Yesterday, the First Circuit delivered its en banc opinion in the long-litigated question whether the Service can have access to the papers prepared to determine its tax reserves for financial accounting purposes (tax accrual workpapers). See ataxingmatter, Textron's SILOs and its Tax Accrual Workpapers: First Circuit Sides with IRS (Aug. 13, 2009).
The opinion is critically important in several ways.
First, it confirms that work-product doctrine only applies to materials that are prepared "for" litigation--i.e., "case preparation materials"--and not for documents produced routinely as part of the ordinary course of business. Although the circuits have split on how to interpret the 26(b)(3) evidence rule codifying the work-product privilege (a relatively easy to satisfy "because of" standard in the First, Second and other circuits; a more defensible "primary purpose of" standard in the Fifth and other circuits), the en banc court's explanation of its "because of" standard with strong language from the seminal Supreme Court Hickman v. Taylor case is a good indication that courts using that standard will not permit the work-product doctrine to eviscerate the search for truth by providing blanket protection for anything that could even remotely be viewed as taking into account a future possibility of litigation. As the court says, the doctrine is "aimed centrally at protecting the litigation process." (emphasis in original). The en banc court notes that the seminal Hickman v. Taylor case addressed case preparation that took place after a claim had arisen, and that the federal rules advisory committee note on the work product rule made clear that even documents "prepared by lawyers and reflecting legal thinking" aren't protected if done in the ordinary course of business for nonlitigation purposes. After noting that "[e]very lawyer who tries cases knows the touch and feel of" case prep materials, the en banc court frankly states that "[a]ny experienced litigator would describe the tax accrual work papers as tax documents and not as case preparation materials."
As I've noted on ataxingmatter at earlier points in the Textron litigation, tax standards require taxpayers to assess the possibility of success on the merits--judicial doctrines that could be raised must be taken into account when determining how to file in respect of a transaction. 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. As the court noted, this fact was not in dispute.
Textron's evidence was to the effect that litigation over specific items was always a possibility; the IRS did not deny that in certain cases litigation could result, although it said that this was often unlikely.
The court then made a clear statement of the relationship between the subject matter of a document and work product protection.
It is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated. Rather, as the Supreme Court explained, 'the literal language of [Rule 26(b)(3))] protects materials prepared for any litigation or trial as long as they were prepared by or for a party to the subsequent litigation. (citing FTC v. Grolier, 462 U.S. 19, 25 (1983), with added emphasis).
Not surprisingly, the dissent heartily disagrees with all of this, though it is not able to frame an argument that responds to the subject matter issue at all. The district court arrived at its understanding of the purpose of the work papers based almost entirely on the fact that the workpapers had to consider litigation possibilities to determine tax reserves (ie, on the subject matter). It misunderstand the key point made by the en banc court about the subject matter issue. The dissent merely continues to argue that determining reserves for financial accounting purposes is anticipation of litigation. It too misses the point (perhaps intentionally). The dissent thinks the district court's possible error --that the prospect of litigation drove the financial audit analysis--doesn't matter much. The dissent's approach would ultimately permit corporations to hide any materials that had anything to do with their consideration of an uncertain tax position, for whatever purpose.
Second, the court provides a useful discussion of tax accrual workpapers and the reasons that they cannot be given work-product protection, citing to language from the seminal Supreme Court Arthur Young case rejecting a privilege for independent auditor materials. Tax accrual workpapers, the court notes, are used to determine tax reserves and that determination is necessary for required SEC filings. And the court noted that no one provided any evidence that the work papers could serve "any useful purpose" in conducting litigation if it did arise.
Texton described generically the contents of the work papers in question: these included (1) summary spreadsheets showing for each disputable item the amount in controversy, estimated probability of a succcessful challenge by the IRS, and resulting reserve amounts; and (2) back-up e-mail and notes....
Neither side disputed that the immediate purpose of the work papers was to establish and support the tax reserve figures for the audited financial statements. ...
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That the purpose of the work papers was to make book entries, prepare financial statements and obtain a clean audit cannot be disputed. ...
Textron's own witness acknwoledged that it would 'have to include in its ... tax accrual work papers any new transactions that the company entered into that year that there might be some tax exposure on' regardless of whether it anticipated likely litigation.
Third, the court affirms what many commentators, including yours truly, have said--that the revelation of tax accrual workpapers simply does not present the concern that the work product doctrine is intended to address--the fear that making materials available would discourage sound preparation for a law suit. That can't be present when there are independent obligations to prepare such papers. (I would go further, and say that is true about all materials relating to the preparation of a tax return. Tax return preparation is not confidential legal work but ordinary "course of business" work, since taxpayers are required to file a return and nonlawyers routinely advise on tax structuring of transactions.)
Fourth, the facts revealed in this case suggest that the government's concerns about widespread corporate abuse of the tax laws are well-founded. In its brief summary of the workpapers in question, the court notes that "[i]n some instances the spreadsheet entries estimated the probability of IRS success at 100 percent." That, my friends, is an example of aggressive tax reporting--obviously hoping 1) that it won't be discovered on audit and 2) if it is discovered, that the company can prevent a real review and 3) that none of the papers that show the company knew the position was intolerably weak will be revealed in the course of the controversy. No wonder Textron didn't want the IRS to get its workpapers! Remember that taxpayers must file returns and that the Code provides standards to guide them in their decisionmaking about possible positions that they can take on those returns. A taxpayer is also supposed to take into account judicial doctrines that apply, such as substance over form and other core tax concepts developed in the federal common law. A taxpayer is not allowed to report a position--even when it provides adequate disclosure--for which is does not have a "reasonable basis." How likely is it that a corporation has a reasonable basis for taking a position if its internal tax department has concluded that it has zero chance of winning on the merits if the case were to be litigated with the government? Sure, these are conclusions in the context of accounting determinations, but still they do make one wonder. Isn't it likely that the basis for these positions was a remarkably slim reed, if anything?
Perhaps I am a perennial optimist, but I can't help hoping that the courts may just be getting it. Tax evasion is a major problem, and the privilegs that exist should not be read broadly so as to give taxpayers a free hand to cheat the government at will. While Hand noted that tax planning was fine, he also wrote an opinion that held against the taxpayer because its planning just created a sham to avoid taxes. Here's what the en banc First Circuit has to say about tax enforcement.
Textron apparently thinks it is 'unfair' for the government to have access to its spreadsheets, but tax collection is not a game. Underpaying taxes threatens the essential public interest in revenue collection. 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. Virtually all discovery against a party aims at securing information that may assist an opponent in uncovering the truth.... (emphasis in original)
The practical problems confronting the IRS in discovering underreporting of corporate taxes, which is likely endemic, are serious. Textron's return is massive--constituting more than 4,000 pages--and the IRS request the work papers only after finding a specific type of transaction that had been shown to be abused by taxpayers. ...
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