BEST PRACTICES FOR CREATING, MAINTAINING & PROTECTING STATE INCOME TAX AUDIT FILES AND HANDLING OPINION LETTERS AFTER TEXTRON

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1 COST s 41 st ANNUAL MEETING October 20-22, 2010 Phoenix, AZ BEST PRACTICES FOR CREATING, MAINTAINING & PROTECTING STATE INCOME TAX AUDIT FILES AND HANDLING OPINION LETTERS AFTER TEXTRON Mark F. Sommer Member and Chair, Tax and Finance Practice Group Greenebaum Doll &McDonald PLLC 3500 National City Tower 101 South Fifth Street Louisville, KY Tel: Fax: mfs@gdm.com Jeffrey M. Vesely Leader, State and Local Tax Practice Pillsbury Winthrop Shaw Pittman LLP P.O. Box 7880 San Francisco, CA Tel: (415) Fax: (415) jeffrey.vesely@pillsburylaw.com COST_41st Ann_Best Practicesv

2 I. INTRODUCTION 1 A. Purpose of this Presentation 1. Our View: The ramifications from the First Circuit s en banc decision in United States v. Textron Inc., 577 F.3d 21 (1st Cir. 2009), that a corporation s tax-accrual workpapers were not protected under the workproduct doctrine and thus discoverable, has forced a shift back to the years ago practice in state and local tax matters of writing a brief opinion letter to clients, while keeping the supporting memoranda on file with counsel in order to ensure protection from disclosure in all state and local tax matters. 2. Uncertainty Requires Change: The days of attaching all relevant documents, analyses (balanced or advocacy), and memoranda to an opinion letter and handing it over to clients may be behind us. However, due to the U.S. Supreme Court denying Certiorari review of Textron, the question of whether tax accrual-type workpapers and related documents are privileged may and likely will remain in limbo for some time to come. 3. The Ultimate Question Remains: With all this uncertainty post-textron, how can state and local tax attorneys reduce this new risk of tax-related, work-product becoming discoverable, while continuing to keep clients informed and satisfied? B. Today s Focus: State and Local Tax Matters (Not Federal Tax) 2 II. THE WORK-PRODUCT DOCTRINE A. Hickman v. Taylor 1. Importance: The U.S. Supreme Court established the work-product doctrine in Hickman v. Taylor, 329 U.S. 495 (1947), to protect documents prepared in anticipation of litigation. 2. Impact: The attorney work-product doctrine was created to provide attorneys with some comfort that all documents expressing mental impressions, conclusions, opinions, or legal theories that they prepare in anticipation of litigation will remain safe from disclosure. Opinion letters and documents in support therein, are many times prepared for just this reason. 1 The authors would like to give special thanks to Daniel G. Mudd of Greenebaum for his help in preparing this outline. 2 Federal tax considerations and requirements in opinion letters, specifically under Circular 230, FIN 48, and Schedule UTP are vast and beyond the scope of this outline. The focus herein remains on opinion letter practices at the state and local level. COST_41st Ann_Best Practicesv

3 B. Fed. R. Civ. P. ( Rule ) 26(b)(3) subsequently codified Hickman 1. Documents and Tangible Things: According to Rule 26(b)(3), a party may not discover documents and tangible things that are prepared in anticipation of litigation, or for trial, by or for another party or its representative. 2. Exception: Rule 26(b)(3) allows a Court to order disclosure when the requesting party can show a substantial need for the material and an inability to procure equivalent information without undue hardship. 3. Special Protection Given to Opinion Work-Product: When a Court orders disclosure under the above exception, however, it must still protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of a party's attorney or other representative concerning the litigation. 4. Partial Codification: Rule 26(b)(3) addresses only documents and tangible things, though the principles of Hickman extends to intangible things. See U.S. v. Deloitte, 610 F.3d 129, 136 (D.C. Cir. 2010). III. TEXTRON: THE TUSSLE OVER TAX-ACCRUAL WORKPAPERS A. Background and Procedural History 1. Background: In Textron, after commencing an audit and discovering what it believed to be abusive listed transactions, the Internal Revenue Service ( IRS ) requested that Textron, Inc. ( Textron ) turn over all of its 2001 year tax accrual workpapers. These workpapers, which were created by Textron s in-house tax attorneys and CPAs, included spreadsheets listing uncertain tax positions, percentage estimates of the hazards of litigation concerning same, and the tax reserve amounts necessary if the IRS challenges the transactions. However, because Textron declined to produce them, the IRS moved to enforce a Summons for the workpapers. 2. Procedural History: a. Upon review, a federal district judge initially held that the workpapers were protected from disclosure under the workproduct doctrine because they were prepared in anticipation of litigation. b. The IRS then appealed the decision, but a First Circuit panel agreed with the lower Court s decision. COST_41st Ann_Best Practicesv

4 c. However, a subsequent en banc panel review majority overturned the panel s decision, holding 3 to 2 that tax accrual workpapers are not subject to the work-product doctrine as same extends only to documents prepared for use in litigation, rather than documents created for the purpose of complying with financial reporting rules. B. What Are Tax-Accrual Workpapers and Dual Purpose Documents? 1. Tax-Accrual Workpapers: These generally include computations and supporting documentation that detail and analyze the soft positions taken on a company s tax return. This subject may also include memoranda discussing the facts and law related to positions taken, and the mental impressions of management and advisers and other factual documents, such as copies of contracts, prospectuses, opinion letters, and research documents. 2. Dual Purpose Documents: Generally are documents prepared by attorneys, businesses, and corporate counsel which have a dual purpose for both anticipating litigation and for business purposes (i.e., riskassessments regarding the likelihood of success in upcoming litigation, reserve litigation fund projections, etc., to name a few). C. En Banc Majority Opinion 1. Holding: Textron s workpapers were independently required by statutory and audit requirements, were not prepared for litigation, and thus were not entitled to the qualified privilege outlined in Hickman and codified in Rule 26(b)(3). Therefore, despite Textron s assertions that these documents also served litigation purposes (i.e., dual purpose documents), the majority held that the documents were not considered privileged work-product. 2. Two Approaches to Anticipation of Litigation: a. Leading Line of Cases: Because of Test - This test, which is adopted by the majority of the Circuits, asks whether in light of the nature of a document and the factual situation in a particular case, the document can be fairly said to have been prepared or obtained because of the prospect of litigation. b. Fifth Circuit s (Minority Line of Cases) Primary Purpose Test - This stricter approach adopted in United States v. El Paso Co., 682 F.2d 530 (5th Cir. 1982), requires that the anticipation of litigation be the primary motivating purpose behind creating the document. COST_41st Ann_Best Practicesv

5 3. Conclusion: The majority en banc essentially rejected the idea that documents having a dual purpose (i.e., prepared both for anticipating litigation and for business purposes) are protected under work-product. Therefore, because the majority believed that these documents were prepared solely for obtaining a clean financial statement, not for use in litigation, the attorney work-product doctrine did not shield the workpapers from the IRS s Summons. 4. Impact on Opinion Letters: After the en banc decision in Textron, it is the dual purpose analysis which creates problems in state and local tax opinion letter practice. D. Judge Torruella s Dissent and Other Criticism of Textron 1. First Argument: Judge Torruella argued that the majority quietly rejected the Circuit precedent by merely giving lip service to the majority because of test and replacing it with a test that is even more restrictive than the widely rejected primary motivating purpose test used in the Fifth Circuit. According to Judge Torruella and other legal scholars, the majority instead created a for use test which requires the documents to be prepared for use in possible litigation. 2. Second Argument: Judge Torruella and others argue that dual purpose documents have long been recognized as protected work-product. More specifically, it has been held in many Circuits that the work-product protection should not be denied to a document that analyzes expected litigation merely because it is prepared to assist in a business decision. E. Supreme Court Denies Certiorari Review 1. No Guidance Given: Although the U.S. Supreme Court had a golden opportunity to resolve conflicting standards in the Circuit Courts on the application of the work-product doctrine, and despite several notable advocacy groups filing Amicus briefs urging the Court to grant review, the Court denied Certiorari review and thus provided no guidance on the issue. 2. Higher Risks: Regardless of the criticism it received, Textron remains the law in the First Circuit and possibly in other Circuits in the future. Thus, Textron has substantially increased disclosure risks involved in the writing of state and local tax opinion letters for clients. COST_41st Ann_Best Practicesv

6 3. Moving Forward: Therefore, because Textron could have far-reaching implications in state and local tax matters, how can we as tax advisors minimize the risk of our opinion letters, memoranda in support thereof, and other dual purpose tax-related, risk assessment documents becoming discoverable? 4. In a case decided after the initial decision by the First Circuit in Textron, the Massachusetts Supreme Judicial Court in Commissioner of Revenue v. Comcast Corp., 901 N.E. 2d 1185 (Mass. 2009), upheld the application of the work product doctrine to protect memoranda prepared by an accounting firm, at the request of in-house counsel, in planning for a transaction. The Court applied the because of test and found that the documents had been prepared because of the prospect of litigation and would not have been prepared but for that prospect. The Court went on to hold that the documents were protected under the dual purpose rule even though they may have been prepared in part to assist in a business decision. a. The Massachusetts Court relied in part on the original First Circuit decision in Textron. Query: What is the effect of the reversal of Textron? IV. EFFECT OF TEXTRON IN PREPARING OPINION LETTERS A. Importance and Ethical Requirements for Opinion Letters 1. Opinion Letters - Key to Client Satisfaction: a. While clients can be kept informed and given explanations orally, lawyers certainly know the value of the printed word over the spoken word: it is not as easily forgotten or misunderstood, to say the least. Letters also create a record of advice given, not only when given but what said, which is useful to both the lawyer and the client. That is why opinion letters are a preferred method of keeping clients informed and satisfied. b. An opinion letter is a sensitive document and normally protected under both the attorney-client and work-product privileges. However, the work-product privilege has traditionally been more likely to ensure protection of opinion letters in certain situations, such as a voluntary disclosure of said opinion to accountants and other third-parties. See infra. COST_41st Ann_Best Practicesv

7 c. Over the years, clients have begun demanding more from their attorneys in order to justify appropriate cost/benefit and best practices standards. Clients not only want top-notch work-product from their attorneys but also want to be constantly informed on their matters, yet as they should have their materials remain protected from adversaries. Thus, the need to continuously create opinion letters and include all documented support and workproduct to these letters seems to have become the norm in recent years. d. However, this may all be changing after Textron. Keeping opinion letters and any information attached protected from disclosure has become a major concern. At a minimum, the status quo should be revisited. 2. Must Consider What Type of Client Are You Dealing With: a. Some clients prefer written opinions to be one-sided rather than balanced. Some clients may like conclusory or short-form opinions because they are direct and to the point. However, many clients may prefer to have all the risks laid out before them. b. After Textron, it may be safer from a disclosure perspective to refrain from laying out the government s case too well to prevent the government from having a roadmap to victory or a client s soft spots. Thus, it is important for a state and local tax attorney to express these concerns with clients who prefer to have everything laid out for them and suggest using a brief opinion instead. 3. ABA Model Rules of Professional Conduct: a. Not only do clients demand a large amount of attention and service, but so do an attorney s ethical responsibilities. Lawyers are regulated under state legal ethics rules that are generally based on the ABA Model Rules of Professional Conduct (the Model Rules ). b. Model Rule 1.4(a) requires a lawyer to keep the client reasonably informed about the status of the matter and promptly comply with reasonable requests for information. In addition, an attorney must explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation. 4. Circular 230: Aspirational Best Practices: COST_41st Ann_Best Practicesv

8 a. In addition, there are standards set out by Circular 230 regulations which parallel the Model Rules. At the federal and non-federal level, Section of the Circular 230 regulations set forth nonmandatory best practices that should be followed by all tax advisors. b. These best practices include advising the client regarding the import of the conclusions reached Because these best practice standards are only aspirational, there is no sanction for failing to adhere to them. However, these standards are highly recommended for all tax practitioners to ensure that the proper procedures and ethical standards are met. 5. Back to the Old Ways??: The risks associated with attaching documents to opinion letters for matters at the state and local level continue to increase. Thus the need to revert back to the traditional practice of preparing brief opinion letters and having the attorney maintain and possess all supporting documentation to ensure work-product protection appears close on the horizon. B. Work-Product Privilege Helps Reduce Risk 1. Great Deeds Are Usually Wrought At Great Risks: a. Risk is something we must all deal with in our everyday lives. Whether we realize it or not, we decide to take on several risks each day. Some are spur of the moment, such as deciding to hit the snooze alarm one more time and risk being late for work or running that almost red light to make sure you do make it to the office on time. However, there are also many calculated-risks that we must take not only in our personal but also professional lives. b. In our professional lives especially, many risks are necessary in order to achieve high reward. These high rewards may include more money, more efficiency, more prestige, or higher client satisfaction. 2. The Million Dollar Question: In all decisions we make as attorneys - in house or outside - we must constantly ask ourselves, is it possible to get a high reward (for my clients and myself) from a low-risk decision? 3. The Advantages of Attorney Work-Product: a. One of the greatest strengths we have as attorneys is the broad protection of the work-product doctrine. COST_41st Ann_Best Practicesv

9 b. Unlike other privileges such as the attorney-client privilege or the privilege given to accountants and other tax practitioners under 26 U.S.C. 7525, the attorney work-product doctrine was meant to provide attorneys with greater protection over any documents expressing mental impressions, conclusions, opinions, or legal theories that we prepare in anticipation of litigation. c. It is much more difficult to waive the attorney work-product privilege through voluntary disclosure to third parties than it is to waive the attorney-client privilege or the tax practitioner privilege under Section 7525 of the Code. See infra. Thus, a lawyer must always be careful about who is copied to an opinion letter (i.e., to an accountant), because this simple act may waive the attorneyclient and tax practitioner privileges. Therefore, it is imperative that the attorney work-product privilege, as a last line of defense in these situations, remains resilient to these accidental waivers. d. The work-product doctrine provides an advantage for attorneys to not only be able to offer high-quality work-product, but most importantly, the protection of such material. However, Textron has shifted this sense of security and may push attorneys into an area of higher risk than they, their firms, or clients are ready to accept. C. The Risk-Reward Matrix 1. The Matrix- How to get Opinion Letters Back into Quadrant 4: a. One of the many responsibilities of a tax attorney is to be able to identify, evaluate, and mitigate risk. Our clients rely on us to make decisions that are in their best interest based on the known risks associated with such decisions. In all decisions made by an attorney, such as which tax position is best for our client, he or she should evaluate where the decision will fall into the classic Risk- Reward Matrix shown below. COST_41st Ann_Best Practicesv

10 b. The four quadrants illustrated above represent the four different levels of risk versus reward that one must consider before making a decision. Realistically however, decisions are never this cut and dry. In a perfect world, all of our decisions would fall into Quadrant 4 which shows a low risk-high reward action. Thus, by taking a minimal risk, we can get a high reward. In the aftermath of Textron, how can we get state and local opinion letters into Quadrant 4? 2. Where Dual Purpose Documents Fall Before and After Textron: a. In the context of state and local tax opinion letter writing, it is safe to say that before the First Circuit s en banc decision in Textron, an attorney s act of attaching memoranda and other documents seemed to fall close to Quadrant 4. (1) It was a high reward in that clients were satisfied with the amount and depth of work-product that was produced, not only in the form of a brief opinion but also being backed up by tangible, documented support that the client could possess for itself. (2) It was also a low risk decision in that all documents created for legal analysis purposes or even for dual purposes were thought to be protected under the work-product doctrine and could not be easily pursued by agencies and the like. COST_41st Ann_Best Practicesv

11 b. However, post-textron, the modern trend of attaching all supporting memoranda, spreadsheets, and documents to a client s opinion letter may be shifting into Quadrants 2 or 1 because of the exponentially increased risk of disclosure. Because the Supreme Court denied Certiorari review in Textron, an attorney s opinion in dual purpose or risk-assessment documents no longer falls in a certain, low-risk area on the Risk-Reward Matrix. 3. Increased Risks May Require Reverting Back to Historical Practices: a. Recent changes in the state and local tax environment may have altered the way that state tax professionals measure the risk/reward equation. One of the most significant changes in the state and local tax environment includes information requests after Textron, which will, and should, have major implications for the litigation of state and local tax related disputes. b. Some state tax agencies, like the IRS, have long sought to discover tax-accrual workpapers and other dual purpose documents created by attorneys, which taxpayers have argued are otherwise protected/privileged materials. c. If Textron continues to be the law going forward, which some believe it may, it is likely to reduce the frequency with which lawyers convey their opinions and risk-assessment in writing addressed to a client in order to make it less risky that they will be discoverable. D. Bottom Line - Remain in Low-Risk, High-Reward Environment: 1. Reduce Risk: The legal landscape in this area is too unstable at the moment to determine for certain what is and is not protected with regard to dual purpose documents. Therefore, prudence suggests that one must adjust best practices to reduce these new, very uncertain disclosure risks. 2. Best Practices: In order to remain in a low-risk, high-reward environment, it may be imperative for a state and local tax attorney to begin to: a. Personally inform his or her clients of the recent development under Textron regarding the possible deterioration of the workproduct doctrine, and b. Recommend to the clients that, henceforth, he or she only provide a brief opinion letter without the accompanying documented support to help ensure the client s sensitive information remains privileged. COST_41st Ann_Best Practicesv

12 V. UNITED STATES v. DELOITTE: THE UNCERTAINTY CONTINUES A. Background 1. Continuously Changing: As many have predicted, Textron will not be the last word on this issue. The law continues to be uncertain regarding how far the protections of the attorney work-product doctrine extend. A good example of this comes from a recent decision in United States v. Deloitte LLP, 610 F.3d 129 (D.C. Cir. Jun. 29, 2010). 2. Background: The dispute over discovery of the documents arose from litigation with the IRS regarding the tax treatment of certain partnerships owned by Dow Chemical Company ( Dow ). The IRS sought documents from Dow s independent auditor, Deloitte & Touche USA, LLP ( Deloitte ). Deloitte declined to provide the documents and the Government sued to compel production; these documents included: a. A 1993 memorandum prepared by Deloitte summarizing a meeting between Dow employees, Dow s counsel, and Deloitte employees regarding the possibility of litigation over the tax treatment of one of the partnerships (the Deloitte Memo ); and b. Two Dow documents: a 1998 memorandum and flow chart prepared by an in-house counsel and in-house accountant at Dow, and a 2005 tax opinion prepared by Dow s outside counsel (the Dow Memos ). B. Deloitte Rejects Textron; Documents Privileged 1. Holding: In short, the D.C. Circuit held in an opinion issued a mere four weeks after the Supreme Court denied Certiorari in Textron, that 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. However, because the district Court failed to review the Deloitte Memo in camera, the D.C. Circuit remanded the case to ensure that the entire document was considered work-product. 2. The Government Argued: The United States argued the Deloitte Memo was not privileged because: a. It was prepared by a Deloitte auditor, not by Dow or its representative as is required under Rule 26(b)(3), and b. It was generated as part of a routine audit process, not in anticipation of litigation (i.e., the Textron argument). COST_41st Ann_Best Practicesv

13 3. The D.C. Circuit Disagreed: a. First, it held that even though it was the auditor who actually wrote the memorandum, it still contained legal analysis from Dow s counsel. The Court explained that Rule 26(b)(3) is only a partial codification of Hickman, which also protects intangible things. Therefore, Dow s attorney s legal opinion and thoughts that were orally expressed to the auditor and written into the Deloitte Memo by the auditor were privileged even though Deloitte and not Dow or its attorney committed them to paper. b. Second, the Court also essentially rejected the prevailing argument in Textron. It instead recognized the idea that dual purpose documents could be protected under the work-product doctrine despite also having a business purpose. The Court followed the majority because of test and decided that the Deloitte memo was prepared, at least partially, because of the prospect of litigation. COST_41st Ann_Best Practicesv

14 C. Deloitte Weighs In On The Waiver of Privilege After Voluntary Disclosure 1. First Impression: Equally important is the D.C. Circuit s opinion regarding whether work-product is waived by disclosure to an independent financial auditor. The D.C. Circuit noted that to its knowledge, no Circuit had addressed this issue before as Textron did not reach such issue. Because the Government conceded that the Dow Documents were workproduct (as they were actually written by Dow s attorneys), the only question remaining was whether the voluntary disclosure of the Dow Documents to Deloitte in furtherance of a financial audit relationship was considered a waiver of the privilege. 2. How Work-Product Protection is Waived: The Court explained that the work-product doctrine is only waived through voluntary disclosure if it is disclosed to a potential adversary or a conduit of an adversary and the discloser did not have a reasonable expectation of confidentiality. 3. No Waiver: a. The D.C. Circuit rejected the Government s argument that Deloitte could be a possible adversary in the future. It instead held that because Dow anticipated a dispute with the IRS, not a dispute with Deloitte, disclosure to Deloitte was not a waiver. b. The D.C. Circuit also held that Dow had a reasonable expectation of confidentiality as Deloitte had an ethical duty as an independent auditor not to disclose such information. Therefore, Dow s disclosure to Deloitte did not waive the work-product doctrine. D. Uncertainty Remains 1. At First Blush: Deloitte appears to be good news for taxpayers and may have swung the pendulum away from the pro-disclosure views of Textron. However, the scope of work-product protection remains uncertain, at best. It is important to remember that Textron initially won at both the district Court and at the First Circuit panel, but was reversed by an en banc panel decision. Therefore, it is possible that the Government will ask the full D.C. Circuit to rehear Deloitte en banc. COST_41st Ann_Best Practicesv

15 2. Supreme Court May Weigh In This Time: Even if the Government fails to pursue or obtain a rehearing, or loses after rehearing, it may still petition the U.S. Supreme Court to review the case. Considering all of the criticism the Supreme Court received for not hearing Textron and these issues the first time around, it may decide to accept the issue now. An additional wrinkle is that if Deloitte does go up to the Supreme Court, it was recently-confirmed Justice Elena Kagan who signed the Government s brief requesting that the Supreme Court not hear Textron. Don t Forget the Matrix: Regardless, until this area of the law shakes out and becomes more clearly defined, as attorneys we must continually keep in mind the Risk-Reward Matrix. Is it worth attaching documents to a client s opinion letter and risk allowing a state department of revenue to force disclosure? Is it worth it to provide a well balanced opinion, laying out in black and white the other side of the issue? At this time, there may be too much risk, with too little additional reward, to continue this practice. VI. TAKE-AWAYS: WHERE DO WE GO FROM HERE A. Impact on State and Local Tax Matters 1. Increased Risks Across the Board: Although Textron is not a state tax related decision, it is likely to affect all taxpayers that end up in litigation with a state taxing authority. In short, Textron has added several risks to our every day practices, and most importantly, to our handling of opinion letters and supporting memoranda. 2. States May Look to the First Circuit: The basic principles of the work product doctrine are generally applicable in each of the fifty states. Some of the states have adopted a work-product privilege that mirrors Rule 26(b)(3). Because of the similarities, state agencies, boards, and courts generally look to the federal courts interpretations of Rule 26(b)(3) for guidance in state and local tax cases. This includes not only looking to decisions from their own Circuit, but also looking to several other Circuits for guidance. Thus a state court will have to decide these matters on a case-by-case basis until the Circuit splits have been cleared up. The uncertainties exacerbated by Textron will not only effect the federal system, but may also wreak havoc in state tax courts. 3. However, it is important to review individual state laws since some states have enacted work product rules which are much broader and provide greater protection than under federal law. a. California Code of Civil Procedure Section provides: COST_41st Ann_Best Practicesv

16 (a) [a] writing that reflects an attorney s impressions, conclusions, opinions, or theories is not discoverable under any circumstances, and (b) [t]he work product of an attorney, other than a writing described in subdivision (a), is not discoverable unless the court determines that denial of discovery will unfairly prejudice the party seeking discovery in preparing that party s claim or defense or will result in an injustice. COST_41st Ann_Best Practicesv

17 b. New York Civil Practice Law and Rules Section 3101 provides that [t]he work product of an attorney shall not be obtainable and that materials otherwise discoverable prepared in anticipation of litigation or for trial by or for another party, or by or for that party s representative (including an attorney, consultant, surety, indemnitor, insurer or agent), may be obtained only upon a showing that the party seeking discovery has substantial need of the materials and is unable without undue hardship to obtain the substantial equivalent of the materials by other means. NYCPLR Section State taxing authorities are becoming more aggressive in requesting tax accrual workpapers as well as workpapers and analyses supporting FIN 48 tax reserves. In many instances, the requests go well beyond tax accrual workpapers for so-called listed transactions. While the facts themselves may well be discoverable, the legal analyses and opinions likely would be protected by the attorney client and/or attorney work product privileges, both of which may be waived if disclosed to external auditors. a. There is a tension between retention of attorney client/attorney work product protection and the needs of external auditors for FIN 48 purposes. It is prudent practice to work with external auditors and balance their desire for all possible information against the Company s need to protect confidential information. 5. Voluntary compliance with a particular state taxing authority s request for information based on the lower standard of work product protection under Textron may waive protection in other states even if the other state follows the because of test. On the other hand, if a taxpayer is compelled to disclose in one state due to Textron, such may not necessarily waive the work product privilege elsewhere. 6. It is critical to utilize so-called Kovel letters when non-lawyers are engaged to assist outside legal counsel in anticipation of litigation. a. In United States v. Kovel, 296 F. 2d 918 (2d Cir. 1961), the attorney client/attorney work product privilege was extended to communications made by a client to an accountant retained by the law firm representing him in order to interpret the client s financial data for his tax attorney. b. The key is that the communications with the accountant (or other consultant) must be for purposes of obtaining legal advice from the attorney. If what is sought is not legal advice, but only accounting services or advice, the attorney client/attorney work product privileges do not exist. COST_41st Ann_Best Practicesv

18 c. The accountant should be formally retained by counsel through use of what is commonly referred to as a Kovel letter. d. The services performed and documents prepared by the accountant should be at the direction of counsel and all written work product should flow through the attorney then on to the client. 7. Notwithstanding the First Circuit s decision in Textron, state taxing authorities do not have the unfettered right to obtain documents. Requests must be specific and the information must be reasonably relevant to the inquiry. Fishing expeditions are not allowed. a. California Revenue and Taxation Code Section is typical of state law and provides that the Franchise Tax Board ( FTB ) shall have the power to require by demand, that an entity of any kind provide information or make available for examination or copying at a specified time and place, or both, any book, paper, or other data which may be relevant to [the purpose of ascertaining the correctness of any return]. b. In Franchise Tax Board v. Firestone Tire & Rubber Co., 87 Cal. App. 3d 878 (1978), a California Court of Appeal confirmed the broad statutory authority granted to the FTB and held that a prohibitory injunction would be issued restraining Firestone from interfering with the FTB s exercise of its power. Id. at 885. The FTB had demanded that Firestone (1) make available to it for audit examination and investigation all of Firestone s books, records and documents pertaining to its business operations and those of its subsidiaries during the income years November 1, 1963, through October 31, 1974, and (2) make available to it for examination Firestone s employees who have any knowledge of such operations. Despite the seemingly broad language of the FTB s request, it should be noted that Firestone never objected on the basis of relevancy or specificity, so the Court had no occasion to specifically address those points. COST_41st Ann_Best Practicesv

19 c. In Western Oil and Gas Association v. State Board of Equalization, 44 Cal. 3d 208 (1987), the California State Board of Equalization ( SBE ) demanded information from oil companies about their lands and rights of way for purposes of property tax assessment. Western Oil and Gas Association and seven oil companies objected to the information request, but the Court agreed with the SBE that the information was relevant and denied the taxpayers appeal. However, in discussing the SBE s authority to demand taxpayer information, the Court stated that the SBE may compel the disclosure of information only in situations where: (1) its inquiry is authorized; (2) the requests are specific; and (3) the information sought is reasonably relevant to the inquiry. Id. at 214. d. Two years later in Union Pacific R.R. Co. v. State Board of Equalization, 49 Cal. 3d 138 (1989), the California Supreme Court again had the occasion to consider the ability of the SBE to compel disclosure of certain taxpayer information. In this case, the SBE issued a subpoena seeking Union Pacific s confidential strategic plan of future acquisitions. The Court held that the SBE was not entitled to Union Pacific s plan because it was not reasonably relevant to the SBE s assessment of Union Pacific s existing property. The Court stated that it is within the jurisdiction of courts to determine whether the Board s inquiry offends the prohibition against unreasonable searches and seizures or violates the right of privacy or privilege against self-incrimination. Id. at 146. The Court then reiterated the three requirements set forth in Western Oil & Gas regarding the SBE s compulsion of the disclosure of taxpayer information. The Court also explained that the reasonable relevance requirement is necessary because it is a requirement that is historically rooted in the Fourth Amendment guaranties against unreasonable searches and seizures. Id. at 147. COST_41st Ann_Best Practicesv

20 e. In a non-tax case, Lawyers Title Insurance Corporation v. United States Fidelity & Guaranty Company, 122 F.R.D. 567 (1988), the plaintiff sought information about the computer system defendant used to store, organize and retrieve data about claims. The plaintiff justified this broadly framed and intrusive request on the ground that it needed the information in order to facilitate the production of the relevant matter. Id. at 570. The Court disagreed with the plaintiff and held that [t]he mere possibility that a party might not produce all relevant, unprotected documents, is not sufficient basis for ordering such a party to disclose its entire computerized system of information management. Nor should the possibility that a lawyer could better frame his discovery requests serve as a sufficient predicate for ordering disclosure of proprietary information about a computer system. Id. While this decision did not involve a taxing agency s request for information, the Court s analysis and conclusions are consistent with the standards set forth in Western Oil & Gas and Union Pacific. f. In Pacific-Union Club v. The Superior Court of San Francisco County, 232 Cal. App. 3d 60 (1991), the Court denied the FTB s demand for Pacific-Union Club s membership list in order to determine whether its members improperly deducted dues paid to a club with discriminatory practices. The Court rejected the FTB s request and held that [w]hile mass audits would be the most convenient means of determining whether a club member violated the regulation, the administrative convenience of the state cannot vitiate a constitutional right of privacy. Id. at 79. g. In addition to the state authorities discussed above, federal authorities also require that the request be specific and reasonably relevant. In United States v. Morton Salt Co., 338 U.S. 632 (1950), the U.S. Supreme Court noted that there are times when a governmental investigation into corporate matters may be of such a sweeping nature and so unrelated to the matter properly under inquiry as to exceed the investigatory power. Id. at 652. However, the Court held that the inquiry is permitted if the inquiry is within the authority of the agency, the demand is not too indefinite and the information sought is reasonably relevant. Id. The gist of the protection is in the requirement, expressed in terms, that the disclosure sought shall not be unreasonable. Id. at (quoting Oklahoma Press Publishing Co. v. Walling, 327 U.S. 186, 208). COST_41st Ann_Best Practicesv

21 B. Parting Words: h. Federal courts have specifically denied discovery requests that they believe are fishing expeditions. See, e.g., Fennell v. First Step Designs, Ltd., 83 F. 3d 526 (1 st Cir. 1996) (an order denying electronic discovery affirmed where that discovery would be a fishing expedition. ) i. Any claim that access to the requested information would be more convenient for the taxing authority in conducting its audit would not withstand judicial scrutiny as the term relevant connotes and encompasses more than convenience. United States v. Matras, 487 F. 2d 1271, 1275 (8 th Cir. 1973). 1. To state the obvious, risk is present in all areas of state and local taxation. It is the attorney s responsibility to manage these ever-changing risks appropriately so as to ensure low-risk actions attain high rewards for clients. Textron may have caused one of the most significant changes in the state and local tax planning environment in recent memory. It has exponentially increased risk associated with one of the most fundamental pieces of attorney work-product no longer being considered privileged. 2. Regardless of whether Textron has completely gutted the work-product doctrine for tax-accrual workpapers and other related documents, it is a reality attorneys must come to terms with at the moment in the context of state and local tax opinions and the like. 3. Documents should always be prepared by both outside counsel and inhouse attorneys, with the expectation that they may not ultimately be protected by the attorney client/attorney work product privileges. 4. In conclusion, in order to reduce these risks and protect a client s state and local tax matters, attorneys should consider reverting back to the traditional practice of providing clients with only a brief opinion letter without the accompanying documented support, and without a balanced analysis of opposing arguments these should stay in the attorney s files and head. COST_41st Ann_Best Practicesv