Thursday, January 24, 2013

Deja Vu All Over Again (1/24/13)

The U.K. Supreme Court held that "Advice by accountants cannot be kept secret in the same way that legal counsel is confidential."  See Estelle Shirbon, Tax advice not secret like legal counsel, UK court rules (Reuters 11/23/13), here.

I use the famous Yogi Berra quote (Wikipedia entry here) as the title of this article, but the U.S. has been through this fight before and reached the same result.

I offer the following on the U.S. rule from the most recent draft of my Federal Tax Procedure book (footnotes omitted):

The Courts have resisted expanding the common-law privileges that are available even when strong policy arguments are made that privileges should be available.  Courts thus routinely reject the existence of an accountant/client privilege even though one may exist under state law.  Couch v. United States, 409 U.S. 322 (1973).  In United States v. Arthur Young & Co., 465 U.S. 805 (1984), the IRS issued a summons to the taxpayer's independent certified public accountants to obtain the information and documents behind the tax reserve reported on the taxpayer's certified financial statements.

At this point, I should explain generally the jargon that helps explain the law and IRS policy and practice in this area.  Publicly held companies prepare and file public financial statements that report the financial results of their operations for a period.  The financial statements include a profit and loss statement for a period (a year period for the major filings), as well as an ending balance sheet, and extensive notes to assist in making the statements comprehensible.  In reporting a result for the period, a company must accrue liabilities that arose during the period and, on the ending balance sheet, must show any accrued but unpaid liabilities.  Under financial accounting standards, reserves for federal income tax liabilities must be accrued and reserved in certain cases.  Specifically, with respect to tax planning that might otherwise be reflected as a benefit on the financial statements, reserves must be accrued to reflect the probability that the benefits may not be ultimately sustained.  In making a decision whether and how much to reserve for such unpaid potential liabilities, a company internally will prepare workpapers that back up its decisions.  Similarly, when the independent auditor then attests the financial statements, the auditor prepares audit workpapers that back up the attestation.  The company’s and the auditor’s workpapers underlying that type of liability or reserve are called “tax accrual workpapers” or some variation of that term.  The tax accrual workpapers should be distinguished from the “tax reconciliation workpapers” which reconcile the financial reporting to the tax return.  The tax reconciliation workpapers are not audit workpapers, because they are not prepared by the company in making the financial statements or by the independent accountants in attesting them.

 The tax accrual workpapers should provide the detail behind the tax reserve on the audited financial statements and thus identify the taxpayer's material risky tax positions.  Particularly since the combination of the Enron/Worldcom scandals and the abusive corporate tax shelters, companies preparing and independent accountants attesting company financial statements are paying greater attention to tax accrual work papers.  Those workpapers could be the “mother lode” for IRS auditors, providing a much easier roadmap for audit.  Although not presaging these developments, the accountants in Arthur Young argued that they should have a privilege from disclosing such information and documents because of the importance of certified financial statements to the market economy.  Denying a privilege, they urged, would result in important information being withheld from the auditors and the quality of and public confidence in financial statements would suffer, with potential dramatic impact on public markets.  In other words, the accountants urged, there were countervailing public policy arguments for allowing a privilege in this limited situation even if there were federally recognized accountant/client privilege generally.  The Supreme Court rejected the argument, simply because the courts could not create a new privilege not allowed at common law or allowed by Congress.

Although Arthur Young was a taxpayer defeat in the Supreme Court, I commend the case to you for two reasons.  First, it illustrates the lawyers' creativity in urging a new privilege with some degree of success before the Supreme Court.  The Supreme Court does not take many tax cases, so success prior to that stage is usually the end of the matter.  Second, it illustrates that despite a seeming loss in Court, the policy arguments made can still have an impact in administrative practice.  An IRS agent concerned about efficiency could simply take Arthur Young at face and routinely request or summons the tax accrual workpapers as the first order of business in an audit.  The audit plan and resulting audit would be far more efficient.  On the other hand, as the taxpayers' lawyers urged in Arthur Young, that easy access would discourage corporate taxpayers from making adequate disclosures to their public auditors and the public market system would be negatively impacted because the quality of financial statements would suffer.  The IRS realized that, should it exploit its victory in Arthur Young by routine access to the tax accrual workpapers, Congress might well act to take away its victory if it felt the public markets would be negatively impacted.  Accordingly, the IRS has adopted policies exhibiting considerable restraint with respect to tax accrual workpapers.

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