Open reserve-ations? United States v. Textron, Inc. and its application to international tax accounting.

• Author: Braun, Adam M.

INTRODUCTION

It has been described as an "upheaval" of established law. (1) It will open up a "Pandora's box" and "turn the tables" on previous legal understandings. (2) It "eviscerates" long-standing legal doctrine. (3) What sort of revolutionary event could invoke such grim language? Surely, "It" must be a headline case involving a high-profile social issue like the constitutionality of same-sex marriage, (4) corporate contributions to political campaigns, (5) or restrictions on First Amendment rights.

Instead, "It" is the First Circuit's opinion in United States v. Textron Inc., (6) a case involving an Internal Revenue Service (IRS) summons for tax accrual workpapers and Textron's attempts to protect the documentation under the work-product doctrine. The First Circuit reversed the Federal District Court of Rhode Island and set aside a First Circuit panel's holding the workpapers as privileged, instead holding that, because the workpapers were prepared "to support financial filings and gain auditor approval," (7) and not for use in litigation, the IRS could freely discover the tax accrual workpapers. The corporate world immediately criticized the controversial ruling, as critics rushed to assert that the ruling makes it more difficult to protect their clients in an increasingly opaque tax system. (8)

Why such strong criticism? First, corporate tax departments and IRS auditors have engaged in a tug-of-war over the IRS's ability to access a corporation's tax accrual workpapers, which are generally prepared both to support tax calculations published in its financial statements and its tax return and to gain insight into certain transactions whose tax effects may not have found their way onto the corporation's tax return. Textron, by rejecting the argument that tax accrual workpapers are prepared "in anticipation of [future] litigation" with the IRS, serves as the latest blow to the corporate world's hopes of work product protection. In addition, the First Circuit's conclusions in Textron have ramifications beyond the current financial reporting regime; as early as 2014, U.S. companies may be required to implement new international standards for income tax accounting, particularly when accounting for uncertain tax positions. This Note attempts to lay the foundation for how (if at all) these new international standards, in conjunction with the Textron decision and recent IRS Announcement 2010-75, will affect corporate tax departments across the United States.

Part I of this Note briefly provides the foundational background on financial statement preparation and the current rules regarding tax accrual calculations. Part II then discusses the current status of work-product doctrine with respect to tax accrual documentation, including an analysis of the First Circuit's Textron decision. Part III lays out the major policy arguments both for and against discoverability of tax accrual documentation. Finally, Part IV considers the upcoming transition to International Financial Reporting Standards (IFRS) and hypothesizes the consequences of the Textron decision with respect to these new rules.

1. THE NECESSARY BACKGROUND: FIN 48 AND THE WORKPRODUCT PRIVILEGE

   As a general matter, all publicly held companies in the United States are required to file financial statements with the Securities and Exchange Commission (SEC), (9) and the SEC requires that an independent auditor must audit all financial statements in accordance with Generally Accepted Auditing Standards (GAAS). (10) The independent auditor evaluates the company's financial statements relative to Generally Accepted Accounting Principles (GAAP), which the Financial Accounting Standards Board (FASB) promulgates, and then expresses an opinion on whether the financial statements fairly present the financial condition of the firm. (11)

   1. Accounting for Uncertain Tax Positions and FIN 48

      More specific to tax accounting, GAAP requires publicly held corporations to provide a reserve (12) for contingent tax liabilities and uncertain tax benefits, (13) which includes estimates of potential liabilities to the IRS if the IRS decides to challenge a corporation's positions in its annual tax return. (14) To prepare its tax reserve, a corporation reviews the positions it takes in its financial statements--that is, which tax benefits the corporation intends to record--and determines the likelihood that the position will be sustained after an IRS audit. (15) If it is "more likely than not" that the tax position will be sustained on the merits, then the "uncertain" tax position (UTP) can be recognized in the corporation's financial statements. (16) Corporations prepare workpapers to support their treatment of UTPs; these workpapers generally contain counsel opinions on the likelihood that the corporation's UTPs will be sustained in the event of an IRS audit. (17) Therefore, these workpapers list the "soft spots" of a corporation's tax return, which "could potentially serve as a 'roadmap' for the I.R.S. on audit." (18)

      Tax lawyers often play a prominent role in the decisionmaking process for recognition of UTPs; consequently, many tax reserve workpapers contain opinions from either in-house or outside counsel regarding whether it is "more likely than not" that UTPs would be sustained after an IRS audit. (19) As one scholar notes, "[w]here a tax position involves any significant amount of uncertainty, an outside opinion often will be the tax director's or CFO's best choice for documenting a decision to recognize all or part of the benefits from the position." (20) Further, in undertaking their duty to evaluate a corporation's financial statements, independent auditors will most likely ask to see the tax reserve workpapers, which may result in the waiver of attorney-client privilege regarding the tax opinions expressed in those workpapers. (21) To protect itself, then, a corporation generally would prefer not to disclose these workpapers, and would be especially averse to allowing the IRS to have access to them.

   2. Hickman v. Taylor and the Origins of Rule 26(b)(3)

      The work-product doctrine is intended to allow attorneys to prepare for litigation without opposing counsel having access to their thought processes, legal theories, or trial preparation work. (22) It is derived from the rule pronounced in Hickman v. Taylor, (23) and is now codified in Federal Rule of Civil Procedure 26(b)(3). In Hickman, the Supreme Court held that the plaintiff could not discover the defendant attorney's notes taken while interrogating a witness. (24) The Hickman Court specifically held that an attorney's mental impressions were not discoverable because "[p]roper preparation of a client's case demands that he assemble information, sift what he considers to be the relevant from the irrelevant facts, prepare his legal theories and plan his strategy without undue and needless interference." (25) The Hickman Court continued by stating its policy considerations:

      Were such materials open to opposing counsel on mere demand, much of what is now put down in writing would remain unwritten. An attorney's thoughts ... would not be his own. Inefficiency, unfairness and sharp practices would inevitably develop in the giving of legal advice and in the preparation of cases for trial. The effect on the legal profession would be demoralizing. And the interests of the clients and the cause of justice would be poorly served. (26) Rule 26(b)(3) codified Hickman's work-product doctrine. Rule 26(b) (3) states that documents prepared "in anticipation of litigation or for trial" by an opposing party or his representative are generally not discoverable, absent a showing of undue hardship. (27) Basing the codification on Hickman's policy concerns, the Advisory Committee enacted Rule 26(b)(3) because it deemed that "each side's informal evaluation of its case should be protected, that each side should be encouraged to prepare independently, and that one side should not automatically have the benefit of detailed preparatory work of the other side." (28) However, Rule 26(b)(3) also states that its protection can be overcome by showing a "substantial need" of the documents and the inability, "without undue hardship," to obtain equivalent documents through other means. (29)

      Rule 26(b)(3) is broader than the attorney-client privilege in that it protects more than just communications between an attorney and his client. (30) The reason behind the work-product doctrine's breadth is that it protects the adversarial system and an attorney's thoughts and impressions in preparation for litigation; alternatively, the attorney-client privilege seeks only to preserve candor in the lawyer-client relationship. (31) Finally, the work-product doctrine may be waived in a number of different ways. For example, work product protection is waived if the material sought to be protected is disclosed "in a way inconsistent with keeping it from an adversary." (32)

   3. Applying Rule 26(b)(3) to Auditing: United States v. Arthur Young

      As a final prefatory note, Textron is not the first time the federal court system has considered privilege and tax accrual workpapers; nearly twenty years prior to the issuance of FIN 48, the Supreme Court took up the issue in United States v. Arthur Young & Co. (33) In Arthur Young, the IRS issued a summons to a corporation's independent auditor requiring it to turn over tax accrual workpapers prepared during its audit of the subject corporation. (34) The independent auditor objected to the disclosure, arguing for the creation of an auditor-client privilege for documents prepared by a corporation's auditors. (35) The Supreme Court, holding that "the independent auditor assumes a public responsibility transcending any employment relationship with the client," refused to extend the work-product doctrine to accountant-client relationships. (36) Therefore, the IRS had the right to obtain tax accrual workpapers pursuant to...