Issues related to privilege for documents prepared related to a tax strategy were the issue decided in the case of United States v. Microsoft Corp. et al., US DC WD Washington, Case No. 2:15-cv-00102.[1]  The case involved Microsoft’s tax liabilities for 2004-2006 and a program that was being considered and then implemented to offset an expected increase in taxes.

The situation was summarized by the Court as follows:

Aware of the impending loss of favorable tax treatment, KPMG LLP (“KPMG”), an accounting firm, recommended that “Microsoft should explore US deferral opportunities taking advantage of the existing manufacturing operations in Puerto Rico.” Dkt. #146-8 at 3. Representing that continuing operations in Puerto Rico would require “[f]ew operational changes” and would provide Microsoft with “expertise in deferral strategies for the US market,” KPMG presented Microsoft with several options for restructuring its Puerto Rico operations to maintain some tax benefit. Id. KPMG also represented that it was the right firm to guide Microsoft through the process as it had “significant experience . . . in the migration of [expiring tax credit benefits] to new deferral structures” and had “successfully negotiated significant tax holidays for U.S. companies with the Puerto Rican government.” Id. at 18.

Central to Microsoft’s options was the use of a cost sharing arrangement. The cost sharing arrangement would allow Microsoft’s Puerto Rican affiliate to co-fund the development of intellectual property and thereby acquire an ownership interest in that intellectual property. Dkt. #143 at ¶ 18. The affiliate could then manufacture software CDs to sell back to Microsoft’s distributors in the Americas. Because some of the intellectual property had already been developed, the Puerto Rican affiliate would need to make a “buy-in payment” to retroactively fund a portion of the development. Id. The transactions would be subject to the arm’s length standard, presenting a balancing act between entering an arrangement that a third party would enter and significantly disrupting or complicating Microsoft’s operations.

Microsoft was interested and retained KPMG to provide “tax consulting services” for a “feasibility phase” which included “modeling the anticipated benefits of the [Intangible Holding Company (“IHCo”)] over a ten-year period.” Dkt. #146-13 at 1-2. The feasibility phase was “to allow [Microsoft] to develop the information necessary to decide whether moving forward with an IHCo structure at this time is an advisable business decision.” Id. at 2.[2]

The IRS became interested in this transaction, believing that it failed the “arm’s length standard” required for such arrangements.[3]  Thus, the IRS requested numerous documents from Microsoft in the examination.

Microsoft objected that certain of these documents were subject to one or more privileges that would bar the IRS from receiving them.[4]  The privileges asserted included a work product privilege, attorney-client privilege and the tax-practitioner-client privilege found at IRC §7525.  Of particular interest to CPAs are the work product and tax practitioner privilege, as work performed by a CPA may, under the proper circumstances, be covered by those privileges.

Work Product Privilege

The work product privilege is summarized in the Court opinion as follows:

The work product doctrine protects documents and tangible things from discovery if they are prepared in anticipation of litigation by a party, or a party’s representative. FED. R. CIV. P. 26(b)(3). Work product protection prevents “exploitation of a party’s efforts in preparing for litigation.” Holmgren v. State Farm Mut. Auto. Ins. Co., 976 F.2d 573, 576 (9th Cir. 1992) (quoting Admiral Ins. Co. v. United States District Court, 881 F.2d 1486, 1494 (9th Cir. 1989)). The court first considers whether the documents were created or obtained “in anticipation of litigation or for trial.” See United States v. Richey, 632 F.3d 559, 567 (9th Cir. 2011) (quoting In re Grand Jury Subpoena, Mark Torf/Torf Envtl. Mgmt. (Torf), 357 F.3d 900, 907 (9th Cir. 2004)). Secondarily, the court considers whether the documents were created or obtained “by or for another party or by or for that other party’s representative.” Id.[5]

The opinion notes that some documents may serve multiple purposes and, in that case, the Court looks to whether the documents were created because of litigation.[6]

In this case the Court found that the papers in question were not created because of litigation, but the very transactions being proposed in the documents is what would lead to the litigation:

Here, Microsoft anticipated litigation because it was electing to take an aggressive tax strategy that it knew was likely to be challenged by the government. From the Court’s perspective, there is a significant difference between planning to act in a legally defensible manner and in defending against an existing legal dispute. The record provides no indication that Microsoft would have faced its anticipated legal challenges if Microsoft had not made the decision to pursue the transactions. Fidelity Intern. Currency Advisor A Fund, L.L.C. v. United States, 2008 WL 4809032 at *13 (D. Mass. April 18, 2008) (“The mere fact that the taxpayer is taking an aggressive position, and that the IRS might therefore litigate the issue, is not enough” to establish work product.”). Even presuming an operational need for the transactions, Microsoft has not provided any reason it could not have planned the transactions in such an unfavorable manner that it was effectively insulated from a tax challenge. Microsoft’s documents were not created in anticipation of litigation. Rather, Microsoft anticipated litigation because of the documents it created.[7]

The Court also found that the documents for which the taxpayer was trying to claim work product privilege did not appear linked to the anticipated litigation.  As the opinion continues:

Microsoft’s arguments to the contrary are further undercut by the relationship between the parties and the actions of the parties. Microsoft indicates that it “hired the best available legal and tax advisors.” Dkt. #143 at ¶ 20. This included Baker & McKenzie, “a well known international law firm that had successfully tried many of the leading transfer pricing cases,” for “tax planning and litigation of [ ] tax cases and transfer pricing disputes.” Id. Microsoft also engaged KPMG “to assist with tax advice.” Id.; Dkt. #144 at ¶ 20 (noting that Mr. “Boyle, a lawyer, made plain that he was hiring KPMG to also help Microsoft prepare its defense to the IRS’s challenge”). But Microsoft gives no indication that KPMG would represent it in the anticipated litigation or that its apparent litigation counsel — Baker & McKenzie — directed KPMG to create any documents necessary to an eventual litigation defense or for use at trial. Torf, 357 F.3d at 907 (focusing on fact consultant was hired by attorney representing the party).[8]

Finally, the Court noted that Microsoft did not appear to treat these documents as ones that would be crucial to its defense in litigation, now claiming to be unable to find certain documents in the class for which it wanted to claim privilege:

Rather, Microsoft represents that it was Mr. Boyle who directed KPMG to prepare materials “in anticipation of an administrative dispute or litigation with the IRS over the Puerto Rican cost sharing arrangement, the pricing of the software sales to Microsoft, and other issues expected to be in dispute relating to those transactions.” Dkt. #143 at ¶ 23. That being the case, the Court finds it odd that Microsoft did not protect many of the records it ostensibly created for this very litigation. Dkt. #145 at 23 (noting that “the United States has discovered through this proceeding that the records of several custodians, including [Mr.] Boyle himself, cannot be located”); Dkt. #146 at ¶ 25. Microsoft, wholly anticipating this dispute would have acted prudently in carefully maintaining the documents it created in anticipation of the dispute.[9]

Tax Practitioner-Client Privilege

IRC §7525(a) provides a limited privilege for tax advice found in a communication with a tax professional of the class authorized to practice before the IRS under Circular 230.  Such practitioners are CPAs, enrolled agents and attorneys and are referred to as “federally authorized tax practitioners” (FATP). 

The general privilege is outlined as follows in the law:

(a) Uniform application to taxpayer communications with federally authorized practitioners

(1) General rule

With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.

(2)Limitations Paragraph (1) may only be asserted in—

(A) any noncriminal tax matter before the Internal Revenue Service; and

(B) any noncriminal tax proceeding in Federal court brought by or against the United States.

However, this privilege does not apply to advice related to the promotion of tax shelters, as defined by IRC §6662(d)(2)(C)(ii).[10]

IRC §6662(d)(2)(C)(ii) defines a tax shelter as follows:

(ii)Tax shelter For purposes of clause (i), the term “tax shelter” means—

(I)a partnership or other entity,

(II)any investment plan or arrangement, or

(III)any other plan or arrangement,

if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.

The opinion notes that this privilege is limited to that which an attorney would have under the more general attorney-client privilege—and there are many situations where that privilege is not applicable:

But section 7525 does not suggest “that nonlawyer practitioners are entitled to privilege when they are doing other than lawyers’ work.” United States v. McEligot, No. 14-CV-05383-JST, 2015 WL 1535695, at *5 (N.D. Cal. Apr. 6, 2015) (quoting United States v. Frederick, 182 F.3d 496, 502 (7th Cir.1999)). Equivalently, communications made primarily to assist in implementing a business transaction are not protected by the tax practitioner privilege. See ChevronTexaco Corp., 241 F. Supp. 2d at 1076-78 (treating FATP privilege congruently with the attorney-client privilege). Rather, and as with the attorney-client privilege, the primary purpose of the communication must be the provision of tax/legal advice.[11]

The opinion notes that making this determination is often not easy, as in the real world it’s often the case that the facts are messy:

The Court’s consideration is inherently messy. See Valero Energy Corp. v. United States, 569 F.3d 626, 630 (7th Cir. 2009) (“Admittedly, the line between a lawyer’s work and that of an accountant can be blurry, especially when it involves a large corporation like Valero seeking advice from a broad-based accounting firm like Arthur Anderson.”). The parties’ broad arguments are often of little help in the consideration of individual documents. Likewise, the limited record before the Court makes it difficult to place each individual record — spanning several years — in its proper context. But the Court also remains mindful that “it is nevertheless the burden of the withholding party to demonstrate that the ‘primary purpose’ was the rendering of legal advice on a document-by-document basis.” Phillips, 290 F.R.D. 615, 631 (D. Nev. 2013) (citing In re Vioxx Prod. Liab. Litig., 501 F. Supp. 2d 789, 801 (E.D. La. 2007)).[12]

The IRS had pointed out that many of KPMG’s documents indicated that the firm was not providing legal advice to Microsoft.  But the Court found that the IRS had read too much into those statements, noting:

The Court was not greatly influenced by the government’s argument — supported by several contemporaneous documents — that KPMG itself represented that it “was not providing legal advice to Microsoft.” Dkt. #145 at 18 (citing to instances). This is too broad a characterization to attribute to the general limitations KPMG placed on its advice. KPMG’s consideration of the complex transactions from the tax perspective obviously did not obviate the need for Microsoft to consider the transactions from additional legal perspectives. The Court has not placed undue weight on KPMG’s admonition that Microsoft should pursue the advice of additional specialists.[13]

But that doesn’t mean that all of KPMG’s advice is going to be covered by the FATP privilege, or that the Court is going to accept the taxpayer’s claim that only such protected advice was involved:

But the Court also is not persuaded by Microsoft’s conclusory argument, supported only by counsel’s declaration, that KPMG provided only tax advice, “not business or non-legal advice.” Dkt. #140 at 19 (citing Dkt. # 141 at ¶¶ 13-14); Dolby Labs. Licensing Corp. v. Adobe Inc., 402 F. Supp. 3d 855, 866 (N.D. Cal. 2019) (“A vague declaration that states only that the document ‘reflects’ an attorney’s advice is insufficient to demonstrate that the document should be found privileged.”) (quoting Hynix Semiconductor Inc. v. Rambus Inc., No. 00-cv-20905-RMW, 2008 WL 350641, at *3 (N.D. Cal. Feb. 2, 2008)). The nature of the advice was no doubt constantly shifting. ChevronTexaco, 241 F. Supp. 2d at 1069 (noting that counsel provided legal advice, assisted with implementation, and addressed legal issues that arose during implementation).[14]

But the Court also notes that, as explained earlier, the law bars from protection advice promoting a tax shelter.  To the extent the Court decides that KPMG’s advice was promoting a tax shelter, the privilege does not apply.

The first issue to be determined is whether the transactions in question were a tax shelter, a question the Court answers in the affirmative:

…[T]he Court finds itself unable to escape the conclusion that a significant purpose, if not the sole purpose, of Microsoft’s transactions was to avoid or evade federal income tax. The government argues persuasively that the transactions served a primary purpose of shifting taxable revenue out of the United States. Microsoft has not advanced any other business purpose driving the transactions and one does not materialize from the record. The only explanation Microsoft attempts is that it entered the cost sharing arrangements to replace annual disputes over its licensing and royalty scheme. But this is not a reason for why Microsoft needed or wanted this arrangement for business purposes. Instead, Microsoft noted favorably that the transaction “should NOT have much impact on how we serve customers” and that, while operational expenses were expected to increase by “$50 million over 10 years,” it would result in “tax savings of nearly $5 billion over 10 years.” PMSTP0000028. With no real impact on how customers were served, the tax savings appears to have driven the decision-making process. Valero, 569 F.3d at 629 (expressing skepticism that “rigamarole” of transactions was necessary restructuring rather than attempt to “avoid paying taxes”).[15]

The second issue is whether the FATP providing the advice (KPMG in this case) was promoting the tax shelter.  If KPMG is not promoting the shelter, then the mere fact the transaction might have been a shelter would not bar the FATP privilege.  But the opinion concludes that, in fact, KPMG was involved in the promotion of this shelter, as the term is used in §7525:

The Court is further left to conclude, after reviewing the records in camera, that all the documents created by KPMG “promoted” the transactions. Other than the unadorned testimony of Mr. Weaver and Mr. Boyle, Microsoft and the record provide no indication that the plans for the transactions originated with Microsoft. Even where testimony is sparse on particulars, the Court does not set it aside lightly. But the record before the Court leads to the conclusion that KPMG originated and drove the structuring of the transactions and that but for its promotion, Microsoft may not have pursued the same or similar transactions. Thereafter, and in furtherance of the transactions, KPMG continued to address possible roadblocks and continued to tweak the transactions to maximize — as far as possible — the revenue shifted while minimizing any operational effects of the restructuring. KPMG’s advice did not, as Microsoft argues, “merely inform a company about such schemes, assess such plans in a neutral fashion, or evaluate the soft spots in tax shelters that [Microsoft] has used in the past.” Dkt. #177-1 at 10 (quoting Valero, 569 F.3d at 629) (quotation marks omitted).[16]

Microsoft argued that such a holding would destroy the FATP privilege, since it is normal for those seeking advice from an FATP to be looking to reduce taxes.

The Court indicates that not all tax reductions are tax shelters—rather, it requires a look into the purpose of a transaction:

But the tax shelter exception turns, at least partly, on the purpose for the transaction. See 26 U.S.C. § 6662(d)(2)(c)(ii). A tax structure may be a permissible method to achieve a legitimate business purpose in one context and an impermissible tax shelter in another. Valero, 569 F.3d at 632 (noting that “[o]nly plans and arrangements with a significant — as opposed to an ancillary — goal of avoiding or evading taxes count” as tax shelters). The Court’s reading is true to the statutory language and does not eliminate the privilege.[17]

The Court also distinguishes the actions of KPMG in Microsoft’s case with that of the tax adviser in the case of Countryside Ltd. Partnership v. Commissioner, 132 T.C. 347:

The Court also is not convinced that its common sense reading of “promotion” conflicts with the statutory privilege. Microsoft relies on Tax Court opinions to argue that Congress did not intend to implicate the “routine relationship between a tax practitioner and a client.” Dkt. #177-1 at 9-10 (citing Countryside Ltd. P’ship v. Comm’r, 132 T.C. 347, 352 (2009); 106 Ltd. v. Comm’r, 136 TC 67, 80 (2011)). From this, Microsoft puts great emphasis on the Tax Court’s conclusion in Countryside that a “FATP was not a promoter, because he ‘rendered advice when asked for it; he counseled within his field of expertise; his tenure as an adviser to the [client] was long; and he retained no stake in his advice beyond his employer’s right to bill hourly for his time.” Dkt. #177-1 at 10-11 (quoting Countryside, 132 T.C. at 354-55). But each case will necessarily turn on its own facts. The Court does not read Countryside as setting forth a static test, but as listing relevant considerations for that case. The existence of a routine relationship between a FATP and a taxpayer is certainly a relevant consideration but should not extend the privilege into the impermissible promotion of tax shelters.[18]

And the Court found a different case more useful in making this promotion call:

In this regard, the Court finds the reasoning of the Seventh Circuit Court of Appeals in United States v. BDO Seidman, LLP instructive. 492 F.3d 806, 822 (7th Cir. 2007). There the court noted the similarities between the crime-fraud exception to the attorney-client privilege and the tax shelter exception to the tax practitioner privilege. Id. In the crime-fraud context, the Supreme Court has indicated that the need for privilege falls away “where the desired advice refers not to prior wrongdoing, but to future wrongdoing.” Id. (quoting United States v. Zolin, 491 U.S. 554, 563 (1989) (emphasis in original)) (quotation marks and citation omitted). Similarly, the Seventh Circuit viewed the tax shelter exception as vitiating the FATP privilege once the privilege no longer served the goals of assuring full disclosure to counsel and compliance with the law. Id.

This reasoning guides the Court’s determination that KPMG strayed into promotion of a tax shelter. As noted previously, the transactions did not appear necessary to satisfy Microsoft’s operational needs. KPMG did far more than flesh out or tweak Microsoft’s preliminary plans where its expertise reasonably permitted it to do so. KPMG worked to make the transaction fit both Microsoft’s existing operations and the relevant tax laws — a task that appeared, at times, to create internal strife. But it did so only to promote Microsoft’s avoidance of tax liability and the Court concludes that all of KPMG’s written communications were “in connection with promotion” of a tax shelter. 26 U.S.C. § 7525(b).[19]

The opinion concludes, noting:

While Congress has provided for certain communications to be treated as privileged, the privilege is not absolute. Where, as here, a FATP’s advice strays from compliance and consequences to promotion of tax shelters, the privilege falls away.[20]

[1] United States v. Microsoft Corp. et al., US DC WD Washington, Case No. 2:15-cv-00102, January 17, 2020 https://ecf.wawd.uscourts.gov/doc1/19718938558 (Pacer registration required, retrieved January 22, 2020)

[2] United States v. Microsoft Corp. et al., pp. 2-3

[3] United States v. Microsoft Corp. et al., p. 1

[4] United States v. Microsoft Corp. et al., p. 4

[5] United States v. Microsoft Corp. et al., p. 5

[6] United States v. Microsoft Corp. et al., p. 5

[7] United States v. Microsoft Corp. et al., p. 6

[8] United States v. Microsoft Corp. et al., pp. 6-7

[9] United States v. Microsoft Corp. et al., p. 7

[10] IRC §7525(b)

[11] United States v. Microsoft Corp. et al., p. 12

[12] United States v. Microsoft Corp. et al., p. 13

[13] United States v. Microsoft Corp. et al., pp. 13-14

[14] United States v. Microsoft Corp. et al., p. 14

[15] United States v. Microsoft Corp. et al., p. 16

[16] United States v. Microsoft Corp. et al., pp. 17-18

[17] United States v. Microsoft Corp. et al., p. 17

[18] United States v. Microsoft Corp. et al., pp. 17-18

[19] United States v. Microsoft Corp. et al., pp. 18-19

[20] United States v. Microsoft Corp. et al., p. 19