Several recent cases have given the government the upper hand in the battle over protection of privileged communications. Arguing that taxpayers cannot use the attorney-client and tax practitioner privileges and work product protection as both a "sword" and a "shield," courts have increasingly required taxpayers to disclose tax advice prepared by their accountants and lawyers.

The attorney-client and tax practitioner privileges are waived when the privileged material is shared with any third person. That waiver then applies to "all other communication relating to that same subject matter." Fort James Corp. v. Solo Cup Co., 412 F.3d 1340, 1349 (Fed Cir. 2005). Work product protection is waived when confidential material is shared with an adversary or a conduit to an adversary. The scope of waiver of work product immunity is more nuanced, depending on the type of work product. The waiver of work product, however, also extends to all non-opinion work product concerning the same subject matter. In re EchoStar Comms. Corp., 448 F.3d 1294, 1302 (Fed. Cir. 2006). Several recent opinions illustrate the application of these waiver rules and the potential ramifications of relying on privileged tax advice as a defense to proposed Internal Revenue Service (IRS) penalties.

In Salem Financial, Inc. v. United States, No. 10-192T (Fed. Cl. Jan. 18, 2012) (opinion and order on motion to compel discovery), as part of its defense to IRS penalties, the taxpayer contended that it had reasonable cause for claiming foreign income tax credits associated with a financial transaction known as STARS (Structured Trust Advantaged Repackaged Securities). Specifically, the taxpayer relied upon "extensive KPMG and Sidley tax opinions, PwC's conclusion that reliance on these opinions was reasonable, and [the taxpayer's] own internal review and approval of the proposed transaction." The taxpayer therefore "put the advisor's advice at issue."

The government, predictably, first sought to obtain the taxpayer's tax reserve workpapers. The taxpayer attempted to distinguish between PwC's "technical analysis of STARS" and the information and analysis that resulted in the taxpayer's tax reserve position. The taxpayer specifically noted that it considered factors other than PwC's technical analysis as part of determining its tax reserve position. The court, however, held that PwC's technical evaluation of the strengths and weaknesses of the transaction "influenced" the taxpayer's analysis of its litigation and settlement positions. By relying on PwC's advice as a defense to the IRS penalties, therefore, the taxpayer waived any work product protection that may have applied to its tax reserve documents.

The court next addressed certain documents that contained KPMG's advice concerning proposed changes in law and the "unwinding" of the STARS transaction. The taxpayer sought to distinguish "pre-closing" advice from KPMG, including the formal tax opinion on which it relied as a defense to penalties, and this "post-closing advice" from KPMG. The court, however, was not persuaded and required the disclosure of the KPMG documents because they related to the same subject matter: the proper tax treatment of the transaction.

The court reached a slightly different but ultimately no less troubling result in Santander Holdings USA, Inc. v. United States, No. 09-11043-GAO (D. Mass. Aug. 6, 2012) (opinion and order on motion to compel discovery). As in Salem Financial, the taxpayer in Santander entered into a STARS transaction and obtained an opinion from KPMG and advice from Ernst & Young (EY). Again the taxpayer relied on the opinion as a defense to penalties asserted by the IRS, and again the government sought to obtain the tax reserve workpapers and KPMG's and EY's post-closing advice.

The court in Santander first summarily held that the tax accrual workpapers must be disclosed. Either the documents were not protected by the work product doctrine in the first place because they were provided to assist EY in assessing the adequacy of the reserves, or, if not provided to EY in its capacity as independent auditor, the disclosure amounted to a waiver of work product. The court did not discuss whether EY was an "adversary" for this purpose.

Next the Santander court disagreed with the Salem Financial court and held that identifying the subject matter broadly as "tax advice about the STARS transaction" was "too general an assessment of the nature of the subject matter." Therefore, the court held that the attorney-client and tax practitioner privileges and work product protection had not been waived as to documents involving advice relating to changes in U.S. and UK law and advice relating to the unwinding of the STARS transactions.

Unfortunately, the court reached a different result with respect to documents categorized broadly as "advice relating to the IRS audit of the STARS transaction." As part of its document productions, the taxpayer intentionally produced a post-closing KPMG "economic substance" memorandum. The memorandum reflected advice tendered by KPMG to the taxpayer and EY in connection with the IRS audit. The memorandum indicated that KPMG continued to stand by its opinion and that the STARS transaction should withstand IRS scrutiny, and differentiated the taxpayer's transaction from other transactions. The government argued that the taxpayer could not selectively disclose documents helpful to its case, and that "all other privileged documents relating to advice tendered to the taxpayer during the IRS audit to assess the legitimacy of the transaction" should be considered together with this KPMG memorandum. The court agreed, holding that the memorandum clearly fell within the scope of the privilege, but that by voluntarily disclosing it, the plaintiff waived the privilege as to it and other KPMG and EY documents discussing the same subject matter, "which includes the IRS positions regarding the audit." This portion of the decision is striking because, of course, it is not unusual for taxpayers to rely on opinions from accounting and law firms as a defense against penalties, and to continue to work with those advisors throughout the course of the audit.

In AD Investment 2000 Fund LLC v. Commissioner, 142 T.C. No. 13 (April 16, 2014), the Tax Court went one step further in extending the waiver doctrine. The case is a partnership-level action involving what the IRS describes as a Son-of-BOSS tax shelter. The IRS asserted penalties alleging a substantial understatement, a gross valuation misstatement, and negligence and disregard of the rules and regulations. The taxpayers, in their Tax Court petitions, asserted as an affirmative defense that they "reasonably believed" that the tax treatment was more likely than not correct, that the underpayment was due to "reasonable cause" and that they acted in "good faith." These are common defenses that are pled in almost every case where the IRS proposes penalties.

The IRS then sought to obtain tax opinions the partnerships received from the law firm Brown & Wood. The taxpayers argued that, although the partnerships received the opinions prior to the filing of the returns, the taxpayers did not rely on them. The Tax Court held that this was beside the point:

The point is that, by placing the partnerships' legal knowledge and understanding into issue in an attempt to establish the partnerships' reasonable legal beliefs in good faith arrived at (a good-faith and state-of-mind defense), petitioners forfeit the partnerships' privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs.

One might suspect that judges are more likely to tip the scales in favor of the government in tax cases involving perceived "tax shelters." One recent case, however, has taxpayers and practitioners scratching their heads as to just how far afield a court can go. In Schaeffler v. United States, No. 1:13-cv-04864 (S.D.N.Y. 2014) (opinion and order on motion to quash summons), the taxpayer acquired shares of a German automotive supplier. As a result of adverse economic conditions, the taxpayer undertook substantial debt refinancing and corporate restructuring. The taxpayer hired outside tax and legal advisers at Dentons and EY because of the complexity of the U.S. tax issues and the material amounts potentially at issue. The taxpayer, EY and Dentons worked closely with a consortium of banks in effectuating the refinancing and restructuring and in analyzing the tax consequences, signing a common interest agreement they referred to as an Attorney-Client Privilege Agreement. The IRS issued a summons to EY, and the taxpayer moved to quash.

The court first held that the attorney-client and tax practitioner privileges were waived when the taxpayer and its lawyers and accountants shared documents with the bank consortium. The parties were found to have a common commercial interest, rather than a common legal interest. The court next held that the taxpayer had not waived work product protection because the disclosure to the bank consortium was not to an "adversary" and did not materially increase the likelihood of disclosure to an adversary. Indeed, the taxpayer had taken the step of entering into the Attorney-Client Privilege Agreement to preserve the confidentiality of the EY documents and lessen the possibility that the IRS could obtain the confidential information.

Unfortunately, the taxpayer won the battle but lost the war. The court also concluded that work product did not attach to the EY documents in the first instance. The taxpayer argued that work product protected each of the approximately 10,000 responsive documents that EY prepared in furtherance of the restructuring and refinancing measures. The only document that the taxpayer described in any detail was an EY "tax memo"—a 321-page document that contained a detailed legal analysis of the federal tax issues implicated by each of the transactional steps that EY proposed for the refinancing and restructuring. The court accepted the taxpayer's assertion that "litigation was highly probable" in light of the significant and difficult tax issues that were raised by the planned refinancing and restructuring. Relying on United States v. Adlman, 134 F.3d 1194, 1202 (2d Cir. 1998), however, the court considered whether the EY tax memorandum "would have been created in essentially similar form" had litigation not been anticipated. The court concluded that it would have, because the taxpayer would have wished to obtain advice to comply with the tax law in the most favorable way possible. The court noted that the memorandum did not discuss actions "peculiar to the litigation process" or "settlement strategies that might be considered." This appears to be a misreading of the standard in the Second Circuit, which does not require documents to have been prepared "primarily to assist in litigation" (the Fifth Circuit applies this test). The result is disturbing because taxpayers that enter into complex transactions regularly and routinely obtain similar "tax memos" from accounting and law firms to help them assess the strengths and weaknesses of their tax position. It is one thing to suggest that the protection afforded these kinds of documents can be waived. It is another thing altogether to suggest that they are not protected by the work product doctrine at all.

The lesson to be learned from these recent cases is that taxpayers must be to some degree prescient in anticipating how and when the government will seek to obtain privileged and confidential documents, and must be diligent in protecting them. Waiver, even inadvertent waiver, is a very real risk that can have unexpected consequences. Privilege battles can be time consuming and expensive, and it is never too early to think through the ramifications of sharing confidential documents or putting tax advice at issue.

Waiver Of Privilege: Disturbing Trends

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