Public Policy May Compel Supreme Court to Review Ruling that Audit Work Papers Discoverable by IRS Since Done for SEC-Filed Financial Statements

The U.S. Supreme Court has been asked to review an en banc First Circuit Court of Appeals ruling that the attorney work product doctrine does not shield from an IRS summons tax accrual work papers prepared by a company’s lawyers to support the calculation of tax reserves for audited financial statements filed with the SEC. Textron Inc. v. United States, Dkt. No. 09-750.

In a 3-2 opinion, the full appeals court held that the purpose of the tax audit work papers was not to prepare for litigation, but rather to make book entries, prepare financial statements and obtain a clean audit

It is always difficult to hazard an opinion on whether the Court will take a given case. In this case, there is no split among the federal circuits since the only two federal appeals courts to decide the issue, the First and Fifth, have ruled in favor of IRS discovery of the tax accrual work papers. However, the issues involved have enormous importance for the corporate and independent auditor communities. In addition, there is an argument to be made on public policy grounds, pitting the need to fairly enforce the federal tax code and the need to have accurate SEC-filed financial statements.

The Association of Corporate Counsel has decried the First Circuit’s en banc ruling that audit work papers were discoverable by the IRS since they were done with SEC-required financial statements not litigation in mind. The group said that the decision hamstrings public companies’ in-house lawyers from advising auditors in a manner that promotes accuracy and transparency in financial reporting and the certification of financial statements filed with the SEC. It eviscerates the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege.

There is also the public polocy issue created by the intersection of federal tax and federal securities regulation. This was discussed in the Fifth Circuit panel opinion in U.S. v. El Paso Company, CA-5 1982, 682 F2d 530.

The federal tax code is a sprawling tapestry of almost infinite complexity. Its details and intricate provisions have fostered a wealth of interpretations. The Code is a finite system of rules designed to apply flexibility to an infinite variety of situations. There are many "gray areas" in the tax world, twilight zones in which one may only dimly perceive how properly to treat a given accretion to wealth or given expenditure of funds.

When a large corporation completes its return, the number of decisions in the gray areas is enormous. To characterize a sale as ordinary income or capital gain, to depreciate equipment over ten years or twenty, to attribute a transaction to this year or to the next: these decisions recur over and over in a course of preparing a return and guarantee that a large corporation has many opportunities to choose in good faith an interpretation of the tax code that leans toward lessening its taxes. The return is filed with the understanding, however, that the IRS may challenge some of these questionable positions and, through settlement or litigation, the corporation may end up owing more taxes than it initially acknowledged.

Federal securities regulation intrudes because business reality compels corporations to recognize on their financial sheets that the return as filed is not the last word in determining the taxes owed. Public companies must file financial statements with the SEC, and SEC regulations require that independent accountants verify these financial statements. To demonstrate to the accountant that a balance sheet does not portray an overly-rosy view of a corporation's financial health, the balance sheet must provide for contingent future tax liabilities. In short, the corporation must set aside an account to cover additional taxes that it may become liable to pay above and beyond the amount indicated on the initial return.

To comply with the securities laws, therefore, companies must prepare in-house or have prepared by outside auditors an analysis of their contingent tax liabilities. The analysis pinpoints the soft spots on the corporation's tax returns and indicates those areas in which the taxpayer has taken a position that may, upon challenge, negotiation, or litigation, require the payment of more taxes. The analysis is known in the trade as the tax pool analysis, the noncurrent tax account, or tax accrual work papers.

In El Paso, the appeals court rejected the company’s plea to refuse to enforce the IRS tax pool analysis summons, even though it sought otherwise relevant and non-privileged documents, on grounds of the public policy underlying the securities laws. To permit routine summoning of tax pool analyses from companies, argued El Paso, would have a chilling effect on the companies' willingness to prepare such analyses searchingly and critically. Moreover, companies would conceal tax pool analyses from their auditors and thereby thwart the accountants' attempts to measure the adequacy of the contingent tax accounts. These consequences obstruct the full and frank disclosure of financial information that the securities laws envision. The public policy of protecting investors, therefore, demands the denial of IRS access to a company's tax pool analysis.

The appeals court squarely rejected the argument that the public policy of the securities laws implicitly overrides the clear grant of summons power to the IRS. While the IRS does not enjoy untrammeled authority to direct the production of documents, noted the panel, Congress has endowed the IRS with broad authority to conduct tax investigations.

The Supreme Court has consistently construed congressional intent to require that if the summons authority claimed is necessary for the effective performance of congressionally imposed responsibilities to enforce the tax code, that authority should be upheld absent express statutory prohibition or substantial countervailing policies. The appeals court was unwilling to make inroads in the plainly-announced congressional policy to allow the IRS broad access to relevant, nonprivileged documents on the basis of the company’s claim of a conflict with the policies underlying the securities laws.

The court rejected as speculative the theory that the accuracy of financial reports would suffer if companies had to divulge their tax pool analyses to the IRS. The court similarly rejected a picture of corporations evading their responsibilities under the securities laws to prepare their financial books properly and to lay open their books and records to independent auditors. The court refused to assume that corporations would dishonor their legal obligations by discontinuing the preparation of tax accrual work papers. If a company blocked the efforts of the outside auditors to ascertain the true state of the company's contingent tax liabilities, the auditor would be obligated to decline to certify the financial statements. The powers of the SEC suffice to ensure that companies will comply with the securities regulation.

.