Protecting accountants' tax advice: a primer on privilege

Whereas clients routinely seek advice from accountants on tax-related matters, the Canadian courts have not yet extended the scope of solicitor-client privilege such that it would attach to tax advice provided by accountants.

Tax authorities in Canada and around the globe have wide-ranging powers to compel the disclosure of taxpayer information. These powers, although broadly exercised, are still subject to common law principles and statutory provisions that protect privileged information.

The protections afforded by solicitor-client privilege apply only to confidential communications that come into existence for the purpose of giving or receiving legal advice. For certain communications, there exists an exception to the general rule that preserves privilege where the content of the advice is shared with a third party (such as an accountant) and the disclosure would otherwise result in waiver. However, this exception is quite limited and is available only where specific conditions are met.

To date, the courts have not extended the scope of solicitor-client privilege such that it would attach to tax advice provided by accountants. This may seem questionable at first blush: both lawyers and accountants belong to highly skilled and regulated professions and confidentiality is a hallmark of both. But the courts have not been sympathetic to accountants' claims for equal treatment. This has been of particular concern in the tax realm, where clients routinely seek advice from both lawyers and accountants.

Recent case law developments reveal that the courts do not see a principled reason for drawing a distinction between the two professions in this context, but believe that any remedial action should be pursued through legislative change. Efforts have thus been underway to codify the confidentiality rights that would otherwise attach to tax advice provided by qualified advisers, including accountants.

This article reviews the governing principles respecting privilege, explains the exception to the rule regarding third-party waiver and outlines best practices for maximizing the likelihood that privilege will attach to communications with accountants. It also outlines measures that have been taken in other jurisdictions to keep tax advice confidential.

The fundamentals

Privilege has two generally recognized branches, one which exists to protect legal advice (solicitor-client privilege), and the other that covers communications relating to actual or anticipated litigation (litigation privilege).

The purpose of solicitor-client privilege is to facilitate full and frank communications between those who need legal advice and those who are able to provide it. Such communications are protected from disclosure to third parties, including the tax authorities.

In contrast, litigation privilege (or the "attorney work product" doctrine as it is known in the US) aims to facilitate the adversarial process. It applies to communications and materials exchanged between lawyers and third parties, including accountants, provided that they have been prepared for the dominant purpose of litigation.

The limitations

While Canadian courts have taken a firm stance on the importance of privilege, they have consistently recognized that claims of privilege are not absolute. Of relevance in the current context are the following limitations to the protection afforded by solicitor-client privilege.

First, the privilege belongs to the client, not the lawyer. It can only be asserted or waived by the client or through his or her informed consent. Second, the privilege applies only to a communication between a lawyer and client, which is of a confidential character, and which is directly related to the seeking, formulating or giving of legal advice. Lastly, privilege is distinct from, and narrower than, the duty of confidentiality and, as such, confidential communications may not necessarily be privileged.

Disclosure to third parties

Communications that convey otherwise privileged information to third parties (such as accountants) may fail each of the definitional requirements: the need for the communications to remain between lawyer and client, the confidentiality criterion, and the fact that such communications will often be for a purpose other than seeking legal advice. Fortunately, however, the resulting waiver is not without exception. More particularly, communications with a third party may continue to be protected by privilege where the involvement of the third party is essential, or necessary, to the existence and operation of the solicitor-client relationship.

The applicability of solicitor-client privilege to third party communications depends on the true nature of the function that the third party was retained to perform for the client. Generally, if the third party is providing services considered to be external to the legal retainer, the fact that its work product may assist the lawyer in providing legal advice will not be sufficient. Instead, the exception effectively requires that the third party act as a conduit between the lawyer and client.

This may occur where the third party acts as an agent entrusted with authority to direct the solicitor-client relationship. As a result, privilege does not apply where the third party is hired to investigate, gather or assemble information, which may subsequently assist the lawyer (but which is not essential to the operation of the relationship), or to act on instructions received from the client through the lawyer.

Auditors and limited waiver

If a taxpayer discloses privileged information to its external auditors in the course of facilitating an audit, does this constitute a waiver of solicitor-client privilege? While the Supreme Court of Canada has yet to directly address this issue, the weight of lower court authority suggests that disclosure of privileged material to an auditor involves only a limited waiver of the privilege for the purpose of the audit, and not for any other purpose.

The leading case in this context is Interprovincial Pipe Line Inc. v. MNR ([1996] 1 FC 367), where the Federal Court held that the Canada Revenue Agency (CRA) was not entitled to compel the production of a legal opinion that had been provided to the auditor by a corporation in the context of an audit.

The court acknowledged in this case that the governing corporate law clearly gives an auditor the authority to demand access to all corporate records – including privileged records – for the purpose of an audit. A company that complies with such a demand does so involuntarily and without any intention to waive privilege. The court indicated, however, that in future cases clients would be well advised to document their intentions when disclosing privileged information to auditors by way of a formal arrangement (that is, a "limited waiver" letter), which is reflected in the terms of the audit engagement.

Potential extension of privilege considered and rejected

The law generally recognizes two broad categories of privilege. The first is a "blanket" privilege that is acknowledged as belonging to a class. Communications falling within this class (for example, solicitor-client) are prima facie privileged.

The second is a "case-by-case" privilege. This refers to communications that are not privileged at first instance, but may acquire privileged status in particular circumstances by application of a four-part test (known as the "Wigmore criteria").

The prospect of extending privilege to accountants' tax advice, both by way of class and case-by-case, has previously been considered, and rejected, by Canadian courts. Specifically, the Federal Court of Appeal has determined the advice given by an accountant in connection with the search and seizure provisions of the Income Tax Act (Canada) (the "Act") is not protected from disclosure (Baron v. Canada, [1991] 1 F.C. 688 (CA), aff'd [1993] 1 S.C.R. 416 (SCC)). The Court of Appeal has also ruled that communications between tax accountants and their clients are not subject to a class privilege and that there is no "overriding policy consideration" that would require such treatment (Tower v. MNR, 2003 FCA 307).

While the policy implications may still be open to question, it is noteworthy that the UK Supreme Court recently came to the same conclusion in R (on the application of Prudential plc and another) v. Special Commissioner of Income Tax ([2013] UKSC 1). In this decision, the Supreme Court confirmed by a five-two majority that solicitor-client privilege (or "legal advice privilege" as it called in the UK) attaches only to advice provided by members of the legal profession.

The narrow issue before the court was whether, in responding to a demand by the UK tax authority, a taxpayer was entitled to resist disclosure on the ground that the information sought was privileged, notwithstanding that it had been prepared by accountants. The taxpayer argued that, in the tax context, it is illogical to distinguish between advice given by lawyers and accountants, and that this distinction does not reflect the reality that such advice is often identical in content. Stated differently, the taxpayer emphasized the nature of the advice, and not the status of the adviser.

Given this emphasis, the broader question raised by the appeal was whether legal advice privilege extends, or should be extended, to cover advice given by professionals other than lawyers. This question proved to be divisive, eliciting six sets of reasons from the seven-member panel. Moreover, all of the presiding justices accepted the position that, from a purely logical perspective, the privilege should be extended to advice given by anyone whose profession ordinarily includes the giving of "legal" advice. Yet the majority declined to do so, noting that the life of the common law has not always been logic. Any extension of the privilege would be considerable, given that accountants are only a subset, albeit an important subset, of a larger group of professionals who might also then be covered.

Basis for statutory intervention

The fact that the taxpayers in Canada and elsewhere have been unsuccessful in protecting accountants' tax advice from disclosure does not necessarily end the debate, particularly in Canada where efforts are ongoing to codify the confidentiality rights attaching to the advice given by tax professionals. It does signal, however, that the courts are reluctant to extend the scope of privilege in the absence of statutory intervention. In the US, Australia and New Zealand, communications with tax accountants are, to varying degrees, protected by an evidentiary privilege. For example, in the US, the Internal Revenue Code has since 1998 afforded a class privilege to "federally authorized" tax practitioners with respect to tax advice given to their clients. Except for criminal matters and communications regarding tax shelters, the scope of that privilege is the same as solicitor-client privilege, where the tax advice involves either the Internal Revenue Service or United States Federal Court proceedings.

In contrast, the act allows for a particularly broad rights of disclosure, and in the absence of privilege, the argument exists that there is a disincentive for clients to retain accountants for tax advice or to be as candid in the course of the retainer. This is compounded by the fact that accountants are the predominant provider of tax services in Canada.

For this reason, efforts are being made to statutorily recognize confidentiality rights attaching tax advice provided by professional accountants. In particular, organizations such as CPA Canada, the Canadian Chamber of Commerce, the Tax Executive Institute and the Canadian Federation of Independent Business have publicly supported this initiative. While it remains to be seen whether, and to what extent, Parliament will respond to these efforts, the measures detailed below may be followed in the interim.

Best practices for preserving privilege

In recent years, the CRA has become increasingly active in exercising its statutory powers to compel the production of taxpayer information. The net result is that taxpayers should be paying closer attention to asserting and preserving privilege in appropriate circumstances, and by taking precautionary measures.

- For instance, all materials containing legal advice or opinions, including notes, memoranda or e-mails that document verbal communications with counsel (in-house or otherwise), should be marked as privileged and confidential. This notation should also be placed on any communications with external counsel, and on any third-party communications for the purpose of litigation. The purpose of the communication should be clearly identified (that is, it is legal advice or for the dominant purpose of litigation).

- If a lawyer works in conjunction with an accountant on a matter, the lawyer should be retained to provide the legal advice to the client and, in turn, the accountant should be retained by the client to act as its agent in facilitating the provision of that advice.

- If the client authorizes an agent, such as an accountant, to act on its behalf in communicating with the lawyer, the agency relationship should be documented. All communications (between the agent and client and between the agent and the lawyer) should be marked as privileged and confidential.

- Depending on the content, notes prepared by lawyers on draft documents, such as agreements and resolutions, can be privileged. If asked to disclose these draft documents, all privileged material should be removed.

Where an auditor has authority to demand privileged information for the purpose of giving an audit opinion, the auditor and client should agree in writing beforehand that: (a) the information is being demanded and released pursuant to the statutory obligation in the relevant corporate statute for the limited purpose of allowing the auditor to audit and examine the financial statements for the corporation; (b) the information is subject to solicitor-client privilege and the client wishes to retain that privilege for all other purposes; (c) the information is not to be disclosed to third parties without the consent of the client; and (d) after the audit is completed, all privileged documents will be returned to the client or its counsel.

By recognizing the limits of privilege and adapting these practices in particular situations, professional tax advisers and their clients should be in a position to strongly defend against a demand for disclosure and promptly assert their rights if information that is potentially subject to privilege, is inadvertently disclosed.

Technical editor: Jay Hutchison, tax managing partner, Canada, E&Y .