The Treatment Of Personal Income Taxes In A Personal Bankruptcy

The Procedure of Managing Personal Income Taxes During Personal Bankruptcy

Bankruptcy is a legally declared inability or impairment of the ability of an individual or organization to pay their creditors. In the case of personal bankruptcy, the management of personal income taxes could be quite complex. This article aims to elucidate the treatment of personal income taxes in a personal bankruptcy.

Dividing the Taxation Year

When an individual declares bankruptcy, the taxation year is bifurcated into two periods:

The period before bankruptcy (pre-bankruptcy period)

The period after bankruptcy (post-bankruptcy period)

 

The end of the taxation year for a bankrupt individual is the day prior to the bankruptcy date. A new taxation year commences on the bankruptcy date and ends on December 31 of that year.

For example, if bankruptcy is declared on April 3, 2023, the taxation year ends on April 2, 2023, and a new taxation year begins on April 3, 2023, and ends on December 31, 2023.

The Stand of the Canada Revenue Agency (CRA)

The CRA’s protocol for collecting personal income tax debt is quite linear. Once a Notice of Assessment or Reassessment is issued to the taxpayer, all assessed taxes that are determined to be owed should be paid in full, as per the Income Tax Act (ITA).

The pre-bankruptcy and post-bankruptcy periods play a crucial role in determining the dischargeability of the tax debt. A pre-bankruptcy tax debt can be discharged during bankruptcy, whereas a post-bankruptcy tax debt cannot. Despite the bankruptcy, the bankrupt person remains liable to the CRA for the payment of post-bankruptcy tax debt.

Handling Pre-Bankruptcy Personal Income Tax Return

According to section 22 of the Bankruptcy and Insolvency Act (BIA), the Licensed Insolvency Trustee (LIT) is not responsible for filing any return that the bankrupt was required to file more than a year prior to the calendar year or the fiscal year when the bankruptcy was declared.

However, if the year of bankruptcy is 2023, the LIT is obligated to file the 2018 tax return with the CRA. Despite the LIT’s responsibility to file the one-year prior-bankruptcy tax return, the bankrupt still has an obligation under the ITA to submit all outstanding tax returns.

If there is a prior-bankruptcy refund, the CRA can claim a set-off to the prior-bankruptcy refund in two scenarios:

 

  • There is one or more prior year tax liability owed to the CRA.
  • There is an enforcement maintenance registered with the CRA, such as a maintenance order by the Family Responsibility Office for child support.

 

In case there is no prior-bankruptcy tax liability or enforcement maintenance registered, the CRA will transfer the prior-bankruptcy refund to the LIT for the general benefit of the bankrupt’s creditors. If a tax liability arises from prior year(s) tax assessment(s), this tax liability is a claim provable in the bankruptcy and is dischargeable. Consequently, the bankrupt will not be liable to the CRA for payment of the prior-bankruptcy tax liability.

Despite section 22 of the BIA, if the LIT determines that significant refunds could be available for the bankruptcy estate, the LIT might decide to file all the outstanding prior year tax returns for which the bankrupt has not filed. This is done to secure any income tax refunds or GST/HST tax credits that might become available to the bankruptcy estate.

Dealing with Pre-Bankruptcy Personal Income Tax Return

For a bankruptcy declared in 2023, the LIT must file the 2023 pre-bankruptcy tax return with the CRA in the year 2020. Similar to the prior-bankruptcy situation, if there is a pre-bankruptcy refund, the CRA can claim a set-off to the refund in two cases:

 

  • Prior year(s) tax liability is owed to the CRA.
  • Enforcement maintenance is registered with the CRA.

 

If there is no prior-bankruptcy or pre-bankruptcy tax liability or enforcement maintenance registered, the CRA will send the pre-bankruptcy refund to the LIT for the general benefit of the bankrupt’s creditors. If a tax liability arises from the pre-bankruptcy return, this tax liability is a claim provable in the bankruptcy and is dischargeable. Consequently, the bankrupt will not be liable to the CRA for payment of the pre-bankruptcy tax liability.

Addressing Post-Bankruptcy Personal Income Tax Return

For a bankruptcy declared in 2023, the bankrupt must file the 2023 post-bankruptcy tax return with the CRA in the year 2024. Although the LIT is not obligated to file the post-bankruptcy tax return with the CRA, as a matter of practice, the LIT typically files the return on behalf of the bankrupt.

If there is a post-bankruptcy refund, the CRA can claim a set-off to the refund if there is enforcement maintenance registered with the CRA. If no post-bankruptcy tax liability or enforcement maintenance is recorded, the CRA will send the post-bankruptcy refund to the LIT for the general benefit of the bankrupt’s creditors.

If a tax liability arises from the post-bankruptcy tax return, this tax liability is not a claim by the bankruptcy estate. The CRA will send the Notice of Assessment or Reassessment to the bankrupt. The bankrupt will be held accountable to the CRA for payment of the post-bankruptcy tax liability.

High-Tax Debtor Status

Section 172.1 of the BIA caters to high-tax debtors. Its purpose is to ensure that bankrupt individuals with:

 

Personal income tax debt ≥ $200,000, and

Personal income tax debt representing 75 percent or more of the total unsecured proven claims

do not become eligible for an automatic discharge from bankruptcy.

 

The LIT will present the bankrupt’s application for discharge before the court for a hearing. The bankrupt will be required to attend the hearing. The types of discharge orders that the court may impose and the factors that the court will consider in deciding the bankrupt’s discharge application differ from that of bankruptcy where the bankrupt is not a high-tax debtor.

To avoid the necessity for a court hearing and the associated consequences, a high-tax debtor would be well advised to consider a proposal to the creditor under the BIA as opposed to an assignment in bankruptcy.

GST/HST payable is not included in the calculation of high-tax debtor. However, taxes on additional income arising from a shareholder loan, draw, or dividend are included in the calculation of high-tax debtor.

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