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October 29, 2018

Murky Waters Regarding Availability of Debtor Property for Set-Off

In two recent cases, Nielsen (Re)[1] and Strellson AG v. Strellmax Ltd.,[2] the Courts of British Columbia and Ontario addressed the application of set-off between pre- and post-filing obligations. In particular, the Courts addressed two situations in which funds that should have been delivered to the debtor were held by a third party. The third parties attempted to set-off obligations that arose post-filing against the funds in their possession. However, in both cases the Courts held that the funds were the property of the debtor – as opposed to debts – and, as such, could not be set off against a debt owed to the third party.

CRA Attempts to Set-Off Tax Debt Against Holdback Funds

In Nielsen, the debtor was adjudged bankrupt on February 5, 2018. BDO Canada Limited (“BDO”) was appointed trustee. Prior to the bankruptcy, the Bank of Montreal (“BMO”) foreclosed on property owned by the bankrupt and obtained an order approving the sale of the property for $558,000. BMO asked the bankrupt to confirm during the foreclosure proceedings whether he was a “non-resident person” for tax purposes. The bankrupt did not confirm his residency status and the purchaser of the property, out of an abundance of caution, held back one half of the purchase price and remitted those funds to the Canada Revenue Agency (“CRA”) pursuant to section 116 of the Income Tax Act (“ITA”).[3] As a result, the CRA held approximately $279,000 of the debtor’s money (the “Holdback Funds”).

Pursuant to section 116 of the ITA, a buyer who pays the full purchase price to a non-resident seller may be personally liable for any outstanding taxes owed by the non-resident as a result of the transaction. The provision applies only if the vendor is a non-resident, a determination that is made when the vendor’s tax return is filed and assessed by the CRA. The bankrupt in Nielsen, however, had also not been cooperating with the CRA and had not filed tax returns for the preceding two years. As such, at the time of bankruptcy, the debtor’s residency status was uncertain.

To complicate matters further, after the date of bankruptcy, the CRA assessed the bankrupt for a total of $271,456 in taxes, penalties, and interest for those two years and subsequently claimed that it was entitled to collect that debt by setting it off against the Holdback Funds that would otherwise have to be refunded. The issue before the British Columbia Supreme Court in Neilsen, then, was whether the Holdback Funds were the property of the bankrupt’s estate.

The Court held that: (i) the Holdback Funds fell within the definition of the bankrupt’s property under section 71 of the Bankruptcy and Insolvency Act (“BIA”); (ii) that section 70(1) of the BIA gives a bankruptcy precedence over all proceedings against property of a bankrupt, except those that have been completely executed; and (iii) that section 69.3(1) of the BIA barred any remedy by a creditor against such property. Therefore, because the holdback funds remained the property of the bankrupt, pending and subject to the determination of his residency status in 2017, the CRA was not entitled to apply any right of set-off against them. 

The CRA argued further that even if the bankrupt were a Canadian resident, it was entitled to set-off the debt it was owed for the years 2015 and 2016, relying on section 152(3) of the ITA, which states that the tax was owing when the income was earned and that liability was not affected by the lack of an assessment notice, and their general statutory right of set-off under section 224.1 of the ITA. The Court rejected this argument on the grounds that, in order for legal set-off to apply, the debts must be for liquidated sums or an amount that can be ascertained with certainty at the date of bankruptcy.

Factoring Company Attempts to Set-Off Against Unremitted Accounts Receivable

In Strellson, Strellmax Ltd., the debtor, had licensed the use of the Strellson brand, a Swiss-based manufacturer and licensor of men’s clothing, in Canada.

Accord Financial Ltd. (“Accord”), in exchange for a fee, would collect the debtor’s accounts receivable and remit the cash receipts to the debtor on a daily basis. Pursuant to their letter agreement, title to the debtor’s accounts did not pass to Accord absent a specific assignment thereof.

Accord also provided a letter of credit to Strellson in the amount of $500,000 and concurrently entered into a letter agreement with the debtor, under which the debtor agreed to pay Accord $500,000 in the event of a “draw” upon the letter of credit. The debtor was placed into receivership, and Strellson subsequently made a demand on the letter of credit. Accord refused to honour this demand.

During the debtor’s receivership, Accord continued to collect accounts receivable on behalf of the debtor. However, Accord refused to remit the funds to the receiver, and instead withheld approximately $550,000 to cover its exposure under the letter of credit and associated legal fees. Accord then remitted a $1 payment to Strellson under the letter of credit in order to trigger the debtor’s obligation to pay Accord $500,000.

The issue before the Ontario Superior Court of Justice was whether Accord was entitled to set-off the amount of the letter of credit and legal costs against the receiver’s claims to the unremitted cash receipts. Accord submitted that it was entitled to do so under the doctrines of legal, contractual and equitable set-off. Strellson, supported by the receiver, argued, inter alia, that the unremitted cash receipts were the debtor’s property and that set-off cannot apply to an obligation to deliver property as opposed to a debt.

In holding that Accord did not have a right of set-off, the Court looked to the agreement that governed the relationship between the parties and found that the unremitted cash receipts remained the property of the debtor until they were specifically assigned to Accord. Since that had not happened with the funds in question, they remained the property of the debtor. Because an obligation to deliver property is not an obligation to pay a debt, the doctrine of set-off had no application to the unremitted cash receipts.

Addressing Certain Set-Off Rights in Insolvency

Both Nielsen and Strellson provide further examples of the obscurity regarding when a creditor may set-off an amount owed to a debtor against funds in the creditor’s possession. Where such funds constitute the property of the debtor – as opposed to a debt owed by the creditor to the debtor – they cannot be used to set-off a debt owed by the debtor to the creditor. The debts owed to the creditors in both cases were also for amounts that were, at the time of bankruptcy in Nielsen and the receivership proceedings in Strellson, unliquidated or unascertainable. This confirms the principle that the claims of creditors are frozen on the date that the relevant proceedings commence, and subsequent events cannot be used to elevate the creditor’s position.

For practitioners faced with – or attempting to enforce – a set-off right against funds held by a third party, it would therefore be advisable to carefully review the circumstances and confirm whether the funds in question have been brought within the definition of the debtor’s property. Where the funds constitute the debtor’s property, the obligation to return them to the debtor will not constitute a debt to which any right of set-off may apply. Where the funds are properly construed, however, as the property of the creditor who possesses them, they may be subject to a right of set-off that creditor may exercise. To the extent possible, factoring companies may therefore seek to protect themselves against the insolvency of their clients by ensuring that the money that flows through their possession becomes a debt owed to their client, thus preserving their ability to set it off against any corresponding debts in the case of the client’s insolvency.



[1] 2018 BCSC 1161.

[2] 2018 ONSC 1808.

[3] R.S.C. 1985, c. 1 (5th Supp).

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