The IRS has imposed increasing disclosure demands on large, multinational taxpayers, requesting filing of a slew of additional documents and forms.
Question: How will the Schaeffler case affect the IRS’ ability to require additional disclosure documents from taxpayers?
Answer: In the last decade, the Internal Revenue Service (IRS) has shifted its compliance focus from domestic issues to multijurisdictional tax transactions. Indeed, transfer pricing and complex cross-border transactions have consumed a significant portion of the IRS’ resources and attention. This is evident in the number of international cases that the IRS has pursued in the last decade,1 as well as the programs and guidance that the IRS has instituted to make audits more efficient and effective. Examples include the transfer pricing audit road map issued by the IRS in 2014, the expansion of the use of outside experts in transfer pricing, and hiring private law firms to assist the IRS with complex international tax cases.2
The IRS, however, often believes that it is at a substantial disadvantage. In an effort to level the playing field, the U.S. government has sought to increase the “transparency” of sophisticated taxpayers and secure information-sharing agreements with foreign tax authorities.3 The IRS is likely to receive more encouragement and additional ideas for transparency from overseas, such as the recent proposal in the United Kingdom’s 2015 summer budget that would require all large businesses to publish their United Kingdom–related tax strategies. The resulting compliance and disclosure demands for large, multinational taxpayers are monumental and keep increasing. For example, U.S. corporate taxpayers are required to file Schedule M-3 to explain book-tax differences on the face of the return; Schedule UTP to describe so-called “uncertain tax positions”; Form 8886 to disclose their involvement in reportable transactions; Form 5471 to disclose foreign-controlled corporations; Form 5472 to disclose transactions between related, multijurisdictional subsidiaries; and perhaps country-by-country reporting in the near future. Given this web of disclosures, the IRS is, in a very real sense, in “disclosure overload.” Nonetheless, these requirements highlight the government’s ongoing quest to obtain a road map of the potential issues on a given taxpayer’s return, including the legal basis for and weaknesses of the reported positions.
Clearly, tension exists between ensuring that taxpayers pay the correct amount of tax owed and placing excessive tax compliance burdens on corporate America. Often this tension is highlighted when the IRS seeks documents or information revealing the tax advice given to a taxpayer—which the IRS believes is the holy grail of disclosures—subject to taxpayer privilege claims. These tensions have intensified in recent years, and the IRS has increased summons enforcement cases, including some with very aggressive positions on whether, for example, a document is protected from disclosure by some privilege claim—attorney-client, tax practitioner, or work product. From the IRS perspective, these claims hinder its access to information and the effective administration of the Internal Revenue Code. For taxpayers, the IRS already has access to tremendous amounts of factual and transactional detail and its own personnel to analyze the tax issues in any given examination. Fundamentally, taxpayers correctly recognize that the ability to preserve confidential legal advice and analysis from disclosure is a bedrock principle of our legal system that must be preserved.
Federal law recognizes several privileges that may apply to protect confidential information from disclosure. The hallmark of privilege law is the attorney–client privilege, which protects confidential communications made by and between attorney and client. Internal Revenue Code Section 7525 extends the common law attorney–client privilege to certain confidential communications made between a taxpayer and a federally authorized tax practitioner. Additionally, the work-product doctrine protects information and documents prepared “in anticipation” of litigation.4 Although these protections are strong, they are not absolute and can be lost or waived if the protected material is shared with third parties.5
The attorney–client privilege is generally waived upon disclosure to third-parties; however, the common-interest doctrine has developed as an exception to waiver of the attorney–client privilege and extends that protection to confidential communications with third parties if the communication was made to further a joint defense or common enterprise, is designed to further the shared interests, is otherwise privileged, and the privilege has not otherwise been waived.6 Work-product protection is generally waived upon disclosure to an adversary or an avenue to a potential adversary.
As a final point, given the global nature of large taxpayers today, it is vital to understand that what is privileged in the United States may not be privileged in other jurisdictions around the world. For example, advice from an attorney is generally not protected from disclosure in countries like China and Kazakhstan. Similarly, advice from certified accountants is not privileged in such countries as India, Luxembourg, Poland, Russia, Switzerland, and the United Kingdom. Numerous countries do not protect advice from in-house counsel at all!7 Accordingly, the increased tax transparency and information-sharing worldwide results in an increased need to understand the nature and scope of privileges and protections in various jurisdictions. The IRS’ recent use of treaty requests to circumvent U.S. privilege protections and obtain materials without having to litigate the issues in the United States is very disturbing and violates core treaty principles.8
Schaeffler v. United States
The case of Schaeffler v. United States presents a good foil to explore the ever-changing nature of privilege in the context of a multinational audit of a very complex international refinancing and restructuring.9 Plaintiff Georg F.W. Schaeffler owns approximately eighty percent of a group of privately held German companies (the Schaeffler Group) that manufacture and distribute bearings and other automotive and industrial components. In August 2008, the Schaeffler Group made a voluntary tender offer, which was primarily financed with debt from a consortium of banks for Continental AG, another manufacturer of automotive and industrial components. Pursuant to an investor agreement between the Schaeffler Group and Continental, the Schaeffler Group agreed to limit its interest in Continental to less than fifty percent of Continental’s outstanding shares. Partial tender offers are not available under the applicable German securities laws, so the tender offer was priced at a point that was anticipated to result in the target share acquisition.
Unfortunately, immediately prior to the close of the tender offer period, Lehman Brothers Holding Inc. filed for bankruptcy, causing a cascading collapse of the financial markets and creating additional incentive for Continental shareholders to accept the tender offer. Once the dust settled, the Schaeffler Group held: (1) upwards of €11 billion of acquisition indebtedness based on the tender offer cost of €75 per share and (2) approximately 89.9 percent of the outstanding Continental shares, which reached a low per-share price of just under €12 in early 2009. This drop in the share price of Continental caused a liquidity event for the Schaeffler Group and significant solvency risks for the bank consortium if the debt could not be serviced. A refinancing of the acquisition debt and a restructuring of the Schaeffler Group was necessary.
The Schaeffler Group engaged Dentons US LLP and Ernst & Young to advise on the U.S. federal income tax aspects of the restructuring and refinancing, which took place during 2009 and 2010. In the process of assisting the Schaeffler Group with the debt restructuring, a comprehensive legal memorandum was created that identified and analyzed various U.S. tax issues regarding the refinancing.
As a part of the refinancing, the bank consortium agreed to share certain tax risks faced by the Schaeffler Group and subordinate its claims on the debt to the extent the Schaeffler Group incurred up to €885 million in personal tax liabilities (the Ringfencing Provisions). Fully understanding and anticipating the personal tax liabilities created for Mr. Schaeffler by the refinancing and restructuring was a central focus for all parties. Consequently, the bank consortium and Mr. Schaeffler entered into agreements confirming that their discussions relating to the tax ramifications of the refinancing would remain confidential and that any applicable privilege or protection from disclosure would be preserved by the parties. Pursuant to those agreements, the EY memorandum was shared with the bank consortium. In August 2010, as part of the process of getting comfortable with the tax aspects of the restructuring, Mr. Schaeffler received a Private Letter Ruling from the IRS blessing aspects of the restructuring.
The IRS commenced an audit of Mr. Schaeffler’s 2009 and 2010 tax returns and, in IDR No. 1, sought the production of “all documents created by [EY], including but not limited to legal opinions, analysis, and appraisals.” After privilege and work-product protections were invoked, the IRS summonsed EY for the withheld documents. Mr. Schaeffler moved to quash the summons, and in support of his claims of privilege, submitted nine separate affidavits from various professionals involved in the restructuring and refinancing that explained the privileged nature of the withheld documents. In response to the request, a voluminous and detailed privilege log, which listed all of the approximately 5,000 documents withheld under a claim of privilege, was provided to the IRS. Some of the withheld documents were shared with the bank consortium during the refinancing and restructuring period. The magistrate who was assigned to rule on the motion to quash asked Mr. Schaeffler to provide the EY memorandum, which was reviewed in camera.
The magistrate ruled that the EY memorandum was not entitled to protection and issued an order to enforce the summons. First, the magistrate held that the EY memorandum was not privileged because the “common interest” of the parties receiving the otherwise-confidential communication was a business and not a legal interest. This meant that disclosure would not be protected by the common legal interest exception to waiver and that any applicable privileges that could have attached to the documents were waived upon disclosure to the bank consortium. Second, although the magistrate agreed that the parties did anticipate litigation, the opinion concluded that the EY memorandum would have been created in the same form even if “no audit or litigation would ensue.”
Mr. Schaeffler filed an interlocutory appeal to the U.S. Court of Appeals for the Second Circuit. Oral arguments took place April 16, 2015, and the Second Circuit’s decision is pending. On appeal, Mr. Schaeffler posited two issues for determination—whether the magistrate erred in: (1) denying work-product protection when it ruled that the EY memorandum would have been created in the same form for ordinary business purposes, negating the application of the work-product doctrine; and (2) holding that Mr. Schaeffler and the bank consortium did not share a common legal interest in analyzing the restructuring and refinancing transactions at issue.
With respect to the work-product claims, Mr. Schaeffler argued the magistrate misinterpreted the applicable precedent. In United States v. Adlman,10 the Second Circuit held that “a document created because of anticipated litigation, which tends to reveal mental impressions, conclusions, opinions, or theories concerning the litigation, does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of the anticipated litigation.” However, the Second Circuit also explained that the work-product doctrine does not apply to “documents that are prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation … [e]ven if such documents might also help in preparation for litigation.”
The magistrate agreed that Mr. Schaeffler anticipated litigation, but relied heavily on Adlman’s “form of the document” discussion to conclude that the 321-page EY memorandum would have been created in the same form even if litigation were not anticipated. The magistrate, in deeply exploring this “form” inquiry, relied heavily on a hypothetical construct11 that misapplies clear Second Circuit work-product precedent for “dual purpose” documents (i.e., documents that are created in anticipation of litigation and are also used to inform a business decision) and glossed over or completely ignored other work-product examples provided in Adlman that are comparable to Mr. Schaeffler’s scenario.
Furthermore, the “what would the EY memorandum look like absent the parties’ anticipation of litigation?” counterfactual scenario posited by the magistrate makes it increasingly difficult, if not impossible, for any dual-purpose document related to a highly regulated body of law such as tax to be considered work product, since professional standards can require practitioners to consider litigation risk in their analysis. This is contrary to well-established precedent. Clearly, every document a party creates is not automatically protected by the work-product doctrine simply because the party anticipates litigation. However, if the document was created “because of” the prospect of litigation, as that inquiry is defined in the applicable circuit court, it may be protected from disclosure even if the document is utilized to inform a business decision.12 The prevailing Second Circuit and majority court test asks whether the document was created “because of” the prospect of litigation—litigation does not have to be occurring or even threatened when the document is created to be entitled to protection.13
Mr. Schaeffler also argued that the magistrate’s definition of what constitutes a common legal interest was too narrow. Indeed, the line between economic and legal interests can be blurred in very large and complex business transactions. In Mr. Schaeffler’s situation, the tax issues involved were intimately tied to and heavily dictated the final form of the restructuring and refinancing transaction. Furthermore, significant IRS adjustments would impact both the bank consortium and Mr. Schaeffler due to the Ringfencing Provisions.
On appeal, the IRS argued that the magistrate correctly interpreted and applied the ruling in Adlman and argued that even if a document may be helpful in litigation, that is not the dispositive factor to support work-product protection. Instead, the IRS took the position that the putatively protected documents must be created “because of actual or impending litigation.” This is an aggressive position that, if permitted to stand, would greatly reduce the application of the work-product doctrine across the board.
The IRS likewise agreed with the magistrate that the common-interest doctrine was not applicable because there was no shared legal interest between Mr. Schaeffler and the bank consortium. The IRS reiterated the magistrate’s finding that the bank consortium had no “common legal stake in Schaeffler’s expected litigation with the IRS.”
The magistrate’s ruling and the IRS’ position in Schaeffler threaten to eviscerate work-product protection in dual-purpose document scenarios and advances a restrictive definition of “legal interest” (as opposed to economic interest) with respect to the availability of the common-interest exception to waiver of the attorney–client privilege. These concerns are not unique to Mr. Schaeffler. The magistrate’s opinion has industrywide ramifications, as evidenced by the Second Circuit amicus support for Mr. Schaeffler provided by the U.S. Chamber of Commerce and the Association of Corporate Counsel. There is broad interest in how the Second Circuit will decide these issues.
The IRS’ recent and aggressive attack on privilege is a direct result of its lack of resources to assess tax compliance. With an increased demand for transparency, we expect more pressure to be placed upon whether information and documents are considered privileged.
Todd Welty and Mark Thomas are partners in the Dallas office and Kevin Spencer is a partner in the Washington, D.C., office of McDermott, Will & Emery LLP.
- See, e.g., Kiplinger Tax Letter, April 13, 2012.
- See, e.g., United States v. Microsoft, No. 2:15-cv-00102 (D.C. Wa.); United States v. Mundie, No. 2:15-cv-00103 (D.C. Wa.).
- For example, the OECD’s Base Erosion and Profit Sharing, or BEPS, project and the Fair and Accurate Credit Transactions Act, or FACTA (Pub. L. 108-159, 111 Stat. 1952).
- See Hickman v. Taylor, 329 U.S. 485 (1947) (attorney’s witness notes considered “work product” and properly withheld from other side in litigation).
- What constitutes waiver is different for each of the privileges.
- See, e.g., In re Bevill, Bresler & Schulman Asset Mgmt. Corp., 805 F.2d. 120, 126 (3d Cir. 1986); Eisenberg v. Gagnon, 766 F.2d 770, 787 (3d Cir. 1985); In re Grand Jury Subpoena Duces Tecum, 406 F. Supp. 381 (S.D.N.Y. 1975). The common-interest doctrine finds its origins in a criminal law context when multiple defendants with separate counsel shared information to pursue a united defense. See, e.g., Chahoon v. Commonwealth, 62 Va. (21 Gratt.) 822, 841-42 (1871). It was later extended to civil matters, including tax cases. See, e.g., Schmitt v. Emery, 2 N.W.2d 413 (Minn. 1942), overruled on other grounds, 215 Minn. 288 (Minn.1943).
- For example, China, France, Germany, India, Luxembourg, the Netherlands, Russia, and Switzerland.
- See, e.g., “The Dark Side of Tax Information Exchange,” 139 Tax Notes 1091 (June 3, 2013).
- 1:13-cv-04864-GWG (S.D. NY). Plaintiff, Georg F. W. Schaeffler, is a German businessman, and owner of approximately 80 percent of the holding company INA Holding Schaeffler GmbH & Co. KG, which includes Schaeffler AG. His mother, Maria-Elisabeth Schaeffler, owns the other 20 percent. The authors represent Mr. Schaeffler in various tax matters, including the case described above.
- 134 F.3d 1194, 1202 (2d Cir. 1998).
- The magistrate asked: “While we have described this as a factual determination, in reality it is a counterfactual determination because it requires the Court to imagine what ‘would have’ happened in a world where Schaeffler did not anticipate litigation as to the restructuring and refinancing transactions but everything else was exactly the same—in other words, Schaeffler still found himself acquiring the unexpectedly large share of Conti stock and still needed to engage in a refinancing and restructuring arrangement that would comply with federal tax laws.”
- The test for determining whether a document is considered protected work product varies by appellate circuit. The Second Circuit’s “because of” litigation standard is at issue in Schaeffler’s litigation. Accord Wright & Miller, Federal Practice & Procedure, vol. 8, section 2024, at 343 (1994); State of Maine v. US Dep’t of Interior, 298 F.3d 60, 68 (1st Cir. 2002); United States v. Adlman, 134 F3d 1194 (2d Cir. 1999); In re Grand Jury Proceedings, 604 F.2d 798, 803 (3d Cir. 1979); Nat’l Union Fire Ins. v. Murray Sheet Metal, 967 F.2d 980, 984 (4th Cir. 1992); United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006); Binks Mfg. v. Nat’l Presto Indus., 709 F.2d 1109–1119 (7th Cir. 1983); Simon v. GD Searle & Co., 816 F.2d 307, 401 (8th Cir.); In re Grand Jury Subpoena (Torf), 357 F.3d 900, 907 (9th Cir. 2004); Senate of Puerto Rico v. U.S. Dep’t of Justice, 823 F.2d 574, 586, n. 2 (D.C. Cir. 1987). But see United States v. Davis 636 F2d 1028 (5th Cir.) (minority court view is that the work-product doctrine protects only documents prepared “primarily or exclusively to assist in litigation”).
- See, e.g., United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006).