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The ongoing saga of the UBS tax shelter scandal has dominated headlines in recent months, but another tax shelter case has grabbed the attention of corporations after an en banc 1st Circuit ruling in August that could have potentially broad repercussions for all public companies.

U.S. v. Textron is the first case to test a 2002 IRS policy change that set forth a more aggressive stance for agency requests to view sensitive tax documents. In the August en banc ruling, the
1st Circuit ordered Textron Inc. to hand over its tax accrual workpapers to the IRS, rejecting the

company’s argument that the papers were protected by attorney work-product privilege. The reversal generated shockwaves.

In his dissent, Judge Juan Torruella sent out a warning in response to the majority decision: “Corporate attorneys preparing such analyses should now be aware that their work product is not protected in this circuit.”

The Association of Corporate Counsel–which had filed an amicus brief with the U.S. Chamber of Commerce in support of Textron–released a statement from its general counsel, Susan Hackett, decrying the ruling: “This decision hamstrings public companies’ in-house lawyers from advising auditors and financial planning in a manner that promotes accuracy and transparency … [and] eviscerates the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege.”

Receding Restraint

While the tax question is critical in its own right, some worry the debate on privilege that Textron has engendered will have impact beyond the narrow tax realm and into any area that deals with legal contingencies. In other words, it has the potential to strike at the heart of an in-house lawyer’s job. But the issue is acute in the uncertain area of tax law, where often, explains Reed Smith partner Michael Jacobs, clients are making their best effort at navigating unclear laws.

“Sometimes they’re dealing with tax issues where there are two sides to the coin, and I can come up with a lot of good reasons why the taxpayer is right on the position they’ve taken,” he says. “But I also have an obligation to tell them the weaknesses in their position–and you’d hate to get into a situation where someday, somebody from either the state taxing authority or the IRS comes up with a document where you’ve taken such an even-handed approach and uses it against your client.”

Tax accrual workpapers–the documents at the center of Textron–lay out just such analyses. Public companies (and non-profits subject to Generally Accepted Accounting Principles, or GAAP) must comply with Financial Accounting Standards Board (FASB) Interpretation No. 48, or FIN 48, the standard for calculating the reserves companies set aside for uncertain tax positions. The tax accrual workpapers underlie such disclosures.

It’s clear to see why companies would not want to make the IRS privy to any and all of its perceived tax vulnerabilities–as well as the amounts at which it would be willing to settle any disputes over those items–and the IRS has recognized that such workpapers “could provide [the agency with] a laundry list of items to challenge.” Accordingly, since 1981 it has followed a voluntary policy of restraint regarding the papers.

Although it continues following this policy of restraint, in 2002 the agency announced a shift in policy. Now IRS examiners request tax accrual workpapers for any potentially abusive “listed transaction,” defined as one that the IRS has cited in published guidance as a tax avoidance transaction or is “substantially similar” to a published tax avoidance transaction.

“In my view, the policy change was really designed to uncover participation in tax shelters and to discourage those companies from engaging in new ones,” says Kevin Kenworthy, a member of Miller Chevalier. “The theory being that if a company knew it was liable to disclose its workpapers if it engaged in a tax shelter, it would be less likely to do the tax shelter in the first place.”

Anticipating Litigation

During the tax years 1998 to 2001, Textron participated in nine SILO (sales-in, lease-out) transactions, in which the company purchased municipal property, resulting in a tax deduction, and leased the land back to the seller. The IRS considers SILO transactions to be listed transactions, and it issued a summons for all of Textron’s tax accrual workpapers for 2001. The company refused.

In 2007, the U.S. District Court for the District of Rhode Island found that Textron’s workpapers were protected by work-product privilege and the company was not obligated to turn them over. The IRS appealed to the 1st Circuit, which in January 2009 upheld the district court decision. However, the en banc panel in August went the other way.

Its analysis focused on whether the documents were subject to work-product protection, which protects documents prepared in anticipation of litigation. The question became why the workpapers had been created in the first place.

The district court applied a test used in most circuits: Was the document prepared because of the prospect of litigation? Both courts concluded that yes, the documents were prepared in anticipation of the possibility of IRS challenges–which it considered “litigation”–to the calculations of Textron’s tax reserve amounts. “If Textron had not anticipated a dispute with the IRS, there would have been no reason for it to establish any reserve or to prepare the workpapers used to calculate the reserve,” the district court wrote.

However, the en banc 1st Circuit disagreed that work-product did apply.The majority noted, “Every lawyer who tries cases knows the touch and feel of materials prepared for a current or possible law suit. … No one with experience of law suits would
talk about tax accrual work papers in those terms.”

Slippery Slope

Linda McKissack Beale, Wayne State University Law School professor and blogger at A Taxing Matter, says the latest ruling got it right. And the en banc 1st Circuit applied the “in anticipation of litigation” test correctly, she says, unlike the district court, which treated any activity connected to tax filings as adversarial.

“[In litigation], giving one side access to the other’s plan of attack could provide a significant advantage,” Beale says. “But tax accrual workpapers are not prepared in that kind of adversarial context. They are part of the ordinary business of reporting on a company’s financial status.”

Detractors say the ruling changes the test for determining work-product, ignores decades of precedent and creates a circuit split. In his dissent, Judge Torruella, joined by Judge Kermit Lipez, wrote that the majority was abandoning the correct “because of” test, instead creating a new “prepared for” test that “is not even a good rule.”

Torruella continues, “In straining to craft a rule favorable to the IRS as a matter of tax law, the majority has thrown the law of work-product protection into disarray.”

Jacobs calls the dissent better reasoned and more based on existing authority than the majority decision, which he says not only narrows the scope of work-product, but also takes a very narrow view of litigation itself.

“A lot of people would think that litigation could be viewed as broadly enough to include all preparations for litigation including the audit and administrative reviews you might go through before filing a judicial appeal,” Jacobs says. “But the majority seems to think of it only in terms of case preparation materials produced in anticipation of or for a judicial trial.”

That would exclude tax accrual workpapers from privilege, but it could also exclude a lot of other things that taxpayers would presume to be protected–such as any documents analyzing the business risks of litigation, which the dissent asserts “nearly every major business decision” requires. The fear of corporate attorneys is that this erosion of work-product could in theory apply to any analysis of legal contingency–from employee discrimination suits to IP disputes.

“Taking the logic of Textron, I would think a plaintiff in a tort suit would seek discovery of those workpapers,” Kenworthy says, echoing the dissent.

A request of cert from the Supreme Court seems inevitable at this point, with even the dissenting judge in Textron noting, “The time is ripe for the Supreme Court to intervene and set the circuits straight on this issue that is essential to the daily practice of litigators across the country.”