Tax Workpapers and Work Product Privilege
Textron and the Auditor-Attorney Relationship

By Alexander L. Gabbin and Jean T. Wells

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APRIL 2008 - The recent decision in United States v. Textron Inc. and Subsidiaries [507 F. Supp. 2d 138 (D.R.I. Aug. 28, 2007)] will have far-reaching implications for the treatment and discoverability of tax accrual workpapers prepared in reliance on advice provided by attorneys. While the court held that disclosure of risk of liability by a client’s attorneys to an independent auditor for the purpose of developing tax accruals waived the attorney-client privilege, it did not waive the “work product privilege,” which exists to serve a different public policy than the attorney-client privilege. In January 2008, the IRS appealed the district court’s decision to the First Circuit Court of Appeals.

Textron involved the government’s attempt to enforce an IRS summons for all of Textron’s tax accrual workpapers. The ultimate outcome of Textron will have implications for the delicate 30-year balance forged between independent auditors and external attorneys, two parties who work together to maintain confidence in financial statements without intruding upon the confidentiality of the attorney-client and the work product privileges.

In Textron, the court affirmed the principle that tax workpapers fall within the protection of work product privilege. Generally, the work product privilege serves as a barrier to prevent a potential adversary from gaining an unfair advantage over a party by obtaining documents prepared by the party or its counsel in anticipation of litigation. Such documents could benefit the adversary by revealing the party’s strategy or the party’s own assessment of the strengths and weaknesses of its case. In Textron, the court ruled that only disclosures by Textron that were inconsistent with keeping the information from an adversary would constitute a waiver of work product privilege. Textron had disclosed the tax workpapers only to its independent auditors, who gave Textron a pledge of confidentiality.

The Textron Facts

The case began when the IRS sought to enforce a 2005 IRS summons issued to Textron to produce all of its tax accrual workpapers for the tax year ending December 29, 2001, and the workpapers in connection with the IRS’s examination of tax liabilities for 1998–2001. The IRS was particularly concerned about nine sale-in, lease-out (SILO) transactions that a Textron subsidiary had engaged in. SILO transactions were classified as “listed transactions” by the IRS in February 2005 (Notice 2005-13).

Textron highlights the IRS’s increased focus on seeking tax accrual workpapers. The IRS has had the right to obtain tax accrual workpapers for more than 30 years, but it seldom exercised this authority prior to 2002. Before Enron’s collapse and the plethora of concurrent corporate scandals, the IRS had requested tax accrual workpapers only five times in 30 years. After 2002, the IRS’s policy of voluntary restraint dramatically changed. In 2005 alone, the IRS requested tax accrual workpapers a total of 50 times (“Reed Smith Bulletin 06-26,” September 2006), including Textron’s. This surge suggests that such behavior may be the start of increased vigilance from other governmental agencies and regulators.

Textron refused to produce its tax accrual workpapers on the basis that they were protected by attorney-client privilege, tax practitioner–client privilege, and work product privilege. Textron claimed that its ultimate purpose in preparing the tax accrual workpapers was to ensure that it was adequately reserved for any future litigation. Textron also asserted that the summons was issued so that the IRS could use the documents related to the SILO transactions as a bargaining lever in settlement negotiations.

The IRS argued that Textron’s tax accrual workpapers should not receive work product privilege protection, because they were prepared in the ordinary course of business. The IRS maintained that Textron would have created the workpapers in essentially similar form irrespective of litigation. The IRS further asserted that Textron’s primary purpose for preparing the workpapers was to demonstrate that its contingent liability reserves were in accordance with GAAP and thereby deserved a clean audit opinion from the independent auditor.

The Textron Decision

The court was not persuaded by the IRS’s “ordinary course of business” argument. Focusing instead on the contingent liability reserves reported in Textron’s audited financial statements, the court reasoned 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 another adversarial proceeding.

The court found that Textron had waived the attorney-client privilege and the tax practitioner–client privilege when it provided the workpapers to its independent auditors. Nevertheless, the court found that Textron did not waive the work product privilege, because the independent auditors had confidentially agreed not to disclose the information in the workpapers. Furthermore, the court relied on AICPA Code of Professional Conduct Rule 301, which expressly states that the independent auditor has a professional obligation to not “disclose any confidential client information without the specific consent of the client.” The court concluded that the IRS failed to demonstrate a “substantial need” for the workpapers, because the determination of any tax owed by Textron must be based on factual information readily available by other means.

Impact on the Auditor-Attorney Relationship

While the immediate effect of the decision is specific to Textron, a larger issue is at stake in this case. Textron is significant because of its potential impact on interactions between auditors and attorneys. More than 30 years ago, the AICPA and the American Bar Association (ABA) approved a 1975/1976 treaty between the ABA (Statement of Policy Regarding Lawyers’ Responses to Auditors’ Requests) and the AICPA (“Standards of Fieldwork,” Exhibit II of AU Section 337) to fulfill their respective professional responsibilities to corporate clients, regulatory agencies, and the public. Today, however, this treaty may be on the verge of unraveling. If it is not replaced with some means of balancing the legitimate responsibilities of a corporation’s external attorneys and independent auditors, the consequences for U.S. corporations competing in a global market could be catastrophic.

What forces are placing the treaty in jeopardy, leading to the auditor/attorney dilemma now confronting corporate management? First, a major change in the landscape for public accountants occurred with the passage of the Sarbanes-Oxley Act of 2002 (SOX) and the resulting power of the Public Company Accounting Oversight Board (PCAOB) over GAAP and generally accepted auditing standards (GAAS). With the passage of SOX, the PCAOB rather than private sector organizations establishes auditing, attestation, ethics, and internal control standards for public companies. This significant development completely changes the parties capable of negotiating and enforcing cooperative arrangements such as the ABA-AICPA treaty.

A second force is the fact that the United States has the dubious distinction of being the most litigious nation in the world. In the authors’ opinion, no corporate endeavor that is less than perfect is safe from unwarranted class action suits, excessive damage awards, and frivolous lawsuits. Aggressive plaintiffs’ lawyers search for every opportunity to launch actions against deep-pocketed corporate targets. These attorneys seek access to confidential corporate documents in hopes of bullying corporations into out-of-court settlements rather than face lengthy public court battles.

Finally, it was justified public outrage at the Enron era corporate scandals and the failure of existing checks and balances to prevent corporate abuses that primarily led to the passage of SOX. The consequences of this legislation include an increased focus on financial reporting transparency and a call for greater vigilance from independent auditors. SOX attempts to convince a post-Enron era investing public that corporate financial reporting can be trusted. Auditors have responded by requiring increased levels of assurance and documentation from audit clients before issuing clean opinions.

Implications of Textron

Textron, therefore, comes at a critical time. The outcome of this case is an important barometer for gauging where the conflict in public policy values between the client, legal counsel, and the independent auditor is headed. On the one hand is preservation of the fundamental provisions of attorney-client and work product privileges so that there remains a zone of privacy for legal research, the development of legal strategies, and the encouragement of full candor between corporate management and its legal counsel. An equally important, though competing, public policy value is the need for reliable financial reporting and effective audits. The auditor-attorney dilemma that corporate management currently faces is how to balance these competing public policy values in today’s litigious and demanding audit environment.

Had the court not ruled in favor of Textron, efforts to avert a complete meltdown between auditors and attorneys over attorney-client and work product privilege issues would have been comparable to steering a small fishing boat through a perfect storm. Corporate management would have to face tough choices. It could choose to keep its legal advice and other confidential materials private from its auditors to protect itself from an adversary’s litigation discovery demands. Alternatively, it could waive its attorney-client and work product privileges and avoid the possibility of repercussions from its independent auditors.

The ABA-AICPA treaty has not received explicit endorsement from the PCAOB. Its usefulness and future applicability in the current financial reporting environment are in a state of flux. Presently, given a lose-lose predicament with few options, corporate management has to look to Congress or the courts to help forge an arrangement that balances these important, but competing, public policies.

The Textron decision fills a need Congress may be unable or unwilling to address. This decision is a model for an arrangement that satisfies the legitimate needs of the auditors while balancing the needs of corporate management. Furthermore, the court’s reasoning in Textron may apply to non–tax-related workpapers, supporting financial statement accruals where litigation is anticipated. Without reasonable protection from regulatory agencies, plaintiffs’ lawyers, and similar adversaries seeking confidential information that could force unwarranted settlements or successful litigation against the company, shareholder value is likely to suffer, as will the competitiveness of U.S. corporations in the global market.

Alexander L. Gabbin, PhD, CPA, is the KPMG LLP Professor of Accounting at James Madison University, Harrisonburg, Va.
Jean T. Wells, JD, CPA, is an assistant professor of accounting at Howard University, Washington, D.C.




















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