The tax shelter battles fought in the first half of this decade have come and gone, and there's little doubt that the government won. But the Internal Revenue Service's (IRS) laser-like focus on shelters also left some unfinished business behind.
"When Congress took aim at tax shelters, the IRS moved from a policy under which it was very reluctant to request tax accrual work papers to one where auditors were expected to ask for work product whenever a taxpayer was involved in a suspicious transaction," says Kevin Kenworthy, a tax partner at Miller Chevalier.
Complicating the situation are the heightened disclosure requirements imposed on public companies in the wake of the Enron era.
"Not only do you have work-product privilege--which protects from disclosure documents created in anticipation of litigation--colliding with the government's investigatory powers, but at the same time companies are required to maintain all kinds of work papers to support the contingent liabilities that appear on their financial statements, including their tax exposure," Kenworthy says.
This triangulation of interests creates a conundrum for companies because it leaves open to the IRS the contention that the work product relating to tax reserves hasn't been prepared in anticipation of litigation, but in support of mandatory statutory financial disclosure.
That's the argument the IRS made in two key cases--Regions Financial Corporation v. USA and United States v. Textron Inc.--now under appeal in the 1st and the 11th Circuits. In both cases, Federal District Courts ruled in favor of the taxpayers and denied the IRS access to the work product.
But reversals on appeal are certainly within the realm of reason, and that would be highly problematic for corporations, with implications far beyond the tax department.
"This isn't just a tax issue, but one that could arise for in-house counsel whenever they're dealing with contingent liabilities of any kind," says Ed Froelich, who is of counsel in Morrison Foerster's tax department. "Any standard that chips away at work-product protection makes it difficult for a company to fully evaluate its position on any number of potential liability issues."
And chip away is what the IRS tried to do in both Regions and Textron. In both cases, the impugned documents were created before the threat of litigation even existed and were used to support tax reserve estimates in the financial statements. Additionally, the District Courts in both cases were asked to choose between two competing versions of the test for the existence of work product. The IRS urged the court to adopt the "primary motivating purpose" test, which requires that pending or imminent litigation must be the primary motivating purpose for the creation of the documents.
"It appears that the Service's argument is that Regions cannot claim work product protection if the contested documents had any use other than litigation preparation," the Regions court noted
The Regions court stated its preference for the "because of" test, which requires only that litigation be one of the reasons for the creation of the documents. But it made no definitive choice because it concluded that, on the facts of this case, the taxpayer had satisfied either test.
For its part, the Textron court came out with a strong ruling supporting the "because of" test.
What is clear on close analysis, however, is that the supporting affidavits filed by the taxpayers in both cases were as critical to the favorable rulings as the tests that the court applied. And therein, perhaps, lies the most important lesson general counsel can glean from these cases.
The work product doctrine was designed to enable parties to prepare for litigation without allowing an adverse party access to benefit from obtaining the party's work product. Because the contested documents in Regions contained the analysis of the company's advisers (three opinions by outside tax counsel Alston & Bird and one authored by Ernst & Young staff, which was not part of the audit team), there was really no dispute that their
content qualified as work product.
"The contested documents contain precisely the kind of legal analysis that the work product doctrine exists to protect," the court stated.
The key to success for the taxpayers, then, was proving the purpose for the creation of the documents. To that end, Regions' affidavits--much like Textron's materials--established that Regions' general counsel solicited the tax opinions; that the general counsel was concerned about potential litigation arising from the transactions in which the IRS was interested; that Regions got outside tax advice because of an anticipated conflict with the IRS; and that both Regions and the authors of the document would maintain their confidentiality.
The affidavits highlight the importance of general counsel's involvement and the importance of documenting that involvement in persuading a court about the impact that the prospect--even the remote prospect--of litigation had on the creation of work product. As Regions demonstrates, evidence of this sort will be particularly meaningful if appellate courts ultimately decide that "primary motivating purpose" is the correct standard for evaluating work product.
And those decisions could come relatively soon.
The Rhode Island District Court released Textron in August 2007. The case is now fully briefed with a hearing likely this fall. The District Court for the Northern District of Alabama's Southern Division gave its Regions ruling in May 2008, and oral argument will likely take place early in 2009. "Textron will be decided first, and it will become the bellwether for the direction appellate courts take," says Richard Walton, of counsel with Buchalter Nemer. "But even if the Textron and Regions courts don't split, other circuits will, and it wouldn't surprise me if someone filed to the Supreme Court."
But as recent proposed changes from the Financial Accounting Standards Board (FASB) demonstrate, even a Supreme Court ruling may not be the end of the work product controversy.
The changes, which opened for public discussion in June, would force public companies to disclose more about the risks of litigation. Indeed, the threshold for reporting potential losses from lawsuits would be lowered from "probable" to anything short of "remote." Companies also would have to estimate the extent of the losses, the likelihood of defending the suit successfully and the reasons for their conclusions.
The proposals have put in-house counsel in a dither. Many believe the changes would force them to reveal their litigation strategies to adversaries, intrude on attorney-client privilege and encourage lawsuits if predictions are wrong.
"FASB has walked right over attorney-client privilege and the work product doctrine in its pursuit of transparency," Walton says. "If the changes go through, they'll be a gold mine for opposing counsel."