A divided panel of the First Circuit has affirmed the key holdings of the district court in Textron regarding work product protection of a taxpayer’s tax accrual workpapers. The court of appeals ruled that these documents generally qualify for work product protection when they contain analysis of the prospects of success on issues that might be challenged by the IRS. The court also ruled that this protection is not automatically waived by disclosure to an independent auditor. The court concluded, however, that the protection can be waived by such a disclosure if the taxpayer’s own analysis is evident from the auditor’s workpapers, and it remanded to the district court to resolve this question on the facts of this case. This closely watched issue thus remains short of a final resolution.

Tax Accrual Workpapers Prepared “In Anticipation of Litigation”

As we previously reported in these pages (Tax Accrual Workpapers - Textron Upholds Work Product Protection, 9/4/07), the trial court ruled that the IRS could not compel the production of tax accrual workpapers prepared by Textron's attorneys. Those workpapers identified issues that the company’s attorneys believed could be challenged by the IRS and reflected their estimate of the company’s odds of prevailing before the IRS or in court. The workpapers were considered to have been prepared “in anticipation of litigation” even though they also plainly served to ensure that the company recorded the appropriate tax reserves for financial accounting purposes. The trial court found that Textron would not have created the tax accrual workpapers but for the fact that the taxpayer reasonably anticipated litigation over one or more matters reflected in the workpapers. Consequently, the court ruled, those documents come within the protection provided by the work product doctrine.

The First Circuit has now affirmed this central holding by the trial court. In determining whether dual-purpose documents such as tax accrual workpapers are “prepared in anticipation of litigation,” and thus eligible for work product protection, the First Circuit and several other circuits apply what has been termed the “because of ” test. The government argued that the trial court had misapplied that test when it looked to whether the documents would have been prepared “but for” potential litigation. The First Circuit acknowledged that the function of the documents was “to analyze litigation for the purpose of creating and auditing a reserve fund.” But the First Circuit interpreted the trial court’s “but for” terminology as simply a means of expressing its conclusion that the documents “were prepared ‘because of’ the risk of disputes and litigation which gave rise to a need to compute and report tax reserves.” In so ruling, the First Circuit also confirmed that adversary administrative proceedings before the IRS constitute “litigation” for purposes of the work product doctrine.

The First Circuit rejected the government’s contention that the presence of a business or regulatory purpose for creating the tax accrual workpapers necessarily defeats work product protection, particularly where, like here, the business purpose fairly evaluating contingent tax liabilities arising from disputes with the IRS is so inextricably related to anticipated litigation. As the majority opinion puts it, “[t]hat the anticipation of such disputes (and corresponding potential litigation) also triggered certain business and accounting obligations does not bar the protection of the work-product doctrine.” Judge Boudin dissented, disagreeing with this application of the “because of” test and arguing that only documents prepared to be useful in litigation come within the work product protection. According to the dissent, the evidence presented here showed that the sole reason for the preparation of the tax accrual workpapers was to establish accounting reserves and to satisfy Textron’s auditors that those reserves were adequate.

The majority soundly rejected the government’s assertion that the trial court’s holding was contrary to the Supreme Court’s decision in Arthur Young & Co., 465 U.S. 805 (1984). In that case, the Supreme Court had declined to recognize a new accountant work product privilege and thus refused to shield disclosure of tax accrual workpapers prepared by an independent auditor. The First Circuit found Arthur Young & Co. inapposite, both because Textron was not seeking recognition of a new privilege and because that case did not involve the kind of dual-purpose documents at issue here.

The First Circuit also rejected a government argument that a decision for Textron would immunize nearly every document prepared by a lawyer because clients can always be said to be aware of possible litigation. The government asserted that Textron did not adequately identify potential litigation that would justify the preparation of protected work product and, indeed, that Textron could not do so given that most matters addressed in its workpapers surely would be resolved short of litigation with the IRS. Nevertheless, the court was satisfied that Textron satisfied this burden and established the potential for litigation. As the court explained, “in the case of tax accrual workpapers, the dual purposes financial reporting and anticipating litigation are necessarily intertwined; the function of preparing adequate financial reports inherently requires Textron to anticipate and analyze litigation.”

The First Circuit readily acknowledged that its holding here highlights a split with the Fifth Circuit over the scope of the work product protection. In United States v. El Paso Co., 682 F.2d 530 (5th Cir. 1982), the court had ruled that a company’s own tax accrual workpapers did not qualify for work product protection. The First Circuit explained that this different outcome is attributable not to any new difference in approach to tax accrual workpapers but rather to an already “existing split” in defining the work product doctrine. The Fifth Circuit has long limited work product protection to documents whose “primary purpose” is to aid in future litigation, whereas the First Circuit and other courts have rejected that approach in favor of the “because of” test.

Issue of Waiver Remains Unresolved

The work product doctrine is intended to preserve fairness in our adversarial system of dispute resolution. Unlike the attorney client privilege, disclosure outside the confidential attorney client relationship does not generally waive work product protection. Instead, work product protection generally is waived only by disclosures that are inconsistent with keeping the information from a litigation adversary. Thus, a waiver may occur if work product is disclosed to an adversary or to a conduit to a potential adversary.

The First Circuit joined a growing number of courts that have held that disclosures to an independent auditor do not automatically waive work product protection. The court noted that the relationship between reporting company and independent auditor is “cooperative not adversarial.” Acknowledging that there might be circumstances in which Textron and E&Y might have a legal disagreement, the court found no evidence that there could be such a dispute arising from the disclosure of Textron’s tax accrual workpapers. However, the First Circuit remanded the case to the trial court for further proceedings to determine if Textron waived the protection on the ground that, on these facts, E&Y was a potential conduit to the IRS.

On remand, the trial court first will determine if Textron can obtain E&Y’s audit workpapers. The IRS summons issued to Textron had sought tax accrual workpapers prepared by Textron or E&Y. Generally, the recipient of discovery may be compelled to produce all discoverable documents within its possession, custody, or control. However, the trial court’s ruling only addressed arguments concerning Textron’s own workpapers and did not rule on whether Textron could be compelled to produce the E&Y workpapers. The First Circuit ruled the failure to address this question was an error. In so doing, the court rejected Textron’s assertion that the IRS had waived its claims with respect to E&Y’s workpapers, finding that trial court was on notice of the issue. Further, the First Circuit rejected Textron’s contention that the record already establishes that the company does not have possession, custody or control of E&Y’s workpapers. In the court’s view, the record merely establishes that Textron did not receive the E&Y workpapers, not that it could not obtain copies of those workpapers upon request.

Assuming the trial court determines on remand that Textron can be compelled to secure and produce copies of E&Y’s workpapers, the trial court will evaluate whether and to what extent E&Y’s workpapers reveal Textron’s own work product analysis. The First Circuit assumed without discussion that the IRS can obtain access to everything in E&Y’s own tax accrual workpapers under the authority of Arthur Young & Co. Based on this assumption, the First Circuit reasoned that, “[s]ince E&Y’s workpapers may be discoverable, the question we must ask is whether disclosure of those workpapers substantially increased the risk that the contents of Textron’s workpapers would be disclosed to an adversary.” In order to answer this question, the trial court was instructed to make this determination on remand through testimony or in camera inspection of the documents.

The court’s reasoning in ordering a remand is questionable. Ordinarily, discoverable documents that contain privileged information can be redacted to protect the privilege. As pointed out in the amicus brief filed by Financial Executives International, there was no claim in Arthur Young that any of the summoned material was attorney work product, and therefore the Supreme Court’s decision did not suggest that an auditor’s workpapers cannot be redacted before production to the IRS if they contain privileged information. The First Circuit’s analysis is fundamentally circular. It assumes that Textron’s legal analysis must be disclosed when embodied in the auditor’s workpapers, but the only reason given for the loss of work product protection is that Textron should be deemed to have waived that protection because of the possibility of this disclosure. Moreover, the extent to which Textron’s analysis can be found in the auditor’s workpapers is outside of Textron’s control; it depends entirely on the auditor’s method of preparing its workpapers. The better analysis is that the work product protection remains intact and can be safeguarded through redaction when the information is incorporated into an auditor’s workpapers. Hence, there is no waiver and no disclosure.

What Next?

The next step in the litigation over the Textron summons is unclear at this time. The most orderly way to proceed would be for the parties to return to district court and resolve the remaining issues framed by the majority opinion. It is possible, however, that the government will be sufficiently unhappy with the First Circuit’s opinion that it will seek further review at this time. The sharply worded dissent of Judge Boudin appears to invite a petition for rehearing en banc in explicitly suggesting that the majority’s ruling exceeded the authority of a court of appeals panel. And given the clear conflict with El Paso and the disharmony in the circuits regarding the test for work product protection, a petition for Supreme Court review is also a distinct possibility. In addition, Textron could pursue further review of the court’s determination to remand the case. A petition for en banc rehearing would be due on March 9, and a petition for certiorari would be due on April 21.

For more information, please contact any of the following lawyers:

Kevin Kenworthy, kkenworthy@milchev.com, 202-626-5848

Alan Horowitz, ahorowitz@milchev.com, 202-626-5839

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