Tax Executives Urge Supreme Court to Create Privilege for Tax Accrual Work Papers Prepared for Audited SEC-Filed Financial Statements

Noting the significant changes in federal securities laws and financial reporting since the Supreme Court’s refusal in 1984 to create an accountant-client privilege in US v. Arthur Young, the Tax Executives Institute urged the Court to revisit the issue and hold that tax accrual work papers are protected by a separate work product privilege for documents prepared in connection with audited SEC-filed financial statements. In an amicus brief submitted in the Textron case, the Institute said that the strong public interest in maintaining a high level of financial reporting outweighs the purported need of the IRS for a roadmap of the arguments that a corporate taxpayer may raise in defending tax positions in the event of an examination. The Institute represents corporate managers responsible for the tax affairs of over 3,000 leading companies.

The brief was filed in a case where the 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.

Tax accrual work papers represent a bridge between the tax and financial reporting worlds, noted the Institute. They are dual purpose documents that help a company’s auditors determine how much to reserve for potential tax liabilities, and also guide the company in making litigation or settlement decisions concerning the treatment of certain tax items.

While respecting the Court’s 1984 view that tax accrual work papers should not be shielded from IRS disclosure, the Institute suggested that common law principles interpreted by federal courts in light of reason and experience support the Court’s reexamination of the issue. In an effort to get the Court to do so, the brief pointed to recent corporate scandals involving Enron, WorldCom and many other companies that cast a spotlight on the fragility of financial controls and the ease with which companies could conceal from the outside auditors of financial statements activities that threatened the viability of their enterprises and, indeed, the underlying integrity of the U.S. securities markets.

In the wake of these scandals, noted the Institute, the Sarbanes-Oxley Act was passed to restore investor confidence in the securities markets. Sarbanes-Oxley heightened public company financial controls, toughened penalties, and imposed new disclosure obligations. Congress did not, however, mandate either the creation or disclosure of tax accrual work papers, even though a robust disclosure regime already existed in the Internal Revenue Code. See, 26 U.S.C. § 6662(b)(2)(B) (penalty for understatement of tax reduced for items disclosed to the Internal Revenue Service).

In addition, new and more demanding accounting rules on the calculation and reporting of tax assets and liabilities have been adopted, including the calculation of contingent tax liabilities for purposes of establishing financial statement reserves. Under the new standards, public companies such as Textron must now evaluate each tax position taken on their returns to determine whether those positions are supported by technical authority that, in the opinion of the company, would more likely than not be sustained by a taxing authority.

This process often results in detailed written analyses of numerous tax issues including the likelihood of succeeding in litigation and the related mental impressions of tax professionals, including both accountants and attorneys. Moreover, in 2002, the IRS mandated broader disclosure of tax accrual work papers than was required at the time of the Court’s decision in Arthur Young. This significant broadening of situations in which the IRS would seek access to tax accrual work papers was a signal event, argued the Institute, since the Court in 1984 cited with approval the IRS’s administrative sensitivity to the intrusiveness of demands for the production of tax accrual work papers.

According to the Institute, the totality of these post-1984 developments place a premium on the assessment of tax risk and the calculation of financial reserves in respect of a company’s tax position. They also place a premium on confidential communications between companies and their legal advisers in aid of that assessment. On the one hand, noted the brief, auditors must pinpoint potentially vulnerable areas of a company’s tax returns, make inquiries into the company’s legal analysis of those positions and its consideration of whether and how to litigate those issues if their reported treatment were challenged by the IRS, and document the review.

On the other hand, if the IRS can freely seek access to a company’s files in pursuit of a blueprint or in the course of a fishing expedition, the company might prepare less documentation for its positions or be less forthcoming in providing it to the auditor, making it more difficult for the auditor to do its job.

Amicus is fully aware that the Court must balance different and sometimes competing interests in resolving the tax accrual work paper disclosure issue. That balance is primarily between the government’s interest in the enforcement of its laws and the collection of revenue and the national public interest in the maintenance of fair and honest securities markets.
Balancing those interests in 1984, the Court in Arthur Young found it unnecessary to fashion a work-product privilege to protect tax accrual work papers.

In the view of TEI, that determination is ripe for reconsideration in light of the intervening changes to the statutory and regulatory landscape applicable to the preparation and auditing of corporate financial statements. The Tax Executives Institute believes that different times require a different balance than that struck by the First Circuit.

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