Just when corporate tax departments might think that the recent Textron1 case had opened the door for IRS discovery of all sensitive tax-related documents, along comes the DC Circuit this week with an opinion affirming important protections for some types of documents, and possibly calling into question the result in Textron.
The new decision, U.S. v. Deloitte, No. 09-5171 (June 29, 2010), has significant implications for how corporate tax departments interact with their independent financial statement auditors.
- The attorney-client and Section 7525 tax advisor privileges can be strong sources of protection concerning a company’s written tax advice, but these privileges are flimsy in that they are generally waived upon disclosure to any third party, even the company’s independent auditor.
- Because companies must often disclose their legal advice to independent auditors to obtain unqualified financial statements, the work product doctrine has become central in discovery disputes with the IRS. Work product is not necessarily waived upon disclosure to any third party.
- But work product requires a showing that the document was created “in anticipation of litigation.” The Deloitte case holds that even if a document is created in the course of a financial audit, and even if the document is created by financial auditors (rather than the taxpayer’s counsel), it is still protected if the content of the document represents work product.
The Context of the Dispute
The Deloitte case is significant because the government made a targeted request for the types of documents that create worries for tax departments of publicly held companies – documents that memorialize or disclose the thinking of tax counsel on tax issues that are likely to be of interest to the IRS. These included (i) a copy of a law firm tax opinion the taxpayer had obtained, (ii) a memo written by one of the taxpayer’s in-house lawyers and (iii) a memo written by the independent auditor memorializing oral opinions made by the taxpayer’s counsel. Because these documents were disclosed to (or created by) a third party, the attorney-client and Section 7525 privileges seemed out of the question here. Therefore, the taxpayer (Dow Chemical Company) asserted the documents were protected by the work product protection as having been prepared “in anticipation of litigation.”
The Deloitte Memo Memorializing Oral Legal Opinions
First, the government argued that a memo written by an independent auditor could not be protected work product at all because it was created not by the taxpayer’s lawyers but by an accounting firm that was not rendering legal advice. Second, the government argued that the Deloitte memo was not protected because it was generated as part of Dow’s financial audit process, which is obviously not litigation. The Court of Appeals rejected both arguments, stating “the question is not who created the document or how they are related to the party asserting work product protection, but whether the document contains work product .” Slip. Op. at 8-9. Therefore, material developed in anticipation of litigation can be safely incorporated into documents produced during an audit “without ceasing to be work product.” Id.at 13. The court sent the case back to the district court with instructions to determine what portions of the memo comprised work product; any other type of material would have to be produced after the work product was redacted.
The Outside and In-house Counsel Documents
The government had conceded that the documents written by outside attorneys and in-house counsel were protected by work product, but stated the protection was waived upon disclosure to Deloitte. Waiver of work product, however, requires that either: (i) the third party who receives the disclosure is an adversary or (ii) the third party is not an adversary, but the disclosure nevertheless makes it more likely that a true adversary will subsequently be able to obtain the document (the so-called “conduit theory”). The court held that there was no waiver of work product protection with respect to the three documents because Deloitte was neither a potential adversary nor a conduit thereto.
- Textron appears under challenge by a significant Court of Appeals decision. The court suggested that the First Circuit had applied an overly exacting standard compared to the standard that would apply in the DC Circuit. Id. at 13. Significantly, it is difficult to reconcile the results in Textron with the content-based approach taken by Deloitte. Textron’s documents (master reserve schedules) could, depending on the facts, easily incorporate or reflect attorney work product. If the work product was itself made in anticipation of litigation, then under the DC Circuit’s rationale, it would be protected work product even if it was subsequently in accountants’ files.
- Forum Shopping. The Deloitte case demonstrates that work product issues relating to multipurpose documents continue to divide the courts and that different courts approach these issues in different ways. At the margins, a company seeking to protect its tax-related document might have an easier time, for example, litigating in Washington DC, as opposed to Boston or Houston.
- Schedule UTP. Many have suspected that the IRS’s recently proposed Schedule UTP,2 in which taxpayers must report information concerning their financial statement tax reserves, was premised on Textron’s holding being adopted as the law of the land across the country. Deloitte suggests that other courts might conclude differently. The decision may provide a springboard for further consideration of the work product implications inherent in the IRS’s new requirement for disclosure of uncertain tax positions.
- Communications with Independent Auditors. Finally, the decision also provides significant authority on the issue of waiver in an independent auditor context. This means that where a document is clearly protected as work product, companies will have more comfort than before that showing the document to their auditor may not result in a waiver.
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1. See our previous Tax Controversy Update, “US First Circuit Changes Course In Textron; Holds Tax Accrual Workpapers Are Not Protected After All,” August 17, 2009.
2. See our previous Legal Update, “US IRS Proposes New Disclosure Rules for Information on Uncertain Tax Positions,” January 29, 2010.