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The Sarbanes-Oxley Act of 2002 has put great pressure on auditors to obtain confidential, privileged information about potential tax liabilities. The Internal Revenue Service has seized on this as an opportunity to encroach on the attorney-client and work-product privileges. How did this come to pass, and what should Congress do about it? In its capacity as the standard-setting agency for conducting public audits, the Public Company Accounting Oversight Board (PCAOB) directed auditors to comply with the guidance of the American Institute of Certified Public Accountants. The AICPA issued recent guidance stating that if the client’s support for the tax accrual is based upon an opinion issued by an outside adviser, “the auditor should obtain access to the opinion, notwithstanding potential concerns regarding attorney-client or other forms of privilege.” Independent auditors now routinely request opinions of tax counsel in evaluating the sufficiency of the tax-liability reserves, and they may even request direct access to tax counsel for the purpose of critiquing the counsel’s legal conclusions. Consistent with the AICPA’s guidance, these requests are made without regard to any attorney-client or attorney work-product privileges. WAIVING PRIVILEGE It appears that in enacting Sarbanes-Oxley, Congress did not intend to override these privileges. Section 105 of Sarbanes-Oxley states that disclosure of privileged information to cooperate with the Securities and Exchange Commission should not result in a waiver of privilege to other parties. It also provides that disclosures by auditors to the PCAOB and by the PCAOB to the SEC, the Department of Justice, or other federal and state regulatory agencies do not waive confidentiality privileges. The problem with Section 105 is one of linkage: Tax-reserve information is disclosed directly to the company’s auditors, who in turn disclose it to the SEC and the PCAOB. The “handover” from the company to the auditors falls outside the protection of Section 105. The consequences of waiving privilege are grave, but the consequences of refusing an auditor’s request for privileged opinions are even worse. A company that refuses the auditor’s request may receive a “qualified opinion” on the company’s financial statement. A qualified audit opinion signals to the investment community that a matter that could materially affect the financial condition of the company has not been disclosed. The consequences could lead to a significant devaluation of share price and possible financial ruin for the company. Auditor demands for tax-reserve information and any related opinions likely will increase in the future. The Financial Accounting Standards Board (FASB) is reconsidering how companies should report uncertain tax positions in their financial statements. The FASB likely will raise the evidentiary bar. Its exposure draft would require that a tax position taken or expected to be taken must be “probable” of being sustained before the benefit of that position can be recognized in the financial statements. The term “probable” means the event is “likely to occur.” This standard requires an assumption that the tax position will be reviewed by the relevant taxing authorities. This means a company cannot use an “audit lottery” approach, under which the low probability of an audit correspondingly diminishes the chances of losing on the merits of the tax position. If this exposure draft is adopted, it will put great pressure on auditors to obtain and second-guess the opinion of tax counsel. LACKING RESTRAINT In today’s overheated tax-shelter environment, the IRS and the Justice Department have shown little restraint in the pursuit of privileged information. The IRS has used auditor disclosures to demand tax counsel opinions, claiming that both the attorney-client and work-product privileges have been waived. Also, the IRS is no longer exercising restraint in requesting tax-accrual workpapers, which, although not privileged, were generally not sought by the IRS. Congress should focus on the importance of the privileges being trodden on. In general, the attorney-client privilege is lost the moment a client discloses the protected communications to an outside party. Most courts have held that disclosure of attorney-client communications to auditors waives the attorney-client privilege, even if disclosed for the purpose of ensuring that loss contingencies, such as future tax liabilities, are accurately reflected in the financial statements. Certain states, however, have statutorily or judicially extended the attorney-client privilege to communications with independent auditors. One wonders whether the federal government should follow the lead of the states. The attorney work-product privilege prevents disclosure to opposing counsel of material that is prepared by an attorney, his agents, or a client representative in anticipation of litigation (as opposed to in the ordinary course of business). A pivotal issue is whether the tax opinion associated with the tax reserves will be considered to have been prepared in anticipation of litigation, presumably with the IRS or the investing public. This can be particularly problematic if the auditor is not considered an adversary. Courts are split on whether disclosure to an auditor of the tax opinions supporting tax-reserve numbers, while potentially fatal to the attorney-client privilege, will waive the work-product privilege. Generally, if a court finds that the auditor and the company have a “common interest” in cooperating to produce accurate financial information, it will hold that the work-product privilege is preserved against disclosure to adversarial third parties. These rulings are consistent with AICPA auditing standards that state that the independence of an auditor does not imply the attitude of a prosecutor but, rather, a judicial impartiality that recognizes an obligation for fairness. Even so, at least one federal district court has held that the work-product privilege was waived by a disclosure to the auditor, finding that there was no “common interest” because the “independent” role of the auditor assumes a public responsibility to the corporation’s creditors and stockholders and to the investing public that transcended any employment relationship between the company and the auditor. Accordingly, great uncertainty still surrounds the work-product privilege and auditor disclosures and the IRS’ ability to breach that privilege. An important issue underlying any waiver of privilege concerns the scope of the waiver � namely, whether the waiver is with respect to the subject matter involved and all other documents regarding the subject matter, or only with respect to the particular document or communication involved. Disclosure to an auditor could open up all communications and work product to an IRS fishing expedition. WHY DO THEY WANT IT? The bottom line in this analysis is to ask why the IRS is seeking privileged information. The American Jobs Creation Act of 2004 already provides a disclosure regime that requires taxpayers to inform the IRS of transactions that may have attributes (as determined by the IRS) of a tax-shelter transaction (reportable transactions) or that have been specifically identified by the IRS as a shelter transaction (listed transactions). Substantial penalties are imposed for nondisclosure. Thus, the IRS inquiry should not be related to transactions that the IRS believes could constitute a tax shelter. Similarly, the IRS should not be using privileged information to determine whether an opinion can be relied upon by the taxpayer. The American Jobs Creation Act also created a new standard for tax opinions that taxpayers can rely upon in establishing their reasonable belief that their tax position is proper and that penalties should not apply. This standard generally requires that the tax adviser (e.g., the attorney) not have a managerial or financial interest in the underlying transaction or in the outcome of the tax benefits of that transaction. This standard also prohibits reliance upon unreasonable facts or legal assumptions in rendering the opinion. Moreover, the Treasury Department recently issued revised rules under Circular 230, which establish new disclosure and reliance standards for opinions on transactions having a principal purpose of avoiding tax. Also, once a legal opinion is given to the IRS as a defense against a penalty assessment, any privilege afforded the subject matter of the opinion is generally waived, barring an agreement with the IRS to limit waiver. Accordingly, the IRS intrusion into privileged communications and work product cannot be based on the agency’s need to review the quality of the opinion. AN EASY ROAD MAP The likely and unfortunate truth probably lies in the view that confidential opinions and work product can be used as a road map for conducting the examination. This relieves the IRS of its historical duty to develop the facts and the law and to reach its own independent conclusion regarding the proper tax treatment of a transaction. An inopportune fact, which may be unknown to IRS National Office personnel, is that IRS field agents frequently seek the opinion of counsel in order to claim that the amount set aside in a tax-contingency reserve of the financial statements is the amount a taxpayer must concede to settle the matter with the IRS. They claim that the opinion of counsel supporting that calculation is, in effect, a taxpayer admission against its own interest. Thus, the field agents are using the auditor disclosures and any attendant communications with counsel as leverage to achieve ever-larger settlements, without doing the work necessary to make a determination on the legal merits of the tax position. A LEGISLATIVE SOLUTION A legislative solution is called for, and the basis for that fix exists in current case law. The idea of “selective waiver” � that is, waiving privilege to one party but not to another � is not new to the courts, but it has yielded very inconsistent results. Courts have found that selective waivers are either permitted or never permitted, or that selective waiver can apply only when the client has obtained a confidentiality agreement with the adverse party. One decision by the U.S. Court of Appeals for the 8th Circuit specifically ruled that voluntary disclosure to a government entity does not waive the attorney-client privilege with respect to third parties on the grounds that the government’s need for such information outweighs allowing access by third-party adversaries. Most courts, however, have not adopted the concept of selective waiver, even if information is compelled by the government. Sarbanes-Oxley has created a crisis of confidence in the privilege process. This is uniquely unwarranted for disclosure of tax-reserve information, based on the legislation and enforcement tools that Congress has given to the IRS. Congress needs to fix this overreach by extending the selective waiver protections afforded by Section 105 of Sarbanes-Oxley to a company’s disclosure of privileged information to its auditors, or, at the very least, by enacting legislation to provide that any such disclosures will waive the privilege only as to the particular documents disclosed and will not result in a broad subject-matter waiver. Without this protection, public companies will refrain from seeking counsel, which, in the end, will create even more conflicts with the IRS and possibly lead to understating contingent tax liabilities, thus damaging the investing public that Sarbanes-Oxley was designed to protect.
Ed McClellan is a partner in the D.C. office of Alston & Bird, where he works in the legislative and public policy group. The views expressed are his own and are not necessarily those of the firm or its clients.

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