Although privilege is frequently viewed as a litigation issue, taxpayers—particularly multijurisdictional taxpayers—should be aware of privilege issues that may arise in the context of an audit and, preferably, plan for such issues long before an audit begins.
Why? Analyzing and preparing for privilege issues early on will help companies better manage their global tax risks and controversies. Companies are more global, and taxing authorities worldwide are focused more than ever on international and cross-border transactions. Taxing authorities also are becoming better coordinated. For example, in 2004 the Joint International Tax Shelter Information Centre, or JITSIC, was formed under a Memorandum of Understanding between the tax administrations of Australia, Canada, the United States and the United Kingdom.1 Today, Japan, China and the Republic of Korea are members, with France and Germany participating as observers.2 JITSIC’s purpose is to supplement the work of the individual members’ tax administrations by identifying and curbing what they view as cross-border tax avoidance. JITSIC representatives do this through treaty mechanisms, and their work includes case-specific written exchanges of information and case conferences. These information exchanges “can involve testing a taxpayer’s commercial rationale for a series of transactions, including whether both tax authorities are being told the same story… ”3 Further evidence of increased cooperation and coordination are the joint audit protocols that were set forth by the Organisation for Cooperative Development in September 2010,4 as well as the joint audit program instituted by the Internal Revenue Service (“IRS”) and the Australian Taxation Office.5
The laws of privilege are complex, and a document that would be privileged in one country may not be privileged in another. Careful consideration of both country-specific rules as to the potential existence of a privilege and choice-of-law issues as to which country’s privilege laws control in a particular situation is therefore necessary before a providing a response to a taxing authority. Ideally, companies also should be mindful of the complexities of privilege in the context of multijurisdictional tax issues when creating and managing documents prior to the initiation of an audit.
An Overview of Privilege in the United States
In the United States, documents and communications may be protected from disclosure under: (i) the attorney-client privilege, (ii) the Internal Revenue Code Section 7525 tax practitioner privilege, or (iii) work product protection.
The first type of protection, the attorney-client privilege, seeks to “protect not only the giving of professional advice to those who can act on it but also the giving of information to the lawyer to enable him to give sound and informed advice.”6 Attorney-client privilege exists when legal advice is sought from a professional legal advisor in his or her capacity as such, the document at issue contains communications relating to the purpose of obtaining legal advice, and the communication is made in confidence by the client.7 The communication must relate to the provision of legal advice rather than business advice.8 Under US law, attorney-client privilege extends to communications with both in-house and outside counsel.9
Section 7525 provides for a tax practitioner privilege, similar to the attorney-client privilege, applicable to certain confidential communications between a taxpayer and a federally authorized tax practitioner.10 The tax practitioner privilege, however, is more limited than the attorney-client privilege. It is limited to federal tax advice11 and it applies only to noncriminal tax matters before the IRS or in federal court and only to the extent that the communication would be privileged if between an attorney and client. Importantly, no Section 7525 privilege can apply to written communications between a federally authorized tax practitioner and any person in connection with the promotion of the direct or indirect participation of the person in a tax shelter. A tax shelter is very broadly defined for purposes of Section 7525 and includes “any plan or arrangement, if a significant purpose of such plan or arrangement is the avoidance or evasion of federal income tax.”12
Neither the attorney-client privilege nor tax practitioner privilege will apply to information provided in connection with the preparation of a tax return.13 Any return-related activity must rise to a level beyond the mere preparation of the return.14 Some courts have interpreted the privilege narrowly, holding that communications relating to both return preparation and litigation are not protected.15 It is therefore important to understand the rules that are applicable in a taxpayer’s jurisdiction. In addition, tax practitioners performing both return preparation and providing tax advice must be vigilant in segregating their work.
In the United States, a third type of protection also may be available. Work product protection is both broader and narrower than the attorney-client or tax practitioner privileges. The work product doctrine is intended to preserve “a certain degree of privacy, free from unnecessary intrusion by opposing parties and their counsel.”16 It is not limited to communications and extends to the attorney’s mental impressions, conclusions, opinions, or legal theories concerning the litigation.17 However, work product protection is only afforded where the documents at issue were prepared in the context of actual or anticipated litigation.18 At a minimum, this requires the documents to have been created “because of” the prospect of litigation, and certain courts have required that litigation be the “primary purpose” of the document.19 Work product protection is not absolute, and a party may be forced to disclose a document upon certain showings by the adverse party.20
The attorney-client and tax practitioner privileges generally are waived by disclosure of confidential communications to a third party (including the taxpayer’s independent auditors).21 Waiver of work product protection is more limited and occurs only upon disclosure to an adversary.22 As discussed below, courts are split on whether the disclosure of work product (such as tax accrual workpapers) to independent auditors waives work product protection.23 The scope of a waiver of the attorney-client privilege or work product protection is now defined by Federal Rule of Evidence 502.24
Tax Accrual Workpapers
To the extent tax accrual workpapers are protected from disclosure, courts have relied upon the work product doctrine. The courts, however, are divided on the extent to which this protection can apply to tax accrual workpapers and on whether disclosure to an independent auditor waives any protection that would otherwise exist.25
Although court decisions are not uniform, the IRS’s policy of restraint (originally set forth in Announcement 2002-63) in seeking tax accrual workpapers is generally helpful to taxpayers.26 However, taxpayers should be aware that the Department of Justice is not obligated to follow the policy articulated by the IRS, and the IRS remains free to modify the policy at any time.
Applicability of Privilege
Because the existence of privilege varies by country, a communication may be privileged under the laws of one country but not another.27 For example, many countries exclude communications with in-house counsel from the scope of attorneyclient privilege while the same communications would generally be privileged under US law.28 In these circumstances, a taxpayer facing a request from a taxing authority for such a document must analyze choice of law principles to determine which country’s law controls in determining whether the communication is privileged.
The differences in privilege laws among countries are extensive and can significantly complicate multijurisdictional audits. For example, in the United Kingdom, the legal professional privilege is comprised of two components: (i) legal advice privilege and (ii) litigation privilege. Legal advice privilege is akin to the attorney-client privilege in the United States and covers confidential communications between a lawyer and his or her client made for the sole or dominant purpose of seeking or giving legal advice. The United Kingdom litigation privilege is akin to work product privilege in the United States, but is arguably narrower, as it requires existing litigation or a “reasonable prospect or pending” litigation. Litigation privilege also defines purpose of the document more narrowly than the US work product doctrine and requires the pending or actual proceeding to be adversarial, rather than investigative, in nature. Neither of these privileges extends to advice given by non-lawyers.29
In addition, certain jurisdictions presume that communications with in-house counsel are not privileged because of the lack of independence arising from the employment relationship.30 Again, however, the rules of the taxpayer’s particular jurisdiction must be considered. Even within the European Union, for example, the privilege rules of member states are not uniform.31 Importantly, the availability of privilege claims for communications with in-house counsel has been seriously called into question by a 2010 decision by the European Court of Justice. In Akzo Nobel Chemicals Limited v. Commission of the European Communities, the court upheld the UK’s determination that no privilege exists with respect to in-house counsel.32 The court held that while privilege does protect memoranda prepared by in-house counsel for the purpose of obtaining outside legal assistance, communications between a company’s general manager and its in-house lawyer were not privileged. The court articulated two requirements for legal professional privilege to attach: (i) the communication must be connected to the client’s right of defense, and (ii) the communication must emanate from independent lawyers and not in-house counsel. In addition, the court appeared to reaffirm its decision in AM&S Europe Limited v. Commission of the European Communities, in which it limited the privilege to only those lawyers governed by the applicable professional rules in one of the Member States.33
Given the complexity of cross-border privilege claims, it is important for taxpayers to consider privilege issues when responding to requests for information from taxing authorities. Companies would benefit by working with tax controversy counsel well-versed in these issues to develop and then implement a series of best practices and then involving skilled tax controversy counsel early on in an audit. In this way, the possibility of responses inadvertently waiving privilege, or a taxpayer determining during an audit that a privilege may be altogether lacking because, for example, of a failure to take the steps required under local law to establish the existence of a privilege in the first instance can be minimized.