Majesty for the purpose of paragraph (1)(a) unless it would be so regarded in the absence of that statutory provision.” A deemed trust that exists only by force of a taxing statute is not a real trust for this purpose — unless it is on the list in subsection (3).

It is a short list, and it is the whole file. Section 67(3) provides: “Subsection (2) does not apply in respect of amounts deemed to be held in trust under subsection 227(4) or (4.1) of the Income Tax Act, subsection 23(3) or (4) of the Canada Pension Plan or subsection 86(2) or (2.1) of the Employment Insurance Act…” Source deductions are named. GST/HST is not.

The Excise Tax Act says the identical thing from the other side. ETA s.222(3) extends the GST/HST trust over a debtor's property and a secured creditor's collateral — “Despite any other provision of this Act (except subsection (4)), any other enactment of Canada (except the Bankruptcy and Insolvency Act)…” — the BIA is carved out of that override, in the statute's own words, not merely by omission from the BIA's list. ITA s.227(4.1) is the mirror image: its override reaches “the Bankruptcy and Insolvency Act (except sections 81.1 and 81.2 of that Act)” — the BIA is carved into the source-deductions override. Two statutes, read from opposite directions, agree on the same asymmetry.

A second, independent provision reaches the same place by a different route. BIA s.86(1), marginal note Status of Crown claims, provides that “all provable claims, including secured claims, of Her Majesty in right of Canada or a province… rank as unsecured claims.” Its own exception list in subsection (3) names ITA s.224(1.2) and (1.3) — a different provision, the one behind a Requirement to Pay — plus the CPP and EI equivalents. GST/HST is not on that list either. Two separate BIA mechanisms — one about what counts as estate property, one about how Crown claims rank — both exclude the GST/HST trust and both preserve the source-deductions trust, and they use different section numbers to say so.

Read the unit once more, because it is the same discipline the non-insolvency file used. The question is never whether CRA has a deemed trust here — it is which statute governs which category of arrears, in which process. Outside bankruptcy, both trusts bind the debtor's property and a secured creditor's collateral. Inside an actual bankruptcy, only the source-deductions trust does; the GST/HST claim drops into the pool BIA s.136 distributes, and that pool is expressly “subject to the rights of secured creditors” — it does not simply move to the front of the unsecured line, it moves behind the bank's own recovery on its collateral.

The outcome

The trustee paid $166,000 to the Receiver General first, ahead of the bank, for the source-deductions trust BIA s.67(3) kept alive. The balance of the sale proceeds satisfied the bank's $1,900,000 secured claim in full. What remained formed the general estate, and CRA's $432,000 GST/HST-related claim (the $402,000 unremitted plus the $30,000 never collected) went into that pool as an ordinary unsecured claim, sharing pro rata with trade creditors — recovering a fraction, nowhere near the full amount it would have received ahead of the bank outside a bankruptcy. The buyer took the purchased assets clear of any Crown trust claim, because none had attached to those specific assets: the GST/HST trust never survived long enough to impress anything.

What it would have cost otherwise

This error cuts both ways. Treat the full $598,000 as a priority claim ahead of the bank — the non-insolvency answer — and the trustee shortchanges the secured creditor by $402,000 it was entitled to receive first. Assume nothing survives bankruptcy at all, and the trustee shortchanges the Receiver General on the $166,000 that stays alive by BIA s.67(3)'s own terms, at the trustee's own risk.

The tell

The tell is not on the balance sheet this time — it is on the front of the file. Ask one question before modelling any Crown-arrears priority: is the target actually in a bankruptcy, or merely insolvent and still trading? The two categories of arrears look identical on a trial balance in either state. They do not behave identically the moment the first question's answer changes.

Takeaways

• • BIA s.67(2) strips a Crown deemed trust of its priority in bankruptcy unless it is on the s.67(3) survivors list — ITA s.227(4)/(4.1), CPP, EI. GST/HST is not on it, and ETA s.222(3) confirms the same result by expressly excepting the BIA from its own override.
• • BIA s.86(1) separately demotes Crown claims generally to unsecured status; its own s.86(3) exception list (ITA s.224(1.2)/(1.3), CPP, EI) does not reach GST/HST either. Two independent BIA provisions, the same result.
• • The two Crown claims that rank identically ahead of a secured lender outside insolvency do not rank identically once the target is actually bankrupt. Source deductions still outrank the bank; GST/HST does not.
• • BIA s.136(1)'s distribution scheme is itself “subject to the rights of secured creditors”. A claim that loses its trust status in bankruptcy does not move to the front of the unsecured queue — it moves behind the secured creditor's own recovery.
• • A buyer purchasing from a trustee's estate does not inherit an unpaid GST/HST claim; that claim runs against the estate, not the specific assets sold, because the trust never attached to them.

Sources

• • Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3, s.67 — s.67(1)(a) property held in trust excluded from the estate; s.67(2) Deemed trusts, stripping most statutory deemed trusts of that protection; s.67(3) Exceptions, naming ITA s.227(4)/(4.1), CPP s.23(3)/(4) and EI Act s.86(2)/(2.1).
• • Bankruptcy and Insolvency Act, s.86 — s.86(1) Status of Crown claims, demoting Crown claims to unsecured status; s.86(3) Exceptions, naming ITA s.224(1.2)/(1.3), CPP and EI provisions — not the GST/HST trust.
• • Bankruptcy and Insolvency Act, s.136(1) — Priority of claims, the distribution scheme, expressly “subject to the rights of secured creditors”.
• • Excise Tax Act, R.S.C. 1985, c. E-15, s.222(1) and (3) — the GST/HST deemed trust and its own express exception of the Bankruptcy and Insolvency Act from the extension of trust.
• • Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1, s.227(4) and (4.1) — the source-deductions trust and its extension of trust, overriding the BIA except ss.81.1 and 81.2.
• • Treadstone Law — how does a lender's security interest rank against unpaid wages owed by an insolvent corporation? — adjacent: the same secured-lender-versus-statutory-priority interaction, for a different and differently limited statutory priority. It does not address the Crown deemed-trust distinction above.
• • Trustee's fees, administration costs and the precise pro-rata recovery on the unsecured pool are illustrative; nothing above depends on the exact percentage recovered, only on the ranking.