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January 07, 2009

Tax-Practitioner Privilege

         Guest Author: M. Pilar Honer, Esq., Columbus, Ohio  

 

        In Valero Energy Corp. v. U.S., 102 AFTR 2d 2008-5916, the court held that under I.R.C. §7525 the tax-practitioner privilege did not apply to a law firm's billing sheets, which contrary to the taxpayer's arguments, went in part to non-privileged Canadian tax matters, business advice, and accounting advice.  Fax cover letters, firm engagement letters, and other internal documents were also held to be non-privileged because they did not reveal any confidential communications.  And, while other communications were privileged, the government was still entitled to disclosure to the extent the communications came under I.R.C. §7525(b)'s tax shelter exception to the tax-practitioner privilege. 

           

        The facts of the case are as follows: In 2001 and 2002, in connection with its merger with a Canadian company, Valero Energy Corporation (“Valero”) retained Arthur Andersen LLP (“Andersen”) for U.S and Canadian tax advice and accounting advice.  This advice in turn was used by Valero to enter into a series of transactions with its Canadian subsidiaries that allegedly resulted in approximately $100 million in foreign currency losses, and produced approximately $46 million in U.S federal income tax savings. Suspicious of Valero’s claimed losses, the Service sought to investigate these transactions for possible tax shelters and income tax liability, and issued a summons for which Valero objected to asserting the tax-practitioner privilege.   

            Like the common law attorney-client privilege, the tax-practitioner privilege “protects confidential communications made between clients and their attorneys for the purpose of securing legal advice.” In re A Witness Before the Special Grand Jury 2000-2, 288 F. 3d 289, 291 (7th Cir. 2002).  This privilege covers both communications made by the client to the attorney and statements made by the attorney to the client “where those communications rest on confidential information obtained from the client or where those communications would reveal the substance of a confidential communication by the client.” Rehling v. City of Chicago 207 F. 3d 1009, 1019 (7th Cir. 2000).  But unlike the common law attorney-client privilege, the tax-practitioner privilege is more limited in that the communications must be made (i) for the purpose of obtaining tax advice, (ii) from a federally authorized tax-practitioner, and (iii) must relate to matters within the scope of the practitioner’s authority to practice. 26 U.S.C. §7525(a)(1)(2)(A)(B).  

            In this case, Valero claimed that the tax-practitioner privilege applied to most of Andersen’s fax cover sheets and internal billing records.  The court, however, held that since those documents merely stated vague descriptions of tasks done, titles of projects, and initials of people, they could not reasonably reflect confidential communications between the client and attorney and were held to be non-privileged.  Other documents were held to be non-privileged because they did not relate to U.S. tax matters, but instead related to Canadian tax advice, and business and accounting advice.  

             

The court also held that the engagement letters between Anderson and Valero, and Valero and Diamond were not privileged because (i) some were too general in the descriptions of the work subject matter and (ii) even those that were specific, they did not reveal any contents of communications made by Valero or advice made by Anderson.  Documents that did obtain both privileged and non-privileged matters, the court ordered redacted and produced where feasible.

           

        The court, however, did find that the tax-practitioner privilege applied to communications regarding to Valero’s 2002 transactions that generated its foreign exchange losses and substantial savings in Federal income tax liability.  Nevertheless, the court ordered production of these communications because they fell within the tax shelter exception to the tax-practitioner privilege.  The tax shelter exception applies to communications that (i) relate to a tax shelter, as defined in I.R.C. §6662(d)(2)(C)(ii); (ii) were made by a director, shareholder, officer or employee, agent, or representative of the corporation; and (iii) were made in connection with the promotion of the direct or indirect participation of the corporation or tax shelter.  26 U.S.C. §7525(b).  The party opposing the privilege meets their burden of proof by showing “enough evidence to show some foundation in fact that the exception applies.” BDO Seidman I, 337 F.3d at 810.

 

As to the first element, a tax shelter is defined as “…any plan or arrangement…if a significant purpose of such …is the avoidance or evasion of Federal income tax.” I.R.C. §6662 (d)(2)(C)(ii).  Since only a “color to the charge” must be asserted, the court held that the government made a prima facie showing of an existence of a “plan or arrangement” with evidence of wire transaction documents discovered in Valero’s income tax returns simply referring to numbered “steps”, and Valero representatives’ acknowledgment of the existence of a plan with a number of steps.  As to the second part of the tax shelter definition, that is whether the transactions’ significant purpose was to avoid Federal income tax, the circular nature of Valero’s 2002 transactions convinced the court that avoidance of Federal income tax was a significant purpose. Valero transactions involved transferring $400 million between banks accounts opened for one day were there was no significant risk of loss.  There were also internal documents of Anderson evidencing and referencing to transactions to incur foreign exchange losses.  Valero rebutted arguing that this was not a tax shelter because the transactions had a legitimate business purpose.  The court, however, held that the statute does not require the government to demonstrate that the underlying transaction lacked economic reality or was driven solely or primarily by tax avoidance.  Rather, the government need only show that the communication relates to a plan or arraignment that has a significant purpose to avoid or evade federal income tax.   

            As to the second element, that communications were between a “director, shareholder…employee…representative”, once the government establishes that the communications are privileged, this element is also satisfied.  And the last element, that the communication is made in connection with the promotion of the direct or indirect participation of the tax shelter, the court clarified the word “promotion” and held that it applied not only to communications aimed at selling or marketing tax shelters, but also to communications made by people who organize or assist in organizing the tax shelters.  Therefore, Anderson’s advice as to the tax consequences on the proposed Canadian refinancing transactions was held to “promote” the tax shelter because he assisted in organizing the tax shelter.  Therefore, as a consequence of the limited nature of the tax-practitioner privilege, and the tax shelter exception to the tax-practitioner privilege, Valero was not able to hide a significant amount of communications evidencing its tax shelter simply because they were made by or to Andersen, its attorney.

 Download Valero Energy Corp. v. U.S.

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January 07, 2009

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