Originally published January 28, 2009

Article by Nathaniel Carden , John T. Hildy , Scott M. Stewart , and Golaleh "Lili" Kazemi

Keywords: Textron, work product protection, tax reserve, tax liabilities, tax accrual workpapers, IRS, Ernst & Young

The Court of Appeals for the First Circuit has issued its opinion in U.S. v. Textron, a highly anticipated case involving the IRS's access to workpapers that were maintained in connection with a taxpayer's reserves for contingent tax liabilities. The First Circuit affirmed the district court's holding that Textron's tax accrual workpapers could be afforded protection as work product, but remanded the case for further analysis of whether that protection was waived. U.S. v. Textron, Inc., Dkt. No. 07-2631 (1st Cir. January 21, 2009). Thus, while Textron has won a significant battle regarding the protection of tax accrual workpapers, the lingering waiver issues may ultimately cause it to lose the war.

The Context of the Appeal

The case involves an IRS appeal from a 2007 district court decision denying enforcement of an administrative summons seeking Textron's tax accrual workpapers.1 The district court focused on Textron's master tax reserve schedule, together with certain supporting schedules and explanatory notes. Textron argued that the workpapers reflected their in-house tax lawyers' analysis and litigation assessment of each tax issue. Textron showed these workpapers to its outside auditor, Ernst & Young (E&Y), but did not provide them with copies.

The district court had held that (i) the work product doctrine protected Textron's workpapers from discovery and (ii) Textron did not waive protection because of disclosure to E&Y. The government appealed both of these holdings to the First Circuit, as well as the district court's failure to address the portion of the summons demanding E&Y's own workpapers.

In a 2-1 opinion, the First Circuit affirmed portions of the district court's holding, vacated other portions, and remanded for further factual determinations.

... Affirmed in Part...

The First Circuit affirmed the district court's holding that the tax accrual workpapers prepared by Textron were protected by the work product doctrine. Generally, documents are protected as work product only if they are prepared "in anticipation of litigation." On appeal, the First Circuit recognized that courts have applied different tests to interpret the phrase "in anticipation of litigation" and that the First Circuit follows the so-called "because of" standard. Under this standard, work product protection applies if the document can be fairly said to have been created because of the prospect of litigation. The court noted, however, that work product protection does not attach to documents that are prepared in the ordinary course of business or that would have been created in essentially the same form irrespective of the litigation.

The government asserted that Textron prepared its workpapers in the ordinary course of business (specifically, SEC reporting), not in anticipation of litigation. The First Circuit rejected this argument, characterizing the tax accrual workpapers as "dual purpose" documents created both for financial statement reporting and in anticipation of litigation. The court concluded that "the mere presence of a business or regulatory purpose" does not overrule the litigation purpose under the "because of" standard and that the workpapers were therefore protectible work product.

A strongly worded dissent took issue with this portion of the panel majority opinion. Failing to see "dual purposes" behind the creation of the tax accrual workpapers, the dissent suggested that the "sole" reason for the creation of the workpapers was compliance with reserve and audit requirements imposed under federal securities laws.

The ruling also clarified the meaning of "litigation" in the context of a tax controversy. The government argued that "litigation" excludes administrative tax audits and that Textron could not conceivably have anticipated litigating each and every item reflected in its reserve workpapers because many tax issues are resolved during IRS audit or administrative appeal. Rejecting this, the First Circuit wrote that, while not all dealings with the IRS during an audit are "litigation," the "resolution of disputes though adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation." The court specifically noted that it was not a prerequisite that the taxpayer be able to demonstrate a historical record that its past tax audits had resulted in courtroom litigation.

... Vacated In Part ...

The First Circuit did not fully accept the district court's conclusion that no waiver resulted from Textron's disclosure to E&Y. The court noted that, unlike the attorney-client privilege, work product protection is not automatically waived by disclosure to any third person; rather, courts find that work product protection is waived only if the disclosure is made (i) to a person who is an actual or potential adversary or (ii) where the disclosure substantially increases the opportunity for potential adversaries to subsequently obtain the information.

The government had argued that E&Y itself was a potential adversary because of the ethical duties that E&Y, as an independent auditor, had to shareholders and others relying on its audit report. In support of its argument, the government cited an earlier First Circuit case, United States v. MIT, in which MIT (a government contractor) provided expense documentation to the Department of Defense's auditing agency. In that case, the First Circuit held that MIT and the auditing agency were potential adversaries because of the potential for dispute with the DOD over MIT's expenses.

Here, the court distinguished MIT because, in that case, the DOD reviewed expenses to determine if it would challenge them. By contrast, E&Y's audit of Textron aimed at certifying its financial statements, not assessing whether it would dispute Textron's tax positions. Instead, the Textron court found no conceivable scenario in which E&Y would sue Textron because of something E&Y would have learned from Textron's disclosures. As a result, the court had little trouble concluding that E&Y itself was not an adversary.

However, even if E&Y itself was not an adversary, a waiver could still result if E&Y was viewed as a "conduit" to a potential adversary — e.g., the IRS or SEC. While the court saw "little likelihood" that E&Y could somehow be required to disclose copies of Textron's actual workpapers, given that E&Y had not been allowed to keep copies of them, E&Y may have based its own workpapers on those of Textron. Under the Supreme Court's holding in Arthur Young , 465 U.S. 805 (1984), the SEC or IRS could demand E&Y's own workpapers. The First Circuit suggested that to the extent E&Y's workpapers substantially increased the risk that the contents of Textron's own workpapers would fall into the hands of an adversary, then the disclosure to E&Y could waive Textron's claim of work product protection. Therefore, the First Circuit vacated the district court's earlier holding that E&Y was not a "conduit" to a potential adversary.

... And Remanded

The First Circuit suggested that the content of E&Y's workpapers "might" reveal Textron's own analysis. On the other hand, it also acknowledged that an E&Y partner submitted an affidavit stating that E&Y applied its own professional knowledge and judgment to Textron's tax positions and did not rely solely on the conclusions of Textron's tax counsel. The district court, however, had made no factual findings concerning the actual content of E&Y's workpapers. (Recall that the district court's focus had been on those workpapers created in-house by Textron.) As a result, the First Circuit ruled that the case should be remanded so that the district court could conduct an in camera review of E&Y's workpapers to determine whether discovery of E&Y's workpapers would effectively constitute disclosure of Textron's own workpapers.

Finally, the First Circuit addressed a possible procedural barrier to the district court's in camera review of E&Y's workpapers. The IRS summons had been served only upon Textron, not E&Y, and Textron had stated that it did not possess E&Y's workpapers. The First Circuit stated that if Textron had the right to get the workpapers from E&Y, it would have to do so. It therefore ordered that as part of the remand, the district court should address the factual issue of whether Textron had the right to demand that E&Y produce its workpapers, which the court again emphasized were not protected under Arthur Young.

Conclusion

The First Circuit's application of the "because of" standard, as well as its broad interpretation the term "litigation" in the administrative tax dispute context, will be welcomed by taxpayers that claim that their tax accrual workpapers were prepared in anticipation of litigation.

However, to the extent that taxpayers routinely share their tax accrual workpapers with their external auditors, as Textron did, the opinion raises as many uncertainties as it resolves. The most significant question is how the district court will review E&Y's workpapers to determine whether E&Y is a conduit to potential adversaries. The directions from the First Circuit create uncertainty for taxpayers because the court seemed to import into the work product doctrine a concept typically used to evaluate waivers of attorney-client privilege: whether the content of Textron's analysis is contained in E&Y workpapers. A more traditional work product analysis would focus on whether Textron's documents themselves (rather than some discussion of the contents) are contained in E&Y's files. This shift in the analysis may significantly reduce a taxpayer's ability to protect its work product materials because taxpayers rarely, if ever, have any input as to what ultimately winds up in their external auditors' files.

Endnote

1 See our previous Client Update, "District Court Denies IRS Request for Textron's Tax Accrual Workpapers,".

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