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Tax Bulletin (September 2007)

District Court Holds Tax Accrual Workpapers
Are Protected by the Work Product Privilege




By Elizabeth P. Askey, a tax partner in the Washington, D.C. office of Pillsbury Winthrop Shaw Pittman LLP.

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Corporate taxpayers were handed an important victory recently when the U.S. District Court for the District of Rhode Island held in United States v. Textron, Inc., D. R.I., No. 06-198T (Aug. 29, 2007), that tax accrual workpapers are protected by the work product privilege. The Textron decision confirms that a company's analysis of soft spots in its tax returns is off-limits to the Internal Revenue Service under certain circumstances.

Background

A number of developments in recent years—including Sarbanes-Oxley, Financial Accounting Standards Board Interpretation No. 48 ("FIN 48"), and the government's assault on tax shelters—have caused the status of tax accrual workpapers vis-à-vis the Internal Revenue Service ("IRS") to take on heightened significance. For years, the IRS has exercised a policy of "restraint" in requesting a corporate taxpayer's tax accrual workpapers as part of an audit. Taking the position that tax accrual workpapers are, for the most part, not protected by any privilege, the IRS has nonetheless established a policy of not requesting tax accrual workpapers as part of an audit except in unusual circumstances. See generally, Internal Revenue Manual section 4.10.20.

The IRS changed this policy in 2002 with respect to tax accrual workpapers related to "listed transactions" as defined at the time in Income Tax Regulations section 1.6011-4T(b)(2). In Announcement 2002-63, 2002-2 C.B. 72, the IRS announced that for returns filed on or after July 1, 2002, it would routinely request tax accrual workpapers related to a listed transaction that was disclosed pursuant to Income Tax Regulations section 1.6011-4T. In addition, the IRS indicated that, as a discretionary matter, it would request all of a taxpayer's tax accrual workpapers in the case of (1) a listed transaction that was not disclosed, (2) tax benefits claimed from multiple listed transactions on a return or (3) reported financial accounting irregularities in connection with disclosed listed transactions. Textron reflects the IRS' first attempt to enforce a summons in connection with a request for tax accrual workpapers related to a listed transaction.

Summary of the Textron Decision

In 2001, Textron engaged in nine "sale-in, lease-out" ("SILO") transactions, which were listed transactions. In connection with the audit of Textron, Inc.'s 1998-2001 returns, the IRS requested Textron's "tax accrual workpapers." In 2005, the IRS issued an administrative summons for "all of the Tax Accrual Workpapers" for Textron's 2001 taxable year.[fn. 1] Textron's tax accrual workpapers included a list of items that might be challenged by the IRS, litigation hazards assessments for such issues, and tax reserve amounts associated therewith along with notes and memoranda written by Textron's in-house attorneys with some assistance from in-house accountants. Textron refused to produce the workpapers in part because, it argued, they were privileged.

The court analyzed each of the possible privileges that could apply. First, the court ruled that the attorney-client privilege applied because the tax accrual workpapers consisted of "nothing more than counsel's opinions regarding items that might be challenged because they involve areas in which the law is uncertain and counsel's assessment regarding Textron's chances of prevailing in any ensuing litigation."

Second, the court found that the tax practitioner-client privilege of section 7525 of the Internal Revenue Code applied to workpapers that reflected advice received from in-house accountants because Textron's tax accountants performed "lawyers' work" by participating in "advising Textron regarding its tax liability with respect to matters on which the law is uncertain and/or estimating the hazards of litigation percentages." The court also found that the exception in section 7525(b) for communications "in connection with the promotion of" a tax shelter did not apply.

The court found that both of these privileges had been waived, however, when Textron provided its workpapers to its independent auditor, Ernst & Young ("E&Y"), notwithstanding the fact that E&Y agreed to keep the workpapers confidential.

Finally, the court addressed the work product privilege. In determining that the tax accrual workpapers had been prepared "in anticipation of litigation," the court rejected the "primary purpose" test of the Fifth Circuit in favor of the "more inclusive 'because of'" test that had been adopted by the First Circuit and several others. The court stated, "[I]t is clear that the opinions of Textron's counsel and accountants regarding items that might be challenged by the IRS, their estimated hazards of litigation percentages and their calculation of tax reserve amounts would not have been prepared at all 'but for' the fact that Textron anticipated the possibility of litigation with the IRS." The court emphasized, "[E]ven if the workpapers were needed to satisfy E&Y that Textron's reserves complied with GAAP, that would not alter the fact that the workpapers were prepared 'because of' anticipated litigation with the IRS." The court also indicated that Textron's anticipation of litigation was "well-founded" given its experience in past audit cycles.

Unlike the attorney-client and tax practitioner-client privileges, however, the court found that the work product privilege had not been waived because disclosure to the company's independent auditors was not inconsistent with keeping the information from an adversary and, specifically, "did not substantially increase the IRS' opportunity to obtain the information contained in them." Finally, the court determined the IRS had failed to demonstrate "'substantial need' for ordinary work product, let alone the heightened burden applicable to Textron's tax accrual workpapers, which constitute opinion work product," stating that such workpapers had "little bearing on the determination of Textron's tax liability."

Lessons Learned

There are a number of important points that can be derived from Textron, including the following:

  • A document can be prepared in anticipation of litigation long before there is any actual threat of litigation. "In anticipation of litigation," in at least the District Court of Rhode Island's view, means in anticipation of the possibility of litigation.

  • Workpapers should be as "lawyerly" as possible. Textron's workpapers were prepared by lawyers or accountants subject to the attorney-client, tax practitioner-client privileges or work product privileges. The court distinguished United States v. Arthur Young & Co., 465 U.S. 805 (1984) in part on the basis that in that case, the workpapers were prepared by the taxpayer's outside auditor. Moreover, the workpapers in question in Textron clearly reflected counsel's assessment of litigation hazards.

  • Although perhaps not helpful in claiming attorney-client or tax practitioner-client privilege, obtaining a written agreement from outside auditors to keep tax accrual workpapers confidential strengthens an argument that the work product privilege has not been waived.

Unanswered Questions

Although Textron has gone a long way in clarifying the privileges that may attach to tax accrual workpapers, corporate taxpayers likely will still find themselves grappling with the following issues.

  • The boundaries of the attorney-client and tax practitioner-client privileges remain unclear where workpapers are not actually disclosed to the company's auditors. Auditor requests for privileged opinions have become increasingly common in recent years, and taxpayers have struggled with ways to meet their auditor's needs without turning over otherwise privileged materials. Notably, the Textron court found that the privilege was waived not because the workpapers were prepared in connection with a public reporting requirement but because the workpapers themselves were disclosed to the company's auditors.

  • As Textron was a pre-FIN 48 opinion, it is not clear what impact FIN 48 may have on the applicability of the work product doctrine to tax accrual workpapers. Not only have tax accrual workpapers taken on a heightened public reporting aspect as taxpayers attempt to comply with FIN 48's very detailed requirements, but the very fact that FIN 48 requires a greater level of certainty than previously required in a company's tax positions begs the question-is analysis supporting a position that meets the "more likely than not" standard less likely to be considered to be prepared in anticipation of litigation? Conservative taxpayers and those establishing small reserves may bear the greatest risk here.

  • In a footnote, the court left open the question of whether tax accrual workpapers should be disclosed to assist the IRS in making a penalty determination. Because the IRS had not even proposed a deficiency at the time of the summons, the court dismissed this argument as "premature, at best."

Looking Ahead

We have not heard the last on the questions addressed by the Textron decision. IRS Chief Counsel Donald Korb has stated publicly that the government is unlikely to back down. Taxpayers, nevertheless, have acted quickly in responding to the Textron decision and are using the decision as a basis to withhold tax accrual workpapers that have been requested by the IRS in audits. Moreover, the IRS has suggested on more than one occasion that it may reconsider its policy of restraint with respect to tax accrual workpapers that are not associated with listed transactions, particularly in light of FIN 48 and increased transparency in financial reporting. Internal Revenue agents are being trained to interpret FIN 48 disclosures. Thus, not only an appeal of the Textron decision but further summons enforcement actions in other circuits are likely in the months ahead. Whether the U.S. District Court for the District of Rhode Island's expansive view of the work product doctrine as it applies to tax accrual workpapers is adopted by other courts remains to be seen.

Notes

  1. The summons defined "Tax Accrual Workpapers" as "all accrual and other financial workpapers or documents created or assembled by the Taxpayer, or the Taxpayer's independent auditor relating to any tax reserve for current, deferred, and potential or contingent tax liabilities, however classified or reported on audited financial statements, and to any footnotes disclosing reserves or contingent liabilities on audited financial statements. They include, but are not limited to, any and all analyses, computations, opinions, notes, summaries, discussions, and other documents relating to such reserves and any footnotes . . . ." This is essentially the definition contained in Internal Revenue Manual section 4.10.20.[return to text]


This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters.


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