Sitting en banc in the highly anticipated case of Textron v. United States, a majority of the U.S. Court of Appeals for the First Circuit has issued a sweeping opinion that will allow the IRS free access to tax accrual workpapers prepared by public companies to comply with public accounting standards. The ruling supersedes a prior ruling by a three judge panel of the 1st Circuit in favor of Textron and appears to allow opposing parties to discover the thinking behind any tax or civil litigation reserve established for accounting purposes.
Writing over a strong dissent by judges Torruella and Lipez, the majority of the en banc panel found that the work product doctrine does not protect from disclosure the documentation behind a company’s self-assessment of the risk of a negative outcome in controversy with the IRS.
The Court reasoned that litigation risk assessments prepared to comply with public accounting standards are not prepared specifically for use in litigation. If litigation were to arise, the Court believed, it would be unlikely that the future litigation team would turn to the company’s earlier self-assessment of litigation risks to aid its preparation. On that basis, the Court found that the risk assessments and associated notes and e-mails were outside the scope of the work product doctrine and subject to disclosure to the IRS.
The dissent, on the other hand, argued that the majority was ignoring one of the historical purposes of the work product doctrine – - to prevent the “sharp practices” of opposing counsel seeking compelled disclosure of the other side’s candid opinion of the risks of its own position in litigation. The dissent further argued that the majority’s approach represents a dramatic narrowing of the work product doctrine, confining it to only those documents prepared specifically for litigation. It pointed out that documents supporting a public company’s civil litigation reserves for any purpose would be subject to disclosure under the majority’s rationale.
Under Generally Accepted Accounting Procedures (GAAP), public companies are required to establish reserves sufficient to fund contingent tax liabilities that might arise out of each transaction with uncertain tax consequences. Typically, the reserves appear as a single figure on the company’s financial report, but GAAP requires companies to show auditors more detail.
In Textron’s case, the detail consisted of a spreadsheet with litigation risk assessments assigned to each transaction together with backup e-mails and notes supporting the percentage assessments. In other cases, the backup may include opinions of tax practitioners on the probability of success on the merits in controversy with the IRS.
By tradition, the IRS has refrained from demanding access to tax accrual workpapers, but it has always maintained the right to do so, following the favorable outcome in U.S. v. Arthur Young, but that case was decided before Congress extended the attorney-client privilege to accountants engaged in tax practice.
In order to stem the growing commercialization of the tax shelter business by major accounting firms, the IRS changed its policy and in 2002 announced that it would seek disclosure of selected tax accrual workpapers if a company engaged in any transaction later listed as a tax shelter by the IRS and Treasury. It would seek all of the company’s tax accrual workpapers for the tax year in question if a company engaged in multiple listed tax shelter transactions.
The First Circuit’s ruling validates the IRS’s approach and has broad implications for the work product doctrine itself. Documents prepared to support any type of accounting reserve for potential litigation could well be subject to disclosure under the Court’s newly-announced standard.