The U.S. Supreme Court rendered this week a highly anticipated
decision that affects tax practitioners and their corporate
clients. It declined to review a decision of the First Circuit
Court of Appeals in Textron v. United States. The
Supreme Court's decision essentially means that, in the First
Circuit, tax accrual work papers will not be protected by the work
product doctrine from disclosure to the IRS even when the tax
accrual work papers are prepared in anticipation of
litigation.
After filing its 2001 tax returns, Textron prepared tax accrual
work papers in connection with the preparation of its U.S. GAAP
financial statements. The tax accrual work papers specifically
considered Textron's prospects of litigation. While auditing
Textron's 1998-2001 tax returns, the IRS learned that one of
Textron's subsidiaries had engaged in nine sale-in, lease-out
("SILO") transactions. The IRS requested production of
Textron's tax accrual work papers for the tax years in
question, which Textron refused.
In response, the IRS filed an enforcement action in the U.S.
District Court in the State of Rhode Island seeking access to the
said tax accrual work papers. Textron argued that the work papers
were protected by the attorney-client privilege, the tax
practitioner privilege and the work product doctrine. The District
Court decided in favour of Textron on the basis of the work product
doctrine. (The District Court also thought the tax accrual work
papers were protected by the attorney-client privilege and the tax
practitioner privilege but stated that those privileges had been
waived when Textron shared the tax accrual work papers with its
external auditors.) The District Court found that the tax accrual
papers were protected because they would not have been prepared
"but for" litigation.
A three-judge panel of the First Circuit affirmed the District
Court's holding that the work product doctrine applied. The
First Circuit panel found that preparation of documents for a dual
purpose (in this case for financial reporting purposes as well as
for litigation) does not defeat the work product doctrine. The
First Circuit remanded the case for a determination of whether
disclosure of the tax accrual work papers to the external auditors
waived the privilege. Both Textron and the IRS requested a
rehearing. The First Circuit held the rehearing en banc
and found that the work product doctrine did not apply because the
tax accrual work papers were required to be prepared for financial
reporting purposes.
The First Circuit's en banc decision will have a
significant impact on information required to be shared with the
IRS. Analysis of litigation that a company shares with its auditors
for financial reporting purposes could be open to disclosure.
Furthermore, if the work product doctrine would not protect
disclosure to the IRS, it would also not protect disclosure to
other parties. This might lead to a situation wherein a dispute
with a competitor or arising from a failed merger, a third-party
could compel production of tax accrual work papers giving them a
road map to the attorney's assessments of the litigation
hazards.
The Supreme Court's decision leaves taxpayers in a difficult
position. They must now assess with great care the information
which is disclosed to external auditors in order to preserve the
attorney-client and tax practitioner privileges, or separate the
documents prepared in anticipation of litigation from those
prepared for financial reporting compliance. This rule may have the
undesirable impact of encouraging decreased disclosure to auditors
thereby putting more pressure on external auditors who need
relevant information when reviewing financial statements.
In Canada, while the law of privilege operates differently, the
issue of the protection from disclosure to the Canada Revenue
Agency ("CRA") of documents or information disclosed to
external auditors in the course of their review of financial
statements pursuant to section 169 of the Canada Business
Corporations Act is of equal concern.
The Income Tax Act ("ITA") recognizes the
solicitor-client privilege attached to opinions given by lawyers or
notaries (in the Province of Quebec). Privilege and confidentiality
rules that govern other professionals, including accountants,
cannot be claimed by taxpayers in order to refuse disclosure of
information to the CRA under the ITA unless the work was done by
the professional in the course of assisting a lawyer in rendering
his/her services to a client or seeking advice from the lawyer. The
solicitor-client privilege belongs to the client and it can be
considered to have been waived if privileged documents or
information are disclosed to a third party subject namely to the
limited waiver doctrine.
Therefore, corporate taxpayers must have internal controls in place
and take active measures to avoid the unintended waiver of the
solicitor-client privilege.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
