What happens to your personal income tax refund in a Consumer Proposal or Bankruptcy?

Many Canadians are struggling to manage rising costs in an uncertain economic landscape. The rising cost of daily necessities such as food and gas and unexpected expenses such as home or vehicle repairs are squeezing household budgets — pushing many closer to the brink of insolvency. You may be considering filing for a Consumer Proposal or Bankruptcy if you are no longer able to meet your debt payments and financial obligations each month. However, you may be wondering what will happen to your income tax refund if you do.

The answer to this question depends on which insolvency option you choose and the timing of the refund. It is important to understand this distinction to prevent surprises that can significantly impact your personal cashflow during a financially stressful time. Let’s discuss what happens during a Consumer Proposal or Bankruptcy and how it impacts your personal income tax refund.

Pre-filing refunds vs. post-filing refunds

Income tax refunds are typically divided into two categories:

1. Pre-filing refund: A refund related to the tax year that ended before you filed a Consumer Proposal or Bankruptcy.
2. Post-filing refund: A refund related to income earned after the date of filing for a Consumer Proposal or Bankruptcy.

The timing of the filing matters a lot, specifically if you choose Bankruptcy as a debt relief option.

Income tax refunds in a Consumer Proposal

Tax refunds do not automatically belong to your creditors in a Consumer Proposal. Instead, you remain in control of your assets, continue filing your tax returns as usual, and any refunds you receive in the past or future typically stays with you. However, there are two important caveats:

1. The Canada Revenue Agency (CRA)’s right to set-off

The CRA can apply your tax refund to pay off tax debts that existed prior to filing the Consumer Proposal. This includes income tax arrears, GST/HST for sole proprietors, or overpaid benefits. However, unsecured tax debt is compromised when your Consumer Proposal is accepted, which generally limits future tax refund set-off.

2. Terms of the Consumer Proposal

In some cases, a Consumer Proposal can be structured to contribute a specific tax refund or increase payments if your income or refunds rise substantially. However, this is not automatic and must clearly be written into the Consumer Proposal.

Key takeaway

• You typically keep your income tax refunds in a Consumer Proposal, unless the CRA sets them off first or the Consumer Proposal specifically requires you to contribute these refunds.

Income tax refunds in a Bankruptcy

Bankruptcy works very differently from a Consumer Proposal. Assets that you own that do not qualify as exempt as to the date of the Bankruptcy belong to the Bankruptcy estate under the Bankruptcy and Insolvency Act (BIA).

This includes any income tax refund relating to a tax year ending on or before the Bankruptcy date. It also includes any portion of a refund earned prior to filing, even if it is paid afterward. These refunds are sent directly to the Licensed Insolvency Trustee managing your Bankruptcy if the CRA is notified or required to be turned over if paid to you in error.

Refunds that relate entirely to income earned after the Bankruptcy filing date are yours to keep, provided that you are discharged from Bankruptcy or the refund relates to a tax year that ended after the Bankruptcy began.

The CRA set-off still applies

It is important to remember that the CRA can still apply refunds against post-Bankruptcy tax debt. This situation is rare unless you incur new tax debt after filing for Bankruptcy. However, the CRA cannot apply the right to set-off against discharged debts.

Key takeaway

• Pre-filing tax refunds are an asset of the estate in a Bankruptcy, which post-filing refunds typically belong to you.

What about tax credits and benefits?

If you are considering filing for a Consumer Proposal or Bankruptcy, it is helpful to distinguish tax refunds from social benefits:

• Canada Child Benefit (CCB): This is not considered income or a Bankruptcy estate asset and will continue to be paid to you.
• GST/HST credits and similar refundable credits: These are typically treated like tax refunds. These types of credits are captured by the Bankruptcy estate if related to pre-filing entitled. The credits are usually retained in a Consumer Proposal, subject to set-off by the CRA.

Reference table

Why timing matters when choosing between a Consumer Proposal or a Bankruptcy

Tax refunds are often one of the largest cash inflows that households receive in a year. A Consumer Proposal may allow you to keep your refund. The refund could be lost if it relates to the pre-filing period in a Bankruptcy.

Timing your filing, especially early versus late in the year, can have a meaningful impact on your finances if you are expecting a large refund. This makes it important to get professional advice before filing instead of assuming all tax refunds are treated the same.

Take the next step

While tax refunds are often overlooked in debt planning, they should be considered. Understanding how tax refunds are treated in each debt relief option can help you make a financially strategic decision, no matter whether you are considering a Consumer Proposal or Bankruptcy.

Meeting with a Licensed Insolvency Trustee can help you understand each option available, how these would affect your tax refund, and make an informed decision that works best for your specific situation. Together, we can help you achieve a debt-free future.