The Internal Revenue Service has lost the first round in a much-anticipated test case against Textron Inc., in which it sought judicial approval for a new program seeking tax accrual workpapers during the examination of corporate clients.The IRS is interested in Textron's and others' workpapers, since they document what the company considers its questionable tax positions.

In 2002, the IRS announced that it was modifying its historic policy of restraint with respect to tax accrual workpapers. The service said that it would, under certain circumstances, seek tax accrual workpapers relating to a taxpayer if the taxpayer has claimed the benefits of a listed transaction on a return.

In a 2005 memorandum to examiners, the Large and Mid-Size Business Division emphasized that a request for tax accrual workpapers is mandatory when a taxpayer claims the benefit of a listed transaction. In Textron's case, the listed transaction was a sale-in, lease-out, or SILO, transaction involving telecommunications and rail equipment. The IRS classifies these as "listed transactions" because it considers them to be engaged in for tax avoidance.

Although the court found that the workpapers were protected by attorney-client privilege and tax practitioner privilege, it concluded that both were waived when they were disclosed to the company's external auditor, Big Four firm Ernst & Young. However, the court found that the work product privilege also applied, and was not waived by the disclosure to E&Y.

The work product privilege shields materials prepared by a party in anticipation of litigation or preparation for trial, according to the court.

J. Walker Johnson and Art Bailey, partners in the Washington office of Steptoe & Johnson, which represented Textron, voiced their reaction to the decision. "We are gratified with the result the district court reached, and we're reviewing the opinion," said Bailey.

AUDITORS REJOICE

"From an auditor's standpoint, this has to be regarded as a great decision," said Randy Elder, director of Syracuse University's Lubin School of Accounting and a professor in the Whitman School of Management. "We want clients to communicate freely with us as auditors, so that when the client prepares tax accrual workpapers, they're willing to share with us freely and not be concerned that they may be subpoenaed by the IRS," he said. "Could it be overturned? Sure, but it may at least slow the IRS down in their desire to have access to workpapers."

Joe Kristan, a CPA and shareholder at Des Moines, Iowa-based Roth & Co. PC, thought that the decision will be reversed. "It just seems too easy that you can protect tax accrual workpapers by running them by a lawyer," he said. "It seems too big a loophole not to be reversed."

However, Elder said that simply passing it by an attorney would not by itself trigger the protection. "The fact that the workpapers have been in the hands of an attorney will not be sufficient," he said. "The courts will look at the substance."

"Tax accrual workpapers can take many different forms," he noted. "In this case, the workpapers were prepared directly by Textron analyzing what they thought their exposures were. The key issue for the court was whether the workpaper was prepared in anticipation or because of litigation. Certainly, if there were no prospect of litigation, they would not have needed to prepare these."

There is no unchangeable definition of tax accrual workpapers, according to the court. It cited the government's expert witness, Prof. Douglas Carmichael, the former chief auditor of the Public Company Accounting Oversight Board, who explained that the content of tax accrual workpaper files varies, because, "Companies organize their records in different ways."

In Textron's case, they consisted of a spreadsheet that contained lists of items on Textron's tax returns, which in the opinion of its counsel involve issues on which the tax laws are unclear, and therefore may be challenged by the IRS; estimates by Textron's counsel expressing, in percentage terms, their judgments regarding Textron's chances of prevailing in any litigation over those issues; and the dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation.

In addition, the workpapers included backup workpapers consisting of the previous year's spreadsheet and earlier drafts of the spreadsheet, together with notes and memoranda written by Textron's in-house tax attorneys reflecting their opinions as to which items should be included on the spreadsheet, and the hazard-of-litigation percentage that should apply to each.

"If Textron had not anticipated a dispute with the IRS, there would have been no reason for it to establish any reserve or to prepare the workpapers used to calculate the reserve," said the court. "Thus, while it may be accurate to say that the workpapers helped Textron determine what amount should be reserved to cover any potential tax liabilities and that the workpapers were useful in obtaining a 'clean' opinion from E&Y regarding the adequacy of the reserve amount, there would have been no need to create a reserve in the first place, if Textron had not anticipated a dispute with the IRS that was likely to result in litigation or some other adversarial proceeding."

PRIVILEGED OR NOT?

"The issue with any of these requests ... is that these documents could easily be argued to be more related to the ordinary course of business than to the core materials that the work product protection is intended to cover," said Linda M. Beale, associate professor at Wayne State University Law School.

"The core of the privileges is the adversarial process," she noted. "But the tax planning and accounting work that goes into how much to put into a reserve is not adversarial in nature, and therefore the application of the privilege to that kind of document seems stretched."

* Tax Court decision a week following Textron illustrates the flip side, according to Jeffrey Frishman, national managing principal for tax quality assurance at Grant Thornton. "Just the other day, the Tax Court, in Ratke, reached a conclusion in favor of the government's claim of privilege in a tax case," he said. "The court concluded that the work product doctrine protected from disclosure internal documents prepared by the IRS that reflected proposed legal arguments and strategy in a case - a classic application of work product protection."

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