The US tax authorities may have the ability to read a lot more internal tax planning memos and e-mails after a decision in February by a US appeals court in Washington.

The court said the fact that a proxy statement filed with the US Securities and Exchange Commission discussed the tax consequences to shareholders of a proposed merger between two companies meant that all internal file memos about the tax consequences of the merger lost any privilege they might have had from disclosure to outsiders.

The decision is important because it means that companies run the risk of having to open their files to the Internal Revenue Service about all transactions for which an offering circular was prepared if the offering circular included a tax analysis of the transaction.

Background

Pioneer Hi-Bred International is a seed company that was acquired by DuPont in October 1999 through a merger. Pioneer had a license agreement giving it the right to use a genetic technology that makes soybeans and canola resistant to a herbicide. Monsanto held the patent for this technology. Monsanto maintained that the license agreement terminated when Pioneer merged into DuPont. The two companies are now fighting over the issue in court.

During depositions in the case, Monsanto asked a Pioneer witness about the tax consequences of the merger with DuPont. The witness refused to answer on grounds that the information was privileged.

Monsanto asked the court in the case to order the witness to answer. It did. Pioneer appealed to the US court of appeals in Washington. The appeals court agreed that the questions had to be answered.

In general, a company can claim information is privileged from disclosure in two situations. One is where the information is legal advice from one’s lawyers. This is called the “attorney-client privilege.” Congress has extended it to tax advice from accountants, but not where the advice involves a tax shelter; the definition of tax shelter was left vague. The other situation where information can be withheld covers work done in preparation for litigation — the “work product privilege.” The idea behind the work product privilege is to prevent opposing counsel from freeloading on information prepared by a company’s own lawyers. However, litigation must have been more than a distant possibility, and it must have been the primary motivating factor for writing the memo.

A company waives any privilege by disclosing information to an outsider.

In this case, Pioneer and DuPont filed a proxy statement with the SEC in connection with the merger. The proxy statement had a standard discussion of the tax consequences of the merger to the Pioneer shareholders. This tax discussion was described in the proxy as representing the joint opinions of Skadden Arps and Fried Frank, the two law firms representing the companies, about the tax consequences.

The court said,

“The disclosure of that advice [from the two law firms] and reliance on that advice waived the attorney-client privilege with respect to all documents which formed the basis for the advice, all documents considered by counsel in rendering that advice, and all reasonably contemporaneous documents reflecting discussions by counsel or others concerning that advice.”

Implications

Under this logic, the IRS would also have access to the same materials.

Most offering circulars in large transactions include a section discussing the tax consequences. The effect of the US appeals court decision will be to force companies behind such offering circulars to open their files about all the tax consequences of the transactions, including internal memoranda and communications with outside advisers.

The most immediate effect is on companies headquartered in the 8th judicial circuit in Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota. The US appeals court in Washington said it was interpreting the law in that circuit because the case was referred by a federal court in Missouri. However, the case should be a warning to everyone to be careful about what one says in writing. The file may be read some day by the IRS.

by Keith Martin and Heléna Klumpp, in Washington