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Case Alert: Work product rule protected taxpayer’s documents, but attorney-expert rule did not

In Veolia Environmental North America Operations, Inc., (DC DE 10/25/2013) 112 AFTR 2d ¶ 2013-5434, a district court has held that certain documents that a U.S. holding company refused to produce in response to an IRS summons were protected by the work product rule. However, it ruled that other of the taxpayer’s documents were not protected by the attorney-expert communications rule.  This is a good case to review as it analyzes and discusses the interplay of the attorney-client privilege, the work product rule, and the attorney-expert communications rule.

Background on work product rule.  Federal Rule of Civil Procedure 26(b)(1) provides that “[p]arties may obtain discovery regarding any nonprivileged matter that is relevant to any party’s claim or defense.” The work product exception to this disclosure requirement is set forth in Rule 26(b)(3)(A), which states: “Ordinarily, a party may not discover documents … that are prepared in anticipation of litigation or for trial by or for another party or its representative.” This work product doctrine functions to “promote… the adversary system” by guarding the confidentiality of documents prepared in anticipation of litigation, allowing a party to prepare for litigation without fear that its work product will be used against it. (Hickman v. Taylor (1947), 329 U.S. 495) Work product protection is limited to documents actually prepared in anticipation of litigation and does not apply to materials assembled in the ordinary course of business. (Rule 26(b)(3))

“Only by looking to the state of mind of the party preparing the document, or … the party ordering the preparation of the document” can the Court determine if a document comes within the scope of Rule 26(b)(3) protection. (Martin v. Bally’s Park, (CA 3 1993) 983 F.2d 1252) In addition to showing the appropriate subjective intent, a party withholding a document on the basis of work product protection must also show that the anticipation of litigation was objectively reasonable.

Background on attorney-expert communications rule.  Federal Rule of Civil Procedure 26(a)(2)(B)(ii) mandates the disclosure of all “facts or data considered by” an expert witness retained or employed to provide expert testimony in forming opinions the witness will express. However, subject to three exceptions that are not relevant here, Rule 26(b)(4)(C) protects communications between the party’s attorney and any expert witness required to provide a report under Rule 26(a)(2)(B)

Background on pre-filing agreement program.  The pre-filing agreement (PFA) program is an IRS program designed to permit a taxpayer to resolve the treatment of an issue before the filing of a return.

Facts. Veolia Environmental North America Operations, Inc. (Taxpayer) is a U.S. holding company owned by Veolia Environment. In ’99, Taxpayer purchased Water Application & Solutions Corporation (WASCO) for $8.2 billion.

In 2006, Taxpayer had come to the conclusion that its investment in its WASCO’s stock was worthless. It retained legal advisors and tax experts to identify a means by which it could claim WASCO’s stock as a $4.5 billion deduction under Code Sec. 165(g)(3) (worthless securities in affiliated corporations). At some point in 2006, Taxpayer decided that converting WASCO to an LLC could be a viable “trigger” for claiming the deduction.

By Mar. 23, 2006, Taxpayer had retained counsel to provide tax advice regarding the worthless stock deduction and about how to best prepare its case. Thereafter, Taxpayer sought and obtained a private letter ruling from IRS interpreting Code Sec. 165(g). In the fall of 2006, Taxpayer hired two valuation firms to evaluate and produce written reports on WASCO’s insolvency. On Dec. 18, 2006, the Boards of Directors of WASCO and Taxpayer met and authorized the companies to pursue the claim. On Dec. 22, 2006, WASCO was converted to an LLC. In February of 2007, Taxpayer -already under audit by IRS forr its 2004 and 2005 returns – applied for and subseqquently enrolled in IRS’s PFA program.

IRS sought numerous documents created in 2006 and thereafter, including certain documents that contained communication of data used by the valuation firms, that had been provided to the valuation firms by entities other than Taxpayer. Taxpayer refused to provide several of the documents.

Taxpayer prevailed on the work product exception issue. The issue with respect to Taxpayer’s assertion of work product protection was: when did Taxpayer anticipate litigation with IRS relating to the $4.5 billion stock deduction? Taxpayer contended that it anticipated litigation as early as March 2006, “when it began to plan in earnest for the potential IRS dispute” by hiring outside counsel to analyze the legal ramifications of the potential tax write-off. Taxpayer asserted that it took this action because “it was essentially provoking a dispute with IRS by choosing to claim a $4.5 billion worthless stock deduction.”

IRS argued that Taxpayer failed to show that it anticipated litigation because Taxpayer’s ordinary business activities involve “acquiring, managing, and divesting operating companies,” such as WASCO, including with the goal of restructuring companies in order to derive tax benefits. In that light, IRS said, WASCO’s conversion to an LLC and Taxpayer’s worthless stock deduction were the types of business actions Taxpayer regularly undertakes.

The court found that Taxpayer anticipated litigation at least as early as March 2006.  It noted that Taxpayer sought the valuation reports because of the prospect of litigation with IRS, believing that an IRS audit was probable. This was also the reason Taxpayer retained outside counsel and chose to seek , and obtained, the private letter ruling. It was also the reason Taxpayer applied to participate in the IRS PFA program, a program intended to address “issues that are likely to be disputed in post-filing audits.” (Rev Rul 2005-12, 2005-1 CB 311) Thus, Taxpayer subjectively anticipated litigation.

Taxpayer’s expectation of litigation was objectively reasonable, particularly given the sheer size of the deduction  -$4.5 billlion – and the fact that Taxpayer was alreaady under audit by IRS for its prior year returns. The Court cited Roxworthy (CA 6, 2006), 98 AFTR 2d 2006-5964, a case that found it reasonable for a taxpayer to anticipate litigation based on the size of transactions and likelihood of IRS challenge.

The court also said, even if it were to agree with IRS’s contention that the conversion of WASCO and the worthless stock deduction were transactions of a type Taxpayer undertakes in the ordinary course of its business, that fact, under the circumstances here, did not deprive Taxpayer of the opportunity to meet its burden to show that it anticipated litigation would arise from these particular transactions. Importantly, it said, there was no evidence that the conversion of WASCO to an LLC was undertaken for any purpose other than to enable to Taxpayer to recognize a $4.5 billion loss on its tax return and then litigate with IRS over the legitimacy of that deduction.

IRS prevailed on the attorney-expert communications issue.  In agreeing with IRS on the attorney-expert communications issue, the court said that Rule 26(b)(4)(C) only protects “communications between the party’s attorney” and that party’s testifying expert. Communications of facts that the expert considered in forming the opinions to be expressed, that were provided to the expert by sources other than the party’s attorney, are not protected by Rule 26(b)(4)(C).

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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