The pursuit of transparency does not trump the work product privilege.

• Author: Henkel, Michelle M.

In the past decade, the role of corporate tax executives has drastically changed, with executives are operating in an environment with more burdensome requirements and with greater demands for transparency by the financial statement auditors and the Internal Revenue Service. Today's environment is largely the result of (i) the tax shelter initiatives by the IRS and other tax authorities after the Enron collapse in 2001, (ii) the enactment of the Sarbanes-Oxley Act in 2002, and (iii) the issuance of FASB's Interpretation No. 48, Accounting for Uncertainty in Income Taxes, (FIN 48) in 2006.

Corporations must grant their auditors complete transparency to avoid a qualified audit opinion. At the same time, this disclosure raises the issue whether the traditional privileges have been waived. For tax executives, the issue at the forefront is the protection of tax accrual and FIN 48 workpapers and other documents that can provide a roadmap to the tax authorities in auditing corporate tax returns. The IRS, for example, is more inclined to summons to taxpayers, and even third parties, to obtain the desired documents. In public forums, the IRS has touted its right to access these documents and has continuously relied on the Supreme Court decision in Arthur Young & Co. v. United States (1) for the proposition that tax accrual workpapers are not privileged. In response, taxpayers have argued that Arthur Young is distinguishable and that the IRS has no bona fide need for these workpapers. There is now case law that should, at a minimum, give the IRS pause in its pursuit of complete transparency. The decisions in United States v. Roxworthy, (2) United States v. Textron, Inc., (3) and Regions Financial Corp. v. United States (4) give tax executives real hope of preserving privilege. These cases represent an emerging line of authority holding that the work product privilege is alive and well in the tax world and that this privilege can protect critical documents from disclosure to the IRS and other tax authorities.

FIN 48: Mandatory Litigation Risk Assessment

For all business enterprises that are subject to generally accepted accounting principles (GAAP), FIN 48 provides rules for recognizing and measuring all tax positions that were previously taken in a filed tax return or that are expected to be taken in a future tax return. (5) In summary, FIN 48 uses the following two-step analysis for evaluating a tax position:

Step 1--Recognition. A tax position cannot be recognized in financial statements unless it is more likely than not that the tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. (6) In making this evaluation, the enterprise must assume that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information. (7)

Step 2--Measurement. If the recognition threshold is met, the amount of the benefit that will be recognized in the financial statements is the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement?

Of course, an assessment of litigation risk is not a new process for corporate taxpayers. They have always undertaken this type of analysis in establishing tax reserves. FIN 48 has simply mandated the methodology by which tax positions are recognized and measured, and this methodology necessarily encompasses the litigation risk assessment.

Although FIN 48 requires a litigation risk assessment, it does not require any specific documentation with respect to its two-step analysis of tax positions. Nevertheless, corporate taxpayers are routinely preparing FIN 48 workpapers to document their analysis. It is not uncommon for these workpapers to include (i) an inventory of uncertain tax positions, (ii) a litigation risk assessment for each tax position, and (iii) a matrix of the probabilities of succeeding on the merits for each tax position. These workpapers are reviewed by the outside auditor as part of the financial statement review and issuance of the related audit opinion.

IRS's Policy of Restraint: Is It Reliable?

1. The Current Policy

   In March 2007, the IRS's Office of Chief Counsel announced its position that FIN 48 workpapers are tax accrual workpapers and are subject to the IRS's current policy for requesting tax-related workpapers. (9) This policy varies by the type of workpapers at issue, and to optimize any privilege against disclosure, it is prudent for taxpayers to segregate these workpapers. In this regard, the IRS has delineated three types of workpapers:

   * Audit Workpapers: These workpapers are created by or for the independent auditor and are retained by the auditor. (10) They include information about the procedures followed, the tests performed, the information obtained, and the conclusions regarding the auditor's review of the financial statements. (11) They may include work programs, analyses, memoranda, letters of confirmation and representation, abstracts of company documents, and schedules or commentaries prepared or obtained by the auditor. (12)

   * Tax Accrual Workpapers: These workpapers are audit workpapers, whether prepared by the taxpayer or an independent accountant, relating to the tax reserve for current, deferred, and potential or contingent tax liabilities and to the footnotes disclosing those tax liabilities. (13) The total reserve amount is not part of the tax accrual workpapers and, therefore, can be requested as a routine part of the tax audit. (14) On the other hand, the existence or amount of a tax reserve for a specific issue is part of the tax accrual workpapers. (15)

   * Tax Reconciliation Workpapers: These workpapers are used in assembling and compiling financial data preparatory to placement on a tax return. (16) They typically include final trial balances for each entity and a schedule of consolidating and adjusting entries and information used to trace financial information to the tax return. (17) Any tax return preparation documents that reconcile net income per books or financial statements to taxable income also are tax reconciliation workpapers. (18)

   Under the IRS's current policy, tax reconciliation workpapers are the only workpapers that should be requested as a routine part of a tax audit. (19) For both audit and tax accrual workpapers, the IRS has announced a policy of restraint even though the IRS takes the position that Arthur Young recognizes the IRS's right to obtain tax accrual workpapers. (20) Under this policy, the IRS should seek audit or tax accrual workpapers only in "unusual circumstances" because the primary source of facts should be the corporation's records. (21) The requisite unusual circumstances exist if (i) a specific factual issue has been identified by the IRS and additional factual information is needed; (ii) the IRS sought this factual data from the taxpayer and third parties; and (iii) the IRS sought a supplementary analysis of facts and performed a reconciliation of the Schedule M-1 or M-3 as it relates to that issue. (22) Even where these circumstances exist, the IRS's request for audit or tax accrual workpapers should be limited to the portion of the workpapers that is "material and relevant" to the tax audit. (23)

   Despite the policy of restraint, the IRS has carved out an exception for corporations that have engaged in one or more "listed transactions." (24) If the listed transaction was properly disclosed, the IRS can request the tax accrual workpapers relating only to that transaction for the year under audit, but can request the same workpapers for other years if relevant to the current year's audit. (25) On the other hand, if the listed transaction was not properly disclosed, the IRS can request all tax accrual workpapers for the year under audit and also can request the workpapers for other years if relevant to the current year's audit. (26) The IRS also can request all tax accrual workpapers for the year if either (i) the taxpayer claimed tax benefits from multiple listed transactions even if they were properly disclosed or (ii) the taxpayer had a single listed transaction that was properly disclosed and also had reported financial irregularities. (27)

2. Growing Concerns

   In the tax community, there is a growing concern about the need to provide the IRS and other tax authorities with tax accrual workpapers, which now include FIN 48 workpapers. These workpapers can highlight "soft spots" in the corporate tax returns and, therefore, can serve as a roadmap to these tax authorities. In addition, corporations are concerned that tax authorities will use the individual reserve amounts in the workpapers as a starting point in settlement negotiations for disputed tax positions. Some of the critical questions faced by today's tax executives are whether the tax accrual workpapers and other documents are protected under a claim of privilege, whether the privilege is waived by disclosure to the outside auditor, and whether the tax authorities have a bona fide need for the documents.

   Many hear references to privilege and immediately think of the attorney-client privilege and the federal practitioner privilege under section 7525 and, as a result, dismiss privilege claims because these privileges are waived upon disclosure of the documents to the outside auditors. A separate privilege, however--the work product doctrine or privilege--may operate to provide complete transparency to the outside auditor, while protecting documents from being disclosed to tax authorities.

3. Precautions for Taxpayers

   Even if a corporation did not engage in a listed transaction, it should consider the significance of the privilege issue because the IRS's policy of restraint may change. Indeed, the IRS has changed its policy before. For years, the IRS used only the "unusual circumstances" standard for requesting tax accrual workpapers, and such...