The holidays seem to bring unexpected 'gifts' of interesting tax tidbits, as always. We'll look at a few that are worth noting.
(1) UBS and hidden offshore assets:
As we head toward the new year, many a wealthy taxpayer who has held a "hidden" account at UBS over the last few years and has not joined the more than 14,000 voluntary disclosures may be experiencing a sensation similar to sitting under Poe's pendulum as it swings lower and lower. Bradley Birkenfeld, the former UBS banker who helped hide assets from US tax authorities and is now headed to prison, filed for postponement and reconsideration of the sentence over the Christmas holiday weekend. See Reuters, Informant says he will assist further in tax case against Swiss bank, NY Times, Dec. 27, 2009. Birkenfeld says he will "cooperate further." Does that mean there is more information about UBS's shady tax evasion assistance practices? or about particular Americans aided by Birkenfeld that have hitherto remained unrevealed? If anyone used Birkenfeld to do their UBS work, their assets may be suddenly more vulnerable to taxation than they thought.
(2) Textron files for certiorari:
The First Circuit reviewed Textron's tax accrual workpaper case en banc, concluding that those work papers could not be withheld under the work product doctrine and clarifying that the "because of litigation" test that the Circuit applies to test for work product protection could not extend to documents routinely required for a non-litigational business purpose and not prepared because of litigation.
I commented extensively on the First Circuit decision here (Textron: is this a turning point in courts' approach to corporate attempts to reduce taxes with aggressive planning? Aug. 14, 2009) and here (Textron's SILOs and its tax accrual workpapers: First Circuit Sides with the Service, Aug. 13, 2009) and on the District Court case here (Textron, Inc.: Tax Accrual Workpapers, Attorney-Client Privilege, and Work Product Protection, Aug. 30, 2007).
In the analysis of the district court decision, 507 F. Supp. 2d 138, I noted that the "because of" test as applied is "so easy to satisfy that any document that provides a rationale for its being created connected with the word 'litigation' would probably qualify. It is a wrong-headed test that turns the purpose of work-product protection on its head, especially in the tax context. Work product protection is supposed to give an attorney a 'zone of privacy' when he is preparing a case for trial, so that he can work through strategies and approaches withouy revealing his every hand to his adversary. Preparation of tax accrual papers to make the determination of how much funds should be considered reserved in the eventuality that the tax positions taken over time by a company on its returns are not held up after an audit is not an activity at that stage of an adversarial process--in fact, it should not be viewed as adversarial at all at that state...The assessments of success on the merits provide the basis for the positions taken in the return, which is a document that is disclosed to the IRS."
In my analysis of the First Circuit decision (553 F.3d 87), I argued that the overly broad workproduct test as applied in several circuits had moved far away from the seminal Hickman v. Taylor case involving attorney investigative efforts to prepare for expected litigation. In the tax context, where tax standards require an assessment of the likelihood of success on the merits, success on work-product protection for tax accrual workpapers "would likely result in most any materials prepared in connection with accounting issues about tax accruals being protected."
In my analysis of the en banc decision (577 F.3d 21), I saw four important contributions.
- First and foremost, the en banc decision recognized that work product protection is not meant for documents that are prepared in the ordinary course of business but only for case preparation materials. And it relied heavily on the Hickman v. Taylor case to underpin its interpretation of the work product protection standard, including the federal rules advisory committee's notes, in doing so. As I commented, "It would completely defeat the IRS summons power if the mere possibility of the subject matter of the papers being litigated were sufficient to provide work product protection, since that possibility exists for every position about which there is any uncertainty."
- Second, the discussion of tax accrual workpapers sheds light on their purpose and use that further supports the conclusion that they do not merit workproduct protection.
- Third, the court made clear that revelation of tax accrual workpapers does not present the concern that workproduct protection addresses--the fear that making materials available would discourage sound preparation for the law suit--since there are independent obligations to prepare the papers.
- Fourth, the facts show that the government's concerns about corporate abuse of the tax laws is well founded.
Christmas eve brought the filing of the petition for certiorari by Textron [hat tip Tax Prof]. The petition notes the conflict among the circuit courts with respect to the standard for applying work-product protection, which protects most work prepatory to litigation unless there is a demonstration of hardship and provides very strong protection for opinion work product. The petition emphasizes the breadth of the "because of" test as applied by various circuits (though I would note that the language in the Wright treatise that gave rise to the "because of" standard seems much less broad than the expanded interpretation given that language in some of the circuit courts' opinions). Adleman, heavily relied on by petitioner, is the Second Circuit case that has been particularly influential, yet Adleman's text on dual -purpose documents does not really support the breadth of the test petitioners' claim. Adlemant provides work-product protection to dual-purpose documents that "would not have been prepared in substantially similar form but for the prospect of [anticipated] litigation." That is a far cry from tax accrual workpapers, which are required to be prepared in a form that analyzes prospects of success on the merits of tax positions, whether or not a company anticipates having to litigate those tax positions. There will likely be no company that has no uncertain tax positions--i.e., positions for which it cannot express clear certainty of the appropriate treatment. That is because companies typically take quite aggressive tax positions and because complex transactions entail innate uncertainties of interpretations regarding the proper application of the law. The low probability of certainty is one of the reasons that taxpayers are permitted to report tax positions for which they have only substantial authority (generally thought to provide only 40-45% likelihood of being correct). They may report such positions even when they believe that an alternative analysis is more likely than not correct.
Does the fact that many commentators are critical of the narrower standard hold much weight on this matter? I don't think so. Regretably, practitioner commentary can be expected to favor taxpayer-biased remedies in spite of our attempt, as members of the bar, to weigh in evenhandedly on policy issues. Academicians, perhaps, tend to be more open-minded on these issues, but even here there are a number whose consulting contracts and other interests push them to identify with the practicing bar and with taxpayers.
The petitioner's assertion that the "because of" standard would clearly cover tax accrual workpapers seems dubious as well. One lower court has concluded as much (N.D. Alabama, in Regions Fin. Corp. v. United States, 2008 WL 2139008) but no court of appeals has yet so held.
The petitioner's assertion that the First Circuit's interpretation of the "because of" test (prepared for use in litigation) directly conflicts with Fed. R. Civ. Proc. 26(b)(3)'s "in anticipation of litigation" language is clearly wrong. The entire phrase "prepared for use in litigation" encompasses both actual use in trial and the preparatory phases of litigation preparation when an attorney foresees litigation. The petitioner's brief erases any line between routine documents that a company creates in the ordinary course of business that are required to look forward, in however weakly a predictive mode, to the possibility that someday the subject matter of the document might be the subject of litigation and litigation-related documents in which a particular issue that is expected to be subject to litigation is analyzed to determine particular steps that should be taken. The civil procedure rule requiring that documents be prepared "for trial" or "in anticipation of litigation" presupposes that documents covered by work-product protection be directly related to impending litigation and not to ordinary business routines that must be undertaken under independent obligations.
Further, the petitioner's assertion that the standard is irreconciliable with policies animating the work-product privilege is misguided for several reasons. Financial accounting serves the public interest by providing appropriate information to investors and creditors who must rely on information in a company's financial statements to make determinations about the success or failure of the firm. Tax accrual workpapers, in particular, satisfy this public interest role of accounting work, since they relate to positions taken by a company on its tax return. The filing of a tax return with the government is an assertion that information is appropriately accounted for and tax liability appropriately reported under the rules. Accordingly, I have argued that evidentiary privileges--including attorney-client privilege and work-product protection--should be reviewed in light of the nature of the tax return filing, and any advice or workpapers prepared in respect of tax return positions prior to the filing of the return should be considered incorporated by reference in the return and available to the IRS under appropriate circumstances.
TAx, here, as in so many cases, presents special dilemmas that are different from other areas of the law. Taxpayers are required to report their income through a filing process that relies on taxpayer self-assessment and payment. A major problem with taxpayers' retaining absolute control over any papers revealing basic information about their taxable transactions is that information here is almost exclusively within their control. The government battles a monster tax revenue shortfall, partly made possible by hidden accounts, transactional gimmicks, and gross misreporting. Without access to documents that underly the transactions reported on returns, it has little hope of reconstructing much of this information. One can't be surprised that taxpayers want to "have their pie and eat it, too" by filing their returns based on their own aggressive interpretations of the Code, while retaining all information that reveals the actual grounds on which those interpretations reside and the likely flimsiness of many of them. But the courts should not further this along by treating tax accrual workpapers as attorney opinion workproduct that merits protection from the IRS. That information is routine business information that should be readily available to the IRS when triggered under its own policies.
Will the Supreme Court grant certiorari to hear the Textron case? It seems likely that they will. There is a substantial circuit split on the issue, and there is a strong lobby--the corporate lobby, the tax bar and the accounting profession--interested in securing work-product protection for tax accrual workpapers, and there is enough uncertainty around the issue to suggest that it is time for the Court to resolve it.
Will the outcome favor the groups that lobby most strenuously for work product protection? That is harder to call, given the precedents that give strong voice to the public interest role played by the accounting profession and financial statements generally. The Court should find the "because of" test too broad--it hardly sets any standard at all, and the inclusion of dual-purpose documents that are primarily created because of ordinary business obligations points to a test that fails to draw the proper line. I hope that the Court recognizes that, if it does take cert here, and that it is attuned to the peculiar nature of the tax system that requires taxpayers to assess their confidence level in the merits of their position when filing a return.