28 January 2014 External T.I. 2013-0506991E5 - Prescribed Security Interest

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: 1. In computing the prescribed security interest, are amounts of principal and/or interest included at the time of a failure to remit withholdings under the Act? 2. Following a failure to remit withholdings, is it the CRA's view that principal and/or interest will constitute payments on account of the obligation by which the prescribed security interest is reduced?

Position: 1. Both principal and interest are included in calculating the amount of the prescribed security interest at the time of a failure to remit withholdings under the Act. 2. Following a failure to remit withholdings, all payments on account of principal and interest are applied to reduce the prescribed security interest.

Reasons: The Act, the Regulations and jurisprudence support this position which is consistent with tax policy on this issue.

XXXXXXXXXX
2013-050699
Katharine Skulski, LL.B.

Attention: XXXXXXXXXX

January 28, 2014

Dear XXXXXXXXXX:

Re: Prescribed Security Interest

We are writing in reply to your letter dated October 1, 2013, in which you requested our views on the application of subsections 227(4) to (4.2) of the Act to creditors who have registered a mortgage against land or property to secure an obligation.

This technical interpretation provides general comments about the provisions of the Income Tax Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R5, Advance Income Tax Rulings.

DEFINITIONS

"ACo" means the XXXXXXXXXX;

"Act" means the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.), as amended to the date of this letter;

"CRA" means the Canada Revenue Agency;

"Crown" means Her Majesty in right of Canada;

"Failure" means the failure of the taxpayer to remit withholdings under the Act to the Crown;

"Loan" means term financing with fixed or floating interest rates;

"prescribed security interest" has the meaning ascribed to it in subsection 2201(1) of the Regulations; and

"Regulations" means the Income Tax Regulations, CRC. 1997, c. 945 as amended to the date of this letter.

BACKGROUND

You have indicated that ACo extends the Loan to a taxpayer, the terms of which generally require the taxpayer to make monthly payments of principal in a fixed amount, as well as monthly payments of interest at the applicable rate based on the terms of the financing. The Loan may be secured by a mortgage in favour of ACo, or another form of security such as a general security agreement or a guarantee. Sometime after the Loan is made and the mortgage registered as security for the Loan, the taxpayer deducts and withholds an amount in compliance with the Act, such as source deductions pursuant to subsection 153(1). However, the taxpayer does not remit such amounts as required by the Act. The taxpayer continues to make payments of principal and interest under the Loan after the Failure.

At a later date, the taxpayer fails to make the regular payments of principal and interest on the Loan, thereby causing an event of default under the Loan. ACo exercises its right under the Loan to sell the property that is encumbered with the mortgage.

After the sale of the property, the CRA either:

(a) makes a claim in priority to ACo in respect of the proceeds of sale of the property on the basis of the statutory deemed trust under the Act; and/or

(b) seeks to reduce ACo's priority over the deemed trust in respect of its prescribed security interest by all amounts received by ACo following the Failure.

ISSUES

On the basis of the background information that has been provided, you have asked for our views concerning the calculation of a prescribed security interest. In particular, you have asked whether, in computing the prescribed security interest, payments on account of interest after the Failure reduce the prescribed security interest. In this regard, you requested our comments in relation to the following issues:

1. Is it the CRA's view that the term "obligation" refers to principal, a combination of principal and interest or something else?

2. There appears to be a difference in the wording of paragraph 2201(2)(b) of the Regulations in the English and French versions of the Act. How does the CRA interpret paragraph 2201(2)(b) to ensure consistency between the two languages?

YOUR VIEWS

You have explained that based on principles of statutory interpretation, the term "obligation" should have a consistent meaning. It is your understanding that the CRA does not include accrued interest in the amount of the obligation that is the prescribed security interest at the time of the Failure. As such, it is your view that payments of interest made after the Failure would not reduce the prescribed security interest.

You have suggested that the CRA's current interpretation and application of the prescribed security interest provisions extends the deemed trust over property that does not belong to the tax debtor insofar as the suggested interpretation requires ACo to reduce the amount of its prescribed security interest by the amount of the interest payments. You suggest that this is analogous to ACo repaying the interest it has received.

Finally, you have raised a concern regarding the English and French versions of section 2201 of the Regulations. You have noted that in paragraph 2201(2)(b) of the French version, the words "en réduction de l'obligation" are used, whereas the English version provides "all amounts applied after the time of the failure on account of the obligation".

You have suggested that in a situation where there is an inconsistency between the two versions of a provision, that preference should be given to the more narrow, restricted or limited version, in this case, to the French version.

OUR COMMENTS

Legislation

Subsection 227(4) of the Act provides that every person who deducts or withholds an amount under the Act is deemed, notwithstanding any security interests in the amount deducted or withheld, to hold the amount in trust for Her Majesty. Subsection 227(4.2) goes further to explain that for the purposes of subsections 227(4) and (4.1), a security interest does not include a prescribed security interest.

Section 2201 of the Regulations sets out the meaning of the term prescribed security interest as:

that part of a mortgage securing the performance of an obligation of the person, that encumbers land or a building, where the mortgage is registered pursuant to the appropriate land registration system before the time the amount is deemed to be held in trust by the person.

Subsection 2201(2) of the Regulations describes how the amount of the prescribed security interest is to be calculated, namely, that it is deemed not to exceed the amount by which the amount of the obligation outstanding secured by the mortgage exceeds the total of amounts:

(a) all amounts each of which is the value determined at the time of the failure, having regard to all the circumstances including the existence of any deemed trust for the benefit of Her Majesty pursuant to subsection 227(4) of the Act, of all the rights of the secured creditor securing the obligation, whether granted by the person or not, including guarantees or rights of set-off but not including the mortgage referred to in subsection (1), and

(b) all amounts applied after the time of the failure on account of the obligation,

The reference in (a) above is to amounts other than those secured by the mortgage (for example, guarantees by third parties). It is our understanding that this paragraph is not an issue for the purposes of this interpretation.

Deemed Trust

As set out above, subsection 227(4) of the Act deems that amounts deducted or withheld under the Act are held in trust for Her Majesty and for payment to Her Majesty in the manner and time provided in the Act. The Department of Finance's Explanatory Notes to subsection 227(4) explain that the most recent amendments were made in response to the Supreme Court of Canada's decision in The Queen v. Royal Bank of Canada, 97 DTC 5089. In particular, the current wording of section 227(4.1) makes it clear that, the deemed trust for the amounts withheld from payments, applies only to property of the payer equal in value to any such amount deemed to be held in trust and that was not paid to Her Majesty as and when required.

In relation to the timing of when the deemed trust arises, the Supreme Court of Canada in First Vancouver Finance v. Great West Transport Ltd., [2002] 2 S.C.R. 720, explained that while the trust arises at the time that the tax debtor fails to remit the source deductions by the specified due date, it is "deemed to have been in existence from the moment the deductions were made". It was further stated by the Court in First Vancouver that, once the tax debtor's property is sold, it is no longer captured by the deemed trust. Instead, "the proceeds of disposition of the alienated property are captured by the trust."

Meaning of "obligation"

You have asked us what we consider to be included in the term "obligation" at the time of the Failure. In your submission, you have explained that your arguments are based on the assumption that the term "obligation" refers only to the amount of the principal secured by the mortgage. For the reasons discussed below, we are of the view that such an assumption is incorrect.

The term "obligation" is not specifically defined in the Act. While subsection 248(26) defines what a "debt obligation" is, this is only relevant in certain scenarios, none of which apply in this case. As such, it is necessary to look to other sources in order to determine the meaning of "obligation" as the term is used in section 2201 of the Regulations.

We note that the Technical Notes to the Draft Regulations amending Regulation 2201 state that "the maximum amount of a prescribed security interest is determined by reference to the amount outstanding on the obligation for which it is a security interest at the time of a failure to remit any source deduction." The Technical Notes go on to explain that

"Paragraph 2201(2)(a) first limits the prescribed security interest to the amount of the obligation that is secured by the mortgage, after deducting the value of all the rights of the secured creditor securing the obligations."

It is our understanding that mortgages secure both the principal and interest owing on the debt. We note that, section 6 of the Interest Act, R.S.C., 185, c. I-15 (the "Interest Act") requires that a mortgage contain a statement showing the amount of principal and the rate of interest that will be charged on the principal money, as follows:

Whenever any principal money or interest secured by mortgage on real property or hypothec on immovables is, by the mortgage or hypothec, made payable on… any plan under which the payments of principal money and interest are blended or any plan that involves an allowance of interest on stipulated repayments, no interest whatever shall be chargeable, payable or recoverable on any part of the principal money advance, unless the mortgage or hypothec contains a statement showing the amount of the principal money and the rate of interest chargeable on that money, calculated yearly or half-yearly, not in advance.

It is our view that this further clarifies that an obligation that complies with section 6 of the Interest Act would therefore include principal as well as the interest charged thereon. As such, to the extent that the obligation secured by the mortgage includes principal as well as interest, then for the purposes of subsection 227(4) of the Act, as well as section 2201 of the Regulations, it is our view that reference to "obligation" includes the principal as well as the interest accrued to the date of the Failure.

Meaning of paragraph 2201(2)(b) of the Regulations and Inconsistency between the English and French versions

Once the value of the obligation is calculated in subsection 2201(1), the next step is to reduce the amount by the amounts referred to in subsection 2201(2). As stated above, paragraph (b) reduces the prescribed security interest by "all amounts applied after the time of the failure on account of the obligation." You have raised a concern regarding the fact that the French version of paragraph 2201(2)(b) provides that "les montants appliqués en réduction de l'obligation après le moment du défaut?, whereas the English version provides that "all amounts applied after the time of the failure on account of the obligation?. In particular, you consider the wording "en réduction de l'obligation" and "on account of the obligation" to have different meanings. It is your view that the French wording would result in amounts reducing the principal being capable of collection by the Minister, and not amounts applied as against the interest.

Given our conclusion that the term "obligation" includes both principal and interest, we do not think there is an inconsistency between the English and French wording. It should be noted that the obligation referred to in subsection 2201(1) is that part of the obligation calculated at the time of the Failure. The obligation referred to in paragraph 2201(2)(b) is the whole of the obligation at the relevant time.

In our view, any interest that accrues after the Failure forms part of the obligation at the relevant time referred to in paragraph 2201(2)(b). Therefore, any payments of interest made by the debtor after the Failure would be "on account of the obligation" and would so reduce it. As such, the full amount of the payments by the debtor (i.e., both principal and interest) would reduce the prescribed security interest.

Nevertheless, even if there was a difference, we note the Tax Court of Canada's decision in Sommerer v The Queen, 2011 DTC 1162 (TCC), in which Court agreed with both the Appellant and the Respondent that, in a situation where there is an irreconcilable difference in the wording between the English and French versions, it is necessary to choose the version that better accords with the intention of Parliament. This accords with the Supreme Court of Canada's decision in Medovarski v. Canada (M.C.I.), [2005] 2 S.C.R. 539. As such, even if there were an irreconcilable difference between the English and French versions of regulation 2201(2)(b), it is our view that the version that better accords with the intention of Parliament would have to be chosen. On the basis of the Department of Finance's Explanatory Notes to subsection 227(4) as well as the Technical Notes to the Draft Regulations set out above, in this case, it would be the English version that is chosen.

Policy

The Department of Finance's Technical Notes provide an explanation of the purpose of the prescribed security interest provisions as follows:

Since secured creditors must generally monitor whether a client-employer remits sufficient amounts of source deductions in a timely manner, the aforementioned restrictions are meant to provide them with an incentive to ensure that source deductions are remitted as and when required by their debtor and prevent potential abuses as well as undue benefits or windfalls that could accrue to secured creditors following the failure to remit moneys held in trust for payment to the Receiver General. (emphasis added)

We are of the view that it was the intent of Parliament to provide creditors with an incentive to ensure that the debtor remitted source deductions as and when required. If creditors were able to continue to collect interest that accrued after the Failure, in our view, it would reduce the creditor's incentive to ensure that source deductions are remitted.

In your letter, you expressed concern that reducing the prescribed security interest by interest paid after the Failure would favour other creditors. In your opinion, the reduction in the prescribed security interest by interest payments made after the Failure effectively means that the prescribed security interest holder forfeits the payments, whereas a secured lender that does not hold a prescribed security interest would get to keep the interest payments. Respectfully, we disagree. Although other secured creditors do not have to return any interest payments made after the Failure, their security interest is subordinated to the Crown's interest, which greatly reduces the value of their security interest. The prescribed security interest holder, on the other hand, is the only creditor with priority over the Crown's claims of the amounts in the deemed trust. Further, the prescribed security interest holder can prevent any reduction in the prescribed security interest by monitoring the status of the debtor's remittance obligations and can take action to realize its prescribed security interest, if necessary.

There is also jurisprudence to support this purpose. In particular, we would draw your attention to Iacobucci, J's comments at paragraph 23 in the Supreme Court of Canada's decision in First Vancouver regarding the position of the Minister:

in contrast to a tax debtor's bank which is familiar with the tax debtor's business and finances, the Minister does not have the same level of knowledge of the tax debtor or its creditors, and cannot structure its affairs with the tax debtor accordingly. Thus, as an "involuntary creditor", the Minister must rely on its ability to collect source deductions under the [Act]…

Limit on the floating charge to include assets no longer held by the debtor

It is noted in your letter that, the deemed trust rules in subsections 227(4) to (4.2) of the Act create a floating charge in favour of the Crown over the assets of the debtor. It is your view that, "if the prescribed security interest holder is required to reduce the amount of its priority by interest payments, it is tantamount to repaying the interest it has received [after the Failure]. This is equivalent to the deemed trust extending over property that does not belong to the tax debtor." Respectfully, we disagree.

The provisions of subsection 227(4.1) of the Act specifically provide that the property of the person and property held by any secured creditor of that person that but for a prescribed security interest would be the property of the person, equal in value to the amount so deemed to be held in trust, is deemed to be held, from the time the amount was deducted or withheld by the person, separate and apart from the property of the person, in trust for Her Majesty whether or not the property is subject to such a prescribed security interest.

The Act is clear that once a person withholds or deducts amounts, they no longer belong to the person. Rather, the person holds the amounts in a trust in order to satisfy the obligations under the Act.

The unanimous decision in First Vancouver stated that:

The intent of Parliament when drafting ss. 227(4) and 227(4.1) was to grant priority to the deemed trust in respect of property that is also subject to a security interest regardless of when the security interest arose in relation to the time the source deductions were made or when the deemed trust takes effect.

Further, the Federal Court in The Queen v. HSBC Bank of Canada, 2004 DTC 6281, noted that "The legislator specifically intended to avoid the need for the Minister to trace tax debtor's assets and to prove what property was covered by the trust." In our view, this supports our position that the provisions of the Act relating to prescribed security interests have been drafted in a manner that allows the Minister to collect outstanding tax debts without the need to trace property and in priority to other creditors.

It is also worth taking note of the Federal Court of Canada's decision in AGC v. TD Bank, 2008 DTC 6275, where Noël, J., at paragraph 17, summarized the findings of the Supreme Court in First Vancouver as follows:

• The collection of source deductions is at the heart of income tax collection;
• The tax debtor's bank is more familiar with the debtor's business and finances than the Minister;
• Source deductions have priority over other creditors with respect to the collection of unremitted taxes;
• The special priority granted to the deemed trust prevails over property given as security, regardless of whether the security interest arose before or after the deductions for income tax or employment insurance were made [.]

As noted above, the prescribed security interest holder is the only creditor with priority over the Crown's claims of the amounts in the deemed trust. The amount subject to priority over the Crown's claims is crystalized as the prescribed security interest at the time of the Failure. Once the prescribed security interest has been fixed, it is our view that any payments made to the prescribed security interest holder after the Failure simply reflect a realization of the prescribed security interest and not an extension of the Crown's floating charge to include the prescribed security interest holder.

However, the prescribed security interest holder can prevent any reduction in the prescribed security interest by monitoring the status of the debtor's remittance obligations and can take action to realize its prescribed security interest if the debtor fails to remit the amounts held in the deemed trust.

Conclusion

For the purposes of the Act, prescribed security interest is the amount of the obligation secured by the mortgage (including principal and interest accrued to that date) prior to the Failure. The prescribed security interest is reduced by the amount of any other rights of the secured creditor as described in paragraph 2201(2)(a) of the Regulations and any payments (including both principal and interest) made after the Failure.

The obligation referred to in subsection 2201(1) is that part of the obligation calculated at the time of the Failure. The obligation referred to in paragraph 2201(2)(b) is the whole of the obligation at the relevant time. Any interest that accrues after the Failure forms part of the obligation at the relevant time referred to in paragraph 2201(2)(b). Therefore, any payments of interest made by the debtor after the Failure would be "on account of the obligation" and would so reduce it. As such, the full amount of the payments by the debtor (i.e., both principal and interest) would reduce the prescribed security interest.

We trust that these comments will be of assistance.

Yours truly,

Terry Young, CPA, CA
Manager, Administrative Law Section
On behalf of Randy Hewlett, Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

cc. Tony Manconi, Director General,
Collections Directorate, Taxpayer Services and Debt Management Branch