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Foreign Records Exception – 2nd Circuit Remands

Yesterday, the Second Circuit remanded a case involving foreign bank records for further development.  In U.S. v. Natalio Fridman, the taxpayer asserted his act of production privilege over certain foreign bank records demanded by an IRS summons.  The District Court held that such records must be produced based on the foregone conclusion doctrine, the collective entity doctrine, and/or the required records exceptions to the Fifth Amendment’s protection.  The Second Circuit found that the record was insufficient to allow meaningful Appellate review of these rulings, and remanded this portion of the case for further development.

This case is important in that it will again examine whether a taxpayer is compelled to produce foreign bank records that may be incriminating under the required records exception.  If the summons is ultimately upheld for those records falling within the 5-year record retention requirement of the required records exception, any remaining records falling outside of that timeframe may need to be analyzed under the forgone conclusion and collective entity doctrines, which were raised by the government.  If the case proceeds in this manner, it will be interesting to see how those doctrines will be applied to foreign bank records involving a trust structure, in yet another foreign bank record production case.


Is the Yates Memo Impacting Internal Investigations? The Importance of Individual Representation

Since it’s release more than ten months ago, the so-called Yates Memo has stirred up its fair share of commentary. The memo, which requires prosecutors to pursue – and companies seeking cooperation credit to identify – individual bad actors, generated concern that the new requirement would make investigations more difficult and even discourage companies from cooperating at all. Now that the Yates Memo is coming out of its infancy, some report that employees are more nervous about cooperating with corporate counsel, and requesting personal legal representation much earlier in the process, such that investigations are, in fact, becoming more challenging and more costly. Others, however, report seeing less of an impact and do not perceive the Yate Memo as (at least as of yet) having had the dire consequences that were feared.

Even with this divide, there seems to be agreement on at least one thing: the Yates Memo has highlighted – and perhaps increased – the need of individual representation in corporate investigations. Cooperation of in-house employees is important to corporate counsel’s ability to conduct a thorough and objective investigation. Since the Yates Memo, companies and their employees are more aware of and sensitive to the possibility that prosecutors will pursue individuals suspected of wrongdoing. It is a tense dynamic, but one that can be allayed by providing employees with individual representation. This has long been a good practice of companies and their corporate counsel, and while it does increase costs, in a post-Yates Memo world, it can go along way toward reassuring employees that their personal interests are being taken into account and foster internal cooperation that will, in turn, help the company pursue its goals.

Next Up: Singapore? Summonses Could Hit More Global Financial Institutions

A recent summons showdown with UBS shows that DOJ and the IRS are far from done with offshore enforcement efforts, and are expanding those efforts beyond Europe Among the most likely of new targets is Singapore, and since there is no Tax Information Exchange Agreement (TIEA) or other tax treaty between the United States and Singapore, foreign financial institutions could see IRS summonses being served on their U.S. branches.

Such summonses often are referred to as Bank of Nova Scotia summons. In the recent case involving UBS, the IRS served a third-party summons on a branch of UBS AG in the United States seeking records for an account at UBS in Singapore held by a U.S. citizen living in Hong Kong UBS refused to turn over the records on grounds that Singapore’s bank secrecy laws prohibited disclosure without permission from the accountholder. The IRS sought to enforce the summons in federal court – and the case was teed up for litigation – until the accountholder consented to release of the records and UBS complied with the summons. The IRS thereafter withdrew the enforcement action.

We cannot know whether UBS or the government ultimately would have won the day in court. Many factors are taken into consideration in such enforcement actions, and past cases have had varied results. What we do know is that the government maintains the summons served on UBS was enforceable, and was willing to go the distance. With Singapore – and potentially other jurisdictions without TIEA’s or tax treaties – on the enforcement horizon, more global financial institutions are likely to see IRS summonses coming their way.

Circuit Split In Summons Procedures

As part of the examination process, the IRS has wide latitude to obtain documents, records, or other information from a taxpayer.  The IRS normally requests and receives information informally.  Other times, however, the IRS resorts to a more forceful tact—an administrative summons.  This approach has teeth, as the federal district courts have statutory authority to compel compliance.

To have a summons enforced in federal district court, the IRS generally must satisfy four prima facie requirements established fifty years ago by the Supreme Court in United States v. Powell.  Those requirements are: (1) the investigation must be conducted for a legitimate purpose; (2) the summons must be relevant to that purpose; (3) the IRS must not already have the information sought; and (4) the IRS must have followed the administrative steps required by the Internal Revenue Code.

Recently, in Jewell v. United States, the Court of Appeals for the Tenth Circuit focused on the fourth requirement.  Code section 7609(a)(1) provides special administrative procedures for third-party summonses (e.g., the IRS summons person A regarding person B).  One of these specified procedures provides that “notice of the summons shall be given to any person identified [person B in the example above] . . . no later than the 23rd day before the day fixed in the summons as the day upon which such records are to be examined.” (emphasis added).  In Jewell, the government admitted that the taxpayer had not received the statutorily-prescribed notice.  Thus, as the Tenth Circuit phrased it, “[t}he resulting question is whether we are free to disregard the statutory requirement.”

The Tenth Circuit’s inquiry focused first on the interpretation of the section 7609(a)(1) 23-day notice requirement.  Was notifying the taxpayer mandatory?  The Tenth Circuit rejected the government’s arguments to the contrary, concluding that Congress intended to require mandatory notice.  The court noted that the authority cited by the government “did not disturb the age-old precept that ‘shall’ means ‘shall'”.

The Tenth Circuit’s inquiry then focused on whether the notice requirement was an “administrative step” under Powell.  Looking at the common meaning of the term, the court concluded that the 23-day notice provision was an administrative step, as contemplated by Powell.  The court concluded that the summonses at issue should be quashed.

Although the 23-day requirement and the Powell requirements both seem rather straightforward—and we agree that the Tenth Circuit is correct—the Tenth Circuit’s opinion created a circuit split.  As the court acknowledged, five other circuit courts have declined to apply Powell in the same manner.  The First Circuit has acknowledged that the IRS must comply with all required administrative steps, but allowed enforcement of a summons where only 21 days of notice was provided.  The Second, Sixth, and Eleventh Circuits are willing to excuse the notice defect where the taxpayer is not prejudiced.  And the Fifth Circuit has allowed enforcement of a summons to avoid elevating “form over substance.”

With such disparate approaches being taken by different circuits, this issue could find its way to the Supreme Court next term.

Anticipate Litigation, Check. Anticipate Communications Between a Testifying Expert and Parties Other than the Taxpayer or the Taxpayer’s Attorney, Ch…Wait, What? To Involve Counsel, Or Not To Involve Counsel Is the Question.

Taxpayers continually find themselves facing decisions that will end up being scrutinized during future IRS examinations, and courts have repeatedly found that such concern, coupled with other factual indicia, can satisfy the “anticipation of litigation” requirement for work product protection under Federal Rule of Civil Procedure (“FRCP”) 26(b)(3).  (For a seminal case on this topic, please see United States v. Adlman, 134 F.3d 1194 (2d. Cir. 1998)).  The U.S. District Court for the District of Delaware recently grappled with this issue in a Government action to enforce several IRS summonses related to an examination of a $4.5 billion worthless stock deduction claimed by Vivendi S.A.’s U.S. subsidiary, Veolia Environment North American Operations, Inc. (the “Taxpayer”), during the 2006 tax year. See United States v. Veolia Environment N. Am. Operations, Inc., D. Del., No. 1:13-mc-03 (Oct. 25, 2013).  The taxpayer previously provided 600,000+ pages of bates-stamped documents to the Government in response to more than 25 summonses and hundreds of Information Document Requests during the examination of the Taxpayer’s 2004-2006 tax years.  Approximately 300 withheld documents remained at issue.

In Veolia, the Court found the Taxpayer adequately established their anticipation of litigation during the transaction’s 2006 planning stages.  The Court was specifically persuaded by the Taxpayer’s 2006 retention of outside counsel to advise on litigation possibilities, a Private Letter Ruling request on certain aspects of the transaction, the Taxpayer’s participation in a pre-audit program for the IRS to review the transaction, the Taxpayer’s audit history, and the amount of the claimed deduction.  Interestingly, the Court even opined that if the government’s contention that the Taxpayer had a history of engaging in similar transactions in the ordinary course of business was true, work product protection could still apply given the facts of the case.  This was all consistent with aspects of the established case law on the anticipation of litigation issue.

Unfortunately for the Taxpayer, the Government’s claims and the court’s analysis did not stop there.  During 2006, the Taxpayer retained a French valuation firm to provide a risk exposure analysis on the transaction and identify and supervise U.S. valuation experts that could prepare valuation reports to substantiate the claimed deduction.  One firm was retained in 2006 and produced a pre-transaction valuation report that supported the claimed position and another firm was retained in 2007 to provide a second valuation report to buttress the argument.  These reports were prepared independently and both were ultimately provided to the Government to support the claimed position.

The Government argued that the Taxpayer’s provision of the two valuation reports made their preparers testifying experts under FRCP 26(b)(4) and any communications that relayed factual data to the testifying experts were not protected according to FRCP 26(b)(4)(C)(ii). The first point was not heavily disputed, and the Taxpayer appears to have provided significant amounts of information to the Government during the examination.  Regarding the second issue, the Court focused on the privilege log and held that some of the documents presented therein appear to be factual communications to testifying experts that are not protected under the work product doctrine.  Importantly, the Court also stated that FRCP 26(b)(4)(C) and its protections did not extend to parties other than the Taxpayer or the Taxpayer’s attorneys.  That final point may have been moot in Veolia, given the court’s indication that the referenced communications constituted facts and data; however, it raises an important aspect of the rule to be mindful of.

The number of litigated summons cases involving privilege and work product claims continues to increase.  And the pace of new cases may continue to grow given the IRS’s new IDR policy, which promises to increase significantly the numbers of summonses that are issued.  For taxpayers and tax advisors, this is an area of concern that should be closely monitored.

Can the IRS Circumvent U.S. Law by Issuing a Treaty Request?

Shortcuts to identifying the “soft spots” of a tax return have long tempted the IRS. Those shortcuts are generally quite controversial and have included the aggressive use of penalties to force a reasonable cause defense and the resulting disclosure of privileged materials and, as another example, transparency programs such as Schedule UTP that arguably strain the credibility of the IRS’s policy of restraint with regard to tax accrual workpapers. More recently, with the increasing prevalence of complex, cross-border transactions having multi-jurisdictional tax consequences, there is often a paper trail of tax analysis strewn around the world that is providing the IRS with a new temptation. Would the IRS be tempted to quietly make a treaty request in an attempt to circumvent U.S. privilege protections and obtain the materials without the fuss of a privilege fight? Unfortunately, the IRS and foreign taxing authorities have succumbed to this temptation, and it is something that practitioners should be aware of. The propriety of any such request must be carefully scrutinized and the appropriate interventions should be considered.

Indeed, the IRS has used treaty requests in lieu of following the administrative summons process (as well as its own internal directives) in order to bypass procedural safeguards for the taxpayer to attempt to obtain privileged and protected documents that would otherwise be unavailable to the IRS under U.S. law. This premature and improper use of treaty requests violates two core principles contained in most bilateral tax treaties, and in articles 18-26 of the Convention on Mutual Administrative Assistance in Tax Matters and article 26 of the OECD Model Tax Convention and its Commentary.

First, the issuance of a treaty request to circumvent domestic law is improper and objectionable because the requested nation is not obligated to employ procedures or obtain information that is at variance with or not obtainable under the laws of either country. This means that, for example, where the U.S. issues a treaty request, the same procedural safeguards that exist in the U.S. would also effectively be available with respect to the request. Additionally, the privileges and protections that exist in the requested country also apply. Under U.S. law, the IRS has broad authority to issue a summons for the production of documents or testimony relevant to the purpose of ascertaining the correctness of a return or determining the liability of any person or any internal revenue tax. But the IRS is subject to specific limitations. Significantly, pursuant to United States v. Powell, 379 U.S. 48 (1964), a summons is not enforceable unless it is (1) issued for a legitimate purpose; (2) the material sought is relevant to that purpose; (3) the information sought is not already within the possession of the IRS; and (4) the administrative steps required by the Internal Revenue Code have been followed. Further, the IRS is limited to materials in the possession, custody, and control of the summonsed party and is not entitled to documents that are privileged or protected under U.S. law, including the attorney-client privilege, attorney work product protection, and the privilege against self-incrimination. A requested nation will not employ measures to circumvent these U.S. laws. As noted in the OECD Commentary, one nation cannot take advantage of its treaty partner’s information system merely because it is wider than its own. Thus, a treaty request at variance with the U.S. law, including those discussed above, should be denied.

Second, the issuance of a treaty request before exhausting domestic measures is a clear violation of the international authorities and is grounds for rejection of a request. Under U.S. law, a summons is not self-enforcing. Instead, if the summonsed party fails to comply with the summons, the U.S. government must bring an enforcement action in the appropriate federal district court. And, both the taxpayer and the recipient of a summons have the right to protest the enforcement of a summons by filing a petition to quash in federal district court. The administrative summons procedures thereby provide the prerequisite mechanisms for a court to review the legitimacy of the summons and/or whether the claims of privilege are well-founded. The IRS cannot circumvent a taxpayer’s privileges or right to have a court review these claims by simply pursuing the documents through a treaty request because a request made prior to exhausting the domestic administrative summons procedures should be denied.

The premature and improper issuance of a treaty request merely shifts the burden of potentially protracted and costly disputes to a foreign nation, attempting to force the foreign nation to interpret and decide U.S. law. In addition to the potentially resulting prejudice against the rights of the taxpayer, this shifting aspect is itself clearly an inappropriate imposition on a treaty partner. See article 26 of the OECD Model Tax Convention and its Commentary. Treaty partners are usually quite receptive to these arguments by the objecting taxpayer in intervention proceedings.