There was only one catch and that was Catch-22. . . . “[A person] would be crazy to fly more missions and sane if he didn’t, but if he was sane he had to fly them. If he flew them he was crazy and didn’t have to; but if he didn’t want to he was sane and had to.” Yossarian was moved very deeply by the absolute simplicity of this clause of Catch-22 and let out a respectful whistle.
“That’s some catch, that Catch-22,” Yossarian observed.
“It’s the best there is,” Doc Daneeka agreed.
—Joseph Heller, Catch-22
In a recent decision of the U.S. Court of Appeals for the First Circuit in Textron, Inc. v. United States, an en banc panel refused to apply the attorney work-product privilege to protect a corporation’s tax accrual papers from disclosure to the IRS. Armed with this decision, the IRS (and other litigants) may soon place many corporations into a modern catch-22 with the likely effect of eroding the quality of certain corporate disclosures to clients.
Like all publicly traded companies, Textron (together with its subsidiaries) is required by federal securities laws to have its financial statements certified by an independent auditor. In 2006, the Financial Accounting Standards Board issued its Interpretation Number 48 (“FIN 48”), which states that companies with audited generally accepted accounting principles (“GAAP”) financial statements must analyze, document and establish reserves for contingent tax liabilities— i.e., companies’ uncertain or controversial tax positions. FIN 48 requires that companies determine the likelihood that the IRS (or any other taxing authority) will reject these positions in subsequent litigation. The taxpayer must also determine the amount and timing of any tax liability it would need to realize in the event that the IRS or another taxing authority rejected the tax positions. This analysismust be included among the tax accrual workpapers that support the audited financial statements. Tax accrual workpapers are sensitive, as they reflect tax counsel’s evaluation as to the likelihood of success if the issues are litigated.
The Textron case began when the IRS issued an administrative subpoena to Textron, seeking tax accrual workpapers in the actual or constructive possession, custody or control of Textron or its accountants for Textron’s 2001 income tax return. Textron’s workpapers included summary spreadsheets listing for each disputable item the amount in controversy, the probability of success if challenged by the IRS and the resulting reserve for such possibility. The workpapers also included backup e-mails and notes. Because these workpapers are the functional equivalent of a general’s evaluation of his own army’s weaknesses and vulnerabilities, taxpayers normally bristle at demands that they disclose them. Textron refused to produce the workpapers to the IRS, asserting, among other things, that the workpapers were protected fromdisclosure by the attorney work-product doctrine. The IRS filed suit in the U.S. District Court for Rh
ode Island, where the court refused to enforce the subpoena, holding that the workpapers were work-product protected from disclosure. A panel of judges fromthe First Circuit (which hears cases from Maine, New Hampshire, Rhode Island, Massachusetts and Puerto Rico) upheld the District Court’s decision, but the IRS appealed the decision, asking the court to consider the issue en banc, i.e., by all of the judges sitting on that court.
Until recently, IRS policy was not to seek tax accrual workpapers except in “unusual circumstances,” such aswhere the tax examiner had been unable to gather all the necessary information fromthe taxpayer. But in 2002, in the wake of the Enron and other contemporary corporate scandals, the IRS revised its policy, requiring that tax accrual workpapers be disclosed where the taxpayer had engaged in any of about three dozen “listed transactions” that the IRS deems to resemble tax avoidance structures. Where the taxpayer had engaged in only one listed transaction, only the workpapers related to that transaction must be disclosed. However, if the taxpayer had engaged in multiple listed transactions, then the taxpayer is required to hand over all its tax accrual workpapers. During the Textron audit, the IRS determined that Textron had engaged in nine listed transactions and issued a summons demanding all its workpapers.
Textron resisted the summons on the grounds that the tax accrual workpapers were privileged material pursuant to, among other things, attorney-client privilege and workproduct privilege. However, attorney-client privilege can be abandoned where a party discloses material to a third party. The District Court found that because Textron had disclosed the workpapers to its independent auditors (as required by FIN 48), attorney-client privilege had been destroyed. As a result, the court’s decision focused on the application of workproduct doctrine to tax accrual workpapers.
The work-product doctrine was formalized in a 1947 Supreme Court case and later codified in a federal rule of civil procedure. That rule states that, “[o]rdinarily, a party may not discover documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative.” In Maine v. United States Dep’t. of the Interior, a 2002 case, the First Circuit determined that documents prepared by the Department of the Interior in connection with its classification of salmon as a protected species were privileged, as the materials “can be fairly said to have been prepared or obtained because of the prospect of litigation” (emphasis added). The First Circuit specifically rejected the lower court’s adoption of a test requiring that litigation preparation be “the primarymotivating factor for the preparation of the documents,” a standard that has been adopted by the Fifth Circuit (which hears cases from Texas, Louisiana and Mississippi).
In Textron, the First Circuit purported to apply the same “because of” rule that it had established in the Maine case in 2002, but the court’s reasoning more closely resembled that exercised by the lower court, which it had reversed in Maine. The First Circuit in Textron noted that tax accrual workpapers are independently required by statutory and audit requirements and that the purpose of creating the workpapers was “to make book entries, prepare financial statements and obtain a clean audit.” The court found that “any experienced litigator would describe the tax accrual workpapers as tax documents and not as case preparation materials.” The workproduct privilege, the court noted,was intended to protect the process of litigation and the work done by attorneys to prepare for litigating a case, not to help lawyers prepare and protect materials prepared in the ordinary course of business. Because tax accrual workpapers were clearly prepared for reasons other than litigation and, in the court’s view, would not likely even be useful in the event that the underlying tax positions were litigated, the workpapers did not qualify for work-product protection.
For corporate counsel, the “catch” of the Textron court’s decision is this: in the interest of assisting its client in properly managing risk and disclosing its financial status, counsel may choose to disclose to the client and its auditors a detailed, full and frank assessment of the client’s tax contingencies. However, this full and frank disclosure, if ultimately required to be disclosed to the IRS, will provide a road map to each of the “soft spots” on the client’s tax returns and, more important, a legal assessment of the likely outcome of litigation on each point. If counsel provides less thorough disclosure to the client and its auditors, it negatively affects the auditor’s ability to assess the sufficiency of the reserves on the financial statements and risks the client’s ability to obtain a clean audit.
The “catch” may extend into tax disclosure at the state level as well. State departments of revenue request tax accrual workpapers even more frequently than does the IRS. Because few state courts have interpreted the phrase “in anticipation of litigation,” they often look to the federal courts for guidance. If other courts agree with the First Circuit and determine that documents prepared for statutory and regulatory compliance are not entitled to work-product privilege protection, then practitioners may find that state tax workpapers are also demanded and obtained by state tax authorities with increased frequency.
The Textron decision may also affect other assessments of counsel that are disclosed to auditors. Where in-house or outside counsel prepare assessments of potential litigation in connection with the creation of a litigation reserve or the preparation of financial statements, if those assessments are submitted to auditors, then opposing counsel may use the Textron decision to justify a demand that such work product be disclosed as a part of discovery. In fact, the dissenting opinion in the Textron case laments that the court’s decision leaves a party exposed to potential discovery of the vast majority of legal analysis prepared by counsel analyzing the legal risks of a pending business decision. The dissenting opinion states bluntly that “[c]orporate attorneys preparing such analysis should now be aware that their work product is not protected in [the First Circuit].”
For now, case law in the U.S. Court of Appeals for the Seventh Circuit (which hears cases from Illinois,Wisconsin and Indiana) holds that documents prepared in order to comply with regulatory obligations may be entitled to work-product privilege protection if such materials were also prepared “because of” the potential for subsequent litigation. However, the Seventh Circuit has not considered a case specifically involving tax accrual workpapers. Furthermore, Textron has petitioned the U.S. Supreme Court to hear Textron and resolve the split among federal circuits on this matter. If the Supreme Court hears the case and affirms the First Circuit, work product that is now protected in Illinois may be subject to discovery.
While the question of work-product protection is an important one for attorneys, it is not corporate counsel alone that finds itself in a difficult situation. If the Supreme Court considers the Textron case, it will find itself in a “catch” of its own. If it rejects Textron, it may be seen as undermining efforts by the IRS to combat tax and other types of corporate fraud. If the Court upholds Textron and requires disclosure of tax accrual workpapers (and other material previously considered by counsel to be privileged), then it threatens the disclosure and consultation among companies and their counsel and auditors that are supposed to be of great value in a post-Enron world. It’s no Catch-22, but Yossarian would no doubt be impressed.