Ford Motor Company of Canada v. Coopers & Lybrand Limited and Her Majesty the Queen, [1995] 2 CTC 506

Halvorson J. Revenue Canada and a bank each assert priority to funds realized by a liquidator from the disposition of inventory of a bankrupt.

The Revenue Canada claim is based on the deemed trusts for unremitted employee source deductions arising from the provisions of the Income Tax Act, R.S.C. 1970, 72, c. 63, the Canada Pension Plan, R.S.C. 1985, c. C-8, and the Unemployment Insurance Act, R.S.C. 1985, c. U-l. The bank claim is based on an assignment of the inventory acquired pursuant to section 427 of the Bank Act, S.S. 1991, c. 46.

There is an issue whether court rulings confirming the priority of the deemed trusts over security interests under personal property security act legislation are equally applicable to security interests under section 427.

An agreed statement of facts was filed. Essentially, HongKong Bank of Canada financed the operations of a car dealership, Manning Mercury Sales Ltd., and secured itself with a standard assignment on inventory under paragraph 427(l)(b). As well, the bank acquired several security agreements. These are the documents which are now in competition with the deemed trusts.

Manning Mercury defaulted in its obligations to the bank, so a liquidator was appointed to take possession and realize on the bank’s security. Then Manning Mercury filed an assignment in bankruptcy, and that liquidator was appointed trustee. The bank is owed $119,334.

For some time prior to its bankruptcy, Manning Mercury failed to remit to Revenue Canada, deductions which had been taken from employee wages for income tax, Canada Pension and unemployment insurance. These sums total $41,350.

In due course, the inventory of the bankrupt was sold for $90,551. These funds are the subject of the rival claims.

Two factors are particularly significant. Firstly, the bankrupt did not keep the employee wage deductions in a separate account, but, instead, intermingled the money with its own funds, and tracing is not possible. Secondly, the bank had agreed that Manning Mercury would be permitted to make sales of its inventory in the ordinary course of its business and would be entitled to receive the proceeds.

In simple terms, the bank says it owned the inventory at all times as stipulated in its security and in section 427. Therefore, the deemed trusts do not apply as Manning Mercury never owned the asset. Revenue Canada argues that because the bank allowed Manning Mercury to sell the inventory and use the money, the trusts were invoked. There is case law to support the Revenue Canada argument in instances where the bank’s security is other than under section 427; that is, less than an ownership interest. Revenue Canada urges the Court to draw an analogy.

Revenue Canada Position

The deemed trust under the Income Tax Act is imposed by ss. (4) and (5) of section 227 which read:

227(4) Every person who deducts or withholds any amount under this Act shall be deemed to hold the amount so deducted or withheld in trust for Her Majesty.

(5) Notwithstanding any provision of the Bankruptcy and Insolvency Act, in the event of any liquidation, assignment, receivership or bankruptcy of or by a person, an amount equal to any amount

(a) deemed by subsection (4) to be held in trust for Her Majesty, or

(b) deducted or withheld under an Act of a province with which the Minister of Finance has entered into an agreement for the collection of taxes payable to the province under that Act that is deemed under that Act to be held in trust for Her Majesty in right of the province

shall be deemed to be separate from and form no part of the estate in liquidation, assignment, receivership or bankruptcy, whether or not that amount has in fact been kept separate and apart form the person’s own moneys or from the assets of the estate.

[Emphasis added.]

Similar provisions appear in subsections (3) and (4) of section 23 of the Canada Pension Plan and subsections (2) and (3) of section 57 of the Unemployment Insurance Act.

Because Manning Mercury did not keep the employee deductions in a separate account, but instead, misappropriated the money, the second subsection trusts were triggered by the bankruptcy. The subject of the trusts, of course, is the amount of the unremitted money.

These statutory deemed trusts were recognized as effective by the Supreme Court of Canada in Dauphin Plains Credit Union Ltd. v. Xyloid Industries Ltd. et al., [1930] 1 S.C.R. 1182, C.T.C. 247, 80 D.T.C. 6123.

Revenue Canada relies on the decision in Royal Bank of Canada and G.M. Homes Inc., Re (1984), 52 C.B.R. (N.S.) 244, 10 D.L.R. (4th) 439 (Sask. C.A.), as authority for the proposition that the deemed trusts outrank a bank’s security by way of debenture and as authority for the adverse ramifications to the bank of allowing the debtor to dispose of the secured property.

In G.M. Homes the courts determined that the deemed trusts under the Canada Pension Plan and the Unemployment Insurance Act for unremitted deductions prevailed over the bank’s claim under a debenture. There, the debenture covered personal property which was seized and sold by the bank’s liquidator. Revenue Canada and the bank claimed the proceeds. The bank was unsuccessful because the debenture permitted the debtor to use the property. When the property proceeds were converted into wages, the trusts were engaged, and the debtor no longer had an interest in that portion of the property reflected by wages. Therefore, neither did the bank.

It is important to note that in G.M. Homes the debenture did not give the bank ownership of the property, nor was section 427 in issue. The case is useful, however, in its analysis of the effect of the deemed trusts. In summary, an employer has no interest in wages once paid and in deductions made. The wages belong to the employee and the unremitted deductions belong to Revenue Canada. In the instant case, Revenue Canada says the unremitted deductions likewise, form no part of the assets of Manning Mercury, so the bank has no claim on them.

Furthermore, Revenue Canada contends there is support for its position in comments found in British Columbia v. Federal Business Development Bank, [1988] 1 W.W.R. 1, 43 D.L.R. (4th) 188 (B.C.C.A.). There, the court ruled that the bank’s fixed and floating charge was subordinate to a provincial Crown lien for taxes. Again, by the terms of the debenture the debtor was permitted to sell the inventory in the ordinary course of its business.

Of particular importance to Revenue Canada is the concept in F.B.D.B. of a fixed charge subject to a licence to deal in the ordinary course of business. Revenue Canada argues that by analogy, the ownership interest asserted by the bank was subject to a similar licence to Manning Mercury to sell the inventory as part of its business. This being so, the analysis in F.B.D.B. respecting incidents of business is helpful.

In that regard McLachlin J.A. observed in F.B.D.B. at page 40 (D.L.R. 226):

Assuming the charges were regarded as fixed subject to a licence to deal in the ordinary course of business. I am of the opinion that that licence or permission to deal must be taken to encompass all the usual legal incidents of dealing with the stock in the ordinary course of business. The transfer of title is not the only incident of sale to which F.B.D.B. was subject. Another incident of selling goods in the ordinary course of business is the lien which arises in support of the vendor's duty to collect and pay sales tax to the Crown. When

F.B.D.B. gave Arcrite the power to sell the mortgaged goods in the ordinary course of business, F.B.D.B. must be taken to have tacitly accepted that it would cede its priority not only to bona fide purchasers for value, but to other persons who might acquire rights incidental to such sales. The Crown is such a person.

The matter may be put another way. The parties must have intended that Arcrite be able not only to effect transfer of the goods, but to do all things incidental thereto, including collecting sales tax. The sales tax must be taken to have been collected under the terms of the licence, with the result that the lien arising from the tax takes priority over F.B.D.B.’s charge.

[Emphasis added. ]

Using this approach, an incident of the Manning Mercury business was the payment of wages and the consequent deemed trusts which arose from unremitted deductions. By the Revenue Canada analogy, the bank must have accepted that its priority would yield to parties, like Revenue Canada, which acquired rights incidental to the sale of the inventory. That is, by allowing Manning Mercury to sell the inventory, the bank must have intended that Manning Mercury should also remit tax, so the bank priority on the amount of the deductions was lost.

There are, of course, several shortcomings in the Revenue Canada submission. Again, section 427 was not in issue. Moreover, the sales tax in F.B.D.B. was a direct incident of selling inventory, whereas the deductions claim of Revenue Canada is only an indirect incident of the inventory sales by Manning Mercury.

The comments of McLachlin J.A. in F.B.D.B. were adopted in Roynat Inc. v. Ja-Sha Trucking & Leasing Ltd., [1992] 2 C.T.C. 139, 89 D.L.R.

(4th) 405 (Man. C.A.). There, the creditor acquired a security interest in receivables but allowed the debtor to collect and use them to finance its business. Statutory deductions were made from wages but not remitted. In the subsequent receivership the creditor and the Crown claimed the proceeds of the receivables. The Court gave precedence to the deemed trusts. Again, the fact the debtor was permitted to use the receivables was critical. Twaddle J.A. observed at page 650 (C.T.C. 144, D.L.R. 413):

By analogy, the interest of Roynat in the receivables, whatever that interest may be, is subject to the deemed trust provisions of the federal legislation. By permitting Ja-Sha to use the cash receipts from receivables to pay wages, Roynat sanctioned the making of the statutory deductions which were then subject to the trust which results from making them. Although Roynat did not then sanction the breach of trust, Roynat’s interest in the receivables was increased in value when the trust moneys were intermingled with them. The

statutes provide that the trust moneys are deemed to be traceable into the intermingled assets.

Revenue Canada equates this to the instant situation saying Manning Mercury intermingled the source deductions with its other money resulting in an advantage to the bank.

A further decision favouring Revenue Canada is that of Armstrong v. Canadian Admiral Corp. (Receiver of) (1987), 42 D.L.R. (4th) 189, 61 O.R. (2d) 129 (Ont. C.A.) affirming (1983), 24 D.L.R. (4th) 516, 53 O.R.

(2d) 468 (Ont. H.C.). Because the case involved a competition with a section 427 security (section 178 there), it is of some assistance. This is somewhat diluted though, as the competitor was not Revenue Canada un- der the federal statutory deemed trusts but, rather, a provincial claim for vacation pay under the Employment Standards Act, R.S.O. 1980, c. 137. However, the deemed trust in that Act resembles the federal trusts.

Anyway, in Armstrong the bank claimed a prior right to inventory based on its ownership of the property under section 427. The province relied on section 15 of the Employment Standards Act which reads:

15. Every employer shall be deemed to hold vacation pay accruing due to an employee in trust for the employee whether or not the amount therefore has in fact been kept separate and apart by the employer and the vacation pay becomes a lien and charge upon the assets of the employer that in the ordinary course of business would be entered in books of account whether so entered or not.

[Emphasis added.]

Obviously, there are differences between the deemed trust in Armstrong and those under federal legislation. For example, the former trust also creates a lien. Nevertheless, the decision is instructive.

Comments by the judge in the trial division of Armstrong temper the assertion of the bank that section 427 gives it an ownership interest in the inventory which cannot be impeded by a deemed trust. The judge stated at page 304-05 (D.L.R. 525):

From these authorities, it appears clear that, by the words of paragraph 178(2)(c), "the same rights and powers as if the bank had acquired a warehouse receipt or bill of lading", the bank, in whose favour security is given under section 178 of the Bank Act, is vested with all the right and title of the owner by whom the goods recovered by the security are assigned to it. In short, the bank is considered to be the owner of the goods assigned to it under section 178. This ownership, however, is not absolute. The bank cannot deal with the goods as its own in the absence of default under the loan; and the bank loses title upon the repayment in full of the loan, when the goods must be returned. In

addition, during the course of the loan, and prior to there being a default, the borrower, in this case, Admiral, is given the right to sell the goods covered by the bank’s security in the ordinary course of business and, in turn, give good title to its purchasers.

[Emphasis added.]

Bank Position

Several arguments are advanced by the bank in an attempt to convince the court of its priority over the deemed trusts. There is the submission already alluded to respecting ownership of the inventory which precludes the application of a deemed trust. As well, the bank says the deemed trust sections must be strictly construed, and when that is done it is obvious they do not deal with priorities. Finally, the bank cites Royal Bank v. Canadian Aero-Marine Industries Inc. (1989), 67 Alta. L.R. (2d) 172, [1989] 5 W.W.R. 355 (Alta. Q.B.) which allowed a section 427 security to prevail over the deemed trusts.

I shall deal firstly with Aero-Marine. Like the situation before me, two of the rival claimants there were Revenue Canada, with its deemed trusts for unremitted deductions, and a bank with section 427 (section 178 there) security. The Court acceded to the bank’s claim for priority. However, it appears Revenue Canada did not contest the general point but contented itself instead, with limiting the bank’s priority to the amount of the revolving line of credit rather than its entire indebtedness.

In furtherance of its contention that the deemed trust provisions must be interpreted strictly, the bank cites Homeplan Realty v. Avco Financial Services Realty Ltd. (1977), 33 C.B.R. (N.S.) 34 (S.C.C.). There, a statutory lien was under scrutiny. Martland J. said at page 39-40:

The lien under section 5A is not limited in its scope, as, for example, under the Workers’ Compensation Act, 1968 (B.C.), c. 59, to property used in, or in connection with, or produced by the industry with respect to which the employer is assessed. The property to which a section 5A lien attaches is not defined or identified. In the absence of a specific statutory provision to that effect, in my view it should not be construed in a manner which could deprive third parties of their pre-existing property rights.

[Emphasis added.]

The absence of priority rules in the deemed trust provisions was the subject of comment by Professors Wood and Wylie, "Non-Consensual Security Interests In Personal Property" (1992), 30 Alberta Law Review, 1055-99 at page 1089:

The provisions creating deemed statutory trusts in respect of source deductions do not contain an express priority rule. The statutes provide that the debtor is deemed to hold the money collected in trust and further provide that the debtor is deemed to keep the money separate and apart even if it has not actually been kept separate and apart...

[Emphasis added.]

These observations must be balanced against Dauphin Plains where the priority component of deemed trust provisions seemed to be accepted.

The main argument of the bank is that Manning Mercury at no time owned the inventory because the bank always retained title. If Manning Mercury was never the owner, the deemed trusts could never attach.

Despite Armstrong, the bank says the combination of paragraph 427(1 )(a) and section 428 grants absolute ownership, particularly when read in conjunction with paragraphs 435(2)(a) and 436(1 )(a). In summary, security under paragraph 427(1 )(a) "vests in the bank in respect of the property" pursuant to subsection 427(2), "the same rights and powers as if the bank had acquired a warehouse receipt or bill of lading in which the property was described". Subsection 428(1) provides that "all the rights and powers of a bank in respect of the property mentioned in or covered by a warehouse receipt or bill of lading acquired and held by a bank ... have ... priority over all rights subsequently acquired in, on or in respect of that property...." Paragraph 435(2)(a) "... vests in the bank ... all the right and title to the warehouse receipt or bill of lading and to the goods...." Paragraph 436(1 )(a) prescribes that "... the bank is, on acquisition of that warehouse receipt or bill of lading, vested with all the right and title of the owner of the goods...."

Although Manning Mercury was permitted to make sales of the inventory owned by the bank, it was allowed to do so only on strict conditions as indicated in the agreed statement of facts and exhibits thereto. Ownership of the inventory was confirmed in the "Inventory Security Agreement" between the bank and Manning Mercury. As well, the "Agreement As To Loans And Advances And Security Therefor" directed that if the bank surrendered the security to Manning Mercury, it would "receive the same in trust". Manning Mercury deposited the sale proceeds with the bank which then applied the proceeds on account of the indebtedness.

According to the bank, all of this establishes that the bank subjected Manning Mercury to rigid obligations regarding the use and disposition of the proceeds generated by Manning Mercury from ordinary course sales of its inventory. Manning Mercury held the proceeds in trust, and its ability to utilize the same was circumscribed by the relevant security documentation.

In the Flintoft v. The Royal Bank of Canada, [1964] S.C.R. 631, 47 D.L.R. (2d) 141, the Supreme Court of Canada interpreted language identical to that in the present documentation as constituting the debtor a trustee of the bank with respect to the sale proceeds.

This trust relationship and the other rigorous conditions respecting inventory sale proceeds are additional factors which distinguish the bank’s security interest from the interests of mere debenture holders, for example, competing against statutory deemed trusts in the cases quoted by Revenue Canada.

Conclusion

Notwithstanding the forceful submissions of the bank, it is my opinion the reasoning in F.B.D.B. should be applied. Even conceding the bank retained ownership of the inventory under the Bank Act and imposed strict sale obligations in the security documents, nevertheless, Manning Mercury was allowed to dispose of the inventory in the ordinary course of business. That is the focus of the F.B.D.B. rationalization.

The bank’s charge was subject to a licence permitting Manning Mercury to deal with the inventory in the ordinary course of business. That permission included all the usual legal incidents of dealing with the inventory, to paraphrase F.B.D.B. One incident was the payment of wages and the statutory deemed trusts arising therefrom, which obligated Manning Mercury to remit source deductions. The bank would have been aware of this obligation and must be assumed to have waived its priority over the consequent rights of Revenue Canada arising in the course of the Manning Mercury business.

There will be an order that the Revenue Canada claim for unremitted source deductions takes precedence over the bank’s s. 427 security. The sum of $41,350.36 shall be released to Revenue Canada together with interest earned thereon. As well, Revenue Canada shall have its costs.

Order accordingly.