Industry Groups Ask Supreme Court to Overturn Ruling That IRS Can Obtain Tax Work Papers Done for Financial Statements

Financial industry groups have asked the U.S. Supreme Court to review a First Circuit Court of Appeals ruling that tax accrual work papers are discoverable by the IRS since they are done for SEC-mandated financial statements and not litigation. The groups have filed amicus briefs with the Court generally arguing that letting the decision stand will have a chilling effect on company management’s communications with their outside auditors, which in turn would adversely impact the accuracy of financial statements filed with the SEC ( Textron Inc. v. U.S., Doc. No. 09-750).

The First Circuit said that the purpose of the tax audit work papers was not to prepare for litigation, but to make book entries, prepare financial statements and obtain a clean audit. IRS expert and former PCAOB Chief Auditor Douglas Carmichael testified that tax accrual work papers include all of the support for the tax assets and liabilities shown in the financial statements. The Supreme Court is expected to act upon the Textron petition early this spring. The outcome of the case has broad implications beyond the tax field and affects every public company and audit firms with public issuer clients.

FASB Standard No. 5 sets the standards for financial accounting and the reporting of all material loss contingencies related to income taxes. FASB Interpretation No. 48 provides guidance on GAAP accounting for income taxes. Taken together, FIN 48 and FAS 5 establish a GAAP requirement that public companies must evaluate the possible impact of tax and non-tax contingencies on their financial statements.

In auditing the financial statements, independent auditors must follow generally accepted auditing standards in order to render an opinion that a company’s financial statements fairly present its financial position, results of operations, and cash flows in conformity with GAAP. In order to prepare their financial statements in accordance with GAAP, public companies share their analysis in tax accrual work papers with their independent auditors.

The importance of Textron was borne out by recent remarks by SEC Enforcement Division chief Robert Khuzami who said that, in light of the First Circuit ruling, the Commission is skeptical of an auditor’s assertion of privilege for tax accrual work papers on behalf of an audit client. What Khuzami described as the First Circuit’s common sense analysis is how the SEC staff evaluates these types of assertions of privilege. The staff does not see how the audit documentation prepared by or relied upon by an auditor in connection with an audit report can be privileged, or how any claimed privilege has not been waived. Audit documentation is collected or prepared for the purpose of issuing an audit opinion, Khuzami said, not for the purpose of litigation. Sharing the work product with auditors, who are supposed to be public watchdogs, strongly undermines any such claim.

In its brief, Financial Executives International said that company management has a powerful incentive to provide an independent auditor with all information the auditor deems necessary to evaluate the adequacy of the corporate financial statements. The interest of investors in having access to accurate financial statements requires that the tax work papers be protected. The integrity of the securities markets requires that published financial statements filed with the SEC fairly reflect a public company’s financial position.

It follows that, in providing assurance that a company’s financial statements fairly reflect its financial position, an independent auditor serves the public interest. The First Circuit ruling that tax accrual work papers are not protected creates a great tension with the public interest in candid communications with an independent auditor. FEI urged the Supreme Court to endorse a test permitting companies to share candid assessments of potential litigation claims with their outside auditors without fear that such information would be accessible by competitors or adversaries.

In its brief, the Association of Corporate Counsel argued that, if the Supreme Court does overturn the First Circuit’s ruling, company executives stand to be less informed than they should be about the legal risks of business and income tax decisions. The inevitable result will be a reduction in effective self-policing and a rise in mismanaged transactions.

The Association asserts that the First Circuit decision is flawed on two grounds. First, the decision derails the sensible development and practical application of the work-product doctrine. Other courts have recognized that modern corporations constantly rely on their attorneys for preventive evaluations of the litigation and regulatory risks of tax-related business decisions before they are undertaken. Second, the decision undermines the important efforts by counsel to promote preventive compliance and important financial accounting functions necessary to assure corporate accountability.

In its brief, the Chamber of Commerce urged the Court to recognize the principle espoused by some lower federal courts that sharing privileged materials between a company and its outside auditor is precisely the type of limited alliance that should be encouraged because it furthers the company’s and the public’s interest in detecting corporate malfeasance. The Chamber also noted that, if allowed to stand, the First Circuit’s standard would hamstring the ability of companies to work efficiently with outside counsel on analyses of financial reporting. FASB expects companies to seek the views of counsel and other advisers with regard to contingent tax liabilities.