Legal dilemma

"Catch 22" isn't a legal phrase, but as a blanket term for paradox in law and government, it's pretty popular. It gets used a lot these days by tax lawyers trying to plot out their obligations to their clients and the law under the federal government's revised mandatory disclosure regime.

The new mandatory disclosure rules (MDRs), which took effect on June 22, substantially expand the number of business transactions that must be reported to the Canada Revenue Agency (CRA) under S. 237.3 and 237.4 of the Income Tax Act (ITA). They extend the range of reportable transactions and introduce a new category of reportable transactions — "notifiable transactions" — defined in a government backgrounder document as "both transactions that the CRA has found to be abusive, and transactions identified as transactions of interest (i.e., where more information is required to determine if a transaction is abusive)."

For tax lawyers, the big problem with the new MDRs is how they pull the profession into the process. The MDRs require that taxpayers, promoters and certain advisers — including legal professionals — report transactions that fall under the new rules to the feds.

That requirement threatens to put lawyers in a very awkward place, ethically and legally. Advice to clients is covered by solicitor-client privilege, a bedrock principle of the legal system and of lawyers' professional codes of conduct. Solicitor-client privilege ensures clients can discuss their options with counsel freely and without fear.

Without that assurance, clients might be inclined to hold back information. And without knowing what the client knows, the lawyer's job becomes far more difficult, if not impossible.

"The system depends on clients telling their lawyers everything, being open and forthright," says Jack Silverson, a partner in tax law at Osler. "Lawyers can't represent their clients fairly without all the facts."
Conflict between lawyers and clients is baked into the revised MDRs. The new law offers one modest concession to solicitor-client privilege — it says that any information that is "reasonable to believe" is subject to privilege does not have to be disclosed to the CRA.
 
But that pushes lawyers into a blind alley. Under threat of federal penalty, they must decide whether the information is covered by privilege. The legislation makes parties who fail to disclose under the new rules subject to fines of up to $110,000, in addition to the "general offence" penalties in the ITA — fines of up to $25,000 or imprisonment for up to 12 months.
If lawyers and their clients disagree on what should be disclosed, their interests cease to align and the professional relationship breaks down.

"These new provisions put lawyers in constant risk of a conflict. Simply asking them to provide information that may or may not be covered by solicitor-client privilege, subject to sanctions, puts them in a conflict," says Élisabeth Robichaud, a partner in tax law at Davies.

"It creates the potential for conflict with the client's wishes. Let's say you're representing a client and determine a certain disclosure would not violate SCP, but your client doesn't agree with you. What do you do then?"

"Typically, the client gets their lawyer's advice and decides, based on their risk tolerance, how to report a transaction," says Silverson. "It's the client's decision alone. But with these new rules, the law firm itself faces a risk and has to take that risk into consideration. The interests of lawyer and client may not line up."

Simply attempting to comply with the law could put a lawyer in a classic Catch-22 situation. "Merely filling out the disclosure form might involve disclosing legal advice — to report or not report," says Silverson. "So how can you fill out that form at all?

"So the fail-safe the government built into the law is not sufficient. How do you withhold disclosure without saying 'because,' and how do you do that without violating privilege?"

The contradictions built into the law border on the ludicrous, says Robichaud. "You could see lawyers filing disclosure forms confirming they are aware of information they can't disclose due to solicitor-client privilege — not even the name of the client," she says.

"The purpose of these rules is to ensure tax authorities are informed early on of any transactions they want to identify. But putting lawyers in a position where they have to file blank forms — I fail to see how that's helpful in any way."

There's a risk that the simple act of a lawyer informing CRA of advice given to a client on whether a transaction is notifiable could waive privilege, says Silverson.

"The privilege is the client's, not the lawyers, and you can't waive it piecemeal," he says. "There is a possibility that disclosure could imply waiving privilege over everything. It's certainly a risk."

He adds that lawyers facing penalties under the new law would find themselves in another wicked bind. How do they defend themselves without deploying privileged client information?

"Do you violate the act, or do you violate the code of professional conduct?" he says. "Which one do you least want to be offside with?"

The new rules are in a holding pattern at the moment. The Federation of Law Societies of Canada filed an application with the B.C. Supreme Court arguing that applying the MDRs to lawyers breaches the Canadian Charter of Rights and Freedoms because of the threat they pose to solicitor-client privilege. The CBA's Board of Directors has authorized seeking leave to intervene in the matter.

The court agreed to give lawyers a temporary exemption from the new rules until it decides whether to extend the injunction until the constitutional argument is settled.

In the meantime, says Silverson, tax lawyers would be wise to get the advice they give their clients in writing — in case they have to defend themselves in court down the road.

"It's going to be much harder to protect privilege for advice given over the phone," he says.

"You want a written record of the advice given, the facts, the risks and anticipated benefits, in case the Crown challenges privilege in court and effectively says, 'We don't believe you.'"