Tax Accrual Workpapers

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Institute of International Bankers Annual Tax
Seminar
Tax Accrual Workpapers

• Issues and Developments

Other Hot Topics for Financial Institutions
Panelists Walter Harris Director, Financial
Services Industry Large Mid-Size Business
Division Internal Revenue Service
Moderator John Gallagher UniCredit Markets
Investment Banking
Raj Madan McKee Nelson LLP
Todd Simmens Ernst Young
June 25, 2008
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Overview

• Current IRS policy regarding TAW
• Update on IRS policy regarding TAW
• Recent developments surrounding taxpayers
  ability to protect TAW
• Other hot topics for financial institutions
• Financial institutions relationship with the IRS
• FTC generator transactions and the IRS response
• Withholding tax issues
• Emerging issues

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Defining Tax Accrual Workpapers

• Tax Accrual Workpapers created by taxpayers for
  purposes of evaluating the strength of the
  positions taken on their tax returns.
• TAW may contain
• Legal analyses probing each positions strengths
  and weaknesses
• Detailed roadmaps of the taxpayers position
• Contingency reserve analysis

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Defining Tax Accrual Workpapers (cont.)

• The Internal Revenue Manual defines TAW as
• Tax accrual workpapers typically include
  determinations and related documentation of
  estimates of potential or contingent tax
  liabilities related to tax positions taken by the
  taxpayer on certain transactions. In addition,
  there may be an audit trail and/or complete
  explanation of the transactions. There may also
  be information on whether there was reliance on
  outside legal advice an assessment of the
  taxpayers position and potential for sustention
  references to promotional materials and comments
  on unwritten agreements, confidentiality
  agreements, restitution agreements, contingency
  fees, expectations, and other material facts
  surrounding the transactions. The workpapers may
  include documents written by the taxpayers
  employees and officers describing or evaluating
  the tax strategies. The scope and quality of the
  workpapers will vary. See I.R.M. 4.10.20.2(2).

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The IRS Policy of Restraint

• IRS maintains an unqualified right to TAW.
• IRS will request TAW in two cases
• Unusual circumstances.
• When the taxpayer has engaged in a listed
  transaction.
• Unusual circumstances exist when
• An issue has been identified by the examining
  agent.
• There are missing facts.
• The examining agent has exhausted other
  reasonable avenues for developing the facts.

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IRS TAW Policy Listed Transactions

• If the taxpayer has engaged in a listed
  transaction
• Before Feb. 28, 2000, the unusual circumstances
  policy still applies.
• Between Feb. 28, 2000 and Jul. 1, 2002, the IRS
  will request TAW for listed transactions that
  were not disclosed.
• After July 1, 2002, the IRS will request TAW for
  listed transactions even if they were properly
  disclosed.
• If disclosed, the request is limited to
  workpapers relating to the transaction in the
  year under examination.
• If not disclosed, the request will be for all
  workpapers for the year under examination and
  workpapers for years not under examination may
  also be requested.

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Recent Developments Disclosure of TAW to
Auditors

• To receive unqualified approval of financial
  statements, companies must often disclose TAW to
  their auditors.
• Additionally, the AICPA requires auditors to
  obtain tax opinions if a client relies on the
  opinion in a material matter. Interpretation of
  AU 9326.
• Two recent cases show that courts may consider
  TAW protected by the work product doctrine even
  if disclosed to auditors.
• United States v. Textron Inc., 507 F.Supp. 2d 138
  (D. R.I. 2007).
• Regions Financial Corp. v. United States, 2008 WL
  2139008 (N.D. Ala.).

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Textron the Work Product Doctrine

• Facts
• The IRS issued a summons for all of Textrons TAW
  for the 2001 tax year because the IRS determined
  that Textron had engaged in a SILO listed
  transaction.
• Textron had been to IRS Appeals in seven of its
  last eight audit cycles. Textron litigated three
  issues during this period.
• Two Textron officials testified that its TAW were
  created for purposes of establishing an adequate
  reserve with respect to any potential disputes or
  litigation.
• The TAW contained opinions of counsel and
  accountants regarding items that might be
  challenged, estimated hazards of litigation
  percentages, and calculations of reserve amounts.
• Textrons auditor was allowed to examine the TAW,
  but the information was to be treated as
  confidential.
• In addition to other arguments, Textron claimed
  its TAW were protected by attorney-client
  privilege, 7525, and the work product doctrine.

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Textron (cont.)

• Work Product
• The IRS argued that Textrons TAW was not work
  product because
• Textrons TAW was not created in anticipation of
  litigation, but rather in the ordinary course of
  business for purposes of obtaining an unqualified
  audit opinion.
• Textron waived its work product protection when
  it disclosed its TAW to an adverse party its
  independent auditor.
• The court first determined that the
  attorney-client privilege, 7525 tax
  practitioner privilege, and work product doctrine
  applied to Textrons TAW.
• Next, the court held that the attorney-client and
  7525 privileges had been waived because Textron
  shared its TAW with its auditors.

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Textron (cont.)

• The courts work product holding
• Textron would not have created the TAW but for
  its anticipation of litigation with the IRS.
• The court noted that there would have been no
  reason to prepare the workpapers or calculate a
  reserve at all but for the reasonably anticipated
  litigation with the IRS.
• Textrons litigation fears were well-founded
  given its past experience.
• Work product was not waived by disclosure to
  Textrons auditors because the disclosure did not
  substantially increase the IRSs opportunity to
  obtain the information contained in the TAW.
• The court noted that
• The auditor had an obligation under the AICPA
  code to maintain confidentiality.
• The taxpayer and auditor had a confidentiality
  agreement in place.
• The auditor was not a potential adversary of the
  taxpayer.

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Regions Financial the Work Product Doctrine

• Facts
• The IRS determined that Regions had engaged in
  two listed transactions in 2002 and 2003. The
  IRS issued a summons to Regions auditor
  requesting all workpapers.
• Regions instructed its auditor to withhold twenty
  documents as privileged. Over 260,000 pages were
  produced.
• The twenty documents withheld consisted of what
  the court labeled Core Documents and
  Derivative Documents.
• The four Core Documents contained opinions,
  evaluations of legal theories and analyses of
  potential IRS attacks on the transactions. Each
  of the Core Documents were created at the
  direction of Regions general counsel. Regions
  general counsel testified that he only becomes
  involved in analyzing tax liabilities if
  litigation is likely to result from a position
  taken on Regions return.
• The Derivative Documents discuss, quote or
  explain the Core Documents.

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Regions (cont.)

• Regions moved the court to quash the IRS summons
  for its TAW with respect to the twenty withheld
  documents because those documents were protected
  by the work product doctrine.
• The IRS argued that Regions TAW were not
  protected by the work product doctrine because
• Regions TAW were not created in anticipation of
  litigation.
• The IRS argued that Regions TAW were created for
  purposes of establishing a tax reserve that
  adequately reflected Regions contingent
  liabilities. Such a reserve and the underlying
  workpapers were necessary to getting an
  unqualified audit opinion.
• Regions waived any work product protection it
  might have had when it disclosed its TAW to an
  adverse party Regions independent auditor.

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Regions (cont.)

• Courts holding
• Relying in part on Textron, TAW were created in
  anticipation of litigation under either the
  because of litigation test or the primary
  motivating purpose test.
• The court stated, were it not for anticipated
  litigation, Regions would not have to worry about
  contingent liabilities and would have no need to
  elicit opinions regarding the likely results of
  litigation.
• According to the court, litigation need not be
  imminent, but merely a possibility at the time
  the relevant documents were created.
• Regions subjective believe that it might be
  forced to litigate with the IRS was not
  objectively unreasonable.
• Regions did not waive its work product protection
  because the auditor was not an adverse party.
• There was no conceivable scenario under which
  the auditor would file suit against Regions as a
  result of its disclosure of TAW to the auditor.

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FIN 48 Overview

• FIN 48 requires companies to undergo a two step
  process prior to recognizing a tax benefit in
  financial statements
• Is it more likely than not that a position will
  be sustained?
• How much benefit can be recognized?
• These two analyses are generally performed and
  maintained in a companys tax accrual workpapers.
• FIN 48 also requires companies to disclose the
  amount of their unrecognized tax benefit (tax
  reserve).
• These disclosures of aggregate reserve levels
  have proven to be largely innocuous from an IRS
  roadmap perspective.

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Does FIN 48 Weaken TAW Work Product Claims?

• Does the requirement that all companies prepare
  TAW for financial accounting purposes mean that
  taxpayers are no longer preparing TAW in
  anticipation of litigation?

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Does FIN 48 Strengthen TAW Work Product Claims?

• The recognition step of the FIN 48 analysis
  requires that a taxpayer determine whether or not
  they are more likely than not to have their
  reporting position sustained.
• This is a direct litigation assessment, which may
  strengthen a claim that the TAW were prepared in
  anticipation of litigation.
• FIN 48s requirement that aggregate tax reserve
  figures be publicly reported arguably diminishes
  the IRS need for TAW.

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Hot Issues for Financial Institutions

• Relationship between the IRS and financial
  institutions
• FTC generators
• Withholding tax issues
• Emerging issues