Double Derivative Tax Liability – Canadian Tax Lawyer Case Analysis

Double Derivative Tax Liability: The Federal Court of Appeal Broadens the Scope of Derivative Tax Liability for Directors and for Non-Arm’s-Length Transferees – The Queen v Colitto (2020 FCA 70) – 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, for example, permits the CRA to assess derivative income-tax liability on a related party who received 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 for employee payroll (e.g., CPP, EI, and employee income-tax withholdings). The Excise Tax Act contains analogous rules relating to GST/HST debts.

In Colitto v The Queen (2019 TCC 88) and The Queen v Colitto (2020 FCA 70), the Tax Court of Canada and the Federal Court of Appeal respectively considered—and reached opposing conclusions about—how these two rules interact. While the Tax Court’s decision tended to limit an unwitting party’s exposure to derivative tax liability, the Federal Court of Appeal reinforced the CRA’s ability to collect tax debts from a third party by strategically assessing under both section 227.1 and section 160.

After examining sections 227.1 and 160 of the Income Tax Act, this article reviews the case facts, the Tax Court’s decision, and the Federal Court of Appeal’s decision. 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. When the Canada Revenue Agency’s efforts to collect against a corporation prove futile, section 227.1 allows the CRA to pursue the director for the corporation’s source-deduction arrears.

In particular, if a corporation failed to remit source deductions—e.g., non-resident withholding tax or employee payroll deductions for CPP, EI, and income 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 applies to both de jure directors and de facto directors. 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.

The rule does not, however, confer unlimited liability. It contains three mechanisms that serve to both limit a director’s exposure and ensure that the CRA first 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.” As hinted above, however, this limitation period offers no protection should a person validly resign as a de jure director yet continue acting as a de facto director.

Finally, subsection 227.1(3) gives the director 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 thwarts taxpayers from keeping assets away from CRA 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—and that related party has outstanding tax debts, section 160 allows the CRA’s tax collectors to pursue you for that person’s tax debt.

Section 160 is a notably harsh rule: it applies even if the transfer wasn’t motivated by tax avoidance, and it can apply even if the tax debtor wasn’t assessed for the tax debt until after the impugned transfer. So, it catches taxpayers who may not even realize that they owe tax, and it catches transferees who don’t even realize that they’re receiving property from a tax debtor.

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 was 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 transferee gave the transferor inadequate consideration or no consideration for the transferred property (e.g., a gift, an inheritance, a dividend, etc.).
• 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 other words, the transferee is thereby independently liable for the transferor’s income-tax debt, as of the tax year in which the transfer occurred. So, the Canada Revenue Agency’s tax collectors 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 transferee 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. For example: In 2020, a corporation has accumulated $600,000 of corporate income-tax debt. In 2020, the corporation pays a $75,000 dividend to its shareholder. Assume that the $75,000 dividend is the only payment that the shareholder has ever received from the corporation; the corporation hasn’t paid any other funds or transferred any no other assets to the shareholder. The shareholder’s derivative liability under section 160 cannot exceed $75,000—even though the corporation has $600,000 in income-tax debt. The shareholder’s section 160 liability is capped at the fair market value of the dividend.

In addition, if the transferee gives the transferor consideration for the transferred property, the value of the consideration will offset the amount of the transferee’s derivative liability under section 160. Suppose that 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. Continuing with this example, suppose that, leading up to the transfer, the tax debtor also owed $500,000 to her daughter. The daughter agrees that her mother may repay the $500,000 debt by transferring the property. Per this agreement, the tax debtor transfers the home to her daughter. In this case, the daughter’s derivative liability under section 160 is nil. This is because the daughter provided consideration by releasing the $500,000 debt obligation, and the value of this consideration matched the value of the transferred property.

When the original tax debtor and the derivative tax debtor make payments toward their joint tax liability, subsection 160(3) governs how these payments apply. If the derivative tax debtor makes a payment, that payment reduces both debts—that is, this payment reduces not only the derivative tax debt of the taxpayer who inherited the liability under section 160 but also the tax debt of the original tax debtor. But if the original tax debtor makes a payment, an ordering rule applies. The original tax debtor must first pay off all tax debts exceeding the joint debt. 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: The Facts

Domenic Colitto was the director and shareholder of a corporation that manufactured tools. Domenic also owned two real properties.

From February to August 2008, while Domenic served as director, his corporation racked up source-deduction arrears totaling over $600,000.

In May 2008, during the time that his corporation amassed the source-deduction debts, Domenic transferred a 50% interest in each of the two real properties to his spouse, Caroline. In exchange, Caroline paid Domenic $4.00 in total, about $230,000 below fair market value.

In October 2008, the CRA assessed Domenic’s corporation for $600,000 in source-deduction arrears. The corporation didn’t object to the assessment.

In summer 2009, the CRA registered the corporation’s debt in Federal Court.

Two years later, in January 2011, an execution for the corporation’s source-deduction arrears was returned unsatisfied.

A couple months later, in March 2011, the CRA assessed Domenic for about $700,000 in director’s liability under section 227.1. The tax debt underlying Domenic’s derivative assessment stemmed from his corporation’s source-deduction arrears and accrued interest. Domenic didn’t object to the assessment, and he apparently hadn’t resigned from his position as the corporation’s director.

In January 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 property interests that she acquired from Domenic.

In sum, the tax debt underlying Caroline’s $230,000 derivative assessment came from Domenic’s own $700,000 derivative assessment for director’s liability, which in turn came from his corporation’s source-deduction arrears.

The Tax Court’s Decision: Colitto v The Queen, 2019 TCC 88

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 under section 227.1.

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. Section 160 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, if Domenic’s director’s liability was “in or in respect of” the 2008 tax year, then Caroline would inherit that tax debt under section 160. But if Domenic’s director’s liability was “in or in respect of” a tax year after 2008, then section 160 wouldn’t apply.

Caroline’s Canadian tax lawyer argued that Caroline didn’t inherit any derivative tax liability under section 160 because, in 2008, when the transfers occurred, Domenic didn’t have any tax debts under the Income Tax Act. Domenic’s director’s liability didn’t arise until January 2011, when the execution for the corporation’s source-deduction arrears was returned unsatisfied.

The CRA argued that, once the conditions in section 227.1 have been satisfied, Domenic’s director’s liability applies retroactively as of the date that his corporation failed to remit the source deductions. So, although the sheriff didn’t execute the certificate until January 2011, Domenic’s director’s liability was “in or in respect of” the 2008 tax year because this was the tax year for which corporation had amassed the source-deduction debts.

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 for a corporation’s unremitted source deductions. The answer, the court concluded, was that the director becomes liable only when the requirements in subsection 227.1(2) have been satisfied. In other words, a director isn’t liable until one of these three things had occurred:

• 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 the Federal Court of Appeal’s jurisprudence, which had 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 had been returned unsatisfied. This in turn meant 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 CRA’s Canadian tax lawyer appealed the Tax Court’s decision to the Federal Court of Appeal.

The Federal Court of Appeal’s Decision: The Queen v Colitto, 2020 FCA 70

Like the Tax Court’s decision, the Federal Court of Appeal’s decision hinged on the question of when exactly a director becomes liable for a corporation’s withholding-tax debts. But unlike the Tax Court, the Federal Court of Appeal concluded that the director becomes liable as soon as the corporation fails to remit the source deductions. The appellate court disagreed with the Tax Court’s reasoning that, when a corporation fails to remit source deductions, the director only becomes liable when the requirements in subsection 227.1(2) have been satisfied. On the Federal Court of Appeal’s reading, subsection 227.1(2) “is a relieving provision that sets out specified circumstances when the liability otherwise imposed by subsection (1) may be avoided [para 22].” The Federal Court of Appeal faulted the Tax Court for, in the appellate court’s view, misreading subsection 227.1(2):

Subsection 227.1(2) does not state that a director is not liable for the corporation’s default “unless and until” the specified actions take place. This is the language that would be required to effect the result found by the Tax Court. The Tax Court impermissibly read the words “and until” into subsection 227.1(2) in order to conclude that a director’s liability does not arise under subsection 227.1(1) “unless and until the relevant preconditions in subsection 227.1(2) are satisfied” [para 23].

The Federal Court of Appeal also brushed off the Tax Court’s use of the appellate court’s own jurisprudence, calling those previous remarks obiter.

As a result, the Federal Court of Appeal reversed the Tax Court’s decision and held that Caroline in fact was liable under section 160 of the Income Tax Act.

Questioning the Federal Court of Appeal on Colitto: Is This Really What Parliament Had Intended?

The Federal Court of Appeal acknowledged that the English version and the French version of subsection 227.1(1) each proved ambiguous:

The phrase “the directors of the corporation at the time the corporation was required to deduct, withhold, remit or pay the amount are jointly and severally, or solidarily, liable, together with the corporation, to pay that amount” may be read to simply specify which directors are liable for the corporation’s failure to deduct, withhold, remit or pay (those directors at the time of default). At the same time, the phrase may equally be read to specify not only which directors are liable, but the point in time at which such liability arose (at the time of the corporation’s failure). [para 18]

The Tax Court failed to consider the equally authoritative French version of subsection 227.1(1). To the extent that any ambiguity exists in the English version, the French version adds no additional clarity. [para 19]

The appellate court insisted, however, that “any ambiguity in the meaning of subsection 227.1(1) is eliminated when one considers the context and purpose of the provision [para 20].” Yet the court provides an unpersuasive examination of the provision’s context and purpose.

The Federal Court of Appeal reasons that subsection 227.1(2) is the “most important contextual factor.” According to the court, subsection 227.1(2) shows that a director becomes liable as soon as the corporation fails to remit the source deductions:

Contrary to the Tax Court’s reading of the provision, subsection (2) makes clear that it is subsection (1) that imposes liability upon directors. Subsection (2) is a relieving provision that sets out specified circumstances when the liability otherwise imposed by subsection (1) may be avoided. Thus, a “director is not liable under subsection 227.1(1), unless” or an “administrateur n’encourt la responsabilité prévue au paragraphe (1) que dans l’un ou l’autre des cas suivants” [para 22].

Subsection 227.1(2) does not state that a director is not liable for the corporation’s default “unless and until” the specified actions take place. This is the language that would be required to effect the result found by the Tax Court. The Tax Court impermissibly read the words “and until” into subsection 227.1(2) in order to conclude that a director’s liability does not arise under subsection 227.1(1) “unless and until the relevant preconditions in subsection 227.1(2) are satisfied” [para 23].

On the Federal Court of Appeal’s view, subsection 227.1(2) doesn’t speak to when a director becomes liable; its purpose is simply the avoidance of double taxation. In particular, it prevents the CRA from recovering unremitted source deductions from a director if the corporation has already paid all the liability.

Finally, the appellate court reasoned that the Tax Court’s interpretation would undermine the purpose of the director’s-liability provisions. The purpose of this rule, according to the Federal Court of Appeal, is “to strengthen the Crown’s ability to enforce the statutory obligation imposed on corporations to remit source deductions [para 25].” But “the interpretation adopted by the Tax Court renders this purpose nugatory and pointless. The Tax Court’s interpretation would allow a director significant time following the corporation’s default to reorganize his or her financial affairs to avoid personal financial responsibility. Parliament cannot have intended the directors’ liability provision to be avoided as it was in the present case [para 26].”

But this reasoning fails to show that a director becomes liable when the corporation fails to remit the source deductions. First, the appellate court seemingly adopts an unnaturally restrictive reading of the word “unless” in the phrase “director is not liable under subsection 227.1(1), unless.” The word “unless” generally means “except on the condition that,” which seemingly implies that the main clause doesn’t apply until the subordinate clause has been satisfied. If a director is not liable under subsection 227.1(1) “except on the condition that” subsection 227.1(2) has been satisfied, then presumably the director isn’t liable until subsection 227.1(2) has been satisfied. The appellate court doesn’t consider that, in the phrase “director is not liable under subsection 227.1(1), unless,” the inclusion of the word “until” is redundant and thus unnecessary.

Second, the French version of subsection 227.1(2) supports the Tax Court’s interpretation. (The appellate court quotes the French version yet says nothing about it.) The French text says, “administrateur n’encourt la responsabilité prévue au paragraphe (1) que dans l’un ou l’autre des cas suivants.” The literal translation is: “A director incurs the liability provided for in paragraph (1) only in one or the other of the following cases.” This arguably supports the Tax Court’s view that the requirements in subsection 227.1(2) are conditions precedent to any liability—that is, a director is liable only when subsection 227.1(2) has been satisfied.

Third, although the appellate court is likely correct that subsection 227.1(2) aims to prevent double taxation, the rule still achieves this purpose when applied as the Tax Court had suggested.

Fourth, the Federal Court of Appeal erred when concluding that the Tax Court’s interpretation had rendered the purpose of the director’s-liability rule “nugatory and pointless.” In particular, the Federal Court of Appeal seemingly conflated the purpose of section 227.1 with the purpose of the CRA’s tax collection powers in general. When evaluating the Tax Court’s decision, the appellate court reasoned that “Parliament cannot have intended the directors’ liability provision to be avoided as it was in the present case [para 26].” Yet no one avoided director’s liability here: Domenic was in fact personally assessed for $700,000 in director’s liability. So, the Tax Court’s decision didn’t undermine how Parliament had intended for that rule to apply. Indeed, the Tax Court’s interpretation had no effect on how section 227.1 applied at all. Rather, the decision affected how section 227.1 and section 160 interacted.

And on that note, the Federal Court of Appeal’s decision itself might be contrary to Parliament’s intent. Consider the following example: A corporation failed to remit source deductions for the 2019 tax year. In 2020, the corporation’s director transfers funds to his child’s bank account so that the child can pay school tuition. None of the requirements in subsection 227.1(2) have been satisfied. So, the CRA cannot assess the director personally for director’s liability. Yet the appellate court’s decision means that the CRA can still assess the director’s child under section 160. It doesn’t seem like Parliament had intended such a peculiar result, but this result is exactly what the Federal Court of Appeal’s decision entails.

Pro Tax Tips – Responding to Derivative Tax Assessments: Director’s Liability & Related-Party Transfers

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, even if a director hasn’t been personally assessed for director’s liability, the director can unwittingly spread derivative tax liability under section 160.

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 should 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 tax 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 a deadline extension. If you fail to object within the statutory deadlines, however, you’ll be personally stuck with the debt—even if the underlying tax debt is discharged in bankruptcy.

So, if you have been assessed for derivative tax liability under section 160 or under 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.