Trust reporting – lawyers beware

On July 27, 2018, the Department of Finance proposed changes to the Income Tax Act to require trusts to file T3 Trust Income Tax and Information Returns to provide prescribed information, applying to non-excepted trusts having taxation years ending after December 30, 2021.

The proposed legislation excepts a number of specific trusts from this filing and reporting requirement. One such exception applies to lawyers’ general trust accounts; paragraph (c) of subsection 150(1.2) of the proposed legislation excepts a trust that:

is required under the relevant rules of professional conduct or the laws of Canada or a province to hold funds for the purposes of the activity that is regulated under those rules or laws, provided the trust is not maintained as a separate trust for a particular client or clients

However, this specific exception will not apply to separate trust accounts maintained for a specific client or clients. The Department of Finance, in its explanatory notes, made specific reference to lawyers’ trust accounts when explaining that the exception will apply only to a lawyer’s general trust account, stating, “this provides an exception for a lawyer's general trust account, but not for specific client accounts.”

On September 10, 2018, the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada made a submission to the General Director of the Legislation Tax Policy Branch of the Department of Finance addressing the issue of lawyers’ separate trust accounts set up for specific clients. The committee made the following recommendation (see appendix for excerpt from submission):

We therefore recommend that proposed paragraph 150(1.2)(c) be amended to specifically exempt from the filing obligation any trust maintained by a lawyer or notary in accordance with the rules of professional conduct governing such person.

The proposed legislation, which has not received Royal Assent as of the date of this alert, remains subject to possible change by the Department of Finance. We are hopeful that the recommendation provided in the joint committee’s submission will be adopted.

If the joint committee’s recommendation is not adopted, a lawyer’s trust account, set up for a specific client or clients, might not be considered an ordinary trust and might be classified as either a “bare trust” or an “agency” relationship. The Canada Revenue Agency (CRA) generally considers a bare trust relationship to exist when:

• the trustee does not have significant powers or responsibility and cannot take action without instruction from the settlor regarding any aspect of the trust;
• the trustee’s sole function is to hold legal title to the property; and
• the settlor is the sole beneficiary and can cause the property to revert at any time.

The CRA considers an agency relationship to exist when:

• the trustee has no significant powers or responsibilities;
• the trustee can take no action without instructions from the beneficiary; and
• the trustee’s only function is to hold legal title to the property.¹

Neither classification is considered a trust for purposes of the Income Tax Act, negating the requirement for filing or reporting. The CRA will determine whether an account is a bare trust or an agency relationship on a case-by-case basis, and the determination may be quite subjective. 

Based on the proposed legislation, only a lawyer’s general trust account will be excepted from the filing and reporting requirements. For specific client trust accounts, if the Department of Finance declines to amend the proposed legislation to extend the exception, a determination will be required to specify whether the account will be considered a bare trust or an agency relationship.

Thus, if a T3 return must be filed for a specific client’s trust account, it would be prudent to anticipate the costs associated with complying with the proposed legislation to ensure that funds are available in the trust.

Please consult with your Baker Tilly advisor on the appropriate next steps.
 

Appendix

Excerpt from the letter to Brian Ernewein, General Director of Legislation Tax Policy Branch of the Department of Finance by The Joint Committee on Taxation of The Canadian Bar Association and Chartered Professional Accountants of Canada

Lawyers’ Trust Accounts

Paragraph 150(1.2)(c) exempts from the filing requirement a trust that “is required under the relevant rules of professional conduct or the laws of Canada or a province to hold funds for the purposes of the activity that is regulated under those rules or laws, provided that the trust is not maintained as a separate trust for a particular client or clients”.

This appears to give effect to the proposal in Budget 2018 to exempt “lawyers’ general trust accounts”, and indeed may go beyond lawyers’ trust accounts and may also cover similar arrangements involving other professionals such as for example notaries and real estate brokers.

We are extremely concerned about the proviso which effectively requires the filing of trust returns for lawyers’ and notaries’ trust accounts maintained for particular clients. On its face, this new requirement appears to require a lawyer or notary who holds monies in a dedicated trust account for a particular client (other than in connection with an arrangement that exists for less than three months² or under a “bare trust” arrangement³) to file a tax return disclosing, among other things, the name of the client, and the amount held in trust. Such a required disclosure is clearly contrary to the fundamental principle of solicitor-client privilege.

This requirement is inappropriate, and should not be enacted in its current form. The proposed rule undermines, and fails to respect, solicitor-client privilege. This raises fundamental legal and constitutional issues.

The Supreme Court of Canada recently considered the impact of onerous tax disclosure obligations as they apply to lawyers and notaries in respect of their clients in the Chambre des notaires du Québec case⁴. In that case, the Court “read down” subsection 232(1) and section 231.7, and declared that they are inapplicable to lawyers and notaries in their capacities as legal advisors. The Court also struck down the so-called “accounting records” exception contained in those provisions, holding that this exception cannot be justified constitutionally in light of the fact that the exception undermined solicitor-client privilege. The Court held that “where the interest at stake is the professional secrecy of legal advisers, which is a principle of fundamental justice and a legal principle of supreme importance, the usual balancing exercise under section 8 [of the Charter of Rights] will not be particularly helpful” [emphasis added]. Instead, privilege must be very clearly protected.

In the course of its reasons in Chambre des notaires, the Court stated (at para. 74):

“It is important to note that clients’ names may appear in accounting records that contain information about amounts received by and owed to a notary or lawyer. In some cases, those names may be privileged, since the fact that a person has consulted a notary or lawyer may reveal other confidential information about the person’s personal life or legal problems”.

The Proposals would in some circumstances obligate a lawyer or notary to file a tax return for a trust account established for a particular client, and to thereby disclose, among other things, the name of the client and the amount received from that client. This information would violate the reasonable expectations of clients to privacy in connection with their dealings with lawyers. Based on the principles in Chambre des notaires, it follows that any legislation that could abrogate privilege in this manner would be subject to being struck down by a Court in the same way the so-called “accounting records” exception in subsection 232(1) and section 231.7 was declared by the Supreme Court of Canada to be unconstitutional, and of no force or effect.

We would also note that the prospect of lawyers’ trust accounts being used in a manner that frustrates CRA’s ability to administer the Act is extremely remote. Rules of professional conduct for lawyers, and provincial legislation governing the practice of law⁵, strictly regulate the use of lawyers’ trust accounts. For example, the Law Society of Ontario’s Rules of Professional Conduct state that “a lawyer shall not use their trust account for purposes not related to the provision of legal services”⁶. The Commentary to this rule states:

“A client or another person may attempt to use a lawyer’s trust account for improper purposes, such as hiding funds, money laundering or tax sheltering. These situations highlight the fact that when handling trust funds, it is important for a lawyer to be aware of their obligations under these rules and the Law Society’s by-laws that regulate the handling of trust funds”.⁷

A lawyer’s trust account may only be used in connection with the lawyer’s legal services. It would be a breach of the Rules for a lawyer to use his/her trust account in any other way or for any other purpose. A lawyer that permits his/her trust account to be used in connection with breaches of tax legislation could be penalized by the Law Society, even potentially disbarred. It is reasonable to expect lawyers to abide by their governing rules of professional conduct, and not to allow their trust accounts to be used to assist clients in escaping their tax obligations. Realistically, an exception for all lawyers’ and notaries’ trust accounts would not materially impair CRA’s ability to enforce the Act, and such an exception is appropriate in view of the constitutional importance of the protection of solicitor-client privilege as a “legal principle of supreme importance”.

We therefore recommend that proposed paragraph 150(1.2)(c) be amended to specifically exempt from the filing obligation any trust maintained by a lawyer or notary in accordance with the rules of professional conduct governing such person.