Disbursement headache?

The following article will appear in an upcoming issue of the HLA Journal.

R v Merchant Law Group[1] will likely represent a nasty shock for some lawyers who incur disbursements on behalf of their clients and who have not been following the CRA’s policy statement on lawyers’ disbursements (GST/HST Policy Statement P-209R “Lawyers’ disbursements”[2]). The case suggests that, for certain types of disbursements, unless a lawyer’s written retainer agreement and other (unspecified) circumstances make it clear that the lawyer is acting as the client’s agent in incurring disbursements that are otherwise not subject to GST/HST, those same disbursements will be subject to GST/HST when the lawyer bills the client for them.

Merchant Law Group, in providing services to its clients, incurred disbursements for appraisal reports, accident reports, courier costs, transcripts, investigation reports, hospital records, security reports, medical reports, parking fees, travel expenses, and searches and certificates. The firm would quote costs to clients that included disbursements and taxes, but the firm would generally consult with clients before incurring large disbursements (eg a medical report). The disbursements were generally paid from the firm’s trust account. The firm took the position that property acquired that were charged as disbursements belonged to the client at all relevant times. The firm did not mark-up the costs of the disbursements to the client.

Certain types of disbursements would generally not be subject to GST/HST if the client incurred them directly. For example, the fee to file articles of incorporation in Ontario is not subject to GST/HST. It follows that if a lawyer incurs the disbursement as agent for the client, then GST/HST will not apply in that case. If, however, the lawyer does not act as the agent of the client in incurring the disbursement, then the disbursement will be assimilated to the supply of legal services for GST/HST purposes, which means that the disbursement will be subject to GST/HST. In that case, the firm should collect and remit tax on the disbursement. If the firm fails to do so, then the CRA could assess the firm for the amount not remitted and impose interest and penalties on that amount. The Federal Court of Appeal explained the difference in this manner:

[13]     In the former situation [where the lawyer acts as agent], the lawyer is not the recipient of the supply as defined by subsection 123(1) of the Act so long as the lawyer is not the entity liable to pay the consideration owing under the agreement with the third-party supplier. The lawyer does not provide a supply. The lawyer is simply acting as an agent or conduit of his or her principal. In such case, the disbursement does not form part of the lawyer’s expenses. It is the client’s obligation and the lawyer pays the account on the client’s behalf.

 [14]     In the latter situation, where the lawyer is a “recipient” of a supply, the disbursement is the lawyer’s expense. The client may reimburse the lawyer for the expense, but the client had no obligation to pay the third-party supplier. The lawyer incurred the expense in order to provide legal services to the client. Because the goods or services were acquired for use or consumption in the course of providing legal services, lawyers who are GST registrants may claim an input tax credit so as to remove GST from the original disbursement. The pre-GST disbursement is then charged by the lawyer to the client. If exigible, GST is then levied on the entire account to the client, including the pre-GST disbursement.

 The Court then reviewed what it called one of the “three essential qualities of an agency relationship”, the authority to affect the principal’s legal position. The Court concluded that, just because a lawyer was generally regarded as an agent for his or her client, it did not follow that the lawyer acted as agent in incurring disbursements.

 [25]      In my respectful view, the Judge erred in law by relying upon the general nature of the solicitor-client relationship. As a matter of law it does not follow that, because the solicitor-client relationship is generally one of agency, all financial obligations incurred by a lawyer while providing legal services are incurred as agent of its clients. Indeed, the Judge recognized this by dismissing that portion of the appeal that related to office expenses incurred by the respondent on behalf of clients. Application of the proper test required the Judge to determine whether the respondent’s clients were bound by the contracts with third-party suppliers and were, therefore, liable for payment under the contracts and also exposed to any risk as a party to the contracts. If so, it follows that the respondent made payments to the suppliers only as an agent.

[26]      The absence of any evidence to support the conclusion that it was the respondent’s clients who were bound to the contracts with third-party suppliers means that the respondent could not meet the onus upon it to establish that it acted as agent for its clients when it incurred disbursements. It follows that goods and services that attracted the disbursements were taxable supplies received by the respondent so that it was required to collect and remit GST on the disbursements.

The Court was unimpressed by the fact that Merchant had paid for disbursements from funds held in trust, that the items acquired with the funds were the property of the client, that Merchant did not alter the items in any way or that the firm did not charge extra for the items acquired.

How could Merchant have avoided making its clients pay GST/HST on items that, had they been acquired by the clients directly, would not have been subject to these taxes? The Court suggested that this could be

addressed to an extent by … a written agreement appointing the lawyer as the client’s agent, expressly delineating the scope of a genuine agency relationship between the lawyer and client and directing that certain disbursements be incurred and paid on the client’s behalf.

The Court provided no guidance on what “to an extent” might mean. Is the agreement by itself enough? Does the lawyer need to go further and disclose to the supplier that the lawyer is acting as an agent? How would a supplier react if the lawyer, in a contract with a supplier, disclosed his or her status as an agent (presumably for an undisclosed principal to ensure that client confidentiality is preserved) and purported to limit liability accordingly? Does this mean that every lawyer must now conclude a written agreement with every client in respect of every disbursement incurred by the lawyer on behalf of the client? Will that be enough to protect the lawyer in an audit if GST/HST is not charged to the client in reliance on the written agreement? Should lawyers consider charging GST/HST on every disbursement as a precaution?

It appears that the CRA assessed Merchant because the latter had not charged GST in accordance with P-209R. The policy statement does not appear to distinguish between disbursements that are taxable and those that are not on the basis of the particular arrangement in place between the lawyer and his or her client. Instead the statement seems to draw the distinction based on the type of disbursement at issue. For example, the policy states that “government fees to create and maintain an entity” are generally incurred by the lawyer as agent for the client. On the other hand, the CRA believes that certain search fees are not incurred by the lawyer as agent for his or her client (eg a title or encumbrance search or a realty tax search).

Frankly, I do not understand the rationale for the distinctions drawn by the CRA in the Policy. The CRA states that it used its policy statement on agency as the basis for its analysis in P-209R. How the the former policy was used is not at all evident to me, but I do not purport to know much about GST/HST. In any case, in P-209R, the CRA states the following:

Generally, the Canada Revenue Agency will treat a disbursement described in this policy statement in the manner indicated, unless there is strong evidence to the contrary that it should not be so treated. If in a specific case strong evidence does exist that a contrary treatment should apply to a particular disbursement, then the general position taken in this policy statement will not apply to that disbursement for that specific case and a separate analysis of the facts surrounding the particular disbursement will be completed.

The good news for firms who have followed P-209R is that the CRA has stated that it will continue to apply the policy even in light of Merchant Law.[3] The bad news is that Merchant Law sets a high bar for firms that have not been complying with P-209R who now want to argue that they have incurred disbursements as agents for their clients.