District Court Decision Illustrates Limitations on IRS Summons Power
A recent case in the United States District Court for the District of Delaware, United States v. Veolia Environment North American Operations, Inc., discusses some of the defenses that a taxpayer has to a summons issued by the IRS to a taxpayer to produce documents in the course of an audit. The decision also provides an example of the complex and lengthy nature of discovery in U.S. courts.
Facts of the Case
The taxpayer in this case is a subsidiary of the French conglomerate, Vivendi SA. In 1999 the taxpayer purchased Water Applications & Solutions Corporation (“WASCO”) for $8.2 billion, but seven years later, in 2006, Vivendi concluded that WASCO’s stock was worthless. Taxpayer thereafter engaged in planning to allow it to claim a deduction on its U.S. federal income tax return for the loss it had sustained. This planning included engaging two valuation firms: Aon Accuracy and X Roads Solutions Group LLP as well as the law firm of Cleary Gottlieb Steen & Hamilton. Later in the planning process, a third valuation firm, Duff & Phelps LLC, was engaged.
Taxpayer subsequently implemented a plan to claim a deduction for its stock loss on its 2006 tax return, which was challenged by the IRS. In December 2008 the IRS issued a summons for a variety of documents generated in connection with the planning process. Taxpayer responded to the summons by producing some of the requested documents and withholding 361 documents and portions of 45 other documents asserting these need not be disclosed for the reasons discussed below.
In January 24, 2013 the IRS brought suit in the U.S. District Court for the District of Delaware to enforce the summons and compel the production of the documents withheld by the taxpayer. In April 2013, the district court held a hearing in the case. As a result of that hearing the government agreed to withdraw its request for 178 documents and requested the district court to conduct a review of a sample of 55 documents that was considered representative of the remaining 228 contested documents. The opinion relates to those documents.
Relevant Judicial Rules, Privileges and Doctrines
In withholding the documents requested by the government, the taxpayer relied on (i) the attorney-client and tax-practitioner-client privileges, (ii) the work product doctrine, and (ii) Federal Rule of Civil Procedure (“FRCP”) 26(b)(4)(B) and (C), which protect from disclosure draft reports of an expert witness and expert-attorney communications. Each of these is discussed in more detail below.
The attorney-client and tax practitioner-client privileges
The attorney-client privilege is founded on the common-long right that communications between a lawyer and client are confidential. This privilege is based upon the related premises:(i) that an attorney needs to know all that relates to the client's reasons for seeking representation if the professional mission is to be carried out; "and (ii) that the privilege is necessary "to encourage clients to make full disclosure to their attorneys." The attorney-client privilege applies to communications both from an attorney to a client and from a client to its attorney.
The burden of demonstrating the applicability of the attorney-client privilege falls on the party asserting the privilege. In order to successfully claim the privilege, the asserting party must show each of the following:
- the asserted holder of the privilege is or sought to become a client;
- the person to whom the communication was made (a) is a member of the bar of a court, or his subordinate and (b) in connection with this communication is acting as a lawyer;
- the communication relates to a fact of which the attorney was informed (a) by his client (b) without the presence of strangers (c) for the purpose of securing primarily either (i) an opinion on law or (ii) legal services or (iii) assistance in some legal proceeding, and not (d) for the purpose of committing a crime or tort; and
- the privilege has been claimed and not waived by the client.
With respect to tax advice given by a “federally authorized tax practitioner”, section 7525(a)(1) of the Internal Revenue Code extends to communications between a taxpayer and the practitioner the same common-law protections of confidentiality that apply to a communication between a taxpayer and an attorney to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
Work product doctrine
The work product doctrine dates to 1947 and the Supreme Court decision in Hickman v. Taylor. In that case, the Court protected from disclosure materials prepared by one party "in anticipation of litigation." The documents at issue in Hickman were summaries of witness statements prepared by an attorney prior to trial and sought by the opposing attorney in discovery. The Supreme Court held that both tangible and intangible work product of an attorney, which can be found in "interviews, statements, memoranda, correspondence, briefs, mental impressions, [and] personal beliefs," should be protected.
The work product doctrine was codified in 1970, when Rule 26(b)(3) was added to the FRCP. Thar rule provides:
Ordinarily, a party may not discover documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative (including the other party's attorney, consultant, surety, indemnitor, insurer, or agent). But, subject to Rule 26(b)(4), those materials may be discovered if:
(i) they are otherwise discoverable under; and
(ii) the party shows that it has substantial need for the materials to prepare its case and cannot, without undue hardship, obtain their substantial equivalent by other means.
FRCP 26(b)(3) is not congruent with the work product doctrine announced in Hickman. The rule does not protect intangible work product, which is protected under Hickman, but it does protect work product prepared by non-attorneys.
There is variation among the circuit courts as to the meaning of “in anticipation of litigation.” Most courts apply a "because of" test, which focuses on whether "in light of the nature of the document and the factual situation in a particular case, the document can be said to have been prepared or obtained because of the prospect of litigation." At least one circuit court, however, uses a more restrictive test, which requires that the "primary motivating purpose" behind the creation of a document be to aid in possible future litigation.
Expert reports and communications
In complex litigation, the parties often rely upon experts to prepare reports or provide advice to support their positions. For example, in this case the taxpayer hired three different valuation firms in order to prepare reports or provide arguments to support its position. Discovery of expert witnesses is allowed by the FRCP in order to facilitate the preparation of effective cross-examination and rebuttal testimony, and to make the court's task more manageable through a measured presentation of complex factual issues.
Experts typically prepare reports and may testify at trial; however, some experts are retained to simply serve as consultants in order to assist the attorneys in preparing their case. A party must disclose to the opposing party the experts that it expects to use a trial. This disclosure must be accompanied by a written report of the expert, including a complete statement of all the expert’s opinions, the data considered by the expert in forming his opinions, all supporting exhibits, the qualifications of the expert witness, the compensation paid to the expert witness, and a listing of all cases in which the witness has testified as an expert within the preceding four years and of all publications authored by the witness during the prior 10 years.
In preparation for trial, each party usually will depose its opposition’s experts. Through these depositions, the examining attorney comes to better understand its opponent’s case. During the deposition the examining attorney will often question the expert in an effort to develop weaknesses in its opponent’s case and to induce the expert to make apparently contradictory statements that may be used strategically at trial to impeach the expert’s credibility. A skillful expert may strengthen his client’s case by his responses to the opposing attorney’s questions.
In general, discovery with respect to experts is broad. There are two major exceptions. Communications between the expert and the attorney are protected from discovery. Also, FRCP 26(b)(3)(A) and (B) of the Federal Rules of Civil Procedure protect from disclosure to the opposing party “drafts of any report or disclosure required under Rule 26(a)(2), regardless of the form in which the draft is recorded.” If draft expert reports were discoverable, the opposing attorneys would scrutinize them for statements that could be used to impeach the credibility of the expert at trial. There are limits on this exemption, however. A draft report shown to another expert may be discoverable.
Opinion of the Court
The court first considered two categories of documents: (i) draft reports of testifying experts and (ii) communications with testifying experts. In general, the court found the draft reports of the testifying experts to be protected under FRCP 26(b)(4)(B).
The communications with testifying experts fell into two categories: (i) communications between counsel and the testifying experts, and (ii) communications between non-attorney employees and the testifying experts. With respect to the first category, the court found some documents were protected, but others were not because the taxpayer failed to meet its burden of proof. With respect to the second category, the taxpayer argued that many of the communications with non-attorney employees were prepared “in anticipation of litigation” and were protected by the work product doctrine. The court found that the taxpayer had waived its protection with respect to those documents. The court notes:
By enlisting X Roads and Duff & Phelps as expert witnesses in its litigation with the IRS, Taxpayer has placed them “in a position to serve as a conduit to transmit” either these documents “or at least [their] conclusions” to the IRS; the reason Taxpayer is submitting documents to these experts is the hope that these experts will agree with their content, incorporate them into an expert report and thereby provide taxpayer with an opportunity to persuade the IRS to agree with taxpayer’s position. . . . Consequently, the documents submitted to the testifying experts here lose their work-product protection, unless the protection as otherwise provided by Rule 26(b)(4)(C)”
The taxpayer also argued that the attorney-client privilege or the tax-practitioner privilege applied to certain other documents. The court divided these documents into two categories: (i) communications with attorneys or tax practitioners, and (ii) internal documents the taxpayer claimed reflected legal or tax advice. With respect to the first category of documents, the court generally found that the relevant privilege had not been waived. With respect to the internal documents, the court concluded that with respect to certain documents the taxpayer had met its burden of proof; however, with respect to others the court concluded the taxpayer had not.
Overall, the decision is favorable to the taxpayer. It appears that the taxpayer was generally successful in defending its position with respect to the 55 documents at issue.
 D. Del. No. 1:13-mc-00003 (Oct. 31, 2014). The IRS has a broad authority to request documents under section 7602(a) of the Internal Revenue Code. Upjohn v. United States, 449 U.S. 383, 389. Id. at 390. Matter of Bevill, Bresler & Schulman Asset Mgmt. Corp., 805 F.2d 120, 126 (3d Cir. 1986). In re Grand Jury Investigation (Sun Co.), 599 F.2d 1224, 1233 (3rd Cir. 1979). 329 U.S. 495 (1947). United States v. Adlman, 134 f.3d 1194, 1202 (2d Cir. 1998). United States v. El Paso Co., 682 f.2d 530 (5th Cir. 1982). FRCP 26(a)(2)(A). FRCP 26(a)(2(B). FRCP 26(b)(4)(C). FRCP 26(b)(4)(B).KEYWORD: Tax Contoversy
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