Electronic Discovery & Information Governance - Tip of the Month: Document Preservation for Tax Litigation

Scenario:

The US Internal Revenue Service (IRS) is auditing a large multinational company. One issue that has emerged is the company’s “transfer pricing,” the pricing of goods, services, and licensed IP between the company and its overseas subsidiaries. It looks as if the IRS might challenge the company’s pricing and try to allocate more of the company’s profit to its US affiliates. In-house counsel is looking for guidance on when and how to implement document preservation procedures.

The Right Perspective

It is important to approach preservation issues in tax disputes from the right perspective.

Many general litigators and in-house lawyers view document holds as an unwanted and burdensome obligation.

In tax controversies, it pays to think about legal holds differently than you would in a typical lawsuit. Unlike cases in which a company finds itself as a defendant and is left guessing as to what may be relevant, in tax controversies, the company is nearly always the plaintiff and bears the burden of proof. To prevail, it must build its own case using its own documents. 

It would therefore be wrong to think of document preservation for tax litigation as a compliance issue to be handled at the lowest possible cost. Burdensome though it is, consider it an opportunity to preserve the evidence you will need to tell your story to the IRS or a court.

The “When”—Anticipating Tax Litigation

We all know that document holds must be issued when there is a reasonable anticipation of litigation. Tax disputes are no different.

But, in tax, it may be hard to pinpoint when litigation is reasonably anticipated.

The problem arises because tax controversies have a longer-than-normal gestation. The company first stakes out its position when it files its tax return. Perhaps a few years later, the IRS may choose to open an audit, which often drags on for several years. If the issue isn’t resolved at that point, the company may attempt to settle the dispute in IRS Appeals, an administrative dispute-resolution process. If the Appeals process—which is also time-intensive—looks as if it is breaking down, the company may then make the formal decision to litigate.

When in this timeframe does the company anticipate litigation? It might be when the company analyzes the tax treatment of a transaction that the IRS will likely challenge—theoretically, before the company even files its tax return. It might be when the company anticipates a contentious audit. Or it might be only when it appears that the company will not reach a resolution with Appeals.

Case law on this timing question is surprisingly baroque, with outcomes varying from jurisdiction to jurisdiction. Deciding when in the process to issue a document hold might therefore involve more art than science.

The “How”—All Potentially Relevant Documents

It is also common knowledge that document holds must preserve documents potentially relevant to the litigation. But what does that mean in tax?

It is often said that tax litigation can “put the entire business on trial.” And transfer pricing cases are a good example: they require a “functional analysis” directed at figuring out which subsidiaries created value that must be compensated through transfer pricing. That analysis may implicate almost all of the company’s operations and may not be limited to the tax years before the court. A staggering amount of non-tax business documents, including many older documents, may thus be relevant.

Think of it this way: major tax controversies—including transfer pricing cases—may combine the topical scope of an antitrust case with the temporal scope of a product liability case. The result is that preserving documents for big-ticket tax litigation may be a real headache.

But there may be a silver lining: the tax department has probably done some of the work already. When the company filed its tax return, the tax department was required to preserve records “sufficient to establish” tax due, such as the return itself and supporting workpapers. To protect against tax penalties, it was also required to preserve basic documentation about the company’s transfer pricing method. And tax departments frequently work diligently to preserve documents that the IRS might request in audit.

As a result, many relevant documents might already have been preserved.

A Few Best Practices

While every tax case is unique, a few strategies are always worth considering when approaching document preservation for tax litigation:

• Going Beyond the Tax Department. A litigation hold order strategy should be crafted with the understanding that many non-tax business documents inform an item on a tax return. For major tax controversies such as transfer-pricing cases, it is probably impossible to avoid preserving documents from numerous custodians across many of the company’s operating divisions. And going beyond the tax department may well pay dividends: the business units might have documents that support the company’s tax position.
• Preserving Early. It might be advantageous to err on the side of an early hold order. Because work product is created “in anticipation of litigation,” some courts have equated the work-product standard with the standard for preserving documents. It may be harder to claim work product over documents created at a time when no hold order was in place.
• Thinking Before Writing. While it is always a good idea to think before you write, that advice is especially salient in tax. The IRS often seeks discovery of emails and other internal correspondence about tax issues. It may be necessary to waive privilege to defend against tax penalties. And the duty to preserve may begin a lot earlier than you expect. Putting that all together, it is hard to rule out the possibility that an ill-advised email you send will show up in tax litigation down the road.