Privilege meets transparency: can we practice safe tax?

• Author: Kaplan, Steven Z.

In the most important aspects of our lives--those that affect our physical, emotional, spiritual, and legal well-being--we intuitively understand the need for strict confidentiality. When a patient seeks treatment from her physician, a penitent solicits guidance and forgiveness in the confessional, or a client requests legal advice from his attorney, the assurance that their communications are confidential enables them to obtain the meaningful help they seek.

There is, of course, a societal cost that must be paid for confidentiality. By shrouding these communications with secrecy, the law denies government agencies and private parties access to that information, even if it is relevant to an issue they may legitimately be pursuing. In such situations, however, society has made the value judgment that the benefits derived from those privileges outweigh the costs of denying others access to the information. The bedrock principle of confidentiality has served us enormously well over the years, despite its cost.

To quote Bob Dylan, the times are changing. In white collar investigations, the Department of Justice routinely insists that corporations and their executives waive claims of privileges as a condition to obtaining the purported benefits of "cooperation" and "acceptance of responsibility" for their actions. In the Valerie Plame-CIA leak investigation, news reporters fend off grand jury subpoenas for disclosure of their confidential sources and notes. Even in the usually lower profile world of civil litigation, claims of privilege often fair only slightly better.

That privilege has fallen out of favor in recent years may largely be a function of the exponentially increasing quantity and probative value of electronic communications. Powerfully revealing communications of the type that never before existed now remain accessible, despite usage of the delete key. The human propensity to express galactically stupid thoughts in writing, the technology to retrieve them, and the breathtakingly reckless (if not criminal) acts of corporate wrongdoing have combined to induce adversaries to seek production of enormous quantities of information in the hope that something may exist to prove their worst allegations.

The courts are now often inclined to accommodate these discovery efforts. For many judges, a claim of privilege poses an interesting intellectual proposition, but also one that should, at least in a close case, yield to the perceived greater good of access to information. With privilege under attack, two essential questions arise for corporate tax practitioners:

* Are there any meritorious claims of confidentiality available to a corporation (and its outside advisers), and

* If so, can the corporation continue to maintain them in the face of the ever increasing demands by government and shareholders for disclosure of potential tax liabilities?

In short, can claims of privilege endure in an increasingly transparent world?

Tax Advice Privileges

1. The Attorney-Client Privilege

   The attorney-client privilege protects communications between the client and the lawyer made for the purpose of enabling the lawyer to provide legal advice or other legal services to the client, as long as both of them intend for the communications to remain confidential and the purpose of the communication is not to further a crime or a fraud. United States v. BDO Sideman, LLP, 2005-1 USTC ¶ 50,264 (N.D. Ill. 2005); United States v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997). The "crime-fraud" exception to the privilege applies even if the lawyer is entirely unaware that the client's purpose in having seemingly innocuous legal work performed is to further a fraud scheme.

   1. The Kovel Doctrine Expands the Privilege. If the taxpayer and her lawyer spoke different languages, they would surely require the assistance of a translator to make possible their communications and the lawyer's rendering of legal advice. Because the presence of the translator would be indispensable to the rendering of legal advice, the translator would be viewed as the client's or lawyer's agent to enable the giving of advice, and the translator's involvement would not destroy the claim of privilege.

      In United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), a law firm that employed an accountant on its own staff represented a taxpayer who was the target of a grand jury investigation focusing on whether he had committed various income tax offenses. To assist the firm in advising the taxpayer, the taxpayer communicated information to the in house accountant who, in turn, helped explain the client's business and tax reporting to a lawyer in the firm.

      The government subpoenaed the law firm's files on the ground that the communications involving the accountant were not subject to the attorney-client privilege. The law firm responded that the use of the accountant was indistinguishable from the use of a foreign language interpreter because the tax and accounting concepts that the accountant communicated to the lawyer were every bit as "foreign" to the lawyer as a language that he did not speak.

      The Second Circuit adopted the law firm's foreign language translator analogy and concluded that because the law firm's use of an accountant to assist it in understanding the content of the client's business and financial affairs fostered attorney-client communications and the giving of legal advice, the accountant's communications with both the lawyer and the taxpayer were privileged.

      Crucial to Kovel's holding was the court's determination that the presence of the third party was essential to effective communication between the lawyer and the client. On the other hand, Kovel recognizes that if a lawyer or the client retains an accountant because the client needs accounting or tax return preparation services, neither the accounting work nor any communications between the accountant and the lawyer or between the accountant and the taxpayer are subject to the attorney client privilege.

      The court in Kovel acknowledged the inherent difficulty in distinguishing between situations in which the lawyer needs the accountant to assist the lawyer in rendering legal advice to the taxpayer and other cases in which the lawyer or the client simply want to retain the accountant to perform accounting services unrelated to the rendering of legal advice. The court concluded, however, that no matter how elusive this distinction may be in a given case, drawing it is necessary in a system in which there is an attorney-client privilege, but no accountant-client privilege.

      The distinction that Kovel drew between communications that merely inform the lawyer and those that enable the lawyer to communicate with the client was presented in the Second Circuit's decision in United States v. Ackert, 169 F.3d 136 (2d Cir. 1999). There, a tax lawyer's discussions with an investment banker, though essential to the lawyer's understanding of the proposed transaction and his giving of legal advice to the client, were not protected by the attorney-client privilege because the conversations between lawyer and investment banker did not directly enable the lawyer and the client to communicate with each other.

   2. In-House Tax Department Advice. Suppose a corporation employs lawyers in its tax department to work with its other tax professionals in performing the company's tax compliance and reporting functions. If the tax lawyers give tax advice to the company to enable the company to comply with the tax law, is that advice subject to claims of attorney-client privilege? Under the existing case law, the presumption is that the advice is not privileged because it is considered "business advice" or "accountant's work" and not legal advice. United States v. Chevron Corp., 1996-1 USTC ¶ 50,201 (N.D. Cal. 1996); United States v. KPMG, LLP, 237 F. Supp.2d 35 (D. D.C. 2002).

      The courts presume that in-house tax lawyers who are not working in the office of the general counsel and who do not therefore provide a broad range of legal advice to the company are likely providing only non-legal business advice. That presumption applies unless the corporations can establish that the advice given by the in-house tax department lawyer is the equivalent of what the company would have obtained had the same lawyer been serving in its general counsel's office or as a member of the company's outside law firm. The opposite presumption...