Ruling Leaves Companies Exposed to Data Scrutiny

Companies may want to reconsider how they assess and document their tax and litigation risks these days, after a federal appeals court ruling that gives potential adversaries unprecedented access to work papers that previously were more protected.

The ruling, handed down in the First Circuit Court of Appeals in Boston, allowed the Internal Revenue Service to see the work papers Textron Inc. had created while studying the tax implications of several sale-in, lease-out (SILO) transactions, a kind of real estate transaction on IRS radar as potentially abusive. Textron objected, saying the papers were protected under the work-product doctrine, which says internal documents drawn up in preparation for litigation do not have to be provided as evidence in a legal discovery process.

Textron originally prevailed in district court; the IRS then appealed, and the case had been watched closely by the corporate and auditing communities. The court’s Aug. 13 ruling (a split decision, three judges ruling in favor of the IRS but two dissenting) leaves both groups wondering how frank they can be when speculating about the wisdom of certain tax or legal strategies.

Of course, assessing the odds that a certain strategy might fail and result in losses is nothing new. Companies must do such an assessment, and establish reserves to cover those possible losses, to comply with Accounting Standards Codification 450, Contingencies (previously known as Financial Accounting Statement No. 5: Accounting for Contingencies). They also assess the likelihood that tax positions they’ve taken on corporate tax returns will be challenged, and report the results of that analysis in their financial statements as required by ASC 740, Income Taxes (previously Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes).

To meet these obligations and to satisfy their external auditors, companies churn out reams of documentation, or work papers, to demonstrate their analysis and reasoning. Now the Textron decision exposes those papers to inspection by regulators and other outside parties.

Peabody

“This opinion reinforces the government’s understanding that they have free access to these documents whenever they choose to ask for them,” says Payson Peabody, a lawyer at the law firm Dykema Gossett.

Ever since the Financial Accounting Standards Board allowed FIN 48 to go into effect in 2007, companies have protested that such disclosures would give the IRS a roadmap to the weakest spots in their tax returns. Ken Werner, a partner at the law firm Richards Kibbe & Orbe, says the Textron opinion essentially affirms that belief.

“This opinion reinforces the government’s understanding that they have free access to these documents whenever they choose to ask for them.”

—Payson Peabody,

Lawyer,

Dykema Gossett

“If you’re a public company, you have to have audited financial statements,” Werner says. “You have to do some facts analysis to figure out what the reserve can be, so you have to accept the fact that the government can ask for that and get it.”

Textron could appeal to the U.S. Supreme Court, although it has not said whether it plans to do so. But given the small number of cases heard by the court and the cost to pursue such an appeal, says Jim Browne, a partner with the law firm Strasburger & Price, it’s not clear whether prolonged litigation is worth the effort. “It's just not clear how damaging the materials really are,” he says. “I'm a little surprised Textron has taken it this far.”

Still, the opinion of the dissenting two judges was telling: “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.”

Reverberations?

Greenhouse

The Textron decision does establish precedent in the First Circuit (New England and Puerto Rico), but doesn’t necessarily carry the same authority in other parts of the country—which generally have afforded work papers more protection, says Robin Greenhouse with the law firm McDermott Will & Emery. But companies would be wise to take some precautionary measures anyway, she warns.

U.S. VS. TEXTRON

In the following excerpt from United States vs. Textron, Inc. and Subsidiaries, the court explains IRS’s reasoning and Textron’s motive:

… the IRS is unquestionably right that the immediate motive of Textron in preparing the tax accrual work papers was to fix the amount of the tax reserve on Textron’s books and to obtain a clean financial opinion from its auditor. And Textron may be correct that unless the IRS might dispute an item in the return, no reserve for that item might be necessary, so perhaps some of the items might be litigated. But in saying that Textron wanted to be “adequately reserved,” the district judge did not say that the work papers were prepared for use in possible litigation—only that the reserves would cover liabilities that might be determined in litigation. If the judge had made a “for use” finding—which he did not--that finding would have been clearly erroneous.

That the purpose of the work papers was to make book entries, prepare financial statements and obtain a clean audit cannot be disputed. This was the testimony of IRS expert and former Chief Auditor of the Public Company Accounting Oversight Board Douglas Carmichael:

Q. Would you please explain what tax accrual workpapers are?

A. Tax accrual workpapers really include all the support for the tax assets and liabilities shown in the financial statements …

A. Well, from the company’s perspective, they’re created because, for example, for a public company, the key officers of the company sign a certification saying that those financial statements are fairly presented, and they need support for that.

From the auditor’s perspective, it’s the same thing, the auditor needs to record in the workpapers what the auditor did to comply with generally accepted auditing standards. So the workpapers are the principal support for the auditor's opinion.

Q. And why do public companies prepare financial statements?

A. Usually, to meet requirements for raising capital. If they’re a public company, they need to file annual financial statements on a form 10K with the SEC and quarterly information on a 10Q.

The Textron witnesses, while using the word “litigation” as often as possible in their testimony, said the same thing. Textron’s testimony differed from that of the IRS expert only in its further assertion that, without the possibility of litigation, no tax reserves or audit papers would have been necessary. For example, Roxanne Cassidy, Textron’s director of tax reporting, testified as follows:

Q. [W]hat was Textron’s purpose in preparing those tax reserve papers?

A. The purpose primarily was to determine whether Textron was adequately reserved with respect to any potential disputes or litigations that would happen in the future. We would need to ensure that we were adequately reserved in the current year on Textron’s financial statements.

Q. And as a publicly traded company, is Textron required to file its financial statements with the Securities and Exchange Commission?

A. Yes.

Q. And do those financial statements include tax reserves?

A. Yes …

Q. And in having its tax reserves audited by an independent auditor, must Textron be able to support the determinations it has made regarding the adequacy of its tax reserves with some type of evidence?

A. Yes, the support needs to be to the satisfaction of the auditors.

As the IRS expert stated, even if litigation were “remote,“ the company would still have to prepare work papers to support its judgment. Textron’s own witness acknowledged that it would “have to include in its … tax accrual work papers any new transactions that the company entered into that year that there might be some tax exposure on” regardless of whether it anticipated likely litigation. Judged by Textron’s own experience, most—certainly those with high percentage estimates of IRS success—would never be litigated.

Source

U.S. vs. Textron, Inc. and Subsidiaries (Aug. 13, 2009).

“Companies need to look at how they prepare their tax accrual work papers to satisfy the FIN 48 requirement,” she says. “They obviously need to meet the requirement, but not put more in those papers than is required.”

Kevin Kenworthy, of the law firm Miller & Chevalier, also warns that Textron has implications well beyond tax work papers, a fact even noted in the court’s dissenting opinion. Liabilities of any kind—tax, environmental, tort, product—use the same sort of analysis to evaluate litigation hazards, he explains. “There would be others on the other side of litigation who would very much like to have that information. In principle, I don’t see how this decision can be limited to tax reserves.”

Peabody agrees. “This opinion … represents a very significant narrowing of the work product doctrine,” he says. “It says if a reserve is created for accounting purposes because of the prospect of litigation, that’s really not enough to qualify for work-product protection.”

Kenworthy

That said, the decision does not mean companies should brace for a rush of demands from the IRS to see tax accrual papers, Kenworthy adds. The IRS has long operated under a “policy of restraint,” acknowledging it had access to work papers but not demanding them unless it had good reason to suspect abusive tax sheltering, he says.

So far that policy remains intact, he says. “My fear, in view of the Textron decision, is the IRS might revisit the policy,” he adds. “They might be pressured by Congress or others to review it. I'm sure it could be perceived as a way to raise revenue, but it’s more likely to be framed as, `You have this tool at your disposal, why aren’t you using it?'”

Browne

Some companies may assume their work papers aren’t terribly informative to a legal adversary anyway, but legal experts say companies should put more care into their risk-assessment and documentation processes to protect privileged information. Browne, for example, says companies should segregate legal analyses from the financial reporting process, to keep privileged information in an entirely separate documentation system that wouldn’t find its way into the hands of auditors or (worse) outside litigants.

“Don't let the documents collected in the risk assessment bleed over into the work papers,” he says. “That's what corporate counsel is going to need to do for non-tax reserves. That’s the same process that should be taking place for litigation, tort, environmental litigation—all types of loss contingencies companies deal with in the financial statements.”

Browne and Werner admit that may create some difficulty for auditors. “If it’s challenged, you know what the reasoning is and you have it in other work papers,” Browne says. “You can refer to them if you need to, but don’t make them part of the tax reserves work papers.”

Werner says companies may be able to satisfy auditors’ demands with affidavits taken from clients. “The whole purpose of doing the analysis is to show it to the accountants and get audited financial statements,” he says. “I'm really not sure if that would work.”