IRS Is Denied Work Papers

By JESSE DRUCKER
August 30, 2007; Page A6

The Internal Revenue Service lost a closely watched legal battle when a federal judge in Rhode Island ruled yesterday that the government didn’t have a right to internal tax documents belonging to aerospace and defense contractor Textron Inc.

The IRS and Justice Department had been trying to obtain tax-accrual work papers belonging to Textron. Such papers generally include legal analysis of transactions that could be challenged by the IRS. If companies think there is a chance the IRS might disallow a tax benefit, they set aside — or accrue — a portion of the expected savings. Those papers also could include analysis by lawyers of the transaction’s legal weaknesses, and have been called the blueprint for complicated tax transactions.

In 2001, Textron, which makes Cessna Aircraft, Bell Helicopters and golf carts, bought several telephone networks and a railroad system overseas and then leased them back to their owners, according to a Justice Department court filing. Such arrangements can produce big tax benefits because depreciation can be claimed on the assets to reduce taxable income.

Some leasing transactions that reduce taxes are legitimate, but the IRS has tried to crack down on aggressive ones it calls “sale in, lease out” deals. In 2004, Congress outlawed future so-called SILOs, and the IRS in 2005 said it would begin presuming that past SILO transactions violated tax laws.

As part of an audit of the Textron transactions, the IRS had requested all of the company’s tax work papers for several years. The company had offered to provide the work papers around the SILO transactions, but declined to provide other work papers, arguing that they were covered by privilege.

Communications between lawyers and their clients generally are exempt from scrutiny by adversaries. The IRS had argued it had legal precedent on its side, stemming from a 1984 Supreme Court case that ruled the IRS had a right to tax-accrual documents.

However, U.S. District Court Judge Ernest C. Torres denied the government’s petition to enforce an IRS summons, writing that papers were protected by “work product” privilege, as “the work papers were prepared ‘because of’ anticipated litigation with the IRS.”

He wrote: “[F]orced disclosure of those opinions would put Textron at an unfair disadvantage in any dispute that might arise with the IRS, just as requiring the IRS to disclose the opinions of its counsel regarding areas of uncertainty in the law or the likely outcome of any litigation with Textron would place the IRS at an unfair disadvantage.”

“We’re gratified the court agreed with our position on what we believe is a very important matter of privilege,” said Karen Quintal, a Textron spokeswoman.

The Justice Department litigated the case on behalf of the IRS. When asked if the decision would be appealed, a Justice Department spokesman said, “It’s under review and the department has made no determination what its next step in this matter should be.”

Textron was represented by two prominent tax-controversy lawyers, Arthur Bailey and J. Walker Johnson of Steptoe & Johnson LLP.

The decision “is a very big deal,” said Lawrence Hill, chairman of Dewey Ballantine LLP’s tax-controversy and litigation group. “The IRS is going to have to step back and evaluate its position.”

Textron Chief Executive Lewis B. Campbell is a director of Dow Jones & Co., publisher of The Wall Street Journal.

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