The Quebec Court of Appeal Kitco Metals Inc. Decision: How to Restrict the Tax Authorities' Use of Set-Off in the Context of a Restructuing (ctd.)

April 3, 2017

On February 20, 2017, Justice Paul Vézina, writing for the three-judge panel of the Québec Court of Appeal, affirmed the Superior Court decision in Métaux Kitco Inc.[1], which had refused to allow federal and Québec tax authorities (the “Tax Authorities”) to set off a tax debt that predated the filing of restructuring proceedings against GST and QST input tax credits/refunds (“ITCs/ITRs”) that had been “earned” subsequent to the filing of the restructuring proceedings, during a period in which the taxpayer was under the protection of the Companies' Creditors Arrangement Act (“CCAA”). This article is a follow-up to our article analyzing the judgment in first instance.

Background

Kitco Metals Inc. (“Kitco”) was in the business of purchasing scrap gold from various suppliers in order to extract and then sell pure gold from it. Although the sale of scrap gold is taxable for GST and QST purposes, the sale of pure gold by the refiner (or by the person on whose behalf gold is refined) is zero-rated. Kitco could therefore claim ITCs/ITRs to recover the taxes it paid to its suppliers, including those that supplied it with scrap gold.

In 2010 and 2011, the Tax Authorities issued notices of assessment to Kitco in order to reclaim ITCs/ITRs for GST and QST that the company had allegedly never actually paid to its suppliers (the “Notices of Assessment”). The Tax Authorities contended that Kitco had taken part in a fraudulent tax scheme involving several of its suppliers. Kitco challenged the Notices of Assessment before the Tax Court of Canada and the Court of Québec. The tax debt in dispute was over $313 million (the “Disputed Tax Debt”).

In June of 2011, as a result of the enforcement measures implemented by the Tax Authorities to collect the $313 million, Kitco filed a notice of intention to make a proposal under the Bankruptcy and Insolvency Act (“BIA”) and a notice of stay of proceedings. One month later, Kitco finally decided to continue the insolvency proceedings under the CCAA instead.

In the meantime, Kitco continued its operations during the restructuring and claimed ITCs/ITRs on a monthly basis. Those claims related to subsequent transactions with suppliers that were unrelated to the Disputed Tax Debt. While the Tax Authorities did not challenge the validity of these ITCs/ITRs (the “Uncontested ITCs/ITRs”), they refused to pay the claims made after the commencement of the insolvency proceedings, preferring instead to set them off against the Disputed Tax Debt. The amount set off in this manner, and therefore not paid out to Kitco, totaled approximately $1.7 million and increased every month.

Kitco, the monitor, as well as an important creditor that we are representing, challenged the validity of this set-off/compensation.

Judgment in first instance

The Québec Superior Court ruled in favor of Kitco and ordered the Tax Authorities to reimburse the Uncontested ITCs/ITRs. It held that the interpretation of section 21 of the CCAA did not allow the Disputed Tax Debt, which stemmed from obligations that predated the insolvency proceedings, to be set off against the debt for the Uncontested ITCs/ITRs, earned subsequent to those proceedings.

The Tax Authorities appealed the ruling, arguing that the wording of section 21 of the CCAA, which allows for set-off, in no way restricted them to debts which predated the insolvency proceedings.

Québec Court of Appeal decision

The Québec Court of Appeal held that the Tax Authorities’ position that the CCAA allows debts that predate the filing of insolvency proceedings and debts subsequent to them to be set off is erroneous since (1) it defeats the restructuring of large businesses in financial difficulty, which is the cornerstone of the CCAA, and (2) it is contrary to the principle of the pari passu treatment of unsecured creditors.

In support of its first ruling, the Court of Appeal held that the Tax Authorities’ literal interpretation of section 21 of the CCAA to the effect that the set-off rules apply to all claims filed against the debtor company, would defeat the purpose of a restructuring under the CCAA by undermining the period of status quo, during which a corporation experiencing financial difficulties can develop a restructuring plan to be submitted to its creditors. The Court of Appeal referred to Century[2], a Supreme Court of Canada decision, pointing out the need to preserve the status quo in a restructuring context and its importance for the survival of businesses in financial difficulty. In doing so, the Court of Appeal rightly points out the unacceptable business consequences that would result from the interpretation proposed by the Tax Authorities, namely that Kitco, which is struggling to remain in business, would have to pay 15% tax on its earnings without being able to receive the refund to which it would normally be entitled, unlike its competitors. According to the Court, a fair interpretation of section 21 of the CCAA must be reconcilable with this goal of restructuring.

As for the second ruling, the Court of Appeal began by pointing out the close relationship between the restructuring regimes under the CCAA and the BIA, which establish a common procedure and stay of proceedings to facilitate the preparation of a restructuring plan to be submitted to creditors with a view to an arrangement or proposal, and recalls that the jurisprudence and doctrine respecting one can be applied to the other. Relying in particular on subsections 66(1) and 97(3) of the BIA and the interpretation of these provisions by the Supreme Court of Canada in DIMS Construction Inc.[3], the Court of Appeal held that the general principles of the BIA, and the CCAA by association, do not allow any transaction which would give security that did not exist before the bankruptcy and that the set-off or compensation right must be construed narrowly in order to protect the creditors. Based on this analysis, the Court of Appeal concluded that by attempting to set off the Uncontested ITCs/ITRs and the Disputed Tax Debt, the Tax Authorities were attempting to exercise security which they did not hold over Kitco’s other assets, thereby giving themselves a prior claim to the detriment of the other unsecured creditors.

The Court of Appeal decision clarifies when set-off is allowed and for what type of debts. The date insolvency proceedings are filed is the relevant date for determining the moment as of which mutual debts can be set off. The Tax Authorities therefore cannot set off the Notices of Assessment, which constitute a “pre-filing” debt, and the Uncontested ITCs/ITRs, which constitute a “post-filing” debt. However, according to the Court of Appeal, for a debt to be considered “post‑filing”, it must not only have arisen after the filing of insolvency proceedings, it must also result from an obligation which arose after that time.

Lastly, the Court of Appeal rejected a final argument submitted by the Tax Authorities based on the assumption that Kitco might ultimately not submit an arrangement plan. The Court held that there was no point examining the alternative of a possible bankruptcy since that would not change its interpretation of section 21 of the CCAA and the rules of set-off which apply during the period in which the status quo is maintained. 

By rejecting the Tax Authorities’ arguments, the Court of Appeal therefore maintained the Superior Court decision that debts that predate the filing cannot be set off against debts which arise following the filing.

Conclusion

Over the past few years, the Tax Authorities have been aggressive in their use of set-off while insolvent taxpayers are restructuring. These practices have had impacts which are not limited to Kitco, as indicated by the intervention of the Canadian Association of Insolvency and Restructuring Professional (CAIRP) in this matter.  In this leading case, which will likely be referred to by courts outside Québec, the Québec Court of Appeal set the record straight by applying the teachings of the Supreme Court of Canada and favoring a business thinking that ensures the goals behind the restructuring rules under insolvency legislation are reached.

As of the date this bulletin is published, it remains to be seen whether the Tax Authorities will apply for leave to appeal the decision to the Supreme Court of Canada and, if not, whether the set-off applied by tax authorities in several other cases will be maintained. In this regard, the Federal Court of Appeal recently held in Bri-Chem[4] that an administrative body which is governed by a court, such as the Agence du revenu du Québec, must abide by court decisions, although it is not bound by prior decisions if the facts do not correspond to those of the matter in question or if it legitimately and in good faith believes that the decision is erroneous and should not be followed.



[1] Métaux Kitco inc. (Syndic de), 2016 QCCS 444 (CanLII).

[2] Century Services Inc. v. Canada (Attorney General), 2010 SCC 60, [2010] 3 S.C.R. 379.

[3] D.I.M.S. Construction inc. (Trustee of) v. Québec (Attorney General), [2005] 2 S.C.R. 564, 2005 SCC 52.

[4] Attorney General of Canada v. Bri-Chem Supply Ltd., 2016 FCA 257.

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