Full Court Reviews First Circuit Panel Ruling Protecting Tax Accrual Work Papers Produced for Dual Purpose of Filings and Anticipating IRS Litigation

In a case of intense interest to independent auditors, the en banc First Circuit Court of Appeals has reviewed a split First Circuit panel ruling that the work-product doctrine protects from an IRS subpoena tax accrual work papers prepared by a company for the purpose of calculating tax reserve liability even though the work papers were also prepared in conjunction with the independent audit of the company’s SEC-filed financial statements. The full First Circuit recently heard oral arguments in the case and a decision should follow in due course. (US v. Textron, CA-1, No. 07-2631, January 21, 2009)

The outcome of this case could determine whether a public company can share with its independent auditors a candid evaluation of its exposure with respect to any pending or threatened claim without fear that this information will be available to litigation adversaries. In an amicus brief filed with the full First Circuit, the Financial Executives International argued that the panel’s decision appropriately balances the competing interests of the IRS, investors, and the fairness considerations that protect attorney work product. This balancing should permit companies to share candid assessments of potential litigation claims with their outside auditors without fear that such information would be accessible by competitors or adversaries

In finding that the tax accrual work papers were protected from the IRS, the appeals panel first found that, while not all dealing with the IRS during an audit is litigation, the resolution of disputes through adversary administrative processes, including proceedings before the IRS Appeals Board, meets the definition of litigation.

The panel then found that one of the purposes behind the creation of the documents was anticipation of litigation by analyzing litigation for the purpose of creating and auditing a reserve fund. Even more, it could fairly be said that the driving force behind the preparation of the documents was the need to reserve money in anticipation of disputes with the IRS. The mere concurrent presence of complying with SEC regulations as a purpose for producing the tax accrual papers did not defeat the work product protection, said the panel. Protection of dual purpose documents is consistent with the purpose of the work product doctrine.

In dissent, Judge Boudin found that the IRS offered compelling evidence that the sole reason for creating the estimates of risks with respect to the tax positions was to prepare the reserve figures for the company’s financial statements and satisfy the outside auditor that the reserves were adequate.

The federal securities laws require public companies to have their financial statements certified by an independent auditor, noted the dissent, and a key element of the audit is evaluating the adequacy and reasonableness of the company’s reserve account for contingent tax liabilities. Judge Boudin interpreted the Supreme Court’s Arthur Young opinion as rejecting privilege for the preparation of tax accrual work papers since companies have to comply with SEC financial statement obligations and accounting rules and would do so with or without a privilege

In its brief, the FEI contended that disclosure of work product to an independent auditor does not waive work product because the disclosure is not inconsistent with keeping material from an adversary. The auditor and the company are working towards the common goal of presenting accurate financial statements to the investing public. If the auditor discovers information warranting a change in the financial statements, said the FEI, the result would be a correction of those statements and not litigation between the auditor and the company.