CRA Entitled To Priority Over Subcontractors To Trust Funds In Owner’s Hands

The Manitoba Court of Queen’s Bench recently held that the Canadian Revenue Agency (CRA) has priority over subcontractors and the bonding company in respect of holdback funds held by the owner in trust for the contractor. The decision in Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., once again underlines the impact of federal legislation on the holdback and trust fund sections of construction and builders’ lien legislation.

This decision raises questions about the scope of the subrogation rights of a bonding company under a labour and materials payment bond, and public policy issues about lien statutes being used for the purpose of collecting taxes.

Background

The Manitoba Housing and Renewal Corporation (MHRC) was the owner on a project In Brandon, Manitoba and Falcon Creek was the general contractor. The bonding company issued performance and labour and materials payment bonds in respect of Falcon Creek’s obligations under the general contract and the subcontracts. MHRC held back 7.5% of the amounts payable to Falcon Creek as mandated by the Manitoba Builders’ Lien Act (BLA). Unpaid subcontractors, and the bonding company which had paid over $600,000 to other lien claimants/subcontractors under the payment bond, asserted that they were entitled to the holdback funds under the payment bond and the BLA.

The Canadian Revenue Agency (CRA) asserted that it was entitled to the funds under s. 224(1.2) of the Income Tax Act of Canada (ITA). That section effectively provides that, once the section is triggered by the CRA, monies owing to a person who is liable to pay an assessment under the ITA (in this case, Falcon Creek) become the property of the CRA in priority to any other interest.

The bonding company and subcontractors asserted that MHRC had the legal right or privilege to pay the trust funds to the subcontractors holding liens, rather than to Falcon Creek. The bonding company asserted that, pursuant to the payment bond and the subrogation principles of the law of guarantee, it entitled to be recompensed out of the holdback funds for the monies it had paid to subcontractors. They argued that MHRC was not obliged to pay Falcon Creek and was entitled to pay the holdback funds to the subcontractors. Accordingly, MHRC was not “liable” to the contractor, Falcon Creek, in respect of those funds and therefore section 224(1.2) of the ITA did not apply.

Decision of the Manitoba Court of Queen’s Bench

The judge of the Manitoba Court of Queen’s Bench held that nothing in the arrangements between the owner, general contractor and bonding company could or did displace the effect of section 224 of the ITA. The court held:

“I am satisfied that the conclusion that the contract and Bond do not create an obligation on the part of MHRC to pay subcontractors is applicable to the case before me. That is, the private arrangements between MHRC, Falcon Creek and Guarantee Company cannot affect the rights of the Crown under s. 224(1.2). The Crown acquired those rights by operation of law and the issuance of a Requirement to Pay; its rights too cannot be displaced by private arrangements….. There are important policy considerations involved in the collection of withholding tax and source deductions. The Income Tax Act entrusts employers with the duty of deducting income tax from the wages of employees and remitting it on their behalf. Employers’ withholding tax or source deductions is at the heart of the collection procedures for personal income taxation in Canada…. Private arrangements between MHRC, Falcon Creek and Guarantee Company cannot interfere with this. (underlining added)

So far as the submissions of the bonding company and subcontractors relating to subrogation and assignment, the Manitoba court held that, while MHRC may have had the right or privilege to pay subcontractors, MHRC had no obligation to do so, and therefore the bonding company or subcontractors did not obtain, by subrogation or assignment, any rights of MHRC to pay the subcontractors. Accordingly, the bonding company and the subcontractors could not interfere with MJRC’s entitlement to pay the monies in it hands to the CRA.   In this respect, the Manitoba court appears to have differentiated between a performance bond, in which a subrogation right might arise compelling the owner to pay the subcontractors and bonding company, and a payment bond, in which case the court says no such subrogation rights arise.

The Manitoba court also rejected the argument that the subcontractors had a right to sue on the general contract as third party beneficiaries of that contract. There was no evidence that MHRC intended to extend the ability to sue on the contract to unpaid subcontractors. In addition, the third-party beneficiary exception to privity of contract is only a shield and not a sword.

In arriving at these conclusion the Manitoba court relied upon the decision of the Alberta Court of Appeal in Iona Contractors Ltd. (Receiver of) v. Guarantee Co. of North America, 2015 ABCA 240, 19 Alta. L.R. (6th) 87 (Alta. C.A.), leave denied (2016), [2015] S.C.C.A. No. 404 (S.C.C.)). In that case, the contest was between a bonding company and the contractor’s trustee in bankruptcy pursuant to the Bankruptcy and Insolvency Act.

Discussion

At one level, this decision raises an important issue about subrogation. The court has held that while the bonding company may be subrogated to the position of the owner under a payment bond, it does not acquire any rights to compel payment of the holdback to the subcontractors rather than the contractor. In this respect, the court appears to differentiate between a performance bond – which might permit the bonding company to compel such payment – and a payment bond – which apparently does not. The court also appears to differentiate between the exercise of subrogation rights in relation to a contractual obligation – in this case payment to the contractor – and the exercise of subrogation rights in relation to a contractual or statutory right or privilege – in this case, the owner’s right to pay the subcontractors.

The right of the owner to pay a liening subcontractor directly is so important that it is enshrined in section 30 of the Manitoba Act, as it is in other provincial lien statutes. Courts have previously recognized that a right – such as the right to settle a claim, or to complete the building – falls within the ambit of subrogation. Indeed, the failure by the obligee to properly exercise its rights and privileges may discharge the bonding company from its obligations under the bond. Yet, in this case, the court seems to say that the subrogation rights of the bonding company under a payment bond do not include the right to be subrogated to the right or privilege of the owner to pay the subcontractors.

It is to be hoped that this issue is addressed by an appellate court. There seems to be no dispute in the decision that, generally speaking, a bonding company is subrogated to the obligee’s right’s (that is, the owner MHRC’s rights) under the building contract (with Falcon Creek in this case). That seems to be black letter law. The Manitoba court did not provide a good rationale as to why those subrogation rights would not include all the rights of the owner, including the right to pay the subcontractors directly, and why subrogation should not apply to that right under a payment bond as well as a performance bond. If the efficacy of the holdback system under the builders’ and construction lien statutes is to be maintained, if the statutory right of the owner to pay subcontractors is to be fully recognized, and if bonding companies are to be encouraged to issue bonds on the basis that they are fully subrogated to the rights of the obligee, then there seem to be good arguments in favour of a bonding company being allowed to exercise the owner’s right to pay the subcontractors, or the bonding company itself if it has paid subcontractors.

At a second level, this decision raises issues of fairness about the purposes of the respective statutes, and in particular the purpose behind builders’ and construction lien statutes.

The purpose behind the holdback and trust fund provisions of those statues is to require the owner (and others down the pyramid scheme) to withhold monies for the purpose of having them paid to the subcontractors and suppliers who are not paid by the contractor. Without those holdback and trust fund provisions of the lien statutes, the owner (and others down the payment chain) would go ahead and pay the contractor. In effect, this case means that the whole scheme of the builders’ and construction lien statues can be used as a tax collection scheme. The tax authorities can wait until the end of the project and scoop up the holdback, a holdback which would not have been there except for the builders’ and construction lien regime.

While the Manitoba judge emphasized the public purpose behind tax statutes, it is arguable that the purpose behind the builders’ and construction lien statutes deserves at least as high a recognition. The taking of the holdback moneys for tax purposes removes those moneys from the payment chain that produced them in the first place through the construction of the building, and takes them from the payment chain that caused them to be preserved. It is only because the builders’ and construction lien statute mandates the holdback that those monies are there in the first place. The taking of those monies for tax purposes impairs the very structure of the lien statutes. Compared to the tax department, contractors and suppliers have few, if any, means to protect themselves from the failure of contractors to pay their taxes. Should the subcontractors suffer when a contractor doesn’t pay its taxes? And will bonding companies provide bonds to the construction industry at the same cost if those bonds can be undermined by the tax authorities? Some might argue that this example of the government preferring itself over the ”little guy” shows why there is angst among some citizens across the western world, who see governments as more the problem than the solution for small businesses.

This decision did not consider the succession-of trust-funds and “no leak” principles in the BLA. The Manitoba Act, like the lien statues in Saskatchewan, Ontario and Nova Scotia starts the trust fund obligation at the owner’s level, and the beneficiary of the trust fund at that level is the contractor which has contracted with the owner. In other provinces, the trust fund starts at the contractor level. In all these provinces, the trust fund provisions apply at the contractor level and below. So in Manitoba, the owner holds the funds payable to the contractor in trust for the contractor, and once the contractor receives the funds, the contractor then holds those monies in trust for the unpaid subcontractors. What is the purpose of the trust fund at the owner’s level? Surely, to ensure that those funds are passed down to the trust fund at the next lower lever, the contractor level. There is no other reason for the trust fund provision at the owner level. It is not to allow the contractor or another person or authority to come in and scoop the funds. The holdback and trust fund provisions do not envision any leakage in the payment scheme.

In the present case and those which it followed, the courts do not apply the second part of the “no-leak” principle, namely, that the monies paid by the owner to the contractor are held in trust by the contractor for the subcontractors.

In this circumstance, the wording in section 224. (1.2) of the ITA may require some re-visiting. That section applies if the recipient of the CRA’s notice is “liable to make a payment …(a) to another person…” In the present case, the Manitoba judge held that MHRC was liable to make a payment to Falcon Creek, so the section applied. But if “another person”, like Falcon Creek, is obliged to hold those funds in trust for others, the subcontractors, can the ITA interfere with the application of trust principles, and has it done so clearly? The Manitoba court has effectively answered Yes to this question, but it deserves consideration at the appellate level.

The drafters of the provincial lien statutes may wish to consider amendments that will address this situation. One way may be to provide that the subcontractors and other person improving the lands are beneficiaries of the trust at the owner level, and similarly at the contractor level, that sub-subcontractors and other persons improving the lands are beneficiaries of the trust at that level. This is what the New Brunswick statute states at the contractor level and below. However, most provinces have amended their lien statues to limit the trust fund obligation to the next lowest level (that is, to the contractor in the case of trust funds held by the owner) and may be unwilling to re-open the scope of the trust fund obligation.

Lastly, while the Manitoba court did appear to hold that the ITA applies no matter what the bonding contract says, the judge did go on to consider the contractual environment, as did the Alberta courts in the Iona case. That being so, it may be that creative drafters of guarantee bonds will go back to the drafting table. If the contracts can change this result, there appear to be several elements to be addressed.

First, the bonding company may have to ensure that the owner is party to the bond, which will normally be the case for a payment or performance bond at the contractor level.

Second, the bond may have to expressly state that the bonding company is subrogated to the owner’s rights and privileges, including the right to pay subcontractors and suppliers (or the bonding company after it pays the subcontractors or suppliers) , and that those rights of the bonding company become effective at some point before the CRA delivers its notice to the owner, perhaps at the time that the first lien arises although not exercisable until, and to the extent that, the bonding company pays the subcontractors or suppliers.

Third, the bond may have to ensure that the holdback monies are beneficially owned by the bonding company once, and to the extent that, it pays subcontractors and suppliers.

Whether provisions such as these could properly be included in a bond and would be effective against the ITA or in light of the builder’s or construction lien statutes, time, future case law and creative drafting may tell.

See Heintzman and Goldsmith on Canadian Building Contracts, 5th ed., chapter 16, part 6(i).

Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., 2017 CarswellMan 56, 2017 MBQB 27

Builders’ and construction liens – holdback – trust fund – bonds- income tax

Thomas G. Heintzman O.C., Q.C., LLD (Hon.), FCIArb                 February 19, 2017

www.heintzmanadr.com

www.constructionlawcanada.caom

This article contains Mr. Heintzman’s personal views and does not constitute legal advice. For legal advice, legal counsel should be consulted.

 

 

Does Posting A Lien Bond Eliminate A Contractor’s Trust Fund Obligations?

When a contractor posts a bond to secure the construction builder’s lien claim of its subcontractor and the subcontractor discharges its lien, does the contractor continue to have any trust fund responsibilities to the subcontractor? Must the contractor continue to pay to the subcontractor the money it receives from the owner, particularly money received from the owner relating to the work done by the subcontractor?

The Manitoba Court of Appeal recently answered Yes to both these question in Stuart Olson Dominion Construction Ltd. v. Structal Heavy Steel. The court held that the filing of the lien bond does not impair the trust fund rights and obligations under the Manitoba Builders’ Liens Act.

Background

Dominion was the general contractor and Structal was the structural steel subcontractor on a construction project. Structal asserted an $8 million delay claim against Dominion. It filed a builder’s lien in the amount of about $15 million which, beside the delay claim, included about $3.5 million in unpaid invoices and about $3.3 million in statutory holds.

Dominion filed a lien bond for the full $15 million. Structal then discharged its builder’s lien but it continued to assert that it was entitled to be paid for the work it had done.  Sructal’s work was entirely completed and there were no lien claims arising from Structral’s sub-contractors’ work.

Structal had not been paid all the progress payments or the statutory holdback and both amounts were being held by the owner. Structal sought payment of that money. Dominion asserted that it was entitled to that money from the owner and applied to the court for an order declaring that the filing of the lien bond satisfied its trust obligations to Structal and that, upon the receipt from owner of the outstanding progress payments on account of Structal’s work, Dominion could pay those funds to other creditors. Structal opposed Dominion’s application and brought its own motion for an order requiring Dominion to pay Structal all of that money.

The motion judge held that the filing of the lien bond by Dominion satisfied its trust obligations to Structal and that, upon receipt of the progress payments from the owner, Dominion was entitled to pay them to other creditors without being in breach of the trust provisions of the Act.  I dealt with that decision in my article on August 26, 2013.

Manitoba Court of Appeal’s decision

The Court of Appeal reversed the decision of the motion judge. The court held that the lien rights and the trust fund rights of contractors and subcontractor are entirely separate. The mere fact that the contractor had chosen to post a bond for the lien rights did not affect the subcontractor’s trust fund rights.

The court pointed out that it was the contractor, not the unpaid subcontractor, which decided to file a lien bond. The lien bond did not secure the claim any more than did the land. The court noted that the claim must still be proved before steps may be taken by the claimant to realize upon the underlying asset. In these circumstances, the contractor’s decision to file the lien bond could not, in the court’s judgment, affect the subcontractor’s trust fund rights.

In addition, the lien bond was no more than a substitute for the lien on the land, and just as placing a lien on the land does not remove or impair the trust fund rights of the subcontractor, nor does the lien bond. As the court said:

“In my view, it would be unheard of for a contractor to say to a subcontractor that, because he had filed a lien claim, the contractor was no longer obligated to comply with the trust obligations under the Act. Indeed, it is almost inevitably the case that lien claims are advanced because of late payment and a concern as to the possibility of non-payment. It is difficult to understand how, in such a circumstance, a subcontractor, by reason of filing a lien claim, should then be deprived of the benefits of the trust provisions of the Act. And, if that is so with respect to the lien claim filed against the land, it must be so with respect to a lien bond which, as the Act clearly provides, stands in the place of the land.”

Discussion

The Manitoba Court of Appeal’s decision preserves the funnel payment system in the Act. If a contractor could, by filing a lien bond, divert monies from the owner out of that system – and monies payable by the owner for the very work done by the unpaid subcontractor – then a leak in that funnel would arise.  If there are adjustments to be made when the owner pays further trust funds to the contractor, then the adjustment can be made to the amount of the lien bond, if necessary.

As I noted in my article of August 26, 2013, there are two aspects of the lien bond and trust fund sections of the construction/builders’ lien legislation that are noteworthy.

First, the provincial lien statutes are different.

In Manitoba, sub-section 5(3) allows the owner to retain or use trust funds if the contractor has been paid and “provision for the payment of other affected beneficiaries of the trust fund has been made.” The words “provision for payment” also appears in sub-sections 4(3) and 4(4) with respect to the trust fund obligations of contractors and subcontractors.  In each case the contractor’s and subcontractor’s obligation to ensure that provision is made for payment of other affected beneficiaries is in addition to the primary obligation to ensure that the next contractor or subcontractor down the chain is paid.  These words seem to contemplate that, as long as the next contractor is paid and if a lien bond is in place to look after other claimants, then the owner, contractor or subcontractor can make payments from trust funds. However, the obligation to see that the next subcontractor in the chain is paid is paramount and that obligation supports the Court of Appeal’s decision that Dominion (the contractor) was not entitled to the trust funds until Structal (the subcontractor) was paid.

In contrast, sub-sections 7(4), 8(2) and 9(2) of the Ontario Act simply state that the trust is in place until the contractors or subcontractors “are paid.” There is no reference to additional protection for other affected beneficiaries. In the Ontario Act, specific provision is made in section 12 for set-off by a trustee such as an owner, but not in respect of the amount of holdback. The Ontario Act seems to clearly recognize that, until the subcontractor is paid, the subcontractor’s trust fund rights are not impaired by the other provisions of the Act.

The Manitoba Court of Appeal has upheld the primary obligation in the trust fund sections- to use the trust funds to pay the next person in the payment chain. The court has effectively held that the extra protection in the trust fund sections of the Manitoba Act –namely, that the owner (or other person with the trust fund obligation) must also protect other affected beneficiaries – does not allow the lien and lien bond provisions of the Act to diminish the primary trust fund obligation. Accordingly, that decision appears to be applicable to other provincial lien statutes like Ontario’s which contain only the primary obligation and do not contain the extra protection.

Second, none of these statutes makes a direct and explicit connection between lien rights and lien bonds, and trust fund rights.  For example, no specific provision for setoff is made in the trust fund sections of the Manitoba Act. None of the courts in the Stuart Olson v Structal case commented on this disconnect but perhaps the Court of Appeal did so by inference. It held that the lien rights are entirely separate from the trust fund rights. For this reason, no connection is necessary.

See Heintzman and Goldsmith on Canadian Building Contracts, 4th ed. Chapter 11, parts 4(m) and 6.

Stuart Olson Dominion Construction Ltd. v. Structal Heavy Steel 2014 MBCA 8

Construction and builders’ liens – lien bond – security for lien claims – trust funds

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                                                 March 8, 2014

www.heintzmanadr.com

www.constructionlawcanada.com

 

 

Does A Construction Lien Bond Satisfy A Trust Fund Claim?

There are several different remedies provided in construction and builders lien legislation that do not necessarily fit together well. Two remedies available to a subcontractor are the lien claim against the land and the trust fund claim against funds received or receivable by a contractor.

In the case of a lien claim, the payment of money into court or the provision of a bond discharges the lien against the land. But does it discharge the trust fund claim?  If it doesn’t, does that mean that a subcontractor can pursue a trust fund claim, so that it gets paid through that remedy while at the same time the monies remain in court or the lien bond remains in place? And if the subcontractor can do that, how does that affect the contractor’s counterclaim and set off for delay? Through its trust fund claim can the subcontractor force the owner to pay the full amount of the subcontractor’s claim before the trial of the contractor’s delay claim?

These were the issues addressed in the recent decision of the Manitoba Court of Queen’s Bench in Stuart Olson Dominion Construction Ltd. v. Structal Heavy Steel.

The Background

In December 2010 Stuart Olson entered into a contract with the owner BB Stadium Inc. for the construction of a new stadium in Winnipeg.  In April 2011, Stuart Olson entered into a subcontract with Structal for the structural steel and other facilities.  The deadlines in the subcontract were not met and the opening of the stadium was delayed for a year.

Claims and counterclaims were asserted between Stuart Olson and Structal.  Structal claimed over $8 million due to work scope changes and other factors. Stuart Olson asserted a delay claim against Structal in an amount over $9 million.

In September 2012, Structal demanded payment from Stuart Olson for its outstanding invoices in the amount of about $4.2 million.  Structal also asserted that the monies due to Stuart Olson from the owner were impressed with a trust fund claim in Stuructal’s favour and that Stuart Olson must use those monies to pay subcontractors and not itself.  Structal also filed a  lien against the land in the amount of about $15 million.

In October, 2012, Stuart Olson obtained a lien bond, approved by Structal, for the full amount of the lien on payment of a premium of $159,003.07 per year, and Structal discharged its lien against the land.

Structal continued to demand that Stuart Olson pay its outstanding invoices and claimed that the monies receivable by Stuart Olson from the owner were impressed with a trust in Structal’s favour.  Stuart Olson continued to maintain that it had a set-off against any claim asserted by Structal and maintained that Structal’s claim, whether in a trust fund form or otherwise, was fully secured by the lien bond that had been filed.

Structal then asked the owner to withhold funds from Stuart Olson failing which it would sue the owner under the trust provisions of the Manitoba Builders’ Liens Act. (the “Act”).   In response, Stuart Olson commenced an application to determine the legal position.

In the meantime, Stuart Olson commenced an action against Structal asserting its delay claim.

A certificate of substantial completion had been issued relating to the subcontract with Structal.  There were no lien or trust fund claimants other than Structal. There are no deficiencies in the work done by Structal and the owner was ready to make the remaining payment to Stuart Olson which had not paid because of Structal’s threat.  The real and remaining issue was the delay claim by Stuart Olson against Structal which would be dealt with in the separate action.

The Decision

The application judge held that the posting of the lien bond exhausted the contractor’s trust fund obligations in the particular circumstances of this case.

First, the judge held that prior judicial authority in Manitoba supported the principle that the filing of a lien bond discharges any trust fund obligations of the contractor.

Second, he held that prior judicial authority also supported the proposition that a set-off could apply to, and reduce, a trust fund claim.

Third, he held that it would be unfair to determine, at this stage, whether Stuart Olsson had or didn’t have a right of set-off. So the present issue could not be decided on the basis that Stuart Olson had no rights of set-off. It would not be fair to order payment of the trust funds to Sturctal in the presence of the delay claim by Stuart Olson.

In all the circumstances, the judge held that the filing of the lien bond by Stuart Olson satisfied its trust fund obligations and that upon receipt of the progress payments from the owner, Stuart Olson could disburse those funds without being in breach of the trust fund obligations under the Act.

Discussion

Assuming that the contractor, Stuart Olson, was financially capable of paying the future lien bond premiums, this decision makes eminent business sense. But it does raise some practical concerns. What if Stuart Olson could not or did not pay the future premiums? Would the bond have remained in place? What protection for the subcontractor would there have been in this eventuality?

What if other subcontractors had liens or trust fund claims? In some provinces, a lienholder must share with other lienholders the amount of a lien bond posted to satisfy its lien.  In these circumstances, a lien bond may be an uncertain source of funds for a trust fund claim.  And why shouldn’t the remaining payments by the owner be paid into court, with the amount of the lien bond being reduced accordingly? Wouldn’t that be a better way of resolving the conflict between the purpose of a lien and the purpose of a trust fund claim?  Since the contractor had no other subcontractors or suppliers to pay, the real question was: whose litigation claim should be financed through the lien bond: the contractor’s delay claim or the subcontractor’s claim to payment under the subcontract? An argument could be made that the purpose of the Act is to give priority to the subcontractor’s claim for payment. If that is so, then that result could be achieved by paying the remaining monies due by the owner into court and reducing the amount of the lien bond.

The present decision highlights the different wording in the different provincial lien statutes. In Manitoba, sub-section 5(3) allows the owner to retain trust funds if “provision for the payment of other affected beneficiaries of the trust fund has been made.” The words “provision for payment” also appears in sub-sections 4(3) and 4(4) with respect to the trust fund obligations of contractors and subcontractors.  These words seem to contemplate a lien bond and may envisage that if a lien bond is in place then the owner, contractor or subcontractor can make payments from trust funds. In contrast, sub-sections 7(4), 8(2) and 9(2) of the Ontario Act state that the trust is in place until the contractors or subcontractors “are paid.”  In the Ontario Act, specific provision is made in section 12 for set-off by a trustee such as an owner, but not in respect of the amount of holdback.   No specific provision for setoff is made in the trust fund sections of the Manitoba Act. The judge did not comment on the presence or absence of these provisions in the Manitoba Act. It certainly seems odd that the trust fund sections of the provincial Acts do not specifically deal with the impact of lien bonds and other forms of security for the lien upon trust fund claims.

See Heintzman and Goldsmith on Canadian Building Contracts, 4th ed., chapter 11, parts 2(g) and 3.

 Stuart Olson Dominion Construction Ltd. v. Structal Heavy Steel, 2013 MBQB 48

Construction and builders liens   –   trust funds   –   discharging liens   –   lien bonds

Thomas G. Heintzman O.C., Q.C., FCIArb                                              August 26, 2013

www.heintzmanadr.com

www.constructionlawcanada.com