On June 17, 2009, the Seventh Circuit examined the tax practitioner privilege in Valero Energy Corporation v. U.S., 103 AFTR 2d 2009-2683. Valero, a large oil refiner, expanded its operations in 2001 by acquiring Ultra Diamond Shamrock Corporation (“UDS”). Prior to the acquisition, Ernst & Young developed a restructuring and refinancing plan for UDS’s Canadian subsidiaries. Valero asked its tax advisors, Arthur Anderson, to review the plan and provide additional tax advice.

Valero implemented the complex plan, which resulted in large foreign currency losses. On audit, the IRS requested various documents from Arthur Anderson related to the transaction, including documents reflecting tax research, planning and analysis. Valero asserted that the tax practitioner privilege provided in Internal Revenue Code (“Code”) section 7525 protected Valero in the government’s attempt to obtain access to the documents. The IRS asserted that even if the privileged applied the documents fell within the tax shelter exception.

Code section 7525 provides that communications of tax advice between a federally authorized tax practitioner and a taxpayer are privileged in the same fashion that such a communication would be privileged if it were between the taxpayer and its attorney, subject to one notable exception. Code section 7525 does not protect 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 any “tax shelter,” as defined in Section 6662(d).

The Seventh Circuit noted that no general accountant-client privilege exists and that it was not until 1998 that Congress extended a limited shield of protection to communications between federally authorized tax practitioners and their clients by enacting Code section 7525. The court was clear to point out that this privilege was narrow and did not cover all tax advice. The court found that the taxpayer had a high burden of proof to establish the privilege.

In analyzing the exception, however, the court found the definition of tax shelter to be broad, encompassing any plan or arrangement a significant purpose of which is the avoidance or evasion of tax. Significantly, the court did not limit the definition of a tax shelter to “cookie-cutter products” that are widely promoted and actively marketed. Moreover, the court found that the IRS’s burden under the exception to overcome a claim of the tax practitioner privilege is relatively light. To overcome the privilege claim the government “need only show that there is some foundation in fact that a particular document falls within the tax-shelter exception.”

In one of the first important decisions interpreting the scope of the Code section 7525 privilege, the Valero court chose to give an unexpectedly broad reading to the tax shelter exception embodied in the statute (notwithstanding that the transaction under scrutiny was not a "promoted" tax product in any sense). Taxpayers that seek tax advice on sensitive tax planning, whether or not the tax planning is a marketed product, should consider availing themselves of the attorney-client privilege, a broader reaching common law privilege that has no exception similar to the tax shelter exception of Code section 7525.