A Tax Planning Memo

A Tax Planning Memo

June 11, 2014 | By Keith Martin in Washington, DC

A tax planning memo was not privileged and had to be disclosed to the IRS after the company shared the memo with its lenders.

The memo, written by Ernst & Young, analyzed the tax consequences of a corporate restructuring and weighed the strength of possible IRS challenges.

A federal district court in New York ordered the memo turned over to the IRS in late May in a case called Schaeffler v. United States. The case is now before a US appeals court.

George F.W. Schaeffler owned 80% of a three-tier chain of companies headquartered in Germany that manufacture and distribute bearings and other automotive and industrial components.

The group made a tender offer for shares of Continental AG, another German auto and industrial parts supplier. It expected to acquire less than 50% of the shares, but ended up buying 89.9% at €70 to €75 a share for a total cost of €11 billion. The acquisition closed in July 2008. Over the next seven months, the share price plummeted to €11 a share. The acquisition was financed by a consortium of banks. The falling share price left the Schaeffler group close to insolvency and forced it to refinance the debt and restructure.

Schaeffler hired Dentons and Ernst & Young to help figure out a plan and advise on the tax consequences. The restructuring took place over the period 2009 to 2010. Ernst & Young wrote a long tax planning memo as part of the process.

Schaeffler received a favorable private letter ruling about the transaction from the IRS in August 2010. The favorable ruling did not stop the IRS from auditing the 2009 and 2010 tax years of the company in 2012. The IRS asked for all “tax opinions and tax analyses that discuss the US tax consequences of any or all of steps of the restructuring,” and it issued a separate administrative summons to Ernst & Young directly for “all documents created by Ernst & Young” that relate to the refinancing and restructuring.

Both the company and Ernst & Young responded that the tax memo was privileged.

US tax law recognizes two types of privileges. One is for attorney-client communications about legal matters. Section 7525 of the US tax code extends this privilege to communications between a client and a “federally authorized tax practitioner.” The other privilege is a work-product privilege for documents prepared in anticipation of litigation.

Both privileges may be lost if documents are shared with third parties.

The bank consortium and Schaeffler entered into an “Attorney Client Privilege Agreement” during work on the transaction in which they expressed a desire to share confidential documents and analyses of the transaction without waiving privileges. The Ernst & Young memo was shared with the bank group. The banks agreed to let Schaeffler pay up to €885 million in personal tax liabilities ahead of repaying the debt.

The court said the memo lost any attorney-client privilege when it was shared with the lenders. The privilege would not have been waived if the memo had been shared as part of an effort by the parties to formulate a common legal strategy, but theirs was a commercial interest rather than a common legal interest. An example of a common legal interest is where the parties could become co-parties in litigation.

In contrast, any work-product privilege for the memo was not waived by sharing the memo with the banks. The work-product privilege is waived only “when the disclosure is to an adversary or materially increases the likelihood of disclosure to an adversary,” the court said. The parties took steps to prevent the memo from falling into the government’s hands by marking it confidential and entering into the joint sharing agreement.

However, the court said there was no work-product privilege for the memo since the memo was not prepared in anticipation of litigation.

Schaeffler argued it had good reason to expect an IRS audit and eventual litigation. The memo ran through the transaction steps and their potential tax consequences, but — the court said — there was no discussion of any litigation strategy. It was a transaction memo rather than a litigation memo.

by Keith Martin