Ruling in Tax-Auditing Case Puts Corporations on Edge
By AMIR EFRATI
A little-publicized ruling in a recent case involving the Internal Revenue Service is causing lawyers for big companies some sleepless nights.
Last week, in a widely anticipated ruling, a federal appeals court in Boston said the IRS could gain access to documents created by a defense-contracting firm to determine whether the company's calculation of its tax liabilities would pass muster during a possible IRS audit. The decision in U.S. v. Textron Inc. reversed a January ruling by a smaller panel of judges on the same court.
Frederick Krebs of the Association of Corporate Counsel fears a troubling precedent in the court ruling.
To some lawyers who represent corporations, the decision signaled an attack by the courts on the "work-product doctrine," the legal rule that shields an individual or business from having to turn over documents created "in anticipation" of litigation. In its ruling, the First Circuit Court of Appeals said the documents at Textron weren't protected under the doctrine because they weren't prepared specifically "for use" in litigation.
The ruling "eviscerates the work-product doctrine," says Frederick Krebs, president of the Association of Corporate Counsel, an organization for in-house corporate lawyers. He says the ruling, which is binding in federal courts in the Northeast where the First Circuit is based but could influence other courts, will embolden the IRS -- as well as plaintiffs' lawyers who bring shareholder lawsuits -- to seek more such documents from public companies. "If the IRS gets access, [it] can immediately figure out where the client thinks it's weak, what it's willing to pay," he says. The IRS praised the ruling in a statement last week but declined further comment.
Thomas Sabatino, general counsel of Schering-Plough Corp., worries the court's decision could transcend the tax arena and make in-house lawyers wary of providing complete assessments of future legal trouble in a variety of areas, from product-liability litigation to patent disputes. "The fear factor for corporate counsel is that...the ruling would say any analysis done by lawyers to ensure the accuracy of financial statements can be exposed," he says. "That makes it much more difficult for lawyers to continue to protect their client."
Some tax experts say the concern is misplaced. Corporate lawyers are "trying to expand the work-product doctrine far beyond its original intent," says Dennis Ventry, a law professor at the University of California, Davis, whose analysis of the Textron case was cited by the court in its opinion. "The IRS operates with significant information deficiencies," he says, "and some companies bury things into a large tax return and try to obscure what they're doing."
The debate is playing out as the IRS in recent years has sought to hunt down illegal tax shelters. As part of that push, the agency increasingly is asking to review documents that show companies' analysis of how much they should set aside in reserves for additional tax payments, should the IRS identify questionable tax accounting. In most instances, the documents, known as tax-accrual papers, include the company lawyers' determination of the likelihood that it will win or lose future tax disputes with the IRS.
Steve Johnson, a law professor at the University of Nevada, Las Vegas, said many companies "were engaged in transactions that pushed the envelope in the tax sense. The game was, 'Could we structure this in a way that the IRS wouldn't be able to figure out what was going on?'"
But corporate lawyers say that because tax law isn't always clear, it isn't fair for the IRS to use a company's evaluations about its own tax decisions against it.
The question at issue in the Textron case was whether tax-accrual documents were protected under the work-product doctrine. The theory, which traces its roots to a 1947 Supreme Court decision, protects material prepared in anticipation of litigation from being revealed to opposing lawyers in a court case. The rationale: seeing those materials gives an opponent the edge by sharing the other side's legal strategy.
The work-product doctrine is different from another rule that also is used to protect sensitive materials, the attorney-client privilege. That privilege is broader, protecting communications between clients and their lawyers, whether or not it deals with anticipated litigation. In this case, Textron, like most other public companies, showed the tax accrual papers to outside accountants, effectively removing attorney-client privilege over these documents.
But Textron said the work-product doctrine applied because the company's lawyers believed there was a chance the IRS would challenge the tax deductions, resulting in litigation. In the end, the court ruled that the documents produced by Textron weren't protected by the doctrine.
Judge Michael Boudin, writing for the majority on the court, said: "Textron apparently thinks it is 'unfair' for the government to have access to its spreadsheets, but tax collection is not a game. Underpaying taxes threatens the essential public interest in revenue collection."
A spokeswoman for Textron, which makes Cessna planes and Bell Helicopters, among other products, said the company is reviewing the decision.
Write to Amir Efrati at amir.efrati@wsj.com
Printed in The Wall Street Journal, page A9
The ruling "eviscerates the work-product doctrine," says Frederick Krebs, president of the Association of Corporate Counsel, an organization for in-house corporate lawyers...Really?
As noted by Gary C. Shockley of theTennessee bar, the work-product does not shield underlying facts from discovery, only documents and things prepared in anticipation of litigation. The work-product protection is not absolute. Unlike the attorney-client privilege, the work-product doctrine is a conditional privilege and can be overcome by a showing of substantial need and hardship.
As excerpted from a Shokley news letter addressing a November 2003 decision, In re Grand Jury Subpoena (Mark Torf/Torf Environmental Management), 350 F.3d 1010 (9th Cir. 2003), the U.S. Court of Appeals for the Ninth Circuit addressed these issues in the context of parallel proceedings.
The Ninth Circuit began its discussion with a review of the work product doctrine under Rule 26(b)(3) of the Federal Rules of Civil Procedure, which protects documents and tangible things prepared by a party or a party's representative in anticipation of litigation or for trial from discovery. Such documents are subject to discovery only upon a showing of substantial need by the requesting party and an inability to obtain equivalent materials without undue hardship. Id. at 1015. Under United States v. Nobles, 422 U.S. 225 (1975), the doctrine extends to materials prepared by an investigator working for attorneys and prepared in anticipation of litigation.
Based on these general principles, the Ninth Circuit applied a two-part test: (1) were the materials prepared in anticipation of litigation and (2) by or for a party or a party's representative?
Because the environmental consultant Torf was hired by the attorney
McCreedy to help him in assessing the company's potential civil and
criminal liability, all documents prepared for this purpose were
entitled to protection under the attorney work product doctrine. As to
these so-called "single purpose documents," the court had no question
that these materials met its two-part work-product test. 350 F.3d at
1015.
Other documents prepared by Torf, however, were prepared both in
anticipation of litigation and to assist in the CERCLA cleanup under
the EPA consent order.
As to these "dual-purpose documents," the Ninth Circuit found that the appropriate test was whether the documents were prepared "because of the prospect of litigation." Id. at 1015-16 (quoting Charles Alan Wright, Arthur R. Miller, and Richard L. Marcus, 8 Federal Practice & Procedure § 2024 (2d ed. 1994)). Relying on the Second Circuit's decision in United States v. Adlman, 134 F.2d 1194 (2nd Cir. 1998), the court rejected a primary vs. secondary motivation test in favor of an inquiry into whether, under the totality of the circumstances, the document would not have been prepared in the same form but for the prospect of litigation.
Because the threat of litigation drove all of Torf's work, including work done to comply with the EPA information request and consent order, even Torf's dual-purpose documents were entitled to protection under the Adlman "because of" test. 350 F.3d at 1016-17.
Shokely cautions that when considering the factual situation presented here, the compliance and litigation defense motives were so intertwined that work-product protection was required. Because Torf's dual purpose documents were prepared at least in part in anticipation of litigation and under the direction of counsel, they were entitled to protection just as much as the single purpose documents. Id. at 1016-18.
The Ninth Circuit also rejected the government's attempt to come within the need and hardship exception to the work product doctrine. The court found that the information supplied by Ponderosa and Torf in response to the information request, coupled with that otherwise available to government representatives while present at the sites in question, belied the assertion of substantial need and hardship.
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