Set-Off by Tax Authorities Involving Pre-Filing and Post-Bankruptcy Claims: the Court of Appeal Rules

In its decision in Arrangement relatif à Métaux Kitco inc. 2017 QCCA 268, rendered on February 20th, the Quebec Court of Appeal upheld a Quebec Superior Court decision prohibiting Revenu Québec (“RQ”) from setting off input tax credits and refunds (“ITC/ITRs”) allegedly claimed illegally by Kitco Metals Inc. (“Kitco”) before filing a notice of intention to make a proposal to its creditors, against ITC/ITRs generated after the filing of the notice. 

The facts of the case can be summarized as follows: Kitco is a retailer of precious metals. In the course of its business, it purchases scrap metal and jewellery, extracts gold and other precious metals therefrom, and resells the latter. Such purchases are subject to the Goods and Services Tax and the Quebec Sales Tax (“GST/QST”), for which Kitco claimed ITC/ITRs totalling $300 million during the period prior to filing its notice of intention. 

In the course of an audit, RQ came to the conclusion that Kitco was engaged in a fraudulent stratagem whereby its suppliers did not remit to RQ the GST/QST they collected on the sales, such that Kitco was claiming ITC/ITRS in respect of taxes that had not in fact been received by the tax authorities. RQ accordingly assessed Kitco millions of dollars in taxes never remitted by Kitco’s suppliers, and brought penal charges. 

Following these assessments, Kitco filed a notice of intention to make a proposal to its creditors on June 8, 2011 and subsequently continued doing business under the protection of the Companies’ Creditors Arrangement Act (“CCAA”) as of the following July 7th

After filing its notice of intention on June 8, 2011, Kitco continued operating its business and claimed ITC/ITRS totalling $1.7 million. However, rather than refunding that amount, RQ set it off against the amounts assessed against Kitco before the filing of the notice of intention. Kitco contested this course of action, claiming it was illegal. 

At first instance, the Superior Court determined that the CCAA did not allow set-off of the post-filing non-contested ITC/ITRS against the pre-filing indebtedness. RQ appealed that decision. 

The issue for the Court of Appeal to decide was thus whether set-off of the pre-filing indebtedness against the post-filing claims was possible. 

According to RQ, section 21 of the CCAA (and subsection 97 (3) of the Bankruptcy and Insolvency Act (the “BIA”), which is to the same effect) which authorizes set-off in insolvency situations, must be broadly and liberally construed, and thus permits setting off post-filing claims of the insolvent debtor against pre-filing debts that were owed by it. 

The Court of Appeal decided however that on June 8, the date of the filing of the notice of intention, all creditors’ claims must be stayed. 

As at the day on which proceedings commenced under the CCAA, pre-filing claims and debts could be set off against each other, and any outstanding difference would become an ordinary claim. 

As for the ITC/ITRS claimed after the date proceedings commenced, the Court held that the pre-filing indebtedness to RQ could not be set off against them. 

The Court disagreed with the proposition that section 21 of the CCAA should be broadly and liberally construed, as it was at odds with the purpose of the statutory insolvency regime, which is to allow large enterprises in difficulty to restructure so as to ensure their survival. In this regard, the Court noted that a post-filing revenue shortfall (the non-refunded ITC/ITRS), representing 15% of Kitco’s annual turnover, jeopardised its successful restructuring and gave an undue advantage to its competitors, who didn’t have to bear such a fiscal burden. The interpretation of section 21 must be compatible with the purpose of the legislated insolvency regime. 

With respect to the set-off argument, the Court stated that the case law likens set-off to a prior claim allowing creditors to realize on their security against a single asset of the debtor, namely the latter’s claim against them. Once such set-off has been effected, any outstanding balance owed the creditor becomes an ordinary unsecured claim. Since set-off is an exception to the rule that all creditors are to be treated equally, section 21 of the CCAA and subsection 97 (3) of the BIA must be construed narrowly, and not broadly and liberally as proposed by RQ. 

Applying this reasoning to the setting off of pre-filing indebtedness against post-filing claims, the Court indicated that RQ was attempting to realize upon its security by exercising set-off against the ITC/ITRS due by it to Kitco both before and after the date on which the CCAA proceedings commenced. Exercising set-off against the ITC/ITRS generated after that date gave it an unjust priority to the detriment of ordinary creditors, which the legislation prohibits. 

The Court of Appeal also took the opportunity to pointedly not follow the decision in Re Air Canada [45 C.B.R. (4th) 13 Ont. S.C.J.], which initiated the debate regarding pre-filing and post-filing compensation or set-off. 

The Court accordingly dismissed RQ’s appeal and appears to have settled an issue that had been outstanding for many years. It remains to be seen, however, whether RQ will appeal the decision to the Supreme Court of Canada.

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