USA: Summons Fights Involving Work Product and Disclosures to Testifying Experts Continue
13 January 2014
Posted by: Authors: Kristen B. Proschold and Ashok Ayyer
Author: Kristen B. Proschold and Ashok Ayyer (Baker & McKenzie)
In 2013, the US courts continued to wrestle with questions of whether documents taxpayers withhold from production to the IRS on grounds of work product, attorney-client, and Code Section 7525 tax-practitioner privileges can survive a summons challenge brought by the US Department of Justice. United States v. Veolia Environment North America Operations Inc., No. 13-MC003-LPS (D. Ct. Del. Oct. 25, 2013), is the latest addition to the evolving body of law surrounding the work-product doctrine in tax controversies. The most recent word from the US District Court of Delaware agrees that taxpayers’ privileges in tax cases can be upheld in a summons fight. However, if a taxpayer is going to assert that it reasonably anticipated litigation when engaging in a tax transaction it viewed as having significant audit risk, that taxpayer also needs to treat its and other parties' communications with outside "experts" with the same eye toward litigation, and take measures in controlling who and what is communicated to a testifying expert.
Veolia's 2006 Worthless Stock Transaction Created Audit Risk
In 1999, Veolia Environment North America Operations, Inc. ("Veolia") acquired Water Application & Solutions Corporation ("WASCO", formerly US Filter Corp.). By 2006, WASCO's stock value had plummeted, causing Veolia to conclude that it was worthless. Veolia's tax department believed that converting WASCO to a Delaware limited liability corporation would be the most likely option to pursue for claiming a worthless stock deduction under section 165(g)(3).
Veolia then engaged outside legal advisors and valuation advisors to evaluate this option for claiming the deduction and ready itself for audit by the IRS. With the assistance of an outside law firm, Veolia sought and obtained a private letter ruling from the IRS on the specific transaction for claiming the worthless stock deduction it envisioned. The IRS issued the ruling on December 5, 2006. See Priv. Ltr. Rul. 200710004 (Dec. 5, 2006) ("the PLR").
In the fall of 2006, Veolia hired two valuation firms to produce written reports regarding WASCO's insolvency. In late December, 2006, after receiving authorization from its Board of Directors and having obtained the PLR from the IRS, Veolia moved forward and converted WASCO to an LLC.
Concurrent with the tax planning for the transaction, Veolia was under IRS audit for its 2004-2005 tax years. Veolia sought to resolve what it viewed as an imminent dispute with the IRS over the worthless stock deduction totaling $4.5 billion by applying for a pre-filing agreement ("PFA") with the IRS. A PFA would allow Veolia to resolve the controversy before it filed its 2007 tax return. At this point, Veolia also engaged a third valuation firm to provide a report to the IRS, along with one of the previous firms.
Almost two years later, on December 5, 2008, the IRS issued summonses for various documents related to the worthless stock deduction. Veolia produced hundreds of thousands of pages of documents responsive to the summonses. The IRS stated that Veolia's responses were not complete but, because Code Section 7602 summonses are not self-enforcing, the IRS had to seek assistance from the Department of Justice to enforce the summonses. The Department of Justice filed suit in the US District Court of Delaware to compel Veolia to produce documents responsive to the summonses that it had withheld on the grounds of work-product protection, attorney-client privilege, and section 7525 tax-practitioner privilege. The government enforcement action sought additional documents that the IRS believed had been provided to the two testifying experts and used in support of their reports. The district court reviewed a sample of documents in camera and issued a Memorandum Opinion in which Veolia prevailed on its work-product claims, but nonetheless had to produce documents and information relied upon by its two testifying experts who had prepared the reports disclosed to the IRS as part of the PFA and audit.
Factors That Can Subjectively and Objectively Demonstrate Anticipation of Litigation For Purposes of Work-Product Protection
Veolia asserted that it had anticipated litigation for purposes of asserting work-product protection over documents related to the worthless stock deduction transaction as early as March, 2006, when it had hired outside counsel to evaluate the transaction and assist in obtaining a PLR. Veolia viewed engaging in the transaction as "provoking a dispute with the IRS by choosing to claim a $4.5 billion worthless stock deduction." The government argued that Veolia's ordinary business activities involve acquiring, managing, and divesting operating companies like WASCO, and that such business activities are not protected as work product.
As other courts have done in the past, the district court pointed to a number of specific factors related to actions Veolia had taken in the planning and dispute-resolution stages to support finding work-product protection attached to some of the documents at issue. The district court initially looked to subjective facts to show that Veolia believed an IRS audit was "probable." First, Veolia sought the valuation reports because of litigation with the IRS even before it had filed its 2007 return, "believing that an IRS audit was probable." Second, Veolia engaged outside counsel to assist in obtaining a PLR.
Third, Veolia also applied for a PFA, and the court observed that the "IRS PFA program [is] a program intended to address 'issues that are likely to be disputed in post-filing audits.’" (citing Rev. Proc. 2005-12, 2005-1 C.B. 311). The government tried to use Veolia's statement in its PFA request that it had viewed the worthless stock issue as one that "can reasonably be resolved" to try to show that Veolia did not anticipate litigation in 2007. However, the district court viewed Veolia's PFA program participation as "looking for avenues in which to resolve the all-but-inevitable dispute it would have with the IRS." Further, the court also pointed to a number of written communications by Veolia with its counsel that documented its expectation of IRS audit and scrutiny.
The next two factors the court relied upon were objective: Veolia claimed a $4.5 billion worthless stock deduction, and Veolia was already under IRS audit for 2004-2005. The court relied on the Sixth Circuit in United States v. Roxworthy, 457 F.3d 590, 600 (6th Cir. 2006) in support of finding that anticipation of litigation can be considered objectively reasonable by the sheer size of the controversy at issue. The size of the deduction, coupled with Veolia's audit history, further supported the claim that Veolia had subjectively and reasonably anticipated litigation such that some documents were properly withheld from production to the government on work-product grounds.
The court ultimately did not resolve the question of whether attorney-client and section 7525 tax-practitioner privileges applied to the documents reviewed in camera.
When In Litigation, Communications with Testifying Experts Must Be Controlled
While the court's view was that Veolia anticipated litigation, it was this same "litigation" environment that caused some of the documents Veolia withheld to have to be produced. Specifically, Veolia had withheld a number of documents related to information that other parties -- not Veolia -- had provided to its two testifying experts. Under Federal Rule of Civil Procedure 26(a)(2)(B), any materials containing facts or data that the expert considered in forming his/her opinion expressed (here, in the form of written reports), even if provided by a non-testifying expert to a testifying expert, are discoverable by the IRS. The two experts that had prepared reports submitted to the IRS as part of the tax controversy, even though the parties were not in a court of law, are treated as "testifying experts" under Rule 26.
Further, Federal Rule Civil Procedure 26(b)(4)(C) protects only communications between Veolia's attorney and the testifying experts, not communications from persons outside of the attorney-expert relationship. For example, communications from other service providers, other taxpayers, or even other non-testifying experts would not be exempt from disclosure to the IRS as facts and data that the experts considered in preparing their reports. Because parties other than Veolia's attorneys provided data to the testifying experts, Veolia had to produce those documents to the government under Rule 26.
Applying Veolia In Cases of Work-Product Disputes and Managing Experts
While Veolia is only one district court's memorandum opinion in an area constantly in dispute between taxpayers and the IRS, it is nonetheless instructive. First, Veolia provides additional factors and confirms some factors listed by other courts that may tip for or against a taxpayer's subjective and objectively reasonable anticipation of litigation. These are factors that Veolia not only memorialized in its privilege log or briefs filed with the court, but also in the underlying documents at issue, include the company's rationale for retaining outside counsel and valuation experts, seeking a PLR and PFA, and preparing for audit. The size of the adjustment and company audit history also may show that a taxpayer's anticipation of litigation was objectively reasonable.
However, if a taxpayer is anticipating litigation (if not before), the taxpayer also should take this as a cue to revisit its communications with outside consultants and advisors preparing reports, opinions, and other materials for submission to the IRS. The taxpayer and its outside counsel must tightly manage and control who is communicating with, and what is communicated to, testifying experts such as valuation experts used in preparing opinions supporting the taxpayer's return position in order to avoid the waiver issue the taxpayer faced in Veolia.
This article first appeared on lexology.com.