In a typically pithy and plain-spoken Seventh Circuit opinion, Valero Energy Corporation v. U.S. (June 17, 2009), the court confirmed a district court's determination that the tax practitioner privilege did not apply to protect certain documents because they were "in connection with" the promotion of a tax shelter. (To hear the oral argument, go to this link.) None of the underlying tax issues have yet been adjudicated; the administrative proceeding is apparently on hold while the discovery issues go forward.
Vallero did a cross-border deal, acquiring Diamond Shamrock, a company with Canadian subsidiaries. That cross-border affiliation opened the way for a tax-motivated transaction to create tax deductible foreign currency losses that, one might well argue, should not be recognized under sham or substance-over-form doctrines. The IRS sought all kinds of documents relating to the tax planning for the deal and the company claimed all kinds of privileges to try to keep the IRS from finding out about its evaluation of its deals. Valero won in a first dispute but eventually there was a new round of document disputes in which Valero again asserted that the tax-practitioner privilege under section 7525 protected the documents. The IRS presented evidence that tax avoidance planning was "one of the driving purposes behind the multitued of transactions in 2002" and so the privilege shouldn't apply, because of the exception for corporate tax shelters. Valero argued that the exception wasn't applicable since Arthur Anderson, its tax adviser in these matters, wasn't peddling it a cookie-cutter deal but just advising it on structuring its business operations. The district court sustained the privilege for some documents, but for others it allowed discovery on the basis that the tax shelter exception to the privilege applied. That decision is what the Seventh Circuit reviewed after granting a stay. It concluded that the exception applied, so the documents had to be given to the IRS.
There are several noteworthy statements along the way in the opinion. First, it soundly applies the holding of Frederick, 142 F.3d 496 (7th Cir. 1999), that the 7525 privilegeis a narrow one that applies only to legal advice, not general accounting advice. Slip Op. at 6. This is an important distinction that can easily suffer narrowing and ultimately slip out of courts' hands, since "the line between a lawyer's work and that of an accountant can be blurry, especially when it involves a large corporation like Valero seeking advice from a broad-based accounting firm like Arthur Anderson."
If you listen to the hearing, you'll note that counsel for Valero made a very strong statement about the importance of a strong privilege. The court asks whether Arthur Anderson was hired for this particular plan or had provided services for other accounting purposes, but the counsel could not answer. He claimed that Arthur Anderson's role here was to review plans that Ernst & Young had developed, and that this was a "typical practitioner client relationship in which the practitioner is advising the client."
Second, the court does so by reaffirming the principle that preparation of tax returns is accounting work and not legal service, so that "information transmitted so that it might be used on a tax return is not privileged." Id. at 7. This means that if documents are used for tax return prep and legal reasons, the dual purpose prevents the privilege from applying. Id. At the hearing, Valero's counsel argued that a document that acknowledged that the accountants had "reviewed" federal tax consequences were facially protected federal tax advice. The court begged to differ in the opinion, noting that documents that consist of federal tax advice--i.e., "worksheets containing financial data and estimates of tax liability ...[or discussions of] deductions and the calculations of gains and losses"-- are discoverable because they "contain the type of information generally gathered to facilitate the filing of a tax return" (and this applies "whether or not the information made it on" the filed return). Id. at 8.
If you listen to the hearing, you'll note that counsel for Valero made a very strong statement about the importance of a strong privilege. The court asks whether Arthur Anderson was hired for this particular plan or had provided services for other accounting purposes, but the counsel could not answer. He claimed that Arthur Anderson's role here was to review plans that Ernst & Young had developed, and that this was a "typical practitioner client relationship in which the practitioner is advising the client."
Third, the court rules that taxpayers claiming the 7525 privilege are not presumptively entitled to an ex parte hearing to present testimony from those who produced the documents to bolster their claim, if there is "adequate information to evaluate the claim of privilege...[from] the documents themselves." This is a welcome conclusion. I suspect that district courts are more easily swayed to grant privilege than they should be by self-serving statements of accountants who want to protect their own work from scrutiny.
Fourth, the court provided an important interpretation of the meaning of the tax shelter exception to the privilege, which applies to documents used "in connection with the promotion of the direct or indirect participation of the person in any tax shelter." Section 7525(b)(2). Valero argued that the exception applied only to cookie-cutter deals and not to the customized tax planning that Arthur Anderson provided to its long-term client. and (in the hearing) claimed that the narrow definition of promotion wouldn't hinder the Service's search for the truth. As I've written in my scholarship on corporate tax shelters, there is no clear line between cookie cutter deals and customized planning, and the tax minimization norm leads to customized planning that aggressively pushes hyper-literal interpretations of the Code to justify deals that are contrary to the underlying purposes of the provisions. So it is significant that the court recognized that customized planning is not outside the scope of this exception.
In the hearing, the court quickly went to this issue, noting that a broad interpretation was fitting, given the rationale behind the tax shelter exception. Isn't this a complex series of transactions planned to create a loss? and doesn't the statute use an "extremely broad" definition of tax shelter, that reflects congressional intent? the court asks (paraphrased). Valero's counsel strenuously objected to treating as a tax shelter "any" tax planning that had tax avoidance as an objective, noting that it is "legitimate" to "avoid getting hit with taxes that they don't have to pay." Valero's counsel pointed to the legislative history that claimed it would not disrupt routine tax advice, noting that one Senator refered to this as targeting those "peddling" tax shelters that the promoters had created, with "cookie-cutter opinions", and so the exception shouldn't be read to include customized tax planning. The argument was that the exception would otherwise be so broad as to swallow the rule.
The opinion ultimately does accept the Service's interpretation that in this context promotion, as argued by the government in response to Valero's assertion of a "peddling" interpretation, means "furtherance" or "encouragement." "Congress left promotion up to judicial interpretation" but it included significant guidance by reference the definition of tax shelter in section 6662(d)(2)(C)(i), which is any plan that has as "a significant purpose" "the avoidance or evasion of Federal income tax." Since the definition is clearly not limited to cookie-cutter deals, the term "promotion" shouldn't be used to limit the definition. The court "decline[d] to read such a contradiction into the statute." Id. at 12. Instead, the court concluded that the term "limits the exception to written communications encouraging participation in a tax shelter, rather than documents that merely inform a company about such schemes, assess such plans in a neutral fashion, or evaluate the soft spots in tax shelters that a company has used in the past." Since that understanding "jibes with the IRS's broad summons power", it ensures that there is some leverage to keep taxpayers honest. Id. at 14.
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