A tax planning memo was privileged and did not have to be disclosed to the IRS, even though 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.
The US appeals court for the 2d circuit overruled a federal district court in November that had ordered the memo turned over to the IRS in a case called Schaeffler v. United States.
Georg 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 appeals court said the memo did not lose protection under the attorney-client privilege when it was shared with the lenders. The privilege is not waived by sharing it with others engaged in a “common legal enterprise.” The enterprise in this case was avoiding a mutual financial disaster. The interests of the parties sharing the information do not have to be perfectly aligned. The parties do not have to be involved in litigation. The tax strategy was central to the restructuring. Information was shared pursuant to a confidential agreement.
Turning to the work-product privilege, the court said there are two ends of a spectrum. At one end is a document that is prepared because of the potential for litigation. At the other end are documents that are prepared in the ordinary course of business and that would have been prepared in largely the same form regardless of litigation.
The court said the memo in this case was “geared to an anticipated audit and subsequent litigation, which was on this record highly likely.”