On January 21, 2009, the U.S. Court of Appeals for the First Circuit issued its much anticipated decision in United States v. Textron, 2009 WL 136752 (1st Cir. 2009), aff’g in part, vacating in part and remanding 507 F. Supp. 2d 138 (D. R.I. 2007). The case involved the question of whether Textron’s tax accrual workpapers, prepared by inside tax counsel, were subject to discovery by the IRS or were protected by the work product doctrine. Textron did not appeal the District Court’s holding that it had waived its attorney-client privilege by sharing its workpapers with its outside auditors, thus making the work product doctrine Textron’s last line of protection.
In a two-to-one decision, the First Circuit held that:
- The work product doctrine protects Textron’s tax accrual workpapers from discovery because the workpapers were prepared “in anticipation of litigation,” and
- Textron’s disclosure of its workpapers to its auditor, Ernst & Young (E&Y), did not in and of itself cause a waiver of work product protection because E&Y was not a potential adversary.
However, the First Circuit vacated the District Court’s holding that Textron had not waived work product protection for its tax accrual workpapers and remanded the case to that court to make two determinations:
- Whether E&Y’s audit workpapers (which are subject to disclosure under the Supreme Court’s decision in United States v. Arthur Young & Co., 465 U.S. 805 (1984)) reveal “the information contained in Textron’s own workpapers,” such that E&Y would be treated as a “conduit to a potential adversary,” thereby causing Textron to have waived its work product protection, and
- Whether Textron had a right to obtain and therefore must produce E&Y’s audit workpapers in response to the IRS summons issued to it.
Sutherland Observation: Textron is one of two recent cases in which courts have held that tax accrual workpapers are subject to work product protection. See also Regions Financial Corp. v. United States, 2008 WL 2139008 (N.D. Ala. May 8, 2008). The IRS recently dismissed its appeal to the Eleventh Circuit in Regions Financial, following a settlement of the underlying tax dispute.
Textron Workpapers Met Requirements for Work Product Protection
The work product doctrine generally protects documents that are prepared in anticipation of litigation or for trial. The two areas of disagreement between the parties were whether Textron contemplated “litigation” of its questionable tax issues and whether its workpapers were prepared “in anticipation” of such litigation or, instead, to comply with securities laws and financial reporting requirements.
On the first point, the First Circuit held that the resolution of tax disputes through the adversarial administrative process, including proceedings before IRS Appeals, qualified as litigation for purposes of the work product doctrine. The court concluded that Textron contemplated “litigation” when preparing its workpapers.
Sutherland Observation: Under the First Circuit’s analysis, any resolution of a tax dispute at a level higher than the audit level will constitute “litigation” for purposes of applying the work product doctrine if the procedure for resolving the dispute is adversarial rather than informal in nature.
In determining whether Textron’s workpapers were prepared “in anticipation” of litigation, the First Circuit applied the “because of” standard, which is the standard applied by the majority of circuits. See, e.g., Maine v. Dept. of Interior, 298 F.3d 60 (1st Cir. 2002); United States v. Adlman, 134 F.3d 1194 (2nd Cir. 1998); United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). One circuit has adopted a “primary purpose” standard. United States v. El Paso Co., 682 F.2d 530 (5th Cir. 1982). Under the “because of” standard, a document that serves a dual purpose (e.g., supporting financial statements and assessing the probability of success in litigation) may well be entitled to work product protection. By contrast, the same dual-purpose document might not qualify for work product protection under the more restrictive “primary purpose” standard adopted by the Fifth Circuit.
Sutherland Observation: The split in the circuits regarding the proper test for work product protection may lead the government to seek certiorari in Textron. The Supreme Court has twice denied petitions for certiorari on this issue filed by private parties, but a government request could be viewed more favorably. See, e.g., El Paso, supra, cert. denied, 462 U.S. 944 (1984); Kaiser Aluminum & Chemical Corp. v. United States, 214 F.3d 586 (5th Cir. 1999), cert. denied, 532 U.S. 919 (2001).
Applying the “because of” standard to Textron’s workpapers, the First Circuit adopted the Sixth Circuit’s view in Roxworthy that the proper test for determining work product protection was whether the taxpayer had a “subjective belief” that litigation was a real possibility, and whether that belief was “objectively reasonable.” Textron undertook to establish that its past history of controversy with the IRS justified a conclusion that it satisfied both the “subjective” and “objective” prongs of the test. The First Circuit held, however, that a taxpayer’s past history of litigation with the IRS was irrelevant. In the court’s view, the very nature of the items being evaluated (questionable tax positions) necessarily involved an analysis conducted “in anticipation of litigation.” The court explained that the process of preparing tax accrual workpapers, with financial reporting requirements in mind, effectively forced Textron into the “hypothetical belief” that litigation would occur. The reasonableness of Textron’s actual subjective anticipation of litigation thus became a non-issue. (Textron involved years prior to the adoption of FIN 48. The First Circuit’s “hypothetical belief” approach would have received additional support had the years involved been governed by FIN 48.)
Sutherland Observation: In a nutshell, the First Circuit’s holding appears to be that tax accrual workpapers are always prepared with a (hypothetical) view toward litigation that is sufficient to justify work product protection. The dissent argued that this was a misapplication of the “because of” standard in the case of dual purpose documents. Given the nature of the disagreement on the panel, the government might seek en banc review. Even if the majority view holds, taxpayers may nevertheless consider memorializing why they anticipate litigation for certain, if not all, issues.
Waiver of Work Product Protection
The First Circuit next turned to the question of whether Textron had waived its work product protection by disclosing its workpapers to E&Y. Disclosure could constitute a waiver if E&Y were to be treated either as an “adversary” or as a “conduit to an adversary.” The First Circuit found that E&Y’s audit was being conducted in a cooperative manner in order to reach a common goal of producing certified financial statements. The court therefore held that E&Y was not an adversary.
Whether E&Y was a “conduit to an adversary” presented a different issue. Here, the First Circuit raised the question of whether E&Y’s workpapers, which could be obtained by the IRS under Arthur Young, might reveal the contents of Textron’s workpapers. Because the District Court had not addressed this issue, the First Circuit remanded the case to that court with instructions to conduct an in camera inspection of the E&Y workpapers if feasible, or otherwise to obtain testimony, to determine whether the potential disclosure of E&Y’s workpapers to the IRS would substantially increase the risk that the contents or information in Textron’s workpapers would be revealed. If the District Court determines that such would be the case, the First Circuit appears to have concluded that Textron would have waived work product protection for its own workpapers by disclosing them to a party that would be a conduit to a potential adversary. Yet, the First Circuit failed to give the District Court any guidance on the extent to which the inclusion in E&Y’s workpapers of information from Textron’s workpapers would trip the waiver wire.
In short, the First Circuit’s holding that Textron’s tax accrual workpapers met the requirements for work product protection could prove to be a hollow victory. Depending on the District Court’s findings with regard to the content of E&Y’s workpapers, Textron may find its own work papers subject to discovery notwithstanding their qualification as otherwise protected work product.
Sutherland Observation: The First Circuit’s theory that E&Y’s potential involuntary disclosure of the contents of Textron’s workpapers through a summons issued for its own workpapers could cause E&Y to be treated as a “conduit to an adversary” is rather novel and certainly stretches the notion of what constitutes a “conduit” in this context. At a minimum, Textron has created substantial uncertainty regarding the risk of a waiver resulting from a taxpayer’s disclosure of its tax accrual workpapers to its auditor. Of course, Textron is binding only in the First Circuit. It has no direct precedential effect on taxpayers in other circuits.
In light of Textron, taxpayers who disclose tax accrual workpapers to their auditors should request that the workpapers be kept confidential, should not permit the auditors to retain a copy (or should only summarize the workpapers orally), and should take steps to ensure that the auditors do not make any written reference to the contents of those workpapers in preparing their audit workpapers. Needless to say, the increased scrutiny of uncertain tax positions dictated by FIN 48 may make the foregoing approach a difficult path to navigate.