March 27, 2007
Protecting against inadvertent and unintended disclosure of sensitive documents has long been an issue faced by in-house corporate counsel. With the advent of FIN 48, protecting sensitive tax materials takes on critical importance.
FIN 48 requires companies with GAAP-compliant financial statements to prepare an inventory of their uncertain income tax positions and subject each issue to a detailed analysis. That analysis includes a written assessment of specific strengths and weakness, and a quantification of likely outcomes. The FIN 48 inventory of tax positions will provide the IRS and other taxing authorities with an audit “roadmap” of issues to examine. That roadmap, coupled with the analytical memorandum prepared for each such tax position, will almost certainly prejudice the Company’s ability to compromise should such tax positions be challenged on audit. Indeed, if the IRS has in its hand a memorandum indicating that the Company believes it has a 55% likelihood of success in defending a tax position, it is difficult to imagine that the IRS would accept anything less 45% of the tax benefits associated with the issue in settlement; and likely would demand more. The Company may find itself in the untenable position of negotiating against its own internal analyses. Many expect State and local taxing authorities to begin examining these documents as well.
How then, can a company best protect its FIN 48 analyses from falling into the hands of the IRS and other taxing authorities? How, in other words, can these documents be kept confidential?
The answer is not easy, and business exigencies may ultimately force the Company to disclose FIN 48 workpapers to the IRS. There are, however, steps that may be taken to protect those records, keep them as confidential as possible, and most importantly control the flow of information to the IRS. If the appropriate steps are taken now to address this important issue, it may be possible to keep highly damaging and sensitive analyses out of the hands of the IRS and other taxing authorities.
First, and foremost, the Company should take care to make sure that the analyses are eligible for the attorney-client privilege from the beginning. As companies begin their FIN 48 compliance, they must ensure that appropriate safeguards are in place to protect whatever privilege may attach. That care must be exercised now; for if the analysis is prepared outside the intimacy of the attorney-client relationship, or later shared outside of the attorney-client relationship, privilege will likely be lost. Contrary to popular belief, privilege is not a litigation issue; failure to create and protect privilege is the litigation issue. Only if care is taken now can privilege be created and protected.
Second, our experience with FIN 48 thus far has shown that as a Company’s internal review of its tax positions progresses, certain particularly troubling issues present themselves. These issues appear headed towards litigation and the need to protect the Company’s internal litigation assessment and risk analysis of these issues becomes paramount. In the event that the Company can establish that these especially troubling tax positions will likely lead to litigation, the Company should consider taking these tax positions outside the “regular” course of its internal FIN 48 review and have them analyzed by litigation counsel. It may be possible to protect litigation assessments in their entirety if they are conducted on a separate track to the traditional FIN 48 analysis. It may even be possible to share the results of those separate litigation assessments with the Company’s financial auditors at a later date without having to thereafter disclose them to the IRS or other taxing authorities. Careful planning, including confidentiality agreements which cover all such limited disclosures to financial auditors, is critical to this process.
Ultimately, companies want to ensure that before engaging in their FIN 48 analyses, they have implemented privilege protocols that give them the best opportunity at safeguarding their FIN 48 analyses. Careful adherence to properly designed protocols may permit the company to maintain its FIN 48 analyses in confidence; and almost certainly will permit the company to control when, where, and how any necessary disclosures take place.
In the past few months, McGuireWoods LLP, in conjunction with the corporate counsel section of various Bar Associations, has presented a number of seminars on this important topic. If you are interested in obtaining the course materials from those seminars, please contact a member of McGuireWoods Tax Litigation Group.
If you would like more information on this important issue, contact Douglas W. Charnas or the other members of the Tax Litigation Group: Michel P. Cassier, Craig D. Bell, Brian C. Bernhardt or Peter G. Stathopoulos.