BANKRUPTCY

Summary:

A tax clinic does not prepare tax returns for the year in which a client declares bankruptcy, nor for the preceding year.

While a clinic could prepare returns for other prior years, this generally provides no advantage to a client. Any tax refund or benefit to which the client was entitled, up to the end of the year of bankruptcy, would be paid to the bankruptcy trustee for the benefit of creditors—even if the client has already been discharged. Unless all creditors were fully repaid during the bankruptcy process, the client will not receive any refund or benefit.

A clinic could prepare returns for years following the year of bankruptcy. However, if a client has not yet been discharged, returns cannot be filed efiled. Attempts will result in an error.

Making an assignment into bankruptcy:

An individual in debt may make an “assignment” into bankruptcy.^[1] In doing so, the debtor is deemed to transfer title and control over certain property to a trustee, for the benefit of creditors. The trustee uses the assigned property to satisfy creditor claims. The assignment begins once the prescribed form is filed with the Official Receiver. The trustee will notify the Canada Revenue Agency (CRA) of the assignment by submitting form DC905, Bankruptcy Identification Form.

The trustee is deemed to act as the agent of the bankrupt for purposes of the Income Tax Act.^[2] Despite the terminology, the bankrupt’s estate is not considered a true “trust” or “estate” under the ITA.

Not all assets are assigned to the trustee. In Ontario, exempt property includes:

• CPP, RRSP, RRIF, LIRA, OAS, pension plans
• A principal residence if jointly owned with a spouse
• Tools of the trade
• Most personal items, furnishings, appliances, and medical devices
• One vehicle

Some limits and exceptions apply to exempt assets, but a detailed explanation is beyond the scope of this document. Note that Tax-Free Savings Accounts (TFSAs) are not exempt.

Discharge:

An individual is automatically discharged from bankruptcy nine months after the date of assignment, unless:

• a creditor files an opposition to the discharge, or
• the individual is required to make payments under section 68 of the BIA.

A discharge releases the individual from most debts. The trustee must provide notice of discharge at least 15 days beforehand to the Superintendent, the individual, and the creditors. A trustee may also oppose a discharge.

For most low-income, low-asset individuals, discharge occurs after nine months.

Filing of tax returns:

When an individual makes an assignment into bankruptcy, the tax year is divided into two periods:

• Pre-bankruptcy period: January 1 to the day before the assignment date.
• Post-bankruptcy period: The date of assignment to December 31 of that year.

For example, if the assignment occurs on June 1, 2024, the pre-bankruptcy period runs from January 1 to May 31, and the post-bankruptcy period runs from June 1 to December 31. Together, these periods form the “year of bankruptcy.”

The trustee will generally file up to four returns on behalf of the bankrupt individual:

1. The return for the year prior to the bankruptcy year (if not already filed).
2. A pre-bankruptcy return covering the pre-bankruptcy period.
3. An in-bankruptcy return reporting taxable income from the sale or liquidation of assets for the benefit of creditors.
4. A post-bankruptcy return covering the post-bankruptcy period.

A tax clinic does not file any of these returns.

For tax years following the year of bankruptcy, the individual is responsible for filing their own returns. A tax clinic may assist with these filings, but if the client has not yet been discharged, e-filing is not possible.

Entitlement to tax refunds:

Unpaid refunds arising out of tax assessments for the year of bankruptcy and all prior years are assigned to the trustee to pay creditors. Similarly, any unpaid benefits due in the year of bankruptcy and earlier will are assigned to the trustee. The CRA will send these amounts to the trustee, even if a return is filed after the date of discharge.

Refunds arising out of tax assessments for years subsequent to the year of bankruptcy will be issued to the taxpayer, including refunds payable prior to the date of discharge, unless there is a court order directing the payments to be made to the trustee. Similarly, benefits due after the year of bankruptcy will be paid to the taxpayer unless a court order directs otherwise.

Debt discharged by bankruptcy:

Bankruptcy eliminates many debts incurred prior to the assignment, including CRA tax debt, Covid debt, credit card balances, and student loans (provided the individual ceased to be a student more than seven years before filing).

Certain debts are not discharged through bankruptcy, such as:

• Child and spousal support obligations
• Debts arising from fraud
• Student loan debt if less than seven years have passed since the individual ceased being a student

Filing returns for years prior to the year of bankruptcy:

A trustee is only required to file a return for the year immediately preceding the bankruptcy year.^[3] For example, if the assignment occurs in 2024, the trustee must file a return for 2023 but has no obligation to file for earlier years.

The trustee may, however, choose to file returns for earlier years if it appears the bankrupt is entitled to refunds or benefits. In such cases, the refunds and benefits are paid to the trustee for the benefit of creditors. Trustees are obligated to act in the best interests of creditors, which includes maximizing available assets.

If a taxpayer files for prior years after being discharged, the CRA will still send any refunds to the trustee rather than the taxpayer.^[4] 

If a person is planning to declare bankruptcy, there is no benefit to holding off on filing tax returns for past years. The person cannot hope to file returns after discharge for past years, and receive refunds or benefits for those past years.

Example:

After meeting with a Licensed Insolvency Trustee, an individual makes an assignment into bankruptcy on July 10, 2021. They last filed a tax return for 2019. They owe a debt to the CRA.

• The CRA debt is extinguished (or “discharged”).
• The Trustee files a 2020 income tax return.

• If the taxpayer owes tax, this debt will also be extinguished.
• If the taxpayer is owed a refund, it is paid to the trustee for the benefit of creditors.

• The Trustee files a 2021 pre-bankruptcy tax return covering January 1 to July 9, 2021.

• If the taxpayer owes tax, this debt will also be extinguished.
• If the taxpayer is owed a refund, it is paid to the trustee for the benefit of creditors.

• The Trustee files a 2021 post-bankruptcy tax return covering July 10 to December 31, 2021.

• If the taxpayer owes tax, the debt is not extinguished.
• If the taxpayer is owed a refund, it is paid to the trustee for the benefit of creditors.

• Automatic discharge was on July 10, 2022 (9 months after assignment). The individual files a 2022 tax return.

• If the taxpayer owes tax, it is not extinguished.
• If the taxpayer is owed a refund, the CRA will pay it directly to the taxpayer but the CRA may pay it to the trustee if the taxpayer has not complied with bankruptcy obligations.

Consumer Proposals:

Instead of declaring bankruptcy, an individual may choose to file a consumer proposal. Once a proposal is filed, all creditor collection actions are suspended. The proposal is essentially a settlement offer to creditors, allowing the debtor to reduce the total amount owed or to extend repayment over a period of up to five years, based on their financial capacity.

Unlike bankruptcy, a consumer proposal allows the debtor to keep their assets. Payments are made through a licensed insolvency trustee, and once all required payments are completed, the debtor receives a certificate of full performance, releasing them from the included debts.

The Income Tax Act does not contain any special provisions for filing tax returns in the context of a consumer proposal.

References:

• Bankruptcy and Insolvency Act, s.49 (Assignments) and s.66.11 (Consumer Proposals)
• Income Tax Act, s.128(2)
• Canada website - Considering Bankruptcy
• WoodGreen Debt Management Guide: A Resource for Social Services Professionals (2012 partially out-of-date, but useful)
• Globe and Mail article suggesting bankruptcy may be preferable to consumer proposal.