From the February 2010 issue of Treasury & Risk magazine

Tax Prep Snooping

A recent decision by the full panel of the First Circuit Federal Court of Appeals that left corporate finance and tax departments concerned about the confidentiality of their papers appears headed for the U.S. Supreme Court. Textron, the defendant in the case, announced on Dec. 24 that it was filing an appeal to the nation's highest court. The 3-2 August decision, which reversed an earlier 2-1 decision by a three-judge appellate panel in the same circuit, establishes that at least for now, in the New England states (and Puerto Rico) covered by the Boston-based First Circuit, a company's tax accrual working papers, long held under the work product doctrine to be confidential documents, can no longer be considered automatically out of reach of the Internal Revenue Service.

In United States v. Textron and Subsidiaries, the case involving the Providence, R.I.-based aerospace and defense conglomerate, the First Circuit panel held that, "If a blueprint to Textron's possible improper deductions can be found in Textron's files, it is properly available to the government unless privileged.

"The work product privilege is aimed at protecting work done for litigation, not in preparing financial statements," the majority opinion said. "Textron's work papers were prepared to support financial filings and gain auditor approval; the compulsion of the securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected; and IRS access serves the legitimate, and important, function of detecting and disallowing abusive tax shelters."

Since 2003, the IRS has been seeking access to Textron spreadsheets relating to some lease-back deals involving equipment from foreign utilities and transit operators--a type of arrangement with vendors called a sale-in, lease-out (SILO)--which the IRS claims had earlier been disallowed. The documents in question were notes from Textron's in-house counsel to the accountants charged with certifying the company's financial statements, including a tax reserve summary spreadsheet that listed the uncertain issues identified by the tax advisers and, for each issue, a percentage indicating the risk to the company if the IRS challenged that issue and an assigned dollar value. The initial federal court ruling in 2007 found that the privilege normally accorded such documents had been waived when they were provided to the auditor.

While the First Circuit ruling only applies as a precedent within that circuit, it can nonetheless be cited in cases being heard in other circuits, says Diana Wollman, a tax attorney and partner in the New York law firm of Sullivan & Cromwell. And because the ruling conflicts with rulings in other circuits, it could be accepted for review by the U.S. Supreme Court, she says.

Meanwhile, Wollman warns that all companies should be alert to the risk that their tax working papers might not be as confidential as they had thought they were. "Executives need to look carefully at their internal procedures, and should have them reviewed by an attorney who is an expert in tax litigation," she says, adding that "just relying on in-house counsel may not be enough."

Says Wollman, "The First Circuit is saying that for papers to be protected, they have to have been created specifically for use in litigation. To be privileged, a document cannot be created in anticipation of litigation. And that's a very scary, brand new test." Documents that are created for GAAP purposes, she says, would not be privileged under this test. "So when you create a document that you want to be privileged, you should make it very clear that it is meant for litigation purposes," she says, "and then don't waive the privilege by using it for something else."

It could "take some creativity" for corporate executives to "figure out how to avoid hazards," Wollman adds.

The First Circuit decision is certainly controversial. The two judges in the minority wrote a stinging dissent, which could carry considerable weight if the Supreme Court were to take up the case. Charging their colleagues on the bench with "straining to craft a rule favorable to the IRS," the dissenting judges said the majority opinion had "thrown the law of work-product protection into disarray." They called on the Supreme Court to take up the matter, saying, "The time is ripe for the Supreme Court to intervene and set the circuits straight on this issue which is essential to the daily practice of litigators across the country."

Matt Miller, senior director for tax and economic policy at Financial Executives International (FEI), which filed an amicus brief in the Textron case, says a primary concern of his organization and its members has been "how this ruling could apply to issues not even related to taxes." As the FEI's amicus brief put it: "The outcome of this case could determine whether a publicly-traded company can prepare, and share with its independent auditor, a candid evaluation of its exposure with respect to any pending or threatened claim without fear that this information will be available to litigation adversaries."

Miller explains, "We worry that once you take away privilege for tax documents, it could also be extended to apply to regulatory or other documents too, not just tax issues. Several national groups we work with have expressed great concern, saying that they need to be able to have very candid relationships with their auditors and corporate counsel," he says. "It would be horrible if you turned a company's trusted advisers into agents of the government, which is what this effectively does.

"The First Circuit ruling, if it stands, could also make it more difficult for companies to seek advice from outside advisers," Miller adds.

So far, FEI has not made any recommendations as to what steps companies should take to protect confidentiality of their work documents, but Miller says it may do so in the future.

Attorneys contacted declined to predict whether the Supreme Court would agree to hear the case, though one noted that the court often tends to select cases where there are conflicting precedents in different circuits, as is now the case with corporate papers privilege. If the Supreme Court does agree to a hearing, the outcome is equally hard to predict: The current court has shown both a sensitivity to business interests and support for expanded federal government authority.

"This case presents an issue of exceptional importance," says Textron spokesman Michael Maynard. "We believe the First Circuit incorrectly narrowed the work product privilege, and that it warrants Supreme Court review."

After this story went to press, the Internal Revenue Service proposed requiring companies to provide details on all their uncertain tax positions, as detailed in IRS Seeks Info on Uncertain Tax Positions.

Comments

Advertisement. Closing in 15 seconds.