How tax returns and tax debt are handled in Bankruptcy and Consumer Proposals

With tax season how upon us, you may be wondering how tax returns are filed in Bankruptcies and Proposals. Specifically, you may be wondering who is responsible for filing your return? And what happens with the resulting income tax refund or balance owing? 

Who files your tax return in a Bankruptcy?

In Bankruptcy, your Licensed Insolvency Trustee (LIT) is responsible for filing your personal income tax return for the Bankruptcy year. This return is somewhat unique in that the tax year is split between January 1 and the filing date of the Bankruptcy (the pre-Bankruptcy return), and the remainder of the year to December 31 (the post-Bankruptcy return). In some cases, your LIT may assist you in filing prior year returns that have not yet been filed.

What happens if I get a tax refund in Bankruptcy? How will my tax debt be handled?

If you are eligible to receive an income tax refund for the Bankruptcy year or any prior year, these funds are considered property of the Bankruptcy estate and the CRA will automatically remit these funds to the Trustee for the benefit of your unsecured creditors. This applies regardless of when, or if, you are discharged from Bankruptcy. This can also include refunds from amending tax returns retroactively to claim the disability tax credit.

Conversely, if you have an income tax liability up to the filing date of Bankruptcy, including on the pre-Bankruptcy return as noted above, this debt can be extinguished (with some exceptions noted below). However, this only occurs if you complete the duties required in your Bankruptcy and obtain your discharge.

Any tax debt assessed by the CRA on the post-Bankruptcy return or future years must be paid and cannot be included in your Bankruptcy.

Who files my tax return in a Consumer Proposal? What happens if I get a refund?

In a Consumer Proposal, you are responsible for filing your own tax return(s) and any refund you are eligible to receive will be remitted directly to you by the CRA. Keep in mind that, while you may be eligible to receive a refund for the year the Proposal is filed, some or all of the refund can be withheld by the CRA and offset against any pre-existing government liabilities — like prior year income tax, defaulted student loans, or overpayments of benefits such as employment insurance, social assistance, or GST.

If the CRA withholds your refund, the tax return for the Proposal year would typically be prorated so that only the portion of refund attributed to the period January 1 to the Proposal filing date would be subject to the right offset. You would remain eligible to receive the assessed refund for the remainder of the year.

How will my tax debt be handled in a Proposal?

Like with Bankruptcy, income tax debt incurred up to the filing date of a Proposal can be included in the proceeding. When the Proposal is filed, the administrator may prepare and file a provisional income tax return. This serves to provide the CRA with an estimate of tax liability (or refund) for the period January 1 to the filing date of the Proposal.

What additional considerations do I need to understand?

More broadly, it’s a common misconception that personal income tax debt cannot be extinguished in a Bankruptcy or Proposal. In most instances, tax-related liabilities (including GST and RST) are treated no differently than credit card debt or any other form of unsecured debt. 

When a Bankruptcy or Proposal is filed, a stay of proceedings is established that provides you with protection from creditors. This stops collection calls, wage garnishments, and other similar measures. When the Bankruptcy or Proposal is completed, most tax-related debts are extinguished along with the general body of other unsecured liabilities.

When does tax debt require special consideration?

Dealing with income tax debt can involve some unique considerations including the following:

• If you have personal income tax debt exceeding $200,000 and it represents 75 percent or more of your total unsecured debt, your LIT cannot grant you an automatic discharge — even though you may have completed all duties required in your Bankruptcy. In cases like this, your application for discharge must be heard by the court and may be subject to certain conditions (usually monetary) and/or a period of suspension. The amount to be repaid, if any, is at the discretion of the court and several factors may be considered including LIT and creditor recommendations, your current financial situation, circumstances under which the debt was incurred, and whether you have previously acted in good faith.

The larger the personal income tax debt, the greater likelihood a monetary condition may be imposed and by extension the greater the amount to be paid.

• In cases where your personal income tax debt exceeds the $200,000 and 75 percent thresholds, the CRA may oppose the discharge and appear in court to advocate for certain conditions to be imposed upon discharge. Often, a monetary condition would be sought, but if an individual’s conduct is considered unacceptably, the court may suspend or outright refuse to grant an order of discharge. However, it’s rare for the court to outright refuse to an order of discharge.

• In Proposals involving substantial income tax debt and a history of late filings, the CRA may not even accept it unless it includes a compliance clause. This clause stipulates that future tax returns and related liabilities will be filed and paid on or before the deadlines set out in the Income Tax Act. This would only apply for the period in which the Proposal is ongoing.

Why timing matters

Time is of the essence when you’re dealing with tax-related liabilities, whether it be personal income tax, GST or HST, RST, or source deductions. For instance, if you own property and the CRA or a provincial taxation authority registers a judgment on the title before the date of Bankruptcy or a Proposal filing, this judgment remains enforceable and maintains its secured status after the filing date of the proceeding.

This is a powerful collection tool that’s not available to other creditors. If you find yourself in this position and have significant tax debt, your LIT should be consulted immediately. Taking action through a Bankruptcy or Proposal before a judgment is registered on title can be critical, as it may determine whether the tax debt is treated as unsecured and extinguished, or secured and able to survive the proceeding.

Your next steps

Our team of LITs are here to help you avoid any misconceptions about how your income tax debt may be resolved. Want to avoid possible garnishment of wages, bank account freezes, or registration of a judgment on your property? We can answer your questions and help you regain control of your finances.

Reach out today for a free, confidential consultation.