Nancy T. Bowen, William S. Lee and Robert C. Morris
August 19, 2009
In a highly controversial 3-2 decision, the United States Court of Appeals for the First Circuit ruled in United States v. Textron, Inc., 2009 U.S. App. LEXIS 18103 (1st Cir. Aug. 13, 2009), that the work product privilege does not protect a company's tax accrual work papers from IRS discovery. The First Circuit concluded that tax accrual work papers are not work product, because they are prepared to support a company's financial statements and gain auditor approval, rather than "for use in possible litigation." Textron is an important decision that may have far-reaching implications, particularly for publicly traded companies.
Tax Accrual Work Papers
Securities laws require that the financial statements of publicly traded companies be audited and certified by an independent auditor. A company's financial statements must reflect the company's reserves or accruals for its potential exposure relating to items that, if identified and challenged by the IRS, may result in additional taxes being assessed. A company's financial statements do not normally identify the specific items that the company has reserved for, but rather reflect the total amount of reserves related to those specific items.
To calculate the total amount of tax reserves, the company's tax and legal personnel generally create tax accrual work papers which may include an analysis that breaks down item by item the "soft spots" on the company's tax return. The company's analysis may include legal opinions and other analysis, including the dollar amount of potential exposure and the company's percentage estimate of success relating to that item. During the course of the company's audit by its independent auditors, the auditors will typically require access to the company's tax accrual work papers so that the auditors may review the adequacy and reasonableness of the company's tax reserves.
Textron's Tax Accrual Work Papers
During an IRS examination of Textron, the IRS agents found that a Textron subsidiary had invested in multiple listed transactions that the IRS had determined to be tax avoidance transactions. The IRS then issued Textron an administrative summons seeking all tax accrual work papers for the tax years in issue. Textron refused to provide its tax accrual work papers on a variety of grounds, including the work product privilege. The IRS then brought a summons enforcement action in federal district court seeking a court order that Textron produce the tax accrual work papers.
Textron's tax accrual work papers included a spreadsheet that listed each debatable item, including in each instance the dollar amount subject to possible dispute and a percentage estimate of the IRS's chance of success. The tax accrual work papers also included backup materials to the spreadsheet, including notes and memoranda written by Textron's in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet and the hazard of litigation percentage that should apply to each item.
The district court concluded that the tax accrual work papers were protected by the work product privilege because Textron would not have prepared the tax accrual work papers "but for" the fact that Textron anticipated the possibility of litigation with the IRS. United States v. Textron, Inc., 507 F. Supp. 2d 138, 150 (D. R. I. 2007). The district court, which was later affirmed by a panel of the First Circuit, rejected the Fifth Circuit's "primary purpose" test which examines whether the primary motivating force behind the tax accrual work papers was to prepare the taxpayer for possible future litigation. See United States v. El Paso Co., 682 F.2d 530 (5th Cir. 1982), cert. denied, 466 U.S. 944 (1984). Instead, the district court and First Circuit panel applied the test that was previously articulated by the First Circuit in Maine v. U.S. Dep't of Interior, 298 F.3d 60 (1st Cir. 2002), which provides work product protection for documents prepared "because of" expected litigation. At the IRS's request, the First Circuit later vacated its panel opinion in Textron and granted the IRS's motion for a rehearing. United States v. Textron, Inc., 560 F.3d 513 (1st Cir. 2009).
First Circuit Reverses Course and Adopts Narrow New Work Product Test
After rehearing, the First Circuit, in a 3-2 en banc decision, reversed the district court and concluded that the work product privilege did not apply to Textron's tax accrual work papers. The majority opinion appears to have created a newly minted "for use in possible litigation" test to determine whether a document is protected by the work product privilege.
The majority focused on the intended use of the tax accrual work papers, rather than whether the work papers were prepared "because of" the prospect of future litigation. The majority noted that even though the tax accrual work papers may represent legal thinking, the work papers were not protected by the work product privilege because Textron did not prepare the work papers for use in possible litigation, but instead to quantify its tax reserves and obtain a clean opinion from its auditors. The majority concluded that "[a]ny experienced litigator would describe the tax accrual work papers as tax documents and not as case preparation materials." Textron, 2009 U.S. App. LEXIS 18103, at *20. The majority buttressed its opinion by citing testimony of an IRS expert that Textron would still be required to prepare tax accrual work papers even if the chances of litigation were remote. Accordingly, the tax accrual work papers were not protected by the work product privilege because they were not prepared "for use in possible litigation."
Possible Implications of Textron Decision
The Textron decision may have implications for a number of taxpayers, and particularly publicly traded companies. At a minimum, Textron adds further uncertainty to the already confused legal arena governing the discovery of tax accrual work papers. Taxpayers will now have to consider which of at least three possible tests may apply to provide (or deny) work product protection to their tax accrual work papers: (1) the "because of" or "but for" potential litigation test; (2) the "primary purpose" of preparing for potential litigation test; or (3) the "for use in possible litigation" test.
In addition to adding to legal uncertainty for all taxpayers, the Textron decision will be particularly problematic for taxpayers in the First Circuit or in other jurisdictions that adopt the Textron "for use in possible litigation" test. The Textron opinion makes clear the majority's view that it is "more than dubious" to conclude that tax accrual work papers would ever be prepared "for use in possible litigation," and thus the work papers would not be protected by the work product privilege. Textron, 2009 U.S. App. LEXIS 18103, at *19.
The potential lack of work product protection for tax accrual work papers is a real concern, despite the IRS's announced policy of self-restraint in requesting tax accrual work papers. First, as in Textron, the IRS will seek a company's tax accrual work papers if the IRS determines that the taxpayer has participated in listed transactions. See IRS Announcement 2002-63, 2002-2 C.B. 72. Second, the IRS may seek a company's tax accrual work papers under certain broadly defined "unusual circumstances" that are set forth in the Internal Revenue Manual, as well as in cases being investigated by the Criminal Investigation Division. Finally, the IRS's policy of self-restraint does not apply in the litigation of a tax dispute. In fact, it is not at all unusual for the government to issue broad-ranging requests for discovery of a company's tax accrual work papers in tax litigation.
Textron Ramifications May Extend Beyond Tax Arena
As noted by the vigorous dissenting opinion, the majority decision also has ramifications that may extend well beyond the tax arena. Under the newly created "for use in possible litigation" test, the adversary in any sort of litigation may seek to discover the opposing party's analysis of the business risks of the litigation, including the amount of money set aside in a litigation reserve fund. Furthermore, documents analyzing anticipated litigation, but prepared to assist in a business decision rather than in the conduct of the litigation, may not qualify for work product protection under the reasoning of Textron.
It is currently unknown whether Textron will petition the United States Supreme Court for a writ of certiorari.
This article was prepared by Fulbright's Tax Practice Group. If you have any questions or need any assistance related to these matters, please feel free to contact Nancy T. Bowen, William S. Lee (firstname.lastname@example.org or 713 651 5633) or Robert C. Morris (email@example.com or 713 651 8404).
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Nancy T. Bowen
William S. Lee
Robert C. Morris