In the wake of the First Circuit's unfortunate decision in Textron, one might be led to believe that documents prepared in order to support the financial accounting treatment of contingent tax liabilities enjoy little or no protection from disclosure to tax authorities. But a recent decision by the D.C. Circuit confirms that work product protection survives even when protected documents or communications are provided to independent auditors to satisfy financial statement reporting obligations. The new decision largely rejects Textron and even casts doubt on the recent IRS initiative to compel tax return disclosure of uncertain tax positions.
In United States v. Deloitte LLP, the D.C. Circuit resolved a discovery dispute arising in litigation between the IRS and Dow Chemical Company concerning the tax treatment of two Dow partnerships. The government sought to compel Deloitte to disclose three documents over Dow's objection that the documents were protected by the work product privilege. The first document, a memorandum prepared by Deloitte, Dow's independent auditor, summarized a meeting with Dow and its outside counsel about potential tax litigation concerning the partnerships and the appropriate accounting treatment resulting from that possibility. The second and third documents were prepared by Dow's inside and outside counsel to address tax issues related to the partnerships. The government argued that the first document was not work product and, although it conceded that the latter two documents were initially protected by the work product privilege, it argued that the privilege had been waived when the documents were disclosed to Deloitte as part of its review of the adequacy of Dow's tax reserves.
At the outset, the court rejected government arguments that the Deloitte memorandum could not be protected work product simply because it was prepared by Deloitte. Relying on the policy considerations that animated the Supreme Court's decision in United States v. Arthur Young & Co., 465 U.S. 805 (1984), that there is no federal "accountant-client privilege," the government argued that an independent auditor like Deloitte has a responsibility to the investing public and thus cannot be seen as representing Dow for purposes of the work product doctrine. Rather than focusing on Deloitte's role in creating the document, the D.C. Circuit instead looked to whether the document contained work product. In this case, the trial court had found that the Deloitte memorandum memorialized the thoughts and opinions of Dow's counsel prepared in anticipation of litigation. Finding that the contents of a document, not the identity of its author, is controlling, the court concluded: "[t]he work product privilege does not depend on whether the thoughts and opinions were communicated orally or in writing, but on whether they were prepared in anticipation of litigation."
More importantly, the court also addressed whether the information contained in the Deloitte memorandum can be viewed as prepared in anticipation of litigation even though it plainly served to support Deloitte's conclusions about the accuracy of Dow's financial statements. This was essentially the same dispute addressed in Textron over IRS access to the taxpayer's tax-accrual workpapers. Applying the "because of" standard followed by most circuit courts, the D.C. Circuit framed the question to be whether the document was prepared because of the prospect of litigation. In a rebuke of the government's litigating position in this and other cases, the circuit declined to look solely to the function of the document rather than its contents. Consistent with the premise of the "because of" standard, the court held that material developed in anticipation of litigation can be incorporated into a document generated by or for an independent auditor without losing its work product status. "[A] document can contain protected work-product material even though it serves multiple purposes, so long as the protected material was prepared because of the prospect of litigation."
Although noting that the First Circuit claimed to follow the "because of" standard in Textron, the Deloitte court distinguished that case on the factual basis that the First Circuit had found that the documents would serve no purpose in litigation. The Deloitte court also questioned whether the Textron majority was not in fact applying a stricter standard than the "because of" standard it purported to follow. As the court tactfully put it, "Judge Torruella's dissenting opinion in Textron makes a strong argument that while the court said it was applying the ‘because of' test, it actually asked whether the documents were ‘prepared for use in possible litigation,' a much more exacting standard." Despite the court's polite efforts to "distinguish" Textron rather than formally reject it, the D.C. Circuit's reasoning is fundamentally at odds with that of the First Circuit.
Despite the court's ruling that the opinions of counsel contained in the Deloitte memorandum are protected work product, the court nevertheless remanded the case to permit the trial court to assess whether the trial court had correctly ruled that the memorandum was entirely work product, or whether a redacted version should be disclosed to the government.
Turning its attention to the other disputed documents - a memorandum prepared by in-house accountants and lawyers and a tax opinion prepared by Dow's outside counsel - the D.C. Circuit held that work product protection was not waived by disclosure to Deloitte in its role as independent auditor. The court noted that work product protection may be waived when a document or communication is disclosed to a litigation adversary or to any third party under circumstances that are inconsistent with keeping the work product secret from such an adversary. However, the D.C. Circuit embraced a line of authority developed in the trial courts and found that Deloitte was neither a potential adversary nor a conduit to an adversary. In so doing, the D.C Circuit became the first court of appeals to adopt this position (putting aside the vacated First Circuit panel opinion in Textron).
The court rejected government arguments that Deloitte was a potential adversary even though the court acknowledged that disputes sometimes arise between auditors and their clients. The court explained that "the question is not whether Deloitte could be Dow's adversary in any conceivable future litigation, but whether Deloitte could be Dow's adversary in the sort of litigation the Dow Documents address. We conclude that the answer must be no."
Addressing government arguments that Deloitte is a conduit to Dow's adversaries, the court found that Dow had a reasonable expectation that Deloitte would not disclose the work product Dow had shared with the firm. The court noted that the AICPA Code of Professional conduct imposes a duty of confidentiality. And though the court conceded that there might be circumstances where an auditor might be required to disclose confidential information obtained from a client, it found that the government failed to point to any regulatory requirement or any specific circumstance requiring disclosure of the work product contained in these documents. In sum, an independent auditor can fulfill its duties without "revealing every piece of information it reviews during the audit process." The court distinguished Arthur Young & Co., noting that in the present case the government was not merely seeking discovery of the auditor's views on a company's financial statements, but an attorney's thoughts and mental impressions developed in anticipation of litigation. Closing with a quote from Justice Jackson's concurring opinion in Hickman v. Taylor, 329 U.S. 495 (1947), allowing the discovery of such materials would "let the government litigate on wits borrowed from the adversary."
The Deloitte decision also calls into question whether the IRS will be able to require disclosure of uncertain tax positions as part of a large corporation's tax return without a serious threat of further litigation. See Ann. 2010-9. The newly proposed tax reporting requirements go behind the published financial statements and arguably intrude on the zone of privacy created by the work product privilege; at a minimum, the reasoning in Deloitte would seem to prevent the IRS from requiring taxpayers to disclose the reasons why a position is considered uncertain. As Deloitte demonstrates, a taxpayer may use work product prepared in anticipation of litigation to meet its financial reporting obligations, and share that work product with its auditor without fear of losing that protection.
The D.C. Circuit's opinion in Deloitte highlights the rift that developed among the circuit courts over the appropriate standard for assessing whether a document was prepared in anticipation of litigation. In particular, it solidifies a conflict in the circuits on the treatment of tax accrual workpapers because the D.C. Circuit's decision is directly contrary to the Fifth Circuit's decision in United States v. El Paso Co., 682 F.2d 530 (1982) (applying the "primary purpose" test for determining work product protection) and, as noted, difficult to reconcile with Textron. Given the government's previous stance in such matters, we would expect the government to seek further review. It would be very surprising if the government did not seek rehearing en banc, the avenue that worked for the government in Textron, and it could well eventually seek Supreme Court review of this decision if rehearing fails. Although the Supreme Court passed up a good opportunity to clarify the work product standards when it declined to review Textron, that does not mean that it would do so again – particularly when presented with a request from the government and with a stronger circuit conflict.
The government's petition for rehearing is due August 12.
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