MR. BERGIN: Good morning. We have some seats around the table here if anybody would like to come up and grab one. This is participatory or we'll get to that phase soon. Okay, anytime.
TAX ACCRUAL WORKPAPERS:
IS CORPORATE AMERICA UNDER SIEGE?
Friday, July 16, 2004
President and Publisher, Tax Analysts
THOMAS J. CALLAHAN
Tax Partner, Thompson Hine, Cleveland
DONALD L. KORB
IRS Chief Counsel
B. JOHN WILLIAMS, JR.
Partner Shearman & Sterling, Washington, D.C.
Audit Partner, Deloitte & Touche (retired)
I'm Christopher Bergin, the executive director of Tax Analysts and I'd like to welcome you to this roundtable on tax accrual workpapers that Tax Analysts is sponsoring. I will be moderating today's discussion.
We feel strongly that this is an area that needs a lot more attention and discussion as the IRS's policy on tax accrual workpapers changes. It is an area that I have only recently been learning about, that I am learning more about every day, and that I hope to learn a lot more about this morning. The idea for this little conference here actually came from one of our members of our board of directors, George Javaras, who cannot be here today because he's actually in the hospital recovering from a recent illness. But true to his nature, George called me this morning from the hospital to wish us all well, so I wanted to recognize him.
Let me give you the Funk & Wagnall's definition of tax accrual workpapers. The term refers to financial audit workpapers, whether created by a company or by that company's independent auditor, that relate to the tax reserve for deferred tax liabilities and to footnotes disclosing contingent tax liabilities appearing on the company's audited financial statements.
Deep breath. That's quite a sentence. More simply stated, and as many observers have noted, these workpapers can provide the IRS with a detailed road map to a company's financial dealings. That can be a good or not so good thing.
Until a couple of years ago, the IRS's policy was to request tax accrual workpapers from taxpayers only in "unusual circumstances." But in the summer of 2002, that policy changed. In response to the abuse of corporate tax shelters the IRS announced that it would become more aggressive in seeking tax accrual workpapers.
I suppose at first glance it may seem that we are centering our discussion this morning on a rather narrow topic, but it's really a microcosm -- it's even more serious than I thought. But it's really a microcosm of what is going on in tax administration in this country more generally, apparently raising alarms all over the place.
I have often written about the pendulum that controls the IRS's focus. At one end of the swing Congress mandates that the IRS treat taxpayers like customers; we all remember that. At the other end of the swing Congress orders the IRS to get tough with taxpayers, to pay better attention to its cop side. For those of us who like the metaphor, and I realize it's not everyone, the pendulum appears now to have swung fully to the enforcement mandate.
Consider this. Not long ago, 1997, in fact, the Senate Finance Committee staged hearings on the so-called abusive treatments of taxpayers by IRS agents. With witnesses testifying from behind screens those hearings took on the distasteful appearance of a mob trial. Maybe the alarms are right at that stage then. Politicians at the time were telling IRS officials to pay attention to taxpayer needs. In 1998, Congress passed a law to reform and restructure the nation's tax collection agency, in part to focus it more on customer service.
What a difference a few years can make. The last time I attended a speech by the IRS commissioner, just this May of the ABA's Tax Section, he said the word "customer" once. He said the word "enforcement" 13 times, I counted. At that speech he also scolded his audience of tax lawyers about their role in the corporate tax shelter scandals.
You don't hear much from the politicians either these days about customer service. They want the IRS to get tougher on tax cheats. In the Senate Finance Committee hearings on IRS abuse of taxpayers have given way to ideas like a recent proposal reported this week in Tax Notes to form a whistle-blower office inside the IRS. The purpose apparently would be to deputize regular taxpayers as bounty hunters and set them after rich individuals and corporations that cheat on their taxes. We can also see the swing toward enforcement in the IRS's change in policy regarding tax accrual workpapers.
So where does that lead us? For me, it leads to a couple of questions. To begin with how will this change in policy regarding tax accrual workpapers affect the IRS and corporate taxpayers? Can this change in policy go too far?
Now let me briefly describe what we're going to do here today. We have four distinguished panelists with us. Our first speaker will lay the groundwork on the issues we will be discussing. His presentation will take about 15 minutes. Our other panelists will speak for about 10 minutes each on their particular views of the issues. We will then open up the discussion for questions and answers. As I said, this is a roundtable, so we encourage your participation whether you're at the table or not.
We have about two hours. Personally, I expect to be much better educated on tax accrual workpapers and their availability to the IRS when we are through.
Now let me introduce our panelists and then I'll get out of the way. Our first panelist is Tom Callahan. Tom is chair of the taxation practice group of the law firm Thompson, Hine. He is a lawyer and a certified public accountant. He advises a wide range of clients from Fortune 500 companies and multinationals to closely held businesses and entrepreneurs on a full range of tax issues. Among other leadership positions he is currently vice chair of the Administrative Practice Committee of the ABA's Tax Section. Through his writings Tom has also been my primary teacher recently on the subject at hand.
Mr. Donald Korb, who will speak next, is chief counsel of the Internal Revenue Service. Prior to this position Mr. Korb was a partner in the taxation area of Thompson, Hine. Among his many positions in both public service and private practice Mr. Korb served as an assistant to the IRS commissioner and recently served as the large-and mid-sized business coordinator for the ABA Tax Section. We look forward to any insights he can give us on the thinking within the IRS about tax accrual workpapers.
B. John Williams is a partner with the law firm Sherman & Sterling in Washington. Mr. Williams has been in and out of government service throughout his career, most recently as IRS chief counsel. He also served five years as a judge on the U.S. Tax Court as well as a senior official in the Justice Department's Tax Division and with the IRS Chief Counsel's Office. In his remarks B. John will give us the lawyer's perspective of the issues for today.
Robert Rohleder, who's right here, is a certified public accountant who retired a few years ago after 36 years with Deloitte & Touche. For many years at Deloitte he managed the audit process for manufacturing and service companies ranging in size from $15 million to $2 billion in revenue, both public and private. He has served in leadership roles in many business, professional, and community organizations. Bob will give us the all-important perspective of the auditor.
So let's get started. I'll turn it over to Tom Callahan.
MR. CALLAHAN: Thanks, Chris, appreciate it. Thank you, everyone, for taking time out of your busy day to come here and join us for this presentation.
If you're in this business long enough you know that whatever's new really isn't and that it's just kind of being recycled again. So I'm going to kind of lay the historical groundwork here with respect to tax accrual workpapers and kind of the ongoing drama that's really played out over the last probably 25 to 30 years.
In the late 1970s, revenue agents were starting, as a matter of routine, to request tax accrual workpapers from their corporate taxpayers. As you'll see in a little while this has made corporate America, and it did at that time, quite edgy because basically the crown jewels have been the tax accrual workpapers, if you will.
What happened ultimately is a number of cases went to court, which culminated in a case in 1984 in the U.S. Supreme Court called United States v. Arthur Young. What happened in the Arthur Young case, Amerada Hess had made some questionable payments, overseas payments. A revenue agent tripped across those payments as part of the audit and requested the tax accrual workpapers. Arthur Young intervened and basically said -- and this was in the context of a summons enforcement action and that's where these things ultimately will be played out. They basically said two things. One, they said there should be an accountant-client privilege and also an accountant work product doctrine.
The District Court dismissed both of those notions saying, well, first of all, there's no federal accountant-client privilege. Also, that there's no work product doctrine.
The Appeals Court, on the other hand, agreed that there was no accountant-client privilege, but they said, now wait a minute, let's think about the work product doctrine. If we force taxpayers to hand over their accrual workpapers, especially public companies, they're likely not to prepare them.
Now what does that mean? Well, that means there's an issue here with the integrity of the financial reporting system. So what we're going to do is we're going to kind of create this doctrine of accountant work product and the IRS hasn't come forward and shown us that they have a substantial need for these workpapers. That's one of the requirements is you have to have substantial need.
It got to the U.S. Supreme Court and the U.S. Supreme Court said nope, that's not the law. We agree there's no accountant-client privilege, but there's no accountant work product doctrine either. Basically what they said is work product really was created to give the attorney kind of what they call, the Supreme Court called a sphere of privacy. So in preparing a case for trial nobody's going to disturb the preparation for trial by the lawyer or the people that he needs to help him prepare -- he or she needs to prepare for trial.
On the other hand, the certified public accountant has a duty of public trust. It's interesting, especially in this post-Enron era, if you actually read the opinion. I mean, this could have been written within the last 6 months or a year. Basically it says because of their duty of public trust they cannot take no for an answer. If they decide they need to see accrual workpapers we're not going to give them any kind of privilege, so all that the IRS has to do is really have a limited showing that they're relevant to the audit, that they're not in the IRS's possession, and we're going to give you the tax accrual workpapers.
That really is the state of the law today. What we're going to be talking about is really a policy of self-restraint that the IRS has imposed on itself beginning back in 1981. But if you go to court, Arthur Young will control. So that's the background.
Well, what happened was -- I mean, I was not a fly on the wall, but I think what happened was somebody in the SEC and the IRS got on a telephone and said we have a big problem here because what's happening is taxpayers just aren't preparing accrual workpapers anymore. So that way they don't have them for the IRS, but when the auditor comes in they don't have them either.
So what happened was, in 1981, then-Commissioner Egger signaled a change in policy at the IRS at a convention of accountants in San Francisco, and basically said we're going to impose upon ourselves a policy of self-restraint. So only in certain exceptional circumstances, what we call unusual circumstances, will we ask for tax accrual workpapers. Those are, in a nutshell, that the revenue agent has to review the return, determine all the facts that they can possibly do, and there still has to be a factual question. It has to be an unusual item.
They also then have to reconcile the Schedule M-1. They have to get prior written approval from higher ups. In fact, I think at that time they had to actually go to the chief of exam in Washington to get an approval for a request for tax accrual workpapers.
Well, it was a very effective policy of self-restraint. Basically everything stopped. I think when we were at breakfast today, I think B. John indicated that maybe in the past 30 years there were 5 summons issued. So it really did impact going forward what happened.
So where are we today? Well, let's talk about what changed. Because of the tax shelter issue, in the summer of 2002, the IRS issued Announcement 2002-63 basically as a response to the corporate tax shelter problem that you've all read about and are certainly aware of. Basically what the IRS said was we are going to alter our policy of restraint in one instance, and that instance has to do with listed transactions or transactions that are substantially similar.
What the policy basically says now -- and I'll just address returns filed after July 1, 2002, because these are now the returns that are starting to work into the pipeline. They basically say if you have a listed transaction or a substantially similar transaction, and really the "substantially similar" is the key issue, how close are you to a listed transaction factually or legally? If you disclose that transaction pursuant to the disclosure rules that are in Section 6011, then we're just going to ask for tax accrual workpapers with respect to that transaction alone.
On the other hand, if you're a bad taxpayer, that is you didn't disclose a transaction -- another prong is even if you did disclose - -- if you have more than one disclosed or not disclosed, or if you have a disclosed transaction and some other financial irregularity, in those instances we are going to ask for all the tax accrual workpapers.
Well, as you can imagine, this made corporate America quite uneasy, and there have been a number of IRS notices issued since then. There has been a question-and-answer format, Larry Langdon issued that. There's also been some other notices coming out of the Chief Counsel's Office.
But I just wanted to call your attention to, and we've passed it out to the program participants here, on July 9th, the IRS issued an Internal Revenue Manual supplement, IRM 4.10.20 of the examination of the IRM, which basically kind of accumulates this material in one place. On the front of the material that I've given you is a memorandum from Debbie Nolan, the commissioner of LMSB, to the troops in the field basically saying that if you meet these requirements, request for tax accrual workpapers is going to be mandatory and you're going to have to follow these provisions.
So without taking a lot of time, I just want to point out a couple of items in the notice. First of all, there's a definition -- there's really three definitions: One of audit workpapers, one of tax accrual workpapers, and then finally, one of tax reconciliation workpapers.
The audit workpapers basically say these are workpapers created by or for the independent accountant. So you can have workpapers created by either party, either by the independent accountant or by the taxpayer. In the Arthur Young case, for example, it happened to be workpapers created by the independent auditor. However, a couple of cases that I'll quickly mention that also dealt with tax accrual workpapers, they were, in fact, created in-house.
Then we have the definition of tax accrual workpapers. If you move to page 2, you'll see a whole page of definitions. So basically they thought through and wordsmithed this very well to, in effect, capture everything that has to do with substantiating the tax accrual, whether it's the amount, the footnotes, or so forth.
The other thing is there's been a narrowing of the definition of tax accrual workpapers in a sense. You'll see that as you read through this, but basic items used to prepare the return or extraneous items that aren't part of the tax accrual workpapers are not included in the definition. That's important because in the tax rules if it's not in the definition you can end up having a bad result, and the bad result is it isn't subject to the presumption of restraint.
Basically there's two policies. Then there's another policy discussed in here. It's a situation where if you're not talking about listed transactions or substantially similar transactions, you're under the old rule. What the IRS has said in Notice 2002-63 as well as in this IRM provision is that we're going to continue with the old policy of restraint with respect to situations where we don't have a listed transaction or a substantially similar transaction.
What is an unusual circumstance? Well, they define it on page 4 as basically a specific issue has been identified by the examiner and they need additional facts. They've tried to get the facts from the taxpayer and third parties. Basically now they decide they have to go into the tax accrual workpapers to find those facts. They also have to reconcile Schedule M-1 or the new Schedule M-3, as the case may be. But basically they're going to limit their review to that specific issue and you need the acquiescence of I believe the director of field operations. A slightly lower sign-off than previously in place, but, nevertheless, a high official.
With respect to listed transactions now, if you move through the notice with respect to returns filed after July 1, 2002, there's some critical points to keep in mind. One, they've articulated in a better manner what kind of tax accrual workpapers we're talking about. It's the tax accrual workpapers for the year at issue, but it may be for other years. What they're going to look at is to see where the impact is. It could go back to the origination year, it could go back to future years where there may be some decision as to whether we should continue with this transaction or not. But the point here is you can have other tax accrual workpapers implicated than just perhaps the years at issue.
The other thing that as you read through this notice, there's a lot of "wills" and "musts" and "shalls" in here. So there isn't a whole lot of room for discretion, if you will, if you end up in the wrong bucket. So that's -- I leave this to your consideration because that's the standard of where we are.
With the last couple of minutes, I'm just going to talk about some of the case law and kind of bring us up currently. As I indicated, cases pretty much stopped after the initial policy of restraint. But there are two cases out there that really dealt with this issue and also constitute the law with respect to tax accrual workpapers.
Now the one thing to remember is, Arthur Young said, you know, unless you can show us why these items are not discoverable, they will be. Really where do you fall back to? Well, you fall back to the things that as lawyers, you know, we're very comfortable with, the traditional privileges. There's the attorney-client privilege, there's the tax-practitioner privilege now, and the work product doctrine.
But in order to sustain these privileges you have to remember you're going to be in a summons enforcement action, you're going to be in a court of law, and you're going to be talking to someone in a black robe. So they are going to look at the definition of attorney- client privilege, which basically says you have to have legal advice from a legal advisor, communication has to be kept confidential, and so forth. So they're going to actually tick off these elements. If you read a lot of these cases that have come up in the last 24 months or so on the various shelter items, it's usually some inability to maintain a prong of the privilege that results in disclosure.
Two cases I just want to mention, and I just have a few minutes. The first case is the case of El Paso. El Paso is a case that goes back to 1982. What happened in El Paso, this was one of these cases that percolated up because of just the usual request for tax accrual workpapers that happened in the late-seventies. This was nothing untoward, if you will, with respect to the company. Basically what happened is they tried to defend on the attorney-client privilege and the work product doctrine. Interestingly, the Court didn't need to get to the issue. The Court had a good quote, which I'll make sure I mention here in a minute, but they basically said you didn't do whatever you needed to do to establish the privilege. You couldn't show that material was prepared at or by lawyers. There were 80 people in the tax department, 10 of whom were lawyers, the rest were accountants. So we don't know who prepared them, even the tax director and legal counsel had no idea of who did what. They just could not establish the privilege.
The other piece of this is everybody agreed that all these accrual workpapers were prepared to aid in the audit. What that means is it's not legal advice, it means it's business advice, okay, and that's not protected. But interestingly, what the Court said is: We would be reluctant to hold that a lawyer's analysis of soft spots in a tax return and his judgments on the outcome of litigation on it are not legal advice.
So the Court left the door open. They said, okay, there may be some circumstances where you have legal advice, but this certainly isn't one of them.
There was a follow-up case of Rockwell International. I think what happened is the tax counsel, who was a lawyer at Rockwell, read El Paso, and he kept the file himself. He kept the reserve file. He actually made notes on the pieces of paper indicating his trial strategy. Unfortunately, we didn't have a final outcome in Rockwell. The Court there made the same statement, that they'd be reluctant to hold that analysis of soft spots is not legal advice, but they basically said there isn't enough information in the record for us to establish that whether or not Rockwell has done all the things that they need to do to protect the privilege either from an attorney- client basis or on a work product basis. That's really where we are from a historical perspective.
Finally, as you're all aware, Congress enacted in the '98 act the Section 7525 privilege, which pertains to accountants. It gives them a limited privilege. Subsequent case law has basically keyed that privilege off the attorney-client privilege. However, an important part of that is it does not apply to written communications attributable to tax shelters. So it's not really a privilege that's very useful and certainly in a tax shelter context.
MR. BERGIN: Thank you, Tom. If you don't have a copy of the update to the IRM that Tom just talked about, we have extra copies here. I think we distributed them through the room, but if you need a copy we can have one for you at the end of this.
Next is IRS Chief Counsel Don Korb.
MR. KORB: I became chief counsel in April, so I wasn't at the IRS when 2002-63 was issued, so B. John is probably a better person to talk about what was the thinking at the time. But from where I sat then, in fact, where I sit today, I do have the following observations.
When the IRS gets access or the fact the IRS can have access under certain circumstances to the accrual workpapers does give greater transparency to what is going on in the tax return. This really does fit within the recent emphasis on disclosure that Pam Olson and B. John and others were so interested in and I agree with. That's become a basic principle in the battle against tax shelters.
But frankly, I thought there was a much more important outcome for taxpayers and benefit to the IRS from 2002-63. In my view, what it did was it changed the cost benefit analysis that a company must go through when it's considering whether to invest in a tax shelter. I personally believe that the IRS has, in fact, lost the battle on the tax shelters sold. We need to be in a position to prevent the sale in the first instance. That's why Section 469 in the 1986 act was so powerful because it stopped tax shelters that were being sold in those days basically in their tracks.
We don't have anything like that today. It'd be nice if we did, but we don't. So in the meantime, we need to do other things to stop them. I think the accrual workpaper announcement and the new IRM provisions is one way to get at it.
Now how does it help? Well, when a company is considering whether or not to invest in a tax shelter they need to think about this announcement. If, in fact, they already have a listed transaction that's going to be on their return, they face the possibility if the IRS later lists the transaction that they're considering -- and remember, as Tom said, this applies to transactions which are listed at the time the Service seeks the workpapers -- they're going to have to understand that it's quite possible, in fact, it's mandatory actually that the Service will seek the accrual workpapers for everything. They have to take that into account. In fact, if this is going to be the only listed transaction they have they're going to have to take into account the fact that the IRS is going to seek the workpapers for that particular transaction.
So I think it really is something. I've seen this actually before I came here. Last summer, I was involved in a number of situations where actually I had attended meetings of boards of directors of companies that were considering -- their tax departments were considering certain transactions. One of the things we had to point out to them was this possibility. I know in one case the transaction probably could have passed muster eventually, but the company decided not to go forward because of this. So it had a very powerful prophylactic effect. I really believe that's the more significant part of this announcement.
I'd also like to mention one of the interesting side effects of the announcement. That is I personally believe over the next, say, 2 to 5 years, law privilege and attorney work product as it applies in the tax world will be fleshed out considerably because of this policy. It's already happening in the context of the promoter audits and the summons enforcement cases, but we are just now -- that's why this is so timely, this meeting this morning -- we're just now entering the period when the audits for the tax years that are covered by the announcement will begin. You know, there will be some push-back from taxpayers, so we're going to have litigation over this. I'm sure it'll be discussed this morning, to some extent privilege, attorney work product, those rules will be the subject of that litigation.
I think we all remember that the first shot across the taxpayers bow on privilege was really launched by my predecessor in a speech he gave in San Antonio, which has become popularly known as B. John's Alamo speech. I thought before we went any further in recognition of that fact that we ought to acknowledge that opening salvo. What I brought B. John here is a Davy Crockett hat.
MR. WILLIAMS: It's better than a toupee.
MR. KORB: I can't top that.
MR. BERGIN: I'm going to go out of order and ask a question. Are you going to talk with that hat on? I can't do a better introduction than that for B. John Williams.
MR. WILLIAMS: Yeah. Are you finished?
MR. KORB: Yes, I am.
MR. WILLIAMS: Thanks. Well, I'm supposed to address this topic from the standpoint of a lawyer. I think very succinctly that means it depends on the interest of your client. If you're an attorney for the government -- and before I get into that, fundamentally the information that's in the tax accrual workpapers is critical both either to the pursuit of the taxes that may be owed as well as critical to a defense from such an attack. That pretty much means, you know, it leads to the obvious conclusion that if you're an attorney for the government you want those papers and if you're an attorney for the taxpayer you want to protect them from government inspection.
From the government's standpoint, as a lawyer, you want those papers because of the pressure that's put on auditors to complete an audit. Historically, audits are from the ground up. They start with the financials, they work through the reconciliation of the M1, and then basically onto particular issues. It can be even a couple of years before auditors get to the point where they understand the transactions that have occurred, the facts that pertain to the particular tax year well enough to be able to even ask critical questions that would lead to a discovery of the issues that are inherent in those transactions, the tax issues that are inherent in those transactions.
Getting the tax accrual workpapers up front shortcuts all of that. Basically you have laid out in front of you all of the critical issues on the return. Given the recent artificial deadlines that have been imposed on agents for completion of the audits, basically 18 months, you have to stand back and say the only way from the standpoint of the public interest and from the standpoint of understanding what the issues are that an agent can do his or her job is to look at those accrual workpapers.
Now from the other side of the table, from the taxpayer's side of the table, the accrual workpapers can be misleading to an agent because let me give you an example of this. The accrual workpapers will or should discuss not only the tax reserves, but the issues that have been considered that you don't have reserves on. They should discuss issues pertaining to whether certain tax matters have been disclosed in the financial statements and reach conclusions pro and con on the disclosure, setting out the reasons for the conclusions.
So for example, if you're arguing with the auditor as an attorney for the client over whether an issue should be disclosed, you're talking about remoteness: The remoteness of success that the government would have challenging the transaction or the tax position taken. That remoteness, you may be arguing about whether the government will have a 15 percent chance of success or a 25 percent chance of success. The remoteness standard being 20 percent. So you're not talking here about an issue which anybody thinks the government's going to win. In fact, in my view, nobody should be litigating an issue unless you have at least a 50 percent chance of success. So you're talking about an issue which, by definition, you're not going to anticipate litigation on.
If that debate and the recording of the comments with respect to remoteness are shown to an agent, depending on the size of the issue the agent's going to pursue that matter. So from the standpoint of a client and the attorney for the client, you want to keep that information out of the hands of the government not because you're afraid of the truth or you're afraid of revealing the fact, but you're afraid of the institutional reaction that is almost inevitable. You have a $300 million issue, which is remote, but an agent sees that, that's gold and will pursue it. At the best, you will spend a lot of resources defending it against a proposed notice of deficiency and, at worst, you'll be in litigation and have to take it to court to prevail.
So from the lawyer's perspective it really boils down to, you know, is this information something that we can protect? Is this information something that we can get?
I note that the policy basically is unchanged from 2002. In 2002, we modified the policy and we believed that the success of the policy would largely turn off of a continuation of the policy of restraint. That is to say the chance in the calculus that Don mentioned was specifically contemplated and works only if, in general, tax accrual workpapers are not disclosable. That is to say the downside risk of investing in aggressive transactions that would lead to the production of tax accrual workpapers is a policy point that can succeed only if it plays against the background of general restraint. Because if the government is generally going to go after tax accrual workpapers routinely, then there's no downside to investing -- that removes it from the calculus of whether there's a downside in investing in an aggressive transaction. What's the difference? They're going to get them anyway. Okay? You have to understand the policy change in 2002 was very much predicated on a continuation of the policy of restraint.
Now from the government standpoint you look at that and you say, well, do we really have to change the policy in order to increase significantly the number of instances in which we ask for these workpapers? I think the answer to that question, at least my view of it, is no, you don't. The unusual circumstances that are identified as the key touchstone for whether you get the tax accrual workpapers have been interpreted over the last 30 years in such a way that basically the policy's strangulated. You can count on one hand the number of times the IRS has asked for tax accrual workpapers in the last 30 years prior to 2002.
I think the policy of restraint can and should continue with, nevertheless, an expansion of the number of occasions in which the government is asking for tax accrual workpapers. We have a very large economy with a large number of taxpayers, very complicated transactions, and an IRS that I think should be equipped to ask appropriately for the papers that -- in the circumstances in which they can get them. I think those circumstances occur much more frequently than 5 times in 30 years.
Also from the government's perspective, and this is really important in reading this policy to understand that summons will not be issued without the approval of the Chief Counsel's Office. The reason that's important is because harkening back to what I said earlier about the perspective of the lawyer representing the taxpayer, you don't want to go down rabbit trails. The government lawyer should be in a position to want to keep the agents from going down rabbit trails as well. So even though there's a huge issue, a lot of money at stake, if there really is a remoteness question and they've concluded, for example, it didn't even need to be disclosed, so the accountants agree with the lawyers that the issue was remote, the lawyers for the government ought not to want the agents to go down those trails and ask for the details on those transactions in the tax accrual workpapers. If they do that, then the summons that will be issued inevitably will be tailored in such a way that what I believe to be the right policy objectives will be achieved.
So I think and I agree with what's been said about the future of the privileges. In the context of the next few years, I think they will be fleshed out. I personally don't believe attorney-client privilege has much place here because once you've given something to the accountants it really is -- you waive your privilege.
MR. WILLIAMS: So if a document were privileged prior to the time that the accountants audit the financials and the associated tax issues, and if that document is turned over to the auditing firm, then, at least in my mind, there's no question that the privilege has been waived and can no longer protect against producing the underlying advice. All of the communications concerning the underlying advice, whether internal or external, and regardless of whether with lawyers, whether with the lawyers that gave the advice or with lawyers that gave other advice, the taxpayer opens the subject matter, and waives privilege not just for that document but for everything related to the subject of the advice -- and by the way, my experience recently is that all Big Four accounting firms are at least initially demanding a turnover of the advice that was given and received with respect to the tax issues.
A much more delicate question and a complicated question is the work product doctrine that would apply not with respect to the accrual workpapers, but with respect to the advice that was turned over and the debate that occurred with respect to the issue. Go back to the example I gave you where there's a debate about the remoteness of an issue. By its very nature you're saying you don't anticipate litigation. That issue's remote, or at least the attorney thinks the issue's remote. Even if the accountant agrees or even if the accountant disagrees, it's simply a disclosure matter. It's a 25 percent chance of success to the government. So you think we wouldn't anticipate litigation here because if an objective analysis is -- and you're hoping the government lawyers at least would be objective in their analysis, they would agree that it's a remote issue, so you're not going to anticipate litigation.
Well, what does that mean? If you're not anticipating litigation the work product doctrine doesn't apply.
On the other hand, you step back and you say knowing the institution, if there's $300 million at stake here and they get these papers, I think they're going to take us to litigation. So you can reasonably make a case that chances litigation. I think questions like that are going to be very troublesome in the next few years until there's sort of a settling here of how the policy's being applied and how taxpayers are defending against it.
MR. WILLIAMS: I think the last note I would like to say is that I hope the bar takes a lesson from the summons enforcement actions that have been filed in connection with the promoter audits. You don't want to fight the government on their terrain. I mean, you can ask any general, any military expert, they're going to tell you if you're going to fight a battle don't do it on the other side's terrain. Summons enforcement is the government's terrain. You don't want to fight them there unless you think you're going to win. Obviously I'm not saying lie down, never fight. But in enforcement you will be dealing with somebody in black robes. You're also going to be dealing with the Justice Department. If you'll recall the designated summons litigation a few years ago, the IRS's administrative question for the issuance of a designated summons was "is the taxpayer being cooperative?" It was pretty clearly the Justice Department's position that the IRS' self-imposed restraint is not a requirement in the statute. There may be an administrative policy of self restraint on the issuance of a designated summons, but the statute has no such requirement. DOJ's position that the designated summons was valid despite the taxpayer's cooperation was ultimately upheld by the 9th Circuit.
So I think in terms of litigating the issue of producing tax accrual workpapers, because the law is very clearly that under Arthur Young they are not privileged documents, in court the IRS will get them regardless of whether the administrative policy of self restraint was followed. I don't think there's going to be much of a debate over "unusual circumstances" in court, because once the summons enforcement action is filed, the standard is the Arthur Young standard under which the IRS is entitled to the tax accrual workpapers. I think the only question will be whether any of the documents are privileged as work product.
So I think from an attorney's standpoint those are the issues that you'd be dealing with and from both the government's standpoint and the private sector's standpoint, those are the issues that'll be joined.
MR. BERGIN: Thank you, B. John. Now we're going to get the accountant's perspective, Rob Rohleder.
MR. ROHLEDER: Thanks, Chris. Good morning to all of you. I'm not sure whether they really needed an auditor here, but here I am. Chris had asked me on the phone if I felt that this whole concept that we're discussing this morning, whether this is going to put the audit firms in the middle. Tom Callahan had co-authored an article that Chris had faxed to me and I read it, and there was some insinuation in there that the auditors would be in the middle, and so we had an interesting discussion at breakfast.
My short answer to that is it would appear that the accountants or the auditors would be put in the middle, but I don't think so. I mean, having spent 36 years auditing a whole variety of companies, I mean, I trust that the audit firms will take the high moral road on all of this, and particularly since Sarbanes-Oxley, and they will demand that they get the documentation to support the transaction.
Now transactions of the type that B. John was talking about, $300 million, I mean, you're talking huge stuff and you're talking companies that have in excess of $2 billion to $3 billion in revenues. So we're not talking small companies, we're talking very large companies and the number of those is finite, at least at this time. So I would expect they would come up on the IRS's radar, but they could easily be noted.
But a large transaction of that sort will either be in the board minutes of the company or in a subcommittee minutes. Therefore, that would give rise for the audit firm to raise the question and find out what kind of evidence and documentation the directors had in order to approve going forward with it. If the auditors stumble across a transaction such as that and find it has not been brought to the board's position, guess what, it raises a flag. If they find a transaction and nothing has been provided for in the accrual accounts and deferred accounts that's another case.
Now remember, since Sarbanes-Oxley came forward auditors now report to the audit committee. The audit committees are made up of directors. Who wants the kind of publicity that being a director has if there's something funny out there? It's a lot of what B. John and Tom have spoken to.
So last night, I spoke with a good old friend of mine who is in charge of quality control of the tax practice in the Chicago office and he basically concluded -- or I told him what I thought after reading all this stuff and he concurred. He said, in fact, he said some clients are not wanting to provide us documentation or analysis, whatever, and so in some cases we're having to start from scratch and develop it. I said, well, are you getting paid for that? He says more times than not we're getting paid because the audit committee knows we need certain stuff in order to do our job, but we're coming up with the analysis.
So now let me just speak the rest of my time about what the IRS or what you would find if you requested the tax accrual workpapers. First of all, you've got accrued income taxes, which is what's currently payable. You've got that for federal, you've got it for state, and you've got it for foreign subsidiaries and maybe some municipalities. Then you've got a file called deferred income taxes and that's for depreciation and reserves and whatever, and that's, again, federal, state, and foreign. On top of that will be summarized what you find in the tax footnotes in the audit reports. It breaks down what are the deferred accounts, what's represented, so you pick up the financial statements you know what they're providing deferred income taxes for. Therefore, there's a difference between book and tax purposes. Anything unusual that might get lumped in as "other," that may be a place you might ask a question.
I've never seen a tax shelter in my life. I've seen some aggressive tax things, but always felt in all cases that there was sufficient business purpose and reason for the transaction and it wasn't just off the wall. But again, that's me.
Then finally, you've got a third file, that being the provision and the provisions both federal, state, and foreign. It'll be summarized by the financial statement footnote that reconciles the effective tax rate to the statutory tax rate, all that being bubbling up.
Now in your large companies the majority of this will be done by, let's say, the end of 9 periods or 9 months. Some may be done at 6 months with the last quarter or the last half estimated. You have a lot of estimates in financial statements, you've got a tremendous number of estimates made to conclude on the tax provision and the various deferred accounts, and you can't do that overnight if you're going to have the auditors issue their report on February 1st or January 25th for a calendar year-end company. So a lot of this stuff is done early if there's multiple subsidiaries, foreign companies.
Then you get questions about is the tax department centralized? Well, it can't be. The companies in France and Germany and Italy have got to be preparing their own tax returns. So you've got to make sure that there's adequate information flowing forth from those locations.
If you think about it from the auditor's perspective I'd say 85 to 95 percent of the time spent by the audit team on the tax accounts is ticking and tying numbers. That is an incredibly laborious process to bring last year's balances forward, adjust them to the filed tax return because, like I said, they were done with estimates. All this is done by the company. But if a company that has 100 people in their tax department, maybe only 10 of them work on the tax return. The other 90 may be preparing state and local and sales tax returns and doing all kinds of tax-related stuff, but they're not necessarily top-notch accountants.
Oftentimes the auditors will find the entries that are made backwards. You know, that takes -- you can't just tick and tie. I've seen ticked and tied stuff that wasn't right, so you got to use a lot of common sense. The staff people have got to be experienced. So there's a lot of supervision in that.
The change in the cushion, it's got to be -- the auditors will test it coming forward, making sure that they understand why it went up or went down or whatever, and whatever's left needs to be explained by management as to what's it for and then bring the items forward. This is all a matter about bringing everything forward from the prior year and seeing if it makes sense. At that point, you get your senior tax partners working with the lead audit partners and the managers, the senior people that really understand things, challenging and making sure.
But that cushion file is relatively negligible compared to these huge volumes, which at Deloitte now are primarily electronic workpapers. So to look at a set of these files, as I mentioned electronically, you're staring at a little 15-inch screen. They're very well done, at least when I last saw them 4 years ago.
Okay. I want to make a point that the cushion is analyzed very carefully because free cushion is not allowed. You cannot have unallocated reserves or accruals for anything. FAS 5, which is at least 15 years old from the Financial Accounting Standards Board, said no free reserves, no allocations of accruals to nothingness. I mean, it's got to be specific.
I mentioned earlier the board of directors and committee meeting minutes. That's one of the first things that I always read every year. Mostly I would read them during the course of the year and be up to speed and just look at the last quarter in January, but that's like the Bible. That's where you start to see what's going on during the year because the directors should have approved everything that's significant.
Picture a company the size of General Electric or General Motors and you've got far-flung subsidiaries, you've got divisions and transactions just flying all over the place. You know, I've been a firm believer for the last 25 years that the lead audit partner or somebody who's his right arm lieutenant should go visit those subsidiaries overseas in a rotating basis of some sort and actually look at the working papers, and that would include the tax files. I recommended in some cases that the tax partner take a trip once in a while and go look at the tax workpapers and be sure that they are up to speed. I mean, I don't have the time here to go into some of the things I've seen.
Then one thing that I brought up at breakfast is in none of the literature that I read, and George Javaras sent me enough that it took me several days to read it all, I didn't see any reference in there to successor auditors and how they get to play in seeing the evidence of transactions from beforehand or whether or not the successor auditor had to go start from scratch in reevaluating, evaluating, and getting comfortable with stuff.
So with sort of throwing that open point out on the floor, thank you. Short and sweet.
MR. BERGIN: Thank you, Rob. All right, I'm going to open it up to questions now. We're amazingly on time. So within reason I think we have time to exhaust all questions.
MR. CALLAHAN: Hey, Chris, could I just intervene for a second?
MR. BERGIN: Sure, Tom.
MR. CALLAHAN: Bob maybe you can explain this. We may not have people who are accountants. Can you explain to them exactly what cushion is? I think that's probably something that certainly would be helpful to the readers as well.
MR. ROHLEDER: Sure. The accrued income taxes is for what's called, generally called currently payable. The deferred income taxes are for those timing differences where something is not deductible this year or it was deductible -- it deductible this year for tax purposes, but not for book purposes. In other words, it's a timing difference between when you deduct it for book and when you deduct it for tax purposes.
The third piece I talked about was the cushion. The cushion is an allocation of -- you provide in your income tax provision as a charge to the income statement at certain times for known liabilities. Those known liabilities would include items likely to arise in a future IRS audit, for example.
Let's say that you're used to having to pay after IRS audits the last 10 years, a million dollars a year. You come up with an average that you haven't been audited for 5 years, so maybe you've got $5 million assigned as a cushion for those things that an IRS auditor would likely find because that's been the experience in the past.
Things like differences in timing items, maybe the IRS will challenge the difference in the timing and want to assess interest. Interest is a frequent item that we'll find in a tax cushion. It's expected to be owed and payable, so it's set up in the differed accounts. Does that help?
MR. CALLAHAN: Isn't the -- I mean, just from an accounting sense, getting away from the tax, the abuse that -- or the concern rather that the auditors have is in the example. Let's say you have too much cushion. Bob referred to it as free-floating cushion. There's an issue that's been around for a long time that the SEC and readers of financial statements are very concerned about smoothing earnings. In the accounting business we refer to that as the cookie jar.
So if you say earnings, we need a few more cents per share, you turn to your tax partner and you say, well, you got any cushion? He says yeah, I got some cushion here. How much do you need? That gets release to earnings and it increases your --
MR. ROHLEDER: It doesn't go like that, but I'll accept it.
MR. CALLAHAN: So that's the concern with too much cushion from an accounting standpoint.
MR. LUBOZYNSKI: Can I --
MR. BERGIN: Sure. I'm just going to ask that people identify themselves and their affiliation if you want and you can call anybody by name. If I could, if anybody in the front or back, whatever that is, has a question, if you could just sort of drift towards us, the microphones will pick you up. So I should use one myself, right?
MR. LUBOZYNSKI: My name's Dennis Lubozynski. I'm with PricewaterhouseCoopers and I'm national leader of quality risk management for the tax practice. I'm a tax partner, but I spend a lot of time with -- interacting with our auditors as the connection between our tax field and auditing.
Just a little add to the background. The cushion and explanation was I guess pretty short and sweet, and probably is accurate to a large degree, but I wanted to add a couple other issues that are really at the mindset right now what's going on. These are changes that happened over the last couple years.
The SEC is clearly focused on reserves. The last year of the SEC, the most significant item in comment letters has moved from revenue recognition to reserves, and tax reserves are one of this. So they're asking for the information that Bob just laid out and getting into analysis of cushion and reasons for that. It really is an issue that gets to the cookie jar accounting and broader issues than that. So it is a very, very crucial area.
Second, tied to that, the new laws in Sarbanes have really made it mandatory that the support and documentation for the financial statements, all of which include the tax accounts, be very, very well done, supported, there are procedures, et cetera, to ensure that the numbers that end up in the account have adequate support, as Bob mentioned about there's no free reserve. How do you support these allocations? It's a very crucial item.
The last point, just to make -- and it ties back to what Bob was saying about the audit process. Last April, April 2003, there was an accounting -- auditing standard issued, Auditing Standard 9326, that very specifically addressed the type of support and documentation that auditors are required to see and review in order to have a complete audit. There's some discussion out there. There's a lot of tension, I think B. John mentioned that as well, about the tension out there. There's issues about privilege, et cetera. But the new standard is clear that access cannot be denied to the auditor of anything related to the tax return and can't be denied even for the sake of waiving privilege, if such privilege exists.
That's very, very crucial. Whether or not -- and then there's a second part of that standard that talks about what has to be actually entered into the files, so there's a documentation. There's an access standard and then a documentation standard. That was brand new, just issued in April of 2003, and then adopted subsequently by the PCAOB as well.
MR. ROHLEDER: I appreciate that because you know that I retired 4 years ago, and I've made it a point not to read.
MR. WHEELER: I think the discussion of what the accountants are -- this is Chuck Wheeler. I'm with Alston & Bird.
MR. BERGIN: Thank you.
MR. WHEELER: The discussion of what the accountants are asking for now it really goes to a part of the tax accrual workpapers question that goes beyond the notice and the request for tax accrual workpapers from the IRS. Anytime -- my experience is, and I would suspect this is B. John's, I think it was Don's before he went in, back to the government, that in any transaction now that fits within a recordable category, not a listed transaction, but any transaction of large size which may have some book tax differences, the IRS is going to come in and they're going to request the opinions and they're going to request as much information as they can.
Well, now, because of the way the tax accrual workpapers are being developed by the accountants, all of this is ending up having to be disclosed. So, as B. John correctly pointed out, this is all waiving attorney-client privilege for all of these documents. Yes, we have, and I think the litigation will move to, whether or not we can protect these under a work product doctrine.
You're going to get to the question whether or not because it's a reportable transaction there is a fear of litigation and a risk of litigation. But all of this is going to come out from a whole different perspective, a much larger issue than the narrower issue of the IRS asking for tax accrual workpapers with regard to listed transactions. The way it's developing I think the prophylactic effect, I agree with B. John, is going to be going away because the fear is going to extend to a much wider range of transactions.
Now the question I think will -- you know, there's going to be some debate between attorneys and the -- the legal profession and the accounting profession as to what can satisfy those new standards that came out this past April. What can be done? Do you end up writing two opinions: One that's a much more detailed opinion that is really to be protected by attorney-client privilege, going into much greater detail or the risks; and another opinion, and I don't want to do one that just says this is our opinion, but that does go through an analysis of what, of where, of why the transaction works, but doesn't go through as much of the road map that you would get into if you're preparing a brief down the road in a court decision?
I don't know where the answers are, but I think it's a much larger issue than just complying with the notice. I think the whole atmosphere that's been created by the Enrons and Sarbanes-Oxley goes beyond.
MR. KORB: See, that's what's interesting about this is you got to put everything on the continuum here and how, in June of 2002, the IRS puts out the announcement and, again, I explained what my view of it is. Now since then, all these other things have developed. Chuck, I think you're really talking -- you're right, you're talking way beyond the announcement here. You're talking a situation, you're talking IDR No. 1, where the IRS comes in on the large audits and asks for a whole series of questions about listed transactions as I understand it. One of the things in there is opinion's everything.
All right. That's independent of this question because what's happened is the accounting firms now feel that they are required to seek all this information to back up their files. So as B. John says, the privilege has been waived. So in a sense, that really has nothing to do with the Announcement 2002-63.
MR. WILLIAMS: I agree that there's -- the accounting profession and the legal profession had this debate 30-some years ago. They resolved it, but it -- because of all of these events coalescing, they're going to have to have it again.
The accountants justify their having the right to practice tax law by virtue of needing the competence to analyze the tax reserves on the financial statements, which gives them the tax advisors they need. So what I advise clients, and it's a business decision, but Chuck's absolutely right, and as you perceived, Don, the business decision the client has now goes way beyond just whether they should invest in aggressive transactions or not and risk giving tax accrual workpapers.
The business decision goes to every time the auditor wants the underlying advice that the lawyers have provided with respect to any tax issue on the return. Because if the underlying advice and communications that the client has had with the lawyer are given to the auditor, then the privilege is waived with respect to everything. In that sense, the issue is huge and that's exactly what's being debated now.
MR. WILLIAMS: I advise clients that you can't get around waiving the privilege by having two opinions, a detailed analysis and a "short form" opinion. If the taxpayer produces either of them, it waives the privilege. What the client can do, though, is say to the auditor these are our financial statements, so we can give you (the auditors) the reasons for the position on the tax return, explain the analysis, and give them the authorities without waiving privilege. In other words, the client can give the auditors a full range of access to the supporting authorities and thinking without revealing the communications and particular advice received from the lawyers. If the client takes that approach, the client is just talking with their auditors about its tax return, about its financial statements, without revealing the actual communications to the lawyers or legal advice received. The tax accountants with the auditing firm can then take the authorities and analysis given by the client and decide whether disclosure is required, and if so, whether the reserve is adequate.
But what's happening is that auditors are saying that's not good enough. We want to see the underlying advice. That's where there is a huge conflict between the accounting profession and the legal profession now.
MS. WOLLMAN: Diana Wollman. This actually was exactly the issue that I was going to bring up as well, and I just wanted to make a few points on it.
The first thing is that I think it's fascinating that you tell your clients that, B. John, but I think the problem is if you read the audit procedures it's very hard to argue that you don't have to give the opinion.
I think that the other -- the second point I wanted to make was Circular 230, I don't think you could issue two opinions even if you were willing to. I also just don't think it's really an appropriate thing to do, but I really think Circular 230, at least it was supposed to stop you from doing that, you know. It's gone through all these, you know, manifestations and changes, but I think that you're not supposed to be able to do that.
The next point I wanted to raise was that if you -- as I understand the law of privilege, if while you are preparing something there's a reasonable expectation that it's going to have to be disclosed or you're preparing it and one of the reasons you're preparing it is so it can be used for a non-disclosed, you know, a non-privileged purpose, then there's no privilege at all. I think that the problem is that you may even -- by putting the pieces together and walking down the dominoes, you may bust a privilege on every piece of written advice that there is because the lawyer and the taxpayer may have to expect that the accountant could request to see every opinion that's written. Therefore, from the very beginning, there's no privilege because you know that every time you write something it could be seen.
I think one thing that I've seen in practice is people saying don't write it down. Just tell me orally. I don't want written advice, which is incredibly different than what was going on, let's say, 10 years ago, where everyone wanted everything written.
The other thing I want to bring up because I do think it's going to affect this in the end and you bring up the point about the SEC wanting to know more about your reserves, is they've recently changed their policy about the comment letters on your initial filings for your registration statements. I think this is huge because if you've ever seen those comments letters, they can -- I mean, they're the same -- just like an opinion is the complete road map to the transaction, those comment letters are a complete road map to every possible, you know, little weakness and tweak and thing that you wanted to hide and exactly -- and the way you end up -- I mean, it's really a negotiating process with the SEC after you get the comment letter if they ask you to put in something you don't really want to put it and you kind of work it out with them one way or another.
For all of that dirty laundry to be opened up to the public, I think certainly it's of great interest in the business community, but it's also of interest to people in the tax community to the extent that it relates to the reserves and what's in the tax disclosures. The way that they -- you know, you have a discussion of your tax situation or a discussion of this or that.
I mean, I just think it's going to -- and when you put all of these pieces together, Circular 230, Sarbanes-Oxley, the audit, when you put -- and of course, they're all related, and today's Martha Stewart's day, so I think it's changing everything.
MS. GREENHOUSE: I have a few comments, it's really on the privilege issues. I know that B. John, you talked about -- oh, I'm sorry, Robin Greenhouse.
MR. BERGIN: I'm going to be obnoxious in reminding people because we're trying to transcribe this, so forgive me.
MS. GREENHOUSE: Robin Greenhouse, McDermott, Will & Emery. B. John, you mentioned when there's discussions on the remoteness that there might be a question there whether there would be an anticipation of litigation. I guess that I would say, though, on the reverse that if you do have a reserve for a particular item I think you would have a very strong claim that you have the anticipation of litigation with respect to those items.
I think, though, that the question isn't are the auditors in the middle? I think that the tax lawyers are being pressed in the middle her because they're being asked to give opinions, but they're obligated to tell their client that, you know, the auditors are now going to ask you for our opinions and you're going to have to make a decision whether you're going to want to waive privilege or do you think you're going to have a good argument for work product?
So, you know, they may decided, one, not to ask for the written opinion, as another participant just said; or they may say, well, write the opinion and make it be a little bit more an advocacy piece in case I would ever have to have this turned over to the IRS as opposed to an opinion you might have written a few years ago.
With respect to opinions that we know we're going to have to cite in an SEC filing, well, we know that we've waived privilege on those because there's been recent court cases on that. So, you know, we're not worried about those opinions anymore because we've already had to deal with those.
Then finally, when the auditors come in and start asking for opinions for everything, we're telling our clients you need to push back, that their audit standards say that they're not supposed to be relying on outside counsel's opinion because they're tax experts. If they're tax experts, they can come to their own analysis. It's going to cost money and that means that they're going to have to bring their own tax experts in to look at the issue themselves.
So once again, it's a business decision. Do you want to waive privilege or do you want to spend the money and have the auditors do the work themselves?
MR. WILLIAMS: There is another point of analysis this suggests and that is whether a document that's prepared without the expectation of confidentiality is privileged. I think the answer to that is no. Therefore, if it's turned over, whether you waive privilege? I think the answer to that is no, because if it wasn't privileged to begin with you're not waiving privilege when you turn it over. So if you can agree with the client that there is a set of communications between you and the client for which there's no expectation of confidentiality, with respect to that set of communications and advice there would be no privilege and, therefore, turning it over would not result in a waiver. That may be another avenue to go down rather than just a work product avenue.
MR. KORB: That's a good point. When you're thinking about privilege, hit the books and read all of the elements of privilege. Most people don't do that and that's one that people ignore, the one that B. John just talked about.
MS. WOLLMAN: When you actually --
MR. KORB: But you got to do it. The laws -- you know, it's more fun to make it up than to look it up, but, you know, you got to look it up sometimes.
MR. BERGIN: Ken?
MR. BUSEY: Ken Busey, PWC. This is not a question about privilege, but one that is about IRS policy and procedure. I mean, am I correct in reading the finalized IRM here to say that when a return has more than one 8886, and the listed transaction box is ticked, so in other words, there are two 8886s in the return related to listed transactions, that as a routine matter the service, the agent will request all tax accrual workpapers?
MR. KORB: That's what 2002-63 says, right?
MR. BUSEY: Thank you.
MR. KORB: Isn't that what it says?
MR. WILLIAMS: Yeah, it does.
MR. KORB: That's the law.
MR. CALLAHAN: That's right and there may be one out if you want to concede the issue, pay penalties and interest and enter a closing agreement. Then maybe they won't issue the --
MR. WILLIAMS: Actually there is another out that -- I'm not sure that it was -- there was an out that we intended, I'm not sure that it's recorded there, and that is the filing of an amended return. If the -- for example, at the beginning, if you claim the benefit on an amended return it's not -- the tax accrual workpaper issue isn't implicated.
Likewise, if you file a return claiming the benefits of a transaction and the transaction's listed after you filed your return so that it wasn't a listed transaction when you filed your return, but it becomes listed afterwards. Once it become listed you could file an amended return and get out of the risk of having to disclose the tax accrual workpapers.
But you can't get out of by filing an amended return is filing a return that claims a benefits of a listed transaction that was listed prior to the time you filed your return. Does that make sense?
MR. BUSEY: I think that's right. Just making a quick follow-up, if you'll allow it.
MR. BERGIN: Sure.
MR. BUSEY: Is that even though -- I mean, again, careful reading of it says that, you know, the words "discretion," "discretionary matter," et cetera, is used, but a careful reading of it indicates that the agent really has no discretion in the situation that I just described or at least he or she would have to defend a decision and get approval for a decision not to request tax accrual workpapers.
MR. KORB: No, go back and very carefully read Announcement 2002- 63. That's what you got to do. If you go through and read it carefully, what it says -- the word "discretion" only appears in the situation where -- you know, those additional situations where you have multiple investments. I'm sorry, it only applies if -- where you have the -- let me read it here.
In addition, the Service determines that the tax benefits from multiple investments and listed transactions are claimed on a return regardless of whether the listed transaction -- disclosed is a discretionary matter will request tax accrual workpapers. The way that's being interpreted is that they will be requested.
MR. CALLAHAN: Yeah, let me follow up on that. Before this was issued last week, there was a couple of subsequent memos that came out. One Larry Langdon had a question-and-answer format and I think there was also a chief counsel memo, which fleshed out, you know, what is discretion and what isn't.
One other thing I'll just point out in the IRM, and I guess it's a question, it basically says if a transaction originally wasn't listed, but becomes listed, okay, subsequent to filing a return, then tax accrual workpapers will be requested as long as the request at the time of the request it's a listed transactions. I guess the question is, the way the disclosure rules work is if it's not listed and it becomes listed, then you have to attach the disclosure form and the following tax return. If you've got -- if you have one that gets listed and that's all you have and then you file the form, this seems to be slightly at odds with Notice 2002-63 because this say -- well, I guess that's right, it will be requested but presumably only for that transaction. So remember, if there's one disclosed you only request for that transaction.
MR. BERGIN: I think I had two guys over here. Steve? Steve Rosenthal from Miller & Chevalier.
MR. ROSENTHAL: I enjoyed the first part of our discussion of privilege, although ultimately I think this is a long transition issue. That is the market will sort itself out and I expect, as B. John suggests, that we will know which opinions are written not intended to be privilege, in which are intended to be privileged. But then that shifts us to the point of this conference. I have one question in terms of the IRS tax policy with respect to tax accrual workpapers.
I thought Don's observation that the policy, in large respect, is to change the cost-benefit analysis of a taxpayer at the front end of a transaction, knowing that when a taxpayer undertakes a potentially abusive transaction of some form that the costs conceivably will be much greater, at least with respect to tax accrual workpapers.
Then B. John correctly pointed out that the cost can only be greater if, in fact, the government exercises some restraint in seeking tax accrual workpapers. The government is not so aggressive and so routine in requesting them that, in fact, taxpayers have deliberate choices to make at the front end when entering a transaction.
The question that I have, though, leaves out the other half of the transaction perspective, which is from the taxpayers' perspective. When can a taxpayer know that the taxpayer's undertaking a transaction that is a listed transaction? That is we know that the nature of listed transactions may change as new transactions are listed. The scope of what a listed transaction is quite broad and, in many respects, also vague, substantially similar.
So I think it's incumbent upon the government to think about ways to help in the cost-benefit analysis for the taxpayer so that they can ascertain when they are considering a transaction, whether that transaction may yet impose costs. The question that I have is what steps can the government take to help taxpayers undertaking a transaction have some confidence as to whether that transaction will or will not ultimately be viewed as a listed transaction that trigger these special accrual workpaper requests?
MR. KORB: Well, to answer your question, and, B. John, I'm not sure if it was on your watch or after Emily moved in, but this idea of this red-light, green-light, yellow-light notice that has surfaced, in fact, one was issued last week, that that fits within the yellow-light category to basically -- the way I would look at it, and correct me if I'm wrong, B. John, is that the listing transaction are clear the red lights, okay. Rulings are put out all the time that explain what situations -- you know, what the tax are. The ruling dealing with the charitable contribution of easements was a yellow- light notice, which basically said this is something that concerns us and we're looking at it, okay. So I think that's one mechanism.
But you need that tension in the system. I think -- I mean, the rule I would follow is it too good to be true? I mean, let's not kid ourselves. If something's too good to be true, you know, people get paid a lot of money to make those judgments and they ought to think about it. Then --
MR. WILLIAMS: I think anytime the tax treatment doesn't follow the economics you need to be wary. I think if you look at it that way it's not all that difficult to figure it out.
MR. KORB: I think that this is too good to be true?
MR. WILLIAMS: Yeah.
MR. JOSEPH: Jim Joseph from Arnold & Porter. I wanted to follow- up on one of Steve's comments and then put it together with something that B. John had said earlier. If you're going through this analysis of what is substantially similar or is this transaction too good to be true or do the economics, follow the tax benefits, or do they match up, and then on audits you have revenue agents coming in and being very broad in what workpapers they request and it becomes very routine that they request workpapers when you have reportable transactions because of completely legitimate book tax differences or other things, and then you go to court and you're going to lose if you go to court under Arthur Young, is it just going to become a routine practice that these workpapers are going to have to be turned over because the requests are going to be so broad and the rulings are such that a lot of times there isn't any protection for the underlying workpapers?
MR. KORB: Well, let me speak to that because, again, reading the materials carefully, that's not the intention. The unusual circumstances standard is the standard in all the cases except for the four that are set forth in the notice and again reiterated in the IRM. There's a number of safety valves that have been put in, again looking in the IRM, to make sure that somebody's looking over the shoulders of the front-line people who have to deal with this. When you get to the end of the day before a decision is made to enforce a summons, it's going to come to my office, the deputy chief counsel for operations, along with the associate, chief counsel for P&A, and the appropriate division counsel are going to have a say in that. So we're trying to build in some review of it so we can make sure that the rules are followed.
Again, you've got to read it very carefully. You got to point that out to the revenue agents. I mean, that's what you got to do.
MR. JOSEPH: Well, that is something that a lot of us who are working on audits currently are having to do because some of the agents are being very aggressive about saying this is what's going to happen.
MR. KORB: You point it out to them.
MR. JOSEPH: It also puts a lot of pressure on the substantially similar issue because if you have a transaction that you're arguing about whether it is substantially similar to a listed transaction, if the agent takes a very aggressive position on that, do a lot of these protections fall away?
MR. KORB: I mean, that's a standard that wasn't created for this.
MR. JOSEPH: No, I know.
MR. KORB: This is a concept that's out there. I happen to think that that was, again, a good rule to put some edge on this. Again, looking from the outside as I was advising clients at the time this came out, working with Tom, is we pointed out to them what we thought in the context what was going on here. The idea -- what's going to happen here is there's going to be a period of time where this is an issue as everyone kind of figures out what the rules are. Eventually this will no longer be an issue, okay, because people -- the marketplace will react and things will change in a way to -- frankly, people will stop investing in these potentially abusive transactions. I mean, that's a large part of it.
MR. WILLIAMS: If I could just harken back to the summer of 2002, when we put this out, we were faced with reputable professional advisers telling clients that in a particular sheltered transaction if you used an S corporation instead of a partnership it wasn't substantially similar.
That's just not -- I mean, you know, so you raise an excellent point and that is I think a lot of the debate is going to take place over how aggressive substantially similar is going to interpreted. But I think in some respects the profession kind of brought it on themselves.
MS. FAHEY: I'm Mary Lou Fahey with the Tax Executives Institute. For good or ill, the requests for tax accrual workpapers is a real hot button issue among our members. I'm hearing a great deal of concern about what kind of effect this will have on the audit relationship because our members can get very exercised about having the papers requested.
Just kind of to follow up on something Don said about people sorting out the rules, I received a phone call yesterday from a practitioner who told me that his clients are beginning to see requests for tax reserves. The way I read this notice at tax reserve is included in your definition of tax accrual workpapers. I don't know if this is supposed to be something that's going to become routine or whether this is something that's supposed to be protected by this notice.
MR. CALLAHAN: I thought the balance of the -- are you talking about the balance, Mary Lou, of the tax reserve?
MS. FAHEY: Yeah.
MR. CALLAHAN: Because I thought that was not covered. I thought that was something that was just routinely, you know, whatever, what's the number.
MS. FAHEY: Well, no, I think what he was -- I think it was the information about the tax reserve was the way it was put to me. The implication I got from the conversation it was outside the scope of this notice, it wasn't a listed transaction, for example.
MR. KORB: Well, that's the first place you've got to start. Again, people should read the notice and read the IRM. You've got to push back.
MR. CALLAHAN: But you raise a good point. This type of thing -- and I understand because, you know, we have clients, too, who like to maintain a good relationship with their audit team, but, you know, in the end, for better or worse, it is am adversarial relationship and, as Don said, you have to push back it seems to me.
MR. BERGIN: I'll come here and I'll come back to you.
MR. BARRIE: I'm John Barrie from Bryan Cave. I want to shift the direction a little bit because I think this is a taxpayer behavior problem and I don't think it's a real issue in the long term with our SEC filing clients, companies. But I think it is a real issue for the privately held company that has an auditor report because that's where there has to be a change in direction and how the auditors and their lawyers interact. I think that's what there needs to be a little more focus on as opposed to what's being done at the SEC level where I think the rules will be fairly certain over a matter of time.
MR. WHEELER: It's not a privilege issue. I just want to throw out one aspect of it. I don't think it's locked in at this point that the IRS is going to have absolute access to all the tax accrual workpapers. The work product doctrine, as B. John mentioned, is still there. If you get to a listed transaction where the IRS has pretty well announced it's going to litigate, the idea that you're doing something in anticipation of litigation may be almost per se established.
Part of the work product doctrine is that you do have the right to share the information with a non-adverse party. So the client may be able to show an opinion done by the attorney, the attorney's work within that, to the auditor and still be within the protection of the work product doctrine. This is not something new. This has been going on in other areas that are of reserves by the companies for years because if we have litigation reserves there are comments between the attorneys and the auditors. But those -- that is still often protected by the courts under the work product doctrine. So this may still be a subject of litigation going forward with regard to this. I don't know where it's coming out, but I don't want to leave everybody with the impression that there is not any litigation or any hope of still establishing some form of privilege within this context.
MR. CALLAHAN: Well, that's why -- look at the El Paso and Rockwell cases because those -- really they do talk about those issues because that's right, that's where the battle has to fought is on the work product.
MR. KORB: Then I would add to that the facts are what's important here. Each case can be different and we can sit here and pontificate all we want, but the facts of each individual case are going to be absolutely critical. My prediction is the funny thing about this in most cases the privilege is going to end up being waived just because of the way the documents were handled inside the company. It's going to be inadvertent. So that's going to happen a lot on the attorney-client privilege side on the work product and that's why I wanted to make sure I included that in my remarks. I think the battle will shift a little bit there. But again, that's going to present some very interesting questions.
We had clients who felt that once they had, in effect, hired us to work on a matter, even if it was before the return was even filed or even thought about, they were just working on the transaction, somehow you were preparing for litigation. That's stretching it I think.
MR. LUBOZYNSKI: I just had a comment on this and there's a lot of discussion about privilege and comments about whether it exists, whether it doesn't exist. I'm not an attorney, so I'm not going to go there and there's a lot of prongs that you have to look at.
There was proposed legislation that actually said turnover of information to the SEC, PCAOB, or your independent auditor will not affect privilege that exists. Because a lot of what this conversation goes around and around is whether or not there's privilege to begin with, and then there's an obvious issue about giving it to your accountant and waiving it or giving it to SEC, quite frankly. I think the accountant issue is overrated because the SEC, with the comment letters that somebody's talked about already, is asking for this type of information and you get into that whole discussion of whether it exists or not.
But I guess I'll just throw that on the table whether that's a possible solution at least to part of this issue to redirect this issue to where it'd be.
MR. KORB: Well, I'm not a legal scholar, but isn't the attorney- client privilege a common law concept? So I don't know if statutorily it could be changed. What do you think, B. John?
MR. WILLIAMS: You're saying legislation that would basically say you don't waive privilege if you turn over the documents to -- I can't imagine Congress passing that.
MR. KORB: Right, that's another thing.
MR. LUBOZYNSKI: That, quite frankly, is part of the tension with this whole area is that transparency to Congress is very hot on and the SEC as well. The SEC's made several recent speeches that just is mandating transparency. So -- but that was one issue that came up. It was actually proposed and removed from the bill 2 years ago.
MR. CALLAHAN: Well, you bring up a very good point. I mean, we're focusing naturally on taxes here on this panel, but I was actually on another panel at TEI where the real issue that many of the people were concerned about was not waiver vis-à-vis the IRS, but some third-party litigant. If I have to turn this over to the SEC or to my auditor as part of an analysts and the plaintiff's lawyer finds out about it, I've waived everything and now I'm in the middle of a big lawsuit. So there was actually more concern about the IRS on that very point.
MR. JOSEPH: Jim Joseph from Arnold & Porter again. I think it's important to keep in mind this whole idea of waiver versus something not being privileged, and this plays into that, too. One thing that I've reminded clients of lately, that the final opinion that a law firm might issue may not be subject to privilege because of all these issues, but all the previous advice and the discussions back and forth and the precursors of here are the different options we considered leading up to it still would maintain that privilege. So it might be very important right from the start to make sure that the opinion is set up in a way that it's clear that you're not going to claim that that's privileged, so you don't have a subject matter waiver issue.
A little off the point, Martha Stewart was sentenced to 5 months in prison.
MR. BERGIN: B. John, I wanted to come back to something that you said before as far as the announcement goes, that restraint is needed or, in my words, I would put it that it'd be a rule that will eat itself. It won't become so much a cross-benefit analysis, it'll be applied across the board. Are there enough procedural safeguards in the rules here to prevent that?
MR. WILLIAMS: I think as long as the Chief Counsel's Office remains independent from the commissioner there is.
MR. KORB: There's still a dotted line there, B. John.
MR. WILLIAMS: Are the procedures you've got to give you the hat back?
MR. KORB: No, B. John is right. I mean, that's part of our job and, you know, we'll be working on that.
MR. BERGIN: Because in an environment of shortened audit cycles it could become a problem.
MR. KORB: Well, that's right. That's exactly right. You don't -- again, everyone should take a deep breath and read the rules and then make sure that they're pointed out to the people in the services you work your way through. There are -- again, read through the IRM. There's ways to elevate the issue and we've laid it out very clearly and that's what I would recommend.
MS. WOLLMAN: It's Diana Wollman again. I think that one of the interesting things that we haven't discussed at all is what is the underlying policy justification for all of this besides enforcement and that sort of -- you know, the general idea of making sure people pay the right amount. I think that one of the ways that I've tried to explain this to my clients who've come to me with the new audit procedures and said why should I have to give them my opinion and this isn't right and how do you explain all this tax accrual workpapers, is to say that anything that goes into the decision about what you're going to pay into the public fisc and what you're going to disclose to your public shareholders is, in my view and the government's view, open territory.
But the idea is that if it's -- I mean, because if you read the cases about the privilege, if you prepared something solely to figure out what's the right amount to go on your tax return, that is technically not privileged. So that a lot of times when you think you have something privileged because it's a memo, if it's really the memo supporting what your tax return position is, then it's not privileged.
So my -- the way that I think about this is that anything that you're using to decide how much you're contributing to the public fisc is open territory. I think that the interesting question is that this -- if I read the Internal Revenue manual correctly this supplies whether you have a public company or a private company, so as long as you have independent auditors doing your financials you can be a private hedge fund or a private this or that.
I guess -- I mean, it raises another question about, well, maybe a private hedge fund, maybe we should be advising them when we're doing their hedge fund partnership agreement, you know. In the past, people have usually hired an independent accountant to give financials. Maybe you don't want to do that because if you don't do that, you don't have to worry about this. Do the financials in-house. Your partners might not care so much. The investors, they're probably trusting you.
MR. WILLIAMS: I think the Justice Department has taken the position in some briefs that tax advice is not privileged. That is any tax advice relates to the filing of a tax return and the numbers on the return and, therefore, it is not privileged. But --
MS. WOLLMAN: Well, at times I've seen the inaccuracy there.
MR. WILLIAMS: You know, Posner on the 7th Circuit in Frederick basically said something of the same thing, and he -- there were a number of motions for reconsideration of the opinion. He withdrew it and then rewrote it in order to make it clear that if you are practicing as a lawyer and giving legal advice, and it's legal advice that's being sought, the communications that the client makes with you are privileged even if it does relate to a tax matter. So I think it's -- going back to the -- Don's point on the work product privilege, it really is a question of fact and I think you really need to get into the specifics of the case. But very clearly, the Justice Department has taken a position on brief.
MR. CALLAHAN: Well, B. John, you're absolutely right. In fact, within the last 2 weeks, a BDO case came down and it was actually adverse to the government, but they threw everything in there, including what we would normally think of as attorney-client privileged communications. It was clear that they went in and said there's nothing privileged, show us what is privileged, and I think the court came down pretty hard on that approach.
MR. WILLIAMS: Yeah, that happens not to be the position of the Internal Revenue Service, though.
MR. CALLAHAN: Yeah.
MR. KORB: That's exactly right.
MR. BERGIN: Please.
MR. LUBOZYNSKI: Just moving a little different topics, there was a TCBI panel earlier this year and there was a panel and a couple of people from the IRS and industry were up there. One of things that was discussed was trying to look at what the IRS was really entitled to, clearly without any privilege debate, and they were trying to draw a line.
But one of the lines is when you look at a cushion analysis there's really two road maps: There's the first road map as to the issues and then there's a road map within a specific issue, and that road map gets into a discussion of alternative arguments, analysis, that sort of thing, judgments. It gets into much more of a judgment issue driven by the accounting aspects.
One of the panelists asked the question whether or not the IRS purposes would be served with a request under these procedures for the first road map, a map listing the issues, and not getting into the judgmental issues or the accounting issues as a separate way and a way to -- which obviously gets into the privilege discussions.
MR. BERGIN: A couple more comments?
MR. BUSEY: I'd like to ask one more question about my example of a return that has more than one 8886 attached to it indicating a listed transaction. I think I've read it fairly carefully.
Counsel is not involved in the IDR process necessarily. In other words, the counsel involvement really steps up upon the discussion of whether a taxpayer has not complied with an IDR and will proceed to a summons type situation. I guess, again, maybe a question and a statement. It just seems as a routine matter that for any return that has, again, more than one 8886 indicating a listed transaction, the agent in the field essentially has no discretion and will proceed to request all tax accrual workpapers. Then, of course, it's up to the taxpayer to either comply with that IDR or not comply with it and move to the next stage of the process. I mean, am I correct in my understanding of that?
MR. KORB: Well, I read this one sentence in here, two sentences. It says: Upon determining that a request for audit and/or tax accrual workpapers should be made, the examiner will prepare an IDR for the workpapers. The examiner should work with field counsel in preparing the IDR.
It sounds like counsel's involved, doesn't it?
MR. BUSEY: Again, my question wasn't necessarily around the counsel involvement, I'm sorry, but the process, the steps in the process obviously.
MR. KORB: Well, that sounds like the first step, doesn't it?
MR. BUSEY: Okay, thank you.
MR. BERGIN: Okay. Anybody have anything else? We're almost at the end. Yeah, please.
MS. MATTSON: I was wondering about -- because a lot of questions have gone around about exactly what's going to be unfolding. My name is Cindy Mattson. I'm the division counsel for LMSB.
MR. BERGIN: I wanted everybody to know, thank you.
MS. MATTSON: You know, I just wanted to supplement a lot of the comments that Don has made, which is basically that on the enforcement side for LMSB, yes, talked about how the system is mandatory, it gives a lot of "wills" and "shalls." In LMSB there are -- we're doing a lot of training and education of the agents and the DFOs so that they understand all those rules. Yes, Don is correct, that there's always going to be coordination with counsel, not only LMSB counsel, but also the national office counsel.
In LMSB counsel we have set up a special program within my organization to have expertise within the five different industries, so the point persons who will be contacted and they'll be allowed to centralize coordination to make sure that the IRS follow -- the rules are followed.
MR. BERGIN: Thank you. All right, well, I started here saying that I came here to learn. Taking on something that Don said early on, I think we're at the beginning. All of us are going to learn a lot in the next couple of years.
I'd like to thank everybody here. It was an interesting discussion. Thank you all for participating. Thanks especially to Tom Callahan, Don Korb, B. John Williams, and Bob Rohleder. I suggest we give them a round of applause.
(Whereupon, at 11:55 a.m., the PROCEEDINGS were adjourned.)