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By Kenneth J. Krupsky, Esq.
Jones Day, Washington, DC
On June 29, 2010, the Court of Appeals for the District of Columbia waived a bright "red card" in the face of the IRS's campaign to obtain disclosure of tax accrual work papers. (Well, not quite a red card. In soccer, players shown a red card must leave the field without a replacement and, unlike in the law, there's no appeal.)
In U.S. v. Deloitte, No. 09-5171, 2010 U.S. App. LEXIS 13226 (D.C. Cir. 6/29/10), the IRS appealed from the district court order that had denied – based on work-product protection – its motion to compel Dow Chemical's independent financial auditor, Deloitte & Touche (DT), to produce three documents in litigation. SeeU.S. v. Deloitte, 623 F. Supp. 2d 39 (D.D.C. 2009). (As we know, under longstanding policy, the IRS does not routinely seek tax accrual work papers, but will do so in unusual circumstances (e.g., litigation over "listed transactions"). See IRS Announcements 84-46 and 2002-63.)
The IRS argued that one document (the "DT Memo") was not work product, because it was prepared by DT during its audit. The DT Memo summarized a meeting between Dow employees, Dow's outside tax counsel, and DT employees concerning Dow's contingency reserve for the possibility of tax litigation. The IRS conceded that the other two documents (the "Dow Memos") were work product, but argued that Dow had waived protection when it disclosed them to DT. The two Dow Memos were prepared by Dow's in-house accountant and attorney, and by Dow's outside tax counsel. Because the IRS sought production in Washington, D.C., the battle for tax accrual work papers found its way to the D.C. District Court and then the D.C. Circuit Court of Appeals. Dow intervened in support of DT's argument.
The Court of Appeals remanded the issue involving the DT Memo to the district court for in camera review on whether it was entirely or only partially work product. The court affirmed the district court's decision that work-product protection was not waived when Dow disclosed the two Dow Memos to DT.
The DT Memo
The court rejected both of the IRS's "categorical arguments" that the DT Memo could not be work product, because: (1) it was created by DT, not Dow or its representative; and/or (2) it was created as part of the audit process, not in anticipation of litigation. First, the court found that the question was not who created the document, but whether the document contained work product – i.e., the thoughts and opinions of counsel developed in anticipation of litigation – which is protected under Hickman v. Taylor, 329 U.S. 495 (1947). And, the court rejected the IRS's argument that a document's function (here, the audit process), rather than its content (an attorney's views of potential litigation), are determinative.
Significantly, the court failed to follow the recent and controversial decision in U.S. v. Textron, 577 F.3d 21 (1st Cir. 2009) (en banc), which held that a corporation's tax accrual work papers were not prepared in anticipation of litigation. As described in one of my earlier commentaries, "After Textron: "What Is to Be Done?" 38 Tax Mgmt. Int'l J.717 (11/13/09), in Textron the First Circuit concluded that the particular work papers before it were "tax documents and not case preparation materials" that were "prepared in the ordinary course of business … to support a financial statement and the independent audit of it." The First Circuit held that "the work product privilege is aimed at protecting work done for litigation, not in preparing financial statements. Textron's work papers were prepared to support financial filings and gain auditor approval …."
In a vigorous dissent in Textron, two judges characterized the impact of the decision by the three-judge majority as follows: "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. … The time is ripe for the Supreme Court to intervene and set the circuits straight on this issue which is essential to the daily practice of litigators across the country." But the Supreme Court announced on May 24 that it would not review the decision. SeeTextron v. U.S., U.S., No. 09-750 (cert. denied 5/24/10).
Thus, the decision of the D.C. Circuit takes on added significance. In stark contrast to Textron, Deloitte holds that a document "can contain protected work-product material even though it serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation." As noted, the court ordered the district judge to determine whether the DT Memo was entirely work product, or whether a partial or redacted version of the document should have been disclosed to the IRS.
The Dow Memos
Deloitte appears to be the first Court of Appeals decision to consider whether disclosing work product to an independent auditor constitutes waiver. Most of the district courts have found no waiver, although two courts did find waiver. The IRS argued that waiver had occurred in this case, because DT was: (1) a potential adversary to Dow; and (2) a potential conduit to other adversaries.
The court firmly rejected both arguments. First, the court held that the question was not whether DT might become an adversary in some conceivable future litigation against Dow, but whether DT could be Dow's adversary in the sort of litigation the Dow Memo addressed – i.e., tax litigation by Dow against the IRS. Clearly, the answer was no. And DT was not a potential "conduit" to other potential adversaries of Dow, because there was no evidence suggesting that it was unreasonable for Dow to expect DT to maintain confidentiality. The court concluded that Dow had a "reasonable expectation" of confidentiality because DT, as an independent auditor, has an obligation to refrain from disclosing confidential client information under Rule 301 of the American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct, as follows: "A member in public practice shall not disclose any confidential client information without the specific consent of the client."
In sum, the D.C. Court of Appeals has concluded in a very different way than the First Circuit on very significant issues of work product privilege impacting many public and private companies. As has been widely noted, the U.S. Tax Court applies the rules of evidence for the U.S. District Court for the District of Columbia. Accordingly, Deloitte – not Textron – is now the law of the circuit on work product protection in Tax Court cases.
This commentary also will appear in the September 2010 issue of BNA's Tax Management International Journal . For more information, in BNA's Tax Management Portfolios, see Schmehl and Fox, 633 T.M., Compelled Production of Documents and Testimony in Tax Examinations , and in Tax Practice Series, see ¶3850, Examination: Audits, Assessments, Appeals.
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