United States: Drawing Lines In The Sand Between More Transparency In Reporting And Privileged Tax Advice

Article by Ruth N. Holzman, James P. Kleier, Catherine R. Nguyen and Phillip Pillar

A series of recent events affecting tax advice, tax accounting rules and tax accrual workpapers¹* underscores the conflict between the protections afforded tax advice under the attorney-client privilege and the work-product doctrine, and the ever-increasing scrutiny of tax reserves by the public and tax authorities:

• In a setback for the IRS, on Aug. 10, 2006, the Court of Appeals for the Sixth Circuit reversed the lower court and quashed a summons of two tax opinions in U.S. v. Roxworthy², holding that the opinions were protected under the work-product doctrine.

• On Aug. 8, 2006, the American Bar Association’s policy-making House of Delegates unanimously approved a resolution urging federal regulators and the accounting and legal professions to adopt standards, policies, practices and procedures to ensure that attorney-client privilege and work-product protections are preserved throughout the audit process.³

• On July 13, 2006, the Financial Accounting Standards Board ("FASB") announced its long-awaited interpretation of FASB Accounting Statement No. 109, Accounting For Income Taxes ("FAS 109"), applicable to income tax uncertainties or contingencies, effective Jan. 1, 2007 for calendar-year companies.

• In the first case of its kind, on April 28, 2006, the Justice Department petitioned the U.S. District Court for the District of Rhode Island to enforce a summons seeking all of the tax accrual workpapers of Textron Inc. and its subsidiaries.⁴

• In 2005, more than 200 public companies reported material weaknesses related to tax, and more than 30 percent of all companies surveyed required significant remediation of controls related to tax.

The following is a brief explanation of this confluence of events and its significance.⁵

Found in FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes ("FIN 48"), the stated goals of the new FASB interpretation are uniformity and consistency in the recognition, derecognition and measurement of contingent tax liabilities. FIN 48 imposes a "more likely than not" threshold that a position must exceed for the company to recognize a tax benefit in its financial statement. This level, however, is lower than the "probable" standard previously proposed in the exposure draft of this interpretation released July 14, 2005.

Section 404 of the Sarbanes-Oxley Act of 2002 ("SOX") requires companies to establish effective internal controls over their tax department that are approved by the company’s outside auditor. In 2005, half of the companies that reported material weaknesses in tax controls had to restate their tax accounts because of errors by the tax function.⁶ The most frequent error was accounting for deferred taxes under FAS 109. The new standards of FIN 48 increase the number of errors, and companies and their tax advisors should plan now to avoid that result.

Both the accounting and legal professions recognize that the increasing scrutiny of the tax reserves means performing a more careful analysis of the presentation of the reserves and the content of the workpaper files behind them. They differ, however, as to what documents must be included in tax accrual workpaper files. The ABA Task Force Report and Recommendation to the ABA House of Delegates on Audit Issues, adopted Aug. 8, 2006, identifies the information that the ABA believes may properly be required in an audit without undermining attorney-client and work-product protections, and calls on federal regulators and the accounting and legal professions to make clear "what information auditors need, and more importantly do not need, for the proper conduct of the audit."⁷

The financial accounting transparency has its counterpart in tax reporting, including Schedule M-3,⁸ "reportable transactions" compliance⁹ and increased IRS enforcement and audit activity. In June 2006, IRS Commissioner Mark Everson testified before the Senate Committee on Finance on how the IRS was achieving that transparency: "The Schedule M-3 provides transaction-specific detail on book-tax differences, enabling us to identify and focus more quickly and precisely on those tax returns and issues that present the highest potential compliance risk."¹⁰ Further to this point, on July 12, 2006, the IRS announced that examinations of more than 200 tax returns would be made simply based on Schedules M-3 filed by those taxpayers.¹¹

Complying with tax return reporting rules is more difficult and costlier than ever before. Federal reportable transactions must be disclosed and reported correctly, or severe penalties may be imposed. This is the case even if the reporting error does not affect the taxpayer’s current tax liability, such as when a corporation reports a net operating loss. These disclosure rules are continually changing—for example, in January 2006, the IRS announced that for most 2006 year returns, transactions with a "significant" book-tax difference will no longer be classified as a reportable transaction, although proper disclosure on Schedule M-3 will still be required.¹²

In the meantime, the IRS may be stepping up its requests for tax accrual workpapers and tax opinions despite taxpayer objections.

While more than 20 years ago the Supreme Court affirmed the IRS’ right to obtain tax accrual workpapers,¹³ soon thereafter the IRS announced a policy of voluntary restraint with procedural safeguards, stating: "The Service will continue its current policy of requesting Tax Accrual Workpapers only in unusual circumstances."¹⁴ However, recent revisions to that policy in the wake of so-called "abusive tax shelters" have placed the IRS’ rights and methods center stage again. In 2002, the IRS announced that it will routinely request all of a taxpayer’s tax accrual workpapers if a so-called "listed transaction"¹⁵ is not properly disclosed on a return, or if tax benefits from multiple listed transactions are claimed on the return, regardless of whether or not they are disclosed.¹6 Prior to this change in policy, the IRS had requested tax accrual workpapers a total of five times in 30 years.¹⁷ In fiscal year 2005 alone, the IRS submitted 50 requests for tax accrual workpapers.¹⁸ Presumably these requests were made in accordance with the policy set forth in Announcement 2002-63. Then last fall, in a speech at a conference of tax executives, Deborah Butler, IRS Associate Chief Counsel (Procedure and Administration), discussed a limited expansion of the policy set forth in Announcement 2002-63, but offered no further detail. She did say that the limited change aims for more transparency in examining workpapers.¹⁹

Should these recent developments raise concern that the IRS may be moving away from its policy of restraint in this area? "No," was the answer given by Donald Korb, IRS Chief Counsel, at a recent seminar in San Francisco. Korb maintained that the policy will not be expanded beyond what the IRS perceives to be "abusive tax shelters." He said, "I think we’ve been successful at limiting it at what it was really intended for." The "real beauty of this rule" is "its prophylactic effects" on tax shelters.²⁰ However, earlier this year, Korb said in an interview that the IRS plans to continue issuing summonses and requests for tax accrual workpapers in cases where taxpayers refuse to turn over information based on privilege claims. "I think taxpayers will find that the so-called privilege in tax cases is not very broad."²¹

Despite Korb’s assurances that requests for tax accrual workpapers will be limited to so-called abusive transactions, there may be cause for concern. Two recent summons enforcement actions brought by the IRS may indicate a move for more transparency in IRS examinations and an erosion of the IRS’ policy of restraint.

In the Roxworthy case, the IRS sought enforcement of a summons for two tax opinions in the possession of the taxpayer, Yum! Brands, Inc. The tax opinions were prepared by KPMG regarding the tax treatment of transactions involving the creation of a captive insurance company and related stock transfers.

The IRS had argued that the work-product doctrine did not apply because the memoranda had been prepared for penalty protection and not in anticipation of litigation. Citing decisions by the First and Second Circuits, the Sixth Circuit held that a document can be created for both use in the ordinary course of business (such as for penalty protection) and in anticipation of litigation without losing its work-product protection.²² It reversed the lower court’s legal conclusion that the likelihood of anticipated litigation was too remote, and adopted a two-part standard for determining whether the document was prepared in anticipation of litigation: a subjective standard (whether the taxpayer believed it may face litigation) and an objective standard (whether the belief was objectively reasonable). The court noted that the "anticipation of litigation" requirement may, in certain circumstances, be met even in the absence of a specific claim. "Although not every audit is potentially the subject of litigation…a document prepared ‘in anticipation of dealing with the IRS’ may well have been prepared in anticipation of an administrative dispute and this may constitute ‘litigation’ within the meaning of Rule 26."²³

In applying the objective standard to the facts of the Roxworthy case, the appellate court found that the taxpayer’s belief was objectively reasonable because it was audited annually by the IRS because of its size; the issue involved a $112 million discrepancy between tax loss and book loss; and the taxpayer had been advised by KPMG that the area of law was unsettled and that the IRS had recently targeted this type of transaction.

In Roxworthy, the IRS’ summons was limited to the two tax opinions and did not seek the production of the taxpayer’s entire tax accrual workpapers. As a result, the summons was outside the scope of Rev. Proc. 2002-63. This may explain why the IRS did not adhere to its "policy of restraint" in this case.

Although the Roxworthy case involved only tax opinions, the court’s two-part standard for determining whether the tax opinions were prepared "in anticipation of litigation" and therefore protected under the work-product doctrine, also should be used to decide work-product claims with respect to any tax document, including tax accrual workpapers. Even so, it may be difficult for a taxpayer to prove that all of its tax accrual workpapers were prepared in anticipation of litigation and not just in the ordinary course of business. For this reason, some commentators have suggested that a corporation should have its legal memoranda prepared to independently analyze the reserve for specific corporate transactions, and that such legal memoranda should be segregated from the aggregate tax contingency reserve documentation in order to preserve the protection of the memoranda under the work-product doctrine.²⁴

In the Roxworthy case, the IRS only sought tax opinions in the possession of the taxpayer. In the Textron litigation, the IRS is taking a more aggressive position and is seeking all of the tax accrual workpapers of Textron, Inc. and its subsidiaries. The IRS asserts that Textron Financial Corp., a wholly owned subsidiary of Textron, Inc., engaged in six separate sale-in, lease-out ("SILO") transactions in 2001, that SILOs were designated as listed transactions in Notice 2005-13²⁵, and that it is seeking all of the tax accrual workpapers of Textron, Inc. and its subsidiaries pursuant to the policy set forth in Announcement 2002-63.²⁶

In its brief supporting the petition in the Textron case, the Justice Department anticipates and addresses the taxpayer’s likely claims of attorney-client privilege and/or work-product doctrine.²⁷ The Justice Department contends that Textron must "bear the burden to prove that the privilege applies," that "when privileged communications are disclosed to a third party, the disclosure destroys the confidentiality upon which the privilege is premised," and that, "in the instant case, if the documents are covered by attorney-client privilege, and if those documents have been shared with the Taxpayer’s outside auditor, then the privilege has been waived."²⁸

With respect to Textron’s possible claims that the workpapers are protected by the work-product doctrine, the Justice Department argues that Textron must demonstrate that the documents have been prepared in anticipation of litigation, and that Textron will most likely be unable to establish this. This is the same argument that was made by the IRS and rejected by the Sixth Circuit in the Roxworthy case. As evidence, the Justice Department has offered the affidavit of a former chief auditor of the Public Company Accounting Oversight Board, who describes tax accrual workpapers as being prepared in the ordinary course of business, placing the workpapers out of the protection of the work-product doctrine.²⁹

In its reply brief filed Aug. 11, 2006, Textron contends that the "IRS’ alleged need for information to conduct its audit is ‘a pretext disguising its real objective[s]’…one of which is to obtain the purely legal analysis of Textron’s tax advisors. A related objective is to exert pressure on Textron to accept IRS settlement terms that require Textron to concede certain disputed taxes and to forego [sic] its right to contest the merits of the IRS’ position on the underlying issue in federal court, in return for which the government will withdraw the request for tax accrual workpapers and the legal analysis contained therein. In this context, the IRS request for tax accrual workpapers is a ‘bargaining chip’" and constitutes an ^improper purpose, i.e., "using the workpaper request as a means of ‘putting pressure on a taxpayer to settle.’"³⁰

If, as Textron asserts, the IRS is using its request for tax accrual workpapers as a bargaining chip, it has strayed far from the path of "voluntary restraint." One would hope this is not the case. This alleged practice is reminiscent of the recent federal court case that involved the U.S. Attorney’s Office’s threat to take into account whether KPMG advanced attorneys’ fees to current or former employees in deciding whether to criminally indict KPMG in connection with its role in certain abusive tax shelters.³¹ Although the KPMG case was a criminal case that involved constitutional issues, the judge’s admonishment of the Justice Department’s practice is still worth noting.

The implementation of FIN 48 may create problems for privilege claims with respect to tax advice. The technical positions underlying the tax benefit may need to be documented and analyzed using the "more likely than not" standard. If the advice is placed in the tax accrual workpapers to satisfy the auditor, the privilege may be irretrievably lost. Furthermore, pressure from SOX 404 is causing auditors to ask for legal memoranda, tax opinion letters and other potentially privileged documents supporting a company’s tax reserve position. The IRS is no longer reticent about requesting the tax accrual workpapers and, despite the IRS’ setback in the Roxworthy case, the outcome of the Textron case may have significant implications in the areas of attorney-client and work-product privileges with respect to tax accrual workpapers.

The confluence of these legislative, regulatory, and enforcement events is a significant development in the movement toward transparency in both financial accounting and tax reporting. The movement toward transparency, in turn, will continue to test the limits of privilege claims. As a result, accountants, lawyers and clients may find themselves re-examining and possibly redefining their roles in the tax and audit processes as lines in the sand are drawn.

This article is presented for informational purposes only and is not intended to constitute legal advice.