Introduction

MNR v BP Canada Energy Company[1] is the first Canadian case dealing with whether a taxpayer’s subjective view of its tax filing position must be disclosed to the Minister of National Revenue (“Minister”) during an audit.[2]  BP came before the Federal Court (“FC”) pursuant to a compliance order application under ss. 231.7(1) of the Income Tax Act (Canada) (“Act”). The FC held in favour of the Minister and ordered that BP’s information had to be disclosed.

Public companies subject to external audit maintain and report reserves for contingent liabilities for accounting purposes, including those for tax risk arising from “uncertain tax positions” (“UTPs”).  Given the complexity and varying interpretations of fiscal statutes, there is always a risk that a taxpayer’s income tax return may be challenged by revenue authorities.  A UTP is a position taken in a tax return that might not ultimately be upheld during the tax dispute resolution and litigation processes, as determined from the subjective perspective of the taxpayer.  In BP,the Minister sought during an audit copies of BP’s tax accrual workpapers (“TAWs”) created by BP’s internal personnel that listed potential UTPs.[3]  Requested documents were produced with a list identifying UTPs redacted, leading to the Minister’s compliance order application.

BP:  Parties’ Arguments and FC Decision

The FC considered the following arguments advanced by the parties and held as follows:

  1. The Minister does not require BP’s subjective analyses to conduct a complete audit.

    The FC held the Minister was entitled to BP’s list of UTPs for statute-barred years to not only expedite the current audit, but to also use in continuing and future audits to determine taxes payable.

    There are merits to both sides of this argument.  On one hand, s. 230 of the Act requires taxpayers to keep books and records to enable the Minister to ascertain taxes payable or other amounts.  The Act does not specify the form of books and records and, as BP’s counsel submitted, the Act does not require taxpayers to prepare financial statements or underlying reserve analysis. 

    On the other hand, the scope of the various audit provisions of the Act vis-à-visdocuments and information is broader than the s. 230 requirements to keep books and records.  The Minister’s audit powers allow her to examine any taxpayer documents or those of another person that may relate to information that is or should be in the taxpayer’s books and records.  Further, there is no statutory exception for documents that exist and which the Minister wishes to receive, based on the taxpayer’s conclusion that the Minister doesn’t really need them.
     
  2. The Minister’s use of BP’s analyses offends Canada’s self-reporting system by conscripting taxpayers into also self-auditing.

    The FC rejected this argument on the basis that BP’s subjective analyses already existed and did not require BP to prepare anything new that could be construed as a self-audit.

    On this point, BP’s counsel correctly observed that self-assessment is a cornerstone of the Canadian tax system.  Taxpayers file what they believe to be accurate income tax returns and the Minister has the power to audit those returns as she sees fit.  There is no statutory basis for requiring a taxpayer to generate a memorandum outlining analyses of potential risks in its tax filings.

    The difficulty with the argument is that the definition of record in ss. 248(1) of the Act is extremely broad and the Minister has the statutory power examine a taxpayer’s records.  While the Minister might not be able to compel a taxpayer to create subjective analyses of its filing position, if analyses exist they are likely “records” and thus producible.  Further, the assertion that there is no obligation to self-audit under the Act is not entirely viable:  see the reportable transactions regime in s. 237.3.
     
  3. BP’s subjective analyses were not compellable because the Act does not require such analyses to be kept.

    The FC rejected this argument, stating that whether the Act required BP’s analyses to be kept is irrelevant, since they were documents relevant to the payment of tax and were within BP’s possession.  The same reasons set out above apply here as well.
     
  4. BP’s subjective analyses do not relate to the determination of tax payable under the Act.

    The FC rejected this on a literal interpretation of the audit provision in s. 231.1 of the Act.  As noted, the Minister’s audit powers are not restricted to books and records required under s. 230 of the Act.  Section 231.1 includes other documents of a taxpayer or another person that relate or may relate to information that is or should be in the taxpayer’s books and records or to any amount payable by the taxpayer.  Thus, the FC held that the TAWs related to the enforcement of the Act, information in BP’s records and also to amounts payable under the Act.

The FC considered BP’s public policy argument that TAWs contain information that allows independent auditors to prepare audited financial statements and that those statements ensure public confidence in capital markets.  BP’s counsel argued that routine requests for TAWs would place public companies in an untenable position: they must take accurate reserves for UTPs, while facing the risk that their analyses may be forcibly disclosed, potentially to the company’s detriment.  The FC refused to rule on this point, stating that if there are concerns about the compellability of TAWs then it is up to the Minister rather than the FC to address them, since the public interest is not within the FC’s purview. 

BP’s counsel argued that the Minister’s representatives conducted themselves in bad faith because those representatives did not divulge their true intentions during exchanges with BP, that there was a “pernicious intention to mislead” on the part of the Minister’s representatives and that the representatives’ conduct was a “charade”.  In this regard, the FC disregarded BP’s argument as based on speculation or belief and that the bad faith motive as never directly addressed to the Minister’s manager of the BP audit.  The FC held that there could not be a finding with respect to the motivation for the audit without providing the Minister’s audit manager a chance to explain. 

Finally, the FC considered BP’s assertion that it was treated unfairly compared with other taxpayers, as BP was a corporation subject to more rigorous financial reporting standards than other taxpayers.  The FC stated that the fairness question is actually a matter of perspective:  if a UTP is not detected and challenged by the Minister within the normal reassessment period, the taxpayer “wins” and the taxpayers of Canada “lose” – thus fairness depends whether it is viewed through the eyes of BP and its shareholders or all other taxpayers in Canada.

Comparison to US Cases

The US tax community was concerned after the US Supreme Court refused to hear theTextron[4] appeal.  In Textron, the US Court of Appeals for the First Circuit held privilege did not apply to TAWs, based on a narrow test.  Other US courts adopted a more lenient approach (Deloitte,[5] Roxworthy,[6] Regions Financial Corp.[7]) while the First Circuit must followTextron.[8]  Wells Fargo was the most recent taxpayer success in an IRS dispute.  In that case, IRS summonses sought TAWs, testimony regarding the preparation and content of the TAWs and processes for identifying and measuring UTPs.  The IRS also asked KPMG to give testimony and provide TAWs.

Wells Fargo’s TAWs included overviews created by WF’s accountants, with the benefit of legal advice.  The TAWs included opinions regarding potential litigation, including possible IRS arguments.  Some analyses predated Wells Fargo’s TAWs, since their lawyers were involved with identifying UTPs when the underlying business transactions were originally structured.  The lawyers’ analyses were relied upon to identify UTPs for financial reporting purposes.  Recognizing a UTP for the accountants was a matter of asking the lawyers about the stage of any dispute[9] and measuring a UTP depended on the lawyers’ views. 

Wells Fargo was in some ways similar to BP.  In Wells Fargo, the Court held that establishing the IRS had no valid purpose for requesting TAWs would be difficult and that violating the IRS’ “policy of restraint” for TAWs would not invalidate an audit.  Similarly, the Wells Fargo Court was not persuaded that the taxpayer was being treated unfairly.  The Wells Fargo Court also held that the recognition and measurement of UTPs was protected by work product privilege (similar to Canadian litigation privilege).  To be protected, documents must be prepared after the threat of litigation becomes palpable.  While identification of UTPs and related facts were not protected because identification arose in the normal course of business, recognition and measurement of UTPs was protected because it required legal analysis.  Communications with the taxpayer’s external auditors were not a waiver of privilege.  The Wells Fargo Court did not hold that all TAWs are created in anticipation of litigation and the hypothetical risk of litigation is not sufficient.  This is similar to the Canadian experience:  whether litigation was “anticipated” was considered in Crown Zellerbach Canada Ltd. v. Canada.[10]  In that case, the British Columbia Supreme Court concluded that for litigation privilege to arise, the litigation risk must be definite and not a mere vague anticipation.

Varying results in US cases may be attributed to a difference of opinion regarding the purpose of TAWs.  If they are viewed as accounting work to facilitate financial reporting, it seems reasonable that TAWs are not privileged.  However, TAWs are fundamentally legal analysis regarding litigation risk in situations where litigation may be reasonably anticipated.  Perhaps paradoxically, the outcome in BP makes it more likely that the Minister would seek to obtain taxpayers’ TAWs, leading to further litigation and therefore more strongly supporting the conclusion that TAWs are prepared in anticipation of litigation.  This would support the assertion of work-product / litigation privilege in the future.

Conclusion

It is difficult for an outside observer to know whether BP was an application the Minister litigated to deal with a single taxpayer, whether the case was a warning shot across the bow for other public companies and/or whether further and greater demands for TAWs will become typical, leading to more compliance order applications. 

The government of Canada has certainly taken steps in recent years to seek to detect what it describes as “aggressive tax planning”, whether by way of the reportable transactions regime or enhanced enforcement programs, for example, the national risk assessment model (“NRAM”).  The NRAM includes the large business audit program, requiring annual review of large businesses to detect aggressive tax planning.  The CRA has stated that it is working towards an automated strategy for identifying aggressive tax planning in the large business community.  Large businesses are subject to risk assessment that takes into account:  historic analysis of audit and behaviour patterns; local risk assessment and knowledge of the taxpayer; comparison of “effective tax rates” for large businesses against average within an industry; issue-based assessment to determine whether the large business is participating in a tax planning scheme; and determining whether there are connections between tax planning schemes and tax intermediaries.[11]

A litigation / compliance order strategy may dovetail with these CRA initiatives and would likely be a powerful tool in the Minister’s kit.  This is because UTPs are not necessary based on aggressive tax planning.  Thus, while the NRAM or the reportable transactions regime are intended to detect aggressive tax planning, a taxpayer’s TAWs likely reveal tax filing positions that while not necessary “aggressive” may be unsustainable.  The Minister may be emboldened by the result in BP and seek to use the more powerful risk detection tool of TAWs more frequently.

The Minister’s audit powers are, of course, limited by legal privilege, but are otherwise broad.  Case law suggests that documents prepared for purposes unrelated to tax liabilities may in any case be relevant to ascertaining tax payable[12] and further that communications between a taxpayer and an accountant are not privileged.[13]  With these principles in mind, public corporations may consider restructuring the way they receive advice regarding UTPs, as follows.

First, involving internal[14] or external legal counsel from the early stages of a transaction with respect to a tax exposure may support the position that the advice was solicitor-client privileged. Further, engaging legal counsel to evaluate UTPs may help establish that they were prepared in anticipation of litigation.  It is recommended that communications regarding UTPs be labeled as solicitor-client privileged and that the scope of advice be limited to legal advice without digression into anything that may be construed as business advice.

Second, to the extent that legal advice related to UTPs must be considered by a corporation’s external auditors, the doctrine of “limited waiver” of privilege may apply.  While the limited waiver doctrine may not apply to the voluntary disclosure of privileged communications, the Courts have held that at corporate law the disclosure of corporate records, including privileged documents, is not voluntary but compulsory.[15]  Thus, such disclosure is not made with the intention of waiving privilege and should not be regarded as a waiver. It is recommended that any privileged documents disclosed to external auditors pursuant to a statutory duty be labeled as privileged, with written confirmation that disclosure was made pursuant to a limited waiver.

Third, communications with accountants may be privileged where the accountant is engaged as the client’s agent to obtain legal advice for the client.[16]  Simply involving a lawyer is insufficient:  privilege does not attach to documents merely handed to a lawyer and put on file and privilege would only arise in respect of the lawyer’s legal work.  Further, third party communications are not automatically privileged simply because they assist a lawyer:  the third party’s expertise must be required to assist the lawyer in giving legal advice.  This further supports the conclusion that protecting TAWs on the basis of legal privilege requires tax analysis by a lawyer at any critical juncture.

Finally, litigation privilege may arise where a lawyer and accountant communicate in relation to anticipated litigation.  The Supreme Court of Canada (“SCC”) fashioned a test for determining whether communications or documents created for more than one purpose could be protected in Blank v Canada.[17]  The SCC considered whether privilege would apply only to communications made for the sole purpose of litigation or whether the correct standard was the “dominant purpose” or the “substantial purpose” of litigation.  In the SCC’s view, the dominant purpose test should apply.  Consequently, communications and documents are only protected by litigation privilege to the extent they are prepared for the dominant or substantial purpose of litigation.  This creates an obvious risk for TAWs, since it may be argued that they are created substantially for accounting purposes, unless the facts support the conclusion that litigation is anticipated and that such litigation is the dominant purpose of the analyses.

In summary:

  1. TAWs are relevant to a tax audit.  However, they are not “books and records” of a taxpayer under s. 230 of the Act.  Section 230 requires books and records “in such form and containing such information as will enable the taxes payable under this Act or the taxes or other amounts that should have been deducted, withheld or collected to be determined.”  Tax or other amounts should be determinable by a taxpayer’s accounting records and source documents.  TAWs are simply interpretations of a tax position at law, based the taxpayer’s books and records.  Arguably, there would be no requirement under the Act to keep TAWs in a taxpayer’s files after they have fulfilled their purpose.
     
  2. The Minister is empowered under s. 231.1 of the Act to not only audit the books and records of a taxpayer but also “any document of the taxpayer or of any other person that relates or may relate to the information that is or should be in the books or records of the taxpayer or to any amount payable by the taxpayer under the [Act].”  The statutory power to audit, inspect or examine “any document of the taxpayer or of any other person that relates … to the information that is [in] the books and records of the taxpayer” should be wide enough to include TAWs, if TAWs are preserved in the files of the taxpayer, its advisors or external auditors.
     
  3. The wording of s. 231.2 of the Act empowers the Minister to require a taxpayer to produce any information or document for any purpose relating to the administration or enforcement of the Act.

    However, despite the FC’s comments in BP there are policy reasons why the Courts should support a restrictive interpretation of both s. 231.1 and 231.2.  For example, taxpayers, accountants and external auditors should be encouraged to share information to ensure that financial and tax information and public filings are accurate and conservative.  Candid and conservative evaluation and limited disclosure of UTPs may be negatively impacted if TAWs were routinely compelled by the Minister. 
     
  4. Furthermore, prudent financial analysis may be based on “worst case” scenarios, even though litigation outcomes are inherently unpredictable, out of an abundance of caution.  If cautious, “worst case” scenarios are forcibly disclosed, there is an inherent risk that a CRA auditor would biased towards those scenarios.

    The CRA’s published policy on accessing taxpayer records as of June, 2010 stated that tax auditors would remain objective and uninfluenced by the subjective views of a taxpayer regarding its filing position.  Experienced tax counsel may be forgiven for being somewhat skeptical of this. This further militates towards a restrictive interpretation of both s. 231.1 and 231.2 of the Act.
     
  5. Disclosure of information to accountants who are auditing a corporation may be protected by the doctrine of limited waiver.
     
  6. If preparing TAWs were held to be an accounting or business exercise, solicitor-client privilege would not apply, regardless of lawyers’ involvement. Determining whether TAWs would be solicitor-client privileged would be a fact specific exercise dependent on the extent of lawyers’ involvement and the nature of their work.
     
  7. Whether litigation privilege would apply to TAWs depends on whether:
    • the dominant purpose for their preparation concerns pending or anticipated/contemplated litigation, where litigation risk is tangible and not remote or vague; or
    • they are prepared for business, financial reporting/accounting or audit purposes, where the risk of litigation is neither dominant nor anticipated.

Underlying legal opinions with respect to TAWs should be segregated as privileged.  Access to legal analyses by third parties should be limited and the doctrine of limited waiver may be relied on to the extent that disclosure is required for financial reporting.  Confirmation should be obtained from external auditors that TAWs would not be released to revenue authorities without consent.  Finally, to the extent that document retention is not otherwise required by law, taxpayers should evaluate purging TAWs and underlying analyses as part of their normal document retention policies.