Double Derivative Tax Liability: How Does Derivate Tax Liability under Section 160 Interact with Derivative Tax Liability of a Director under Section 227.1? Colitto v The Queen (2019 TCC 88) – A Canadian Tax Lawyer’s Analysis

Introduction: Inheriting the Tax Liability of Another Taxpayer

Canada’s Income Tax Act contains several rules allowing the Canada Revenue Agency to collect tax debts by pursuing someone other than the original taxpayer. Section 160 of the Income Tax Act, for example, permits the CRA to assess derivative income-tax liability on a related party who receives assets from the original tax debtor. Likewise, section 227.1 gives the CRA a means of pursuing a corporation’s director for the corporation’s unremitted source deductions. (The Excise Tax Act contains analogous rules relating to GST/HST.)

Colitto v The Queen (2019 TCC 88) considered how these two rules interact—in particular, when may one taxpayer’s derivative liability under section 227.1 pass to another taxpayer by means of section 160?

After examining sections 227.1 and 160 of the Income Tax Act, this article reviews the Tax Court’s decision in Colitto. Finally, it concludes by offering some tax tips.

Director’s Liability under Section 227.1 of the Income Tax Act

Section 227.1 is a tax collection tool. It essentially serves to expand the CRA’s ability to collect a corporation’s unremitted source deductions when efforts to collect against the corporation prove futile.

In particular, if a corporation failed to remit source deductions—e.g., employee payroll deductions or non-resident withholding tax—subsection 227.1(1) renders derivative tax liability on “the directors of the corporation at the time the corporation was required to remit.” Each director becomes “jointly and severally, or solidarily, liable, together with the corporation, to pay” the amount that the corporation failed to remit, plus any related interest or penalty

The derivative tax liability under section 227.1 may apply to either a de jure director or a de facto director. A de jure director is one who is appointed in accordance with the governing corporate statute. A de facto director, by contrast, is an individual who either (i) was never a de jure director yet acts like a director or (ii) ceased being a de jure director yet continued acting as a director. In other words, the Canada Revenue Agency may assess director’s liability on a person who simply fulfils the duties of a director.

Section 227.1 contains three checks designed to limit a director’s exposure and to ensure that the CRA attempts to satisfy the corporation’s tax debt with the corporation’s assets before pursuing its directors.

First, subsection 227.1(1) says that a director isn’t liable for a corporation’s unremitted source deductions unless one of the following occurs:

• The CRA registered a certificate for corporation’s unremitted source deductions with the Federal Court, and execution for that amount has been returned unsatisfied (e.g., the sheriff attempted to enforce the writ but the assets available for seizure were insufficient to cover the debt);
• The corporation commenced liquidation or dissolution proceedings (or was involuntary dissolved), and the CRA proves a claim for the unremitted source deductions within six months of the earlier: the date that proceedings commenced and the date of the dissolution; or
• The corporation made an assignment in bankruptcy (or a creditor obtained a bankruptcy order against the corporation) and the CRA proves a claim for the unremitted source deductions within six months of the date of the assignment or bankruptcy order.

Second, subsection 227.1(4) prescribes a two-year limitation period on a director’s exposure to a corporation’s unremitted source deductions. The Canada Revenue Agency cannot assess a director for a corporation’s withholding-tax debts “more than two years after the director last ceased to be a director of that corporation.” But even if a person validly resigned as the director, the clock on the two-year period does not start running if the person continues as a de facto director.

Third, subsection 227.1(3) offers the benefit of a due-diligence defence. A director isn’t liable for the corporation’s withholding-tax debts if, to prevent the corporation’s failure to remit, the director “exercised the degree of care, diligence and skill” that “a reasonably prudent person would have exercised in comparable circumstances.”

Derivative Tax Liability under Section 160 of the Income Tax Act

Like section 227.1, section 160 of Canada’s Income Tax Act is a tax collection tool. It aims to thwart taxpayers who try to keep assets away from Canada Revenue Agency tax collectors by transferring those assets to friends or relatives. Basically, if you receive assets or cash from a related party—e.g., a spouse, a child, a business partner, or a trust or corporation in which you have an interest—that has outstanding tax debts, section 160 allows the CRA’s tax collectors to pursue you for that person’s tax debt. (Your liability, however, is capped at the fair market value of the transferred asset, and it is reduced by the value of what you paid in consideration for that asset. We detail the mechanics of section 160 in the following section.)

Section 160 is a harsh rule: it applies even if the transfer wasn’t motivated by tax avoidance, and it catches transferees who don’t even realize that they’re receiving property from a tax debtor, and it applies even if the tax debt arose after the transfer of assets.

Indeed, section 160 is perhaps even more unforgiving than director’s liability under section 227.1. Unlike section 227.1, section 160 offers no due-diligence defence. And, in contrast to section 227.1, which precludes the CRA from assessing a director more than two years after resignation, section 160 doesn’t contain a limitation period. So, even years after a purported transfer, the Canada Revenue Agency may assess the recipient for derivative tax liability under section 160.

Section 160 applies if four conditions are met:

• A property must have been transferred.
• At the time of the transfer, the transferor and transferee were not dealing at arm’s length—e.g., spouses, common-law partners, a trust or corporation in which the transferor or transferee has an interest, etc.
• The consideration flowing from the transferee to the transferor must have been either inadequate or non-existent.
• The transferor must have been liable to pay an amount under the Income Tax Act (e.g., income-tax debt, penalty, interest, derivative tax liability) that related to the year of the transfer or any preceding year.

When section 160 applies, the transferor and the transferee both become “jointly and severally” liable for the transferor’s debts under the Income Tax Act. In particular, the transferee becomes independently liable for the transferor’s income-tax debt leading to the time of the transfer. This means that the Canada Revenue Agency can now pursue both the original tax debtor and the transferee for that tax debt. In fact, even if the original tax debtor is later discharged from bankruptcy and thus released from the underlying tax debt, the recipient remains liable to the CRA (see: Canada v Heavyside)

That said, the transferee’s derivative liability under section 160 is limited to the fair market value of the transferred property. Further, the amount of the transferee’s consideration for the property will offset the amount of the transferee’s derivative liability. For example, sat a tax debtor owns a home (with no mortgage) worth $500,000, and that tax debtor owes $1 million to the CRA. If the tax debtor gifts the home to her daughter, the daughter’s derivative liability under section 160 is $500,000—i.e., the value of the home. If, on the other hand, the daughter purchased the home from the tax debtor for $250,000, the daughter’s derivative liability under section 160 is $250,000—i.e., the value of the home minus the purchase price.

Finally, subsection 160(3) governs how payments apply to discharge the joint liability. A payment by a taxpayer who has inherited a tax debt under section 160 shall reduce both debts—that is, this payment reduces not only the tax debt of the jointly liable taxpayer but also the tax debt of the original tax debtor. But an ordering rule governs a payment by the original tax debtor. The original tax debtor must first pay off all tax debts exceeding the joint debt.

For example, say the original tax debtor owed $1 million, and the joint debtor inherited $500,000 of that tax debt under section 160.

• If the joint debtor pays off the full $500,000 of inherited tax debt, then she extinguishes her liability under section 160. The original tax debtor’s liability is also reduced by $500,000.
• If the original tax debtor pays $500,000 toward his tax debt, then he will reduce his own tax debt by $500,000. The joint debtor’s inherited tax debt, however, remains unchanged; it is still $500,000.
• If the original tax debtor had paid $750,000 toward his tax debt, then he would reduce his amount owing by $750,000, from $1 million to $250,000. The joint debtor’s inherited tax debt would also be reduced by $250,000, from $500,000 to $250,000.

In other words, before his tax payments will discharge the joint debt, the original tax debtor must first pay off all tax arrears that are solely his own.

Colitto v The Queen, 2019 TCC 88

In 2008, Domenic Colitto was the director and shareholder of a corporation that manufactured tools. From February to August 2008, the corporation failed to remit source deductions totaling over $600,000 to the Canada Revenue Agency.

In May of that year, Domenic transferred a 50% interest in each of two real properties to his spouse, Caroline. In exchange, Caroline paid Domenic $4.00 total, about $230,000 below fair market value.

By the end of 2008, the CRA had assessed Domenic’s corporation for the unremitted $600,000 in source deductions. In summer 2009, the CRA had registered the corporation’s debt in Federal Court.

Two years later, in January 2011, an execution for the corporation’s withholding-tax debt was returned unsatisfied. Two months later, the CRA issued a director’s liability assessment under section 227.1 to Domenic for about $700,000.

In 2016, the Canada Revenue Agency assessed Caroline Colitto under section 160 for $230,000, the amount by which her $4.00 payment fell short of the value of the real-property interests she received from her husband. In response, Caroline appealed the section 160 assessment to the Tax Court of Canada.

During the Tax Court proceedings, all parties agreed that the CRA had correctly assessed both the corporation for its withholding-tax debt and Domenic for director’s liability. Section 160, however, requires that the transferor have an unpaid tax liability “in or in respect of the taxation year” in which the transfer occurred—in this case, the 2008 taxation year.

So, the dispute centered on the question whether Domenic’s derivative tax debt under section 227.1 was “in or in respect of” the 2008 taxation year. If so, then Caroline would inherit that tax debt under section 160. If not, section 160 wouldn’t apply.

The Tax Court of Canada allowed Caroline’s appeal and held that she wasn’t liable under section 160 of the Income Tax Act.

The Tax Court’s decision ultimately turned on the question of when exactly a director becomes liable under section 227.1 for the corporation’s withholding-tax debts. The answer, the court concluded, was that the director becomes liable only when one of the requirements in subsection 227.1(2) had been satisfied. In other words, the director wasn’t yet liable unless:

• The CRA registered a certificate for corporation’s unremitted source deductions with the Federal Court, and execution for that amount has been returned unsatisfied (e.g., the sheriff attempted to enforce the writ but the assets available for seizure were insufficient to cover the debt);
• The corporation commenced liquidation or dissolution proceedings (or was involuntary dissolved), and the CRA proves a claim for the unremitted source deductions within six months of the earlier: the date that proceedings commenced and the date of the dissolution; or
• The corporation made an assignment in bankruptcy (or a creditor obtained a bankruptcy order against the corporation) and the CRA proves a claim for the unremitted source deductions within six months of the date of the assignment or bankruptcy order.

In support, the court relied on Federal Court of Appeal jurisprudence, which described the requirements in subsection 227.1(2) as “conditions precedent” or “statutory preconditions” that “intended to ensure that a director is not held liable for a tax debt of a corporation unless the Crown has taken specified steps on a timely basis to satisfy the debt from the assets of the corporation.”

The Tax Court also viewed the text of subsection 227.1(2) as “very clear and unambiguous” in supporting the same point:

Subsection 227.1(2) of the Act provides that a “director is not liable under subsection (1), unless” the preconditions set out in subsection 227.1(2) have been satisfied. In my view, the text of subsection 227.1(2) is very clear and unambiguous, and strongly suggests that a director’s liability for unremitted source deductions and other amounts specified under subsection 227.1(1) of the Act does not arise until the relevant preconditions set out in subsection 227.1(2) of the Act are met. [para 48]

So, according to the Tax Court, Domenic’s liability under section 227.1 didn’t arise until January 2011, when, in satisfaction of paragraph 227.1(2)(a), the execution for the corporation’s withholding-tax debt was returned unsatisfied. This in turn mean that the CRA couldn’t assess Caroline under section 160 because the impugned transfer occurred in 2008, when Domenic wasn’t yet liable for the corporation’s withholding-tax debts.

The Crown has since commenced the process of appealing the Tax Court’s decision. On June 5, 2019, the Attorney General of Canada filed a notice of appeal to the Federal Court of Appeal. It will take some time before the appellate court actually hears the appeal. In the meantime, the Tax Court’s decision stands.

Tax Tips – Responding to Derivative Tax Assessments

If you have outstanding tax debts and transfer property to your friends and relatives in an attempt to keep assets away from the Canada Revenue Agency, you expose them to CRA collections action. The Colitto case demonstrates that section 160 might rear its ugly head to further spread an already derivative tax debt.

In addition, if you’re a director (or merely acting as a director) of a corporation with withholding-tax debts or GST/HST debts, you’re exposed to derivative tax liability. You may limit your exposure by resigning—thereby starting the clock on the two-year limitation period. But the resignation must meet the requirements of the governing corporate law. For example, it won’t suffice if you simply file a notice of change removing yourself as the director on the corporate registry. Moreover, you’ll remain vulnerable to a director’s liability assessment if you continue to carry out the duties of a director.

If you plan on entering a transaction with a related party and either you or that party has tax debts (or might later be reassessed for a prior tax year), or if you’re a director or acting director of a corporation with withholding-tax or GST/HST debts, consult one of our expert Canadian tax lawyers for advice on reducing the exposure to an assessment for derivative tax liability under section 160 or under section 227.1.

If you receive a notice of assessment under section 160 or under section 227.1, you may challenge both (i) the merits of the assessment itself and (i) the merits of any assessment relating to the underlying tax debt. In addition, you may challenge the underlying tax debt even if the original tax debtor failed to do. If the original tax debtor did in fact challenge the debt but failed to lower the amount, you may still challenge the underlying tax debt—and you may raise independent arguments. In addition, if you’ve received a director’s-liability assessment under section 227.1, you may raise arguments speaking to your due diligence.

That said, you have only a limited amount of time to object to a derivative-tax assessment. Generally, you must object within 90 days of the date on the assessment, but you may qualify for extended deadline. But if you fail to object within the statutory deadlines, you’ll be personally stuck with the debt—even if the underlying tax debt is discharged in bankruptcy.

So, if you have been assessed under section 160 or section 227.1, speak with one of our experienced Canadian tax lawyers today. We thoroughly understand this area of law, and we can ensure that you deliver a forceful, thorough, and cogent response to the Canada Revenue Agency.