Friday, May 28, 2010

Supreme Court Cert. Denial in Textron Leaves Intact IRS Discovery of Tax Accrual Work Papers

The US Supreme Court declined to review the First Circuit’s en banc opinion in the Textron case, thereby leaving intact a 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.

This was the testimony of IRS expert and former PCAOB Chief Auditor Douglas Carmichael, who said that tax accrual work papers include all the support for the tax assets and liabilities shown in the financial statements. From the company's perspective, said the former Chief Auditor, they are created because the key officers of the company sign a certification saying that the financial statements are fairly presented; and they need support for that. From the auditor's perspective, the auditors need to record in the workpapers what they did to comply with GAAP. So the workpapers are the principal support for the auditor's opinion, testified the former PCAOB official.

The court emphasized that the tax work papers were independently required by statutory and audit requirements and that the work product privilege does not apply. It is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated. A set of tax reserve figures, calculated for purposes of accurately stating a company's financial figures, has in ordinary parlance only that purpose, said the en banc court, which is to support a financial statement and the independent audit of it.Moreover, the tax work papers have to be prepared by exchange-listed companies to comply with federal securities regulations and accounting principles for certified financial statements. The compulsion of the federal securities laws and auditing requirements assure that they will be carefully prepared, in their present form, even though not protected, noted the court, and IRS access serves the legitimate and important function of detecting and disallowing abusive tax shelters.

The Association of Corporate Counsel called the Supreme Court’s refusal to hear the case an egregious blow to the well-established precedent on application of work product doctrine. In the ACC’s view, this refusal undermines important efforts by in-house and outside counsel to contribute to greater accuracy and better-considered financial accounting and disclosure decisions necessary to assure corporate accountability, and transparency. In earlier comments, the ACC criticized the appeals court ruling as eviscerating the notion that the in-house lawyer can share legal assessments with company auditors without risking waiving the client’s privilege.

A number of amici urged the Supreme Court to take the case. In its brief, Financial Executives International said that company management has a powerful incentive to provide an independent auditor with all information the auditor deems necessary to evaluate the adequacy of the corporate financial statements. Moreover, the interests of investors in having access to accurate financial statements requires that the tax work papers be protected. More broadly, the integrity of the securities markets requires that published financial statements filed with the SEC fairly reflect a public company’s financial position. It follows that, in providing assurance that a company’s financial statements fairly reflect its financial position, an independent auditor serves the public interest.

The importance of Textron was borne out by recent remarks by SEC Enforcement Division chief Robert Khuzami that, in light of the First Circuit ruling, the Commission is skeptical of an auditor’s assertion of privilege for tax accrual work papers on behalf of an audit client. What the Director described as the First Circuit’s ``common sense analysis’’ is how the SEC staff evaluates these types of assertions of privilege. The staff does not see how the audit documentation prepared by or relied on by an auditor in connection with an audit report can be privileged, or how any claimed privilege hasn’t been waived. Audit documentation is collected or prepared for the purpose of issuing an audit opinion, he emphasized, not for the purpose of litigation. And sharing the work product with auditors, who are supposed to be public watchdogs, strongly undermines any such claim.