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
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.