The U.S. Court of Appeals is expected to rule this summer on a case that could determine whether companies have a right to keep secret their tax accrual work papers. The appeal, being brought by the Internal Revenue Service, involves conglomerate Textron Inc., and the company’s effort to keep proprietary work papers private.
The appeals court decision could have wide-ranging consequences. Many companies produce tax accrual work papers, which contain legal opinions about tax positions, to inform their accounting decisions and support those decisions during independent audits. Exposing the work papers to public scrutiny, however, could give potential legal adversaries insight into the company’s tax strategies, and a leg up on litigation. The work papers could also act like a bread crumb trail for the IRS, pointing the agency to aggressive tax strategies.
Last August, the U.S. District Court in Rhode Island ruled in favor of Textron, finding that the documents — related to nine “sales-in, lease-out” (SILO) transactions — were protected by the work product privilege doctrine. That principle protects the confidentiality of documents that are prepared in anticipation of litigation. Although the work papers are not part of a current law suit, they contain legal opinions about Textron’s tax positions and the likelihood that the transactions would be challenged by the IRS and survive a tax audit.
And while Textron won its case under the work products doctrine, it lost its argument that the tax documents fell under the protection of attorney-client privilege. The attorney-client privilege protects confidential communication between the two parties related to legal advice sought from the attorney. Indeed, the court knocked down that Textron argument on the grounds that the company waived that protection when it shared the documents with a third party — its independent auditor.
In the ruling, Judge Ernest Torres wrote that “it is well established that ‘voluntary disclosure to a third party waives the attorney-client privilege even if the third party agrees not to disclose the communications to anyone else.’” That principle, asserted Torres, has been applied specifically to disclosures made to independent auditors in cases involving First Federal Savings Bank of Hegewisch, Dupont, and Pfizer, and has been cited in specific tax-related cases involving BDO Seidman and KPMG.
Others have weighed in on the pivotal Textron case, including Financial Executives International, the trade group that counts among its ranks professionals who prepare both financial statements and tax returns. In an amicus brief filed this month in anticipation of the appeal, FEI asserted that the government’s position “threatens the ability of companies to develop and protect assessment of their litigation positions, in tax and other areas, that are necessary for the proper operations of their businesses.”
Among other claims, FEI argued that generally accepted accounting principles — specifically FAS 5, Accounting for Contingencies, requires companies to share tax work papers with auditors. Under FAS 5 companies must account for and disclose “material loss contingencies, which including potential litigation.” Further, when evaluating whether accrual or disclosure is required under FAS 5 a company also should consider, among other things, “the opinions or views of legal counsel and other advisers.” Indeed, an independent auditor will want to review the tax work papers, including the company’s estimated tax reserves, before giving the client a “clean” audit.