Bankruptcy: The End or the Beginning?

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Headed for bankruptcy? Find out what you need to know.

This article will be helpful to someone who is trying to deal honestly with overwhelming personal indebtedness and who has a genuine desire to make a fresh start financially.

Briefly noted are two of the changes to Canada’s Bankruptcy and Insolvency Act (BIA) applicable to individuals since July 7, 2008. The topics are:

a slightly more lenient handling of government student loans and
broader protection for registered retirement savings plans (RRSP). Both relate to a lifetime’s most laudable endeavours – getting an education and planning for retirement.

Briefly noted also are two of the changes to the BIA applicable to individuals as of September 18, 2009:

the automatic discharge from bankruptcy for individuals has been changed, and
an exception was created to deal with certain personal income tax debtors who become bankrupt.

These modifications are intended to prevent abuse of the bankruptcy law.

A fundamental purpose of the BIA and the personal bankruptcy process is the financial rehabilitation of the honest but unfortunate debtor.

Make a Proposal or Go Bankrupt

The BIA requires the debtor to be advised of the merits and consequences of the options available to resolve financial difficulties, including making a proposal to creditors, rather than voluntarily going into bankruptcy. This advising is the duty of a licensed trustee in bankruptcy.

The BIA enables a person (an insolvent debtor who is an individual) to make a formal proposal to his or her creditors to settle debts and avoid (the stigma of ) bankruptcy. Proposals under the BIA are either general or consumer. Since 1992, the streamlined process of a consumer proposal is available to a person where total debts do not exceed $250,000 (increased from $75,000 as of September 18, 2009) excluding mortgages against a principal residence. A successful proposal settles the debts on the terms set out in the proposal.

Bankruptcy involves a liquidation of the bankrupt’s available assets (if any) and distribution of the proceeds by the trustee of the bankrupt’s estate to the creditors. A discharge from bankruptcy releases the bankrupt from the unsecured debts existing when the bankruptcy began except for certain specified claims. A controversial exception since 1997 is that unpaid government student loans continue to exist after bankruptcy until paid or released by the bankruptcy court.

Bankruptcy and Government Student Loans

Unpaid loans under the Canada Student Loans Act, the Canada Student Financial Assistance Act, or similar provincial laws are problematic because of several economic, moral, and social factors. The subject is frustrating for students, governments, bankruptcy court, and our society.

A post-secondary (or other advanced) education is an appreciating asset attainable by capable students and, where necessary, by accessing affordable financing. Government-provided financial assistance is typically for lower-income students. It is unique financing because the most essential lending criterion is the financial need (not the future creditworthiness) of the student. The adage that the best borrower from a lender perspective is someone who does not need to borrow the money cannot be applied in the marketplace for government student loans.

The reality is that most college and university graduates do repay their student loans. Be that as it may, an alarming number of government student loans in Canada are not being repaid.

Before restricting most Crown claims in a bankruptcy to either the legislated deemed trusts or unsecured status since 1992, government student loans as Crown claims had preferred status (ranking ahead of unsecured creditors). The government student loan administrators routinely objected to a bankrupt’s discharge because any additional funds recovered were not shared with unsecured creditors. This did not solve the chronic problem of unpaid student loans.

In 1997, the BIA was changed to discourage going bankrupt to avoid repaying a student loan. Government student loans became one of the debts not released by a discharge from bankruptcy when the bankruptcy occurred while the debtor was a student or within two years (changed to 10 years in mid-1998) of ceasing to be a student. The bankrupt could be discharged from bankruptcy with the student loan still owing. Ten years after ceasing to be a student, the debtor could apply to the bankruptcy court seeking a release of the student loan debt. This is known as “the hardship provision.”

A government MP speaking in the House of Commons in May 1997 explained the rationale for making that change to the BIA: “Students who receive financial assistance from taxpayers owe it to society and to future generations of students to reimburse the loans they have received. At the same time, however, the governments and bankruptcy laws have to recognize that some students may find themselves in a hardship situation. This is reflected in the legislation by limiting the period during which student loan debt would be non-dischargeable.”

Since July 7, 2008, government student loans are excluded from the claims released by a discharge from bankruptcy when the bankruptcy occurred while the bankrupt was a student or within the seven years (reduced from 10 years) after the bankrupt ceased to be a student. This change applies to a bankrupt who was not yet discharged as of July 7, 2008 or a person who became bankrupt on or after July 7, 2008. The applicable federal or provincial student loan legislation determines when the person ceased to be a full-time or part-time student. The BIA also stipulates that five years after ceasing to be a student (reduced from 10 years), the bankrupt (or an already discharged bankrupt) may apply to the bankruptcy court requesting the restriction on the release of the student loan debt be removed. The bankrupt must show that he or she “has acted in good faith in connection with the bankrupt’s liabilities under the debt; and … has and will continue to experience financial difficulty to such an extent that the bankrupt will be unable to pay the debt.”

Some “good faith” indicators which a bankruptcy court may consider are:

was the money used for the purposes of the loan?
did the bankrupt complete the educational program?
was economic benefit derived from the education?
have reasonable efforts been made to repay the loan?
was the availability of interest relief and remission used to reduce the burden of the loan?
what was the timing of the bankruptcy?
was the student loan a significant portion of the bankrupt’s total indebtedness?

The bankruptcy court will respond favourably to the request for release from a government student loan debt when the answer to each of the first five questions is yes. The court will likely respond more negatively where the timing of the bankruptcy was to avoid the student loan debt and the student loan was a significant part of the bankrupt’s total indebtedness. The bankruptcy court cannot ignore or condone misuse of publicly funded student loans.

A non-government student loan is ordinarily released by a discharge from bankruptcy.

Bankruptcy and Registered Retirement Savings Plans

The registered retirement savings plan (RRSP) was conceived as a tax deferral device. It also encourages saving for retirement. The contributions, being property of the contributor, were available to his or her creditors, subject to any exemption found in provincial law. The property of the bankrupt available to creditors under the BIA specifically excludes property exempt from execution or seizure under law (federal or provincial) applicable in a province. By legislation, some pensions (and pension benefits) are exempt from the claims of employee’s creditors.

Employer-sponsored pensions for employees are diminished or non-existent. RRSPs are personally-sponsored defined contribution self-directed pension plans. A registered retirement income fund (RRIF) provides an income during a person’s retirement.

For many years, Alberta’s Insurance Act has protected from creditors annuity products of insurance companies that comply with the required designation of a specified family member as beneficiary. An annuity with an insurance element can qualify as an RRSP under federal income tax law. In Alberta, this discriminated among RRSPs being an exempt or non-exempt asset of a debtor based upon the supplier of the product. Effective October 1, 2009 under Alberta’s Civil Enforcement Act, contributions in an RRSP and in an RRIF, as those plans are defined in Canada’s Income Tax Act, are protected from creditors, but a payment out of a registered plan to a plan holder is not exempt. These provincial laws apply in a bankruptcy.

The BIA now also protects registered retirement savings from creditors. Effective July 7, 2008, contributions in an RRSP and in an RRIF, as those plans are defined in Canada’s Income Tax Act, are protected from the bankrupt’s creditors. Contributions made before July 7, 2008 are protected. There is presently no maximum amount limit. However, under the BIA, contributions made to RRSPs or RRIFs in the 12 months prior to bankruptcy are not protected.

The Alberta Insurance Act, where applicable, and the Alberta Civil Enforcement Act exempt all contributions in an RRSP and in an RRIF including any made in the 12-month period preceding a bankruptcy. A trustee in bankruptcy or creditors could challenge a large contribution made by an insolvent debtor.

The RRSP and RRIF exemption under the BIA is for persons who became bankrupt on or after July 7, 2008. The right to an exemption is determined as of the date of the bankruptcy.

Although an RRSP and an RRIF are exempt, the bankruptcy court may consider the amount of the RRSP or the RRIF in deciding what payments the bankrupt should make as a condition of discharge from bankruptcy.

Automatic Discharge from Bankruptcy

Prior to September 18, 2009, all first-time bankrupt individuals were eligible for an automatic discharge from bankruptcy after nine months in bankruptcy unless the trustee, a creditor, or the Superintendent of Bankruptcy gives notice of an opposition to the automatic discharge. Since September 18, 2009, except for the personal income tax debtors mentioned below, an automatic discharge may be available to first-time and second time bankrupt individuals. The timing of the automatic discharge depends on whether or not there is surplus income. Surplus income is the portion of a bankrupt individual’s total income that exceeds what is necessary for the bankrupt to maintain a reasonable standard of living based on the applicable standards set by the Superintendant and by the bankrupt’s trustee.

A first-time bankrupt individual, where there is no opposition and no surplus income payable to the trustee for the bankrupt’s estate, will be automatically discharged after nine months in bankruptcy.
A first-time bankrupt, where there is no opposition filed and with surplus income payable to the trustee, is only eligible for an automatic discharge after 21 months.
A second-time bankrupt, where there is no opposition filed and no surplus income payable, is only eligible for an automatic discharge after 24 months.
A second-time bankrupt, where there is no opposition filed and with surplus income payable, is only eligible for an automatic discharge after 36 months.

The obligation to pay surplus income to the trustee ceases when the bankrupt would have been automatically discharged from bankruptcy had the opposition not been filed. The new automatic discharge provisions only apply to personal bankruptcies that start on or after September 18, 2009. First-time and second-time bankrupts may apply to the bankruptcy court for an earlier discharge.

Personal Income Tax Debtors

There have been too many tax-driven personal bankruptcies. Some individuals have achieved the nefarious reputation of having had multiple personal income tax-driven bankruptcies. As of September 18, 2009, the BIA addresses the problem of chronic personal income tax debtors who go bankrupt solely or primarily to wipe out personal income tax debt.

A bankrupt with $200,000 or more of personal income tax debt representing 75% or more of the total unsecured proven claims against the bankrupt is not eligible for an automatic discharge from bankruptcy. “Personal income tax debt” means personal income tax payable under the Income Tax Act or similar tax payable under any provincial legislation including any interest, penalties, or fines. A personal income tax debtor who is a first-time bankrupt may apply to the bankruptcy court for a discharge after nine months in bankruptcy if the bankrupt has not had to pay any surplus income to the trustee. Otherwise the bankrupt must wait 21 months before seeking a discharge. Such a personal income tax debtor, who is a second-time bankrupt with no surplus income, is not eligible to apply for a discharge until 24 months after the date of the bankruptcy. A second-time bankrupt with surplus income payable to the trustee must wait 36 months before being eligible to apply for a discharge. All other personal income tax debtors who are more repetitive bankrupts must wait 36 months after the date of bankruptcy before being eligible to apply to the bankruptcy court for a discharge. The bankruptcy court can refuse the discharge, suspend the discharge, or grant a conditional discharge. An absolute discharge is not available to these personal income tax debtors.

Conclusion

Society embraces optimism and forgets pain. Historically (mid-1500s to present), changes to bankruptcy legislation when the economy was strong made the process more rigorous for debtors and changes made during an economic downturn were more lenient for rehabilitation of debtors.

Canada’s present bankruptcy law for government student loan debt is a work-in-progress. The personal bankruptcy playing field is more level for RRSPs and RRIFs going forward.

Bankruptcy must not operate as a clearinghouse for repeat bankrupts and excessive personal income tax debt. Protecting the integrity of the bankruptcy system is the top priority.

These topics and many more must be discussed thoroughly and candidly with a licenced trustee in bankruptcy when a person is contemplating the debtor relief provided for in the BIA.