In-house perspectives on considerations to protect privilege with respect to tax-related materials.

• Author: Haas, B. Benjamin

Introduction

There has been quite a buzz surrounding the 3-2 decision of the United States Court of Appeals for the First Circuit in United States v. Textron. (1) The majority in Textron effectively created a new and troubling standard for protecting documents under the work-product doctrine. Specifically, the majority crafted a new standard of "prepared 'for use' in potential litigation" with respect to spreadsheets that detailed Textron's tax accruals. (2) The majority determined that Textron's workpapers were not produced "for use" in litigation because they were "independently required by statutory and audit requirements and that the work-product privilege does not apply." The decision in Textron left many unanswered questions, including (i) whether backup memoranda can be considered work product even if the accompanying spreadsheets are not, and (ii) if the subject documents are shared with an outside auditor, whether work-product protection is waived under a theory that the auditor could be a conduit to a potential adversary (e.g., a taxing authority). Textron's petition for a writ of certiorari was denied by the Supreme Court on May 24, 2010, making actions to protect privileged documents more important. (3)

As discussed in an article in the January-February 2010 issue of The Tax Executive, the Textron decision has broad implications in the state tax arena. (4) For example, states generally request tax accrual workpapers in more circumstances than the Internal Revenue Service does and few state courts have defined "in anticipation of litigation" for state tax purposes; instead, most rely on the standards set by federal law. (5) Many state departments of revenue (both within and outside the First Circuit) may begin using Textron's "for use" standard. It also is possible that providing workpapers to one state department of revenue could result in the waiver of work product protection in other states, regardless of the other states' standards for determining when work product protection applies.

Background

In addition to Textron-related issues, the Commissioner of Internal Revenue and IRS Chief Counsel have undertaken to modify the general relationship that the IRS has with large taxpayers by increasing the emphasis on tax risk management and transparency. (6) Since the Supreme Court's decision in United States v. Arthur Young & Co., (7) the IRS generally has adhered to a "policy of restraint" with respect to tax accrual workpapers. (8) In 2002, the IRS revised its policy to permit the IRS to request tax accrual workpapers related to "listed transactions." (9) This self-imposed policy was not intended by the IRS as an acknowledgment that tax accrual workpapers are somehow protected under the attorney-client or statutory tax practitioner privilege. In fact, case law has fairly consistently held that tax accrual workpapers, once shared with an outside auditor, lose any potential for attorney-client or tax practitioner privilege. (10)

Most recently, the IRS issued Announcement 2010-9, (11) which effectively paves the way for the IRS to receive a road map that identifies uncertain tax positions of certain large corporate and partnership taxpayers. Announcement 2010-9 states that the IRS is developing a schedule that will require large business taxpayers to report uncertain tax positions on their tax returns. A draft of the schedule was released on April 19, (12) and while it may be revised, Schedule UTP currently requires (i) a concise description of each uncertain tax position for which the taxpayer or a related entity has recorded a reserve in its financial statements and (ii) the maximum amount of potential federal tax liability attributable to each uncertain tax position (determined without regard to the taxpayer's risk analysis regarding its likelihood of prevailing on the merits). In addition to uncertain tax positions required to be reported under FIN 48, the IRS would also require the reporting of any position related to the determination of any federal income tax liability for which the taxpayer or related entity has not recorded a tax reserve because (i) the taxpayer expects to litigate the position or (ii) the taxpayer has determined that the IRS has a general administrative practice not to examine the position. (13)

Announcement 2010-9 does not purport to seek everything that typically is in a taxpayer's workpapers, including, for example, the odds of success or allocated reserves, which is the information that is the subject of Textron. In addition, IRS Chief Counsel William Wilkins has stated that the new reporting obligation "does not directly change the IRS's policy of restraint with respect to tax accrual workpapers or make an end run around summons enforcement." (14)

Although the final contours of these developments are unclear, they collectively should cause in-house tax professionals to review their processes and procedures with respect to confidential documents. A key component from an in-house tax practitioner's perspective will be defining the line between collaboration with the IRS and protecting privileged material, as well as ensuring that internal tax risk management policies are adhered to in a consistent and uniform manner.

The following discussion presents an in-house perspective on potential considerations to protect tax documents from discovery by taxing authorities. The issue of privilege protection is particularly relevant with respect to tax-related documents. For example, these documents could provide a roadmap of the technical issues and the taxpayer's legal analysis of the strengths and weaknesses of such technical issues. In addition, such documents likely reveal the taxpayer's reserve for each item, as well as facts that the taxing authority may not otherwise discover. Furthermore, these documents may present facts and issues in a less favorable light due to the nature of their preparation.

A well-defined policy that takes into account as many of the following considerations as practicable under the circumstances should place a taxpayer in the best possible position to defend against privilege challenges with respect to its tax accrual workpapers. (17)

Practical...