First off, Canada != US, fellow American.
Second: people and businesses can limit the forms of payment they'll accept for practical reasons all the time. As in: no bills over a certain amount, or refusing payment in pennies. Coins CAN be legal tender, but no merchant or private party MUST accept a particular form of currency. Don't want to accept $1 bills, only $5 and $10? That's fine:
"Legal tender is the default method of payment assumed in contractual agreements involving debts and payments for goods or services unless otherwise specified."
Third: the currency is defaced. That is the whole point - it's potentially not legal currency if you've drawn all over it. If you interfere with security features in the bill and it becomes more risky to trust as valid (such as, counterfeit bills that meet other security features elsewhere on the bill)...then they are right to refuse it.
I'm kind of shocked Canada doesn't specifically outlaw defacement of the currency; the US sure does.