Opinion
8823-18
07-01-2021
Cboe Global Markets, Inc. f.k.a. Cboe Holdings, Inc. and Subsidiaries, Petitioner v. Commissioner of Internal Revenue, Respondent
ORDER
Albert G. Lauber Judge
Petitioner is the operator of a major U.S. securities exchange. On its Federal income tax returns for 2011-2013 it claimed deductions for "domestic production activities" under former I.R.C. § 199. The Internal Revenue Service (IRS or respondent) disallowed those deductions, determining deficiencies and negligence penalties totaling $17, 547, 496 and $3, 474, 170, respectively.
Petitioner timely petitioned this Court in May 2018, asserting a "reasonable basis" defense to the negligence penalties. See § 1.6662-3(b)(1) and (3), Income Tax Regs. Respondent requested discovery concerning that defense, which has prompted a vigorous dispute over discovery privileges. Currently before the Court is respondent's Motion to Compel Production of Documents, to which petitioner responded on June 23, 2021. We shall direct respondent to file a reply.
Petitioner engaged Deloitte Tax LLP (Deloitte) to perform what petitioner describes as two phases of service in connection with its potential claim to section 199 deductions. During phase 1, Deloitte was to analyze petitioner's facts and circumstances with a view to determining whether it qualified for such deductions. If the answer to that question was "yes," Deloitte was to focus, during phase 2, on actual tax return analysis and documentation. Deloitte's work product during phase 2 included tax computation workpapers and a memorandum explaining the magnitude of the section 199 deductions claimed on petitioner's tax return.
During the IRS examination and in response to respondent's discovery requests, petitioner has supplied most or all of the documents generated during phase 2 of Deloitte's work. However, petitioner has maintained claims of privilege--the attorney-client privilege, the section 7525 accountant-client privilege, and the work product doctrine--with respect to most or all of the material generated during phase 1 of Deloitte's work. Petitioner has provided respondent with privilege logs detailing its claims of privilege.
Respondent has requested production of documents relating to petitioner's "reasonable basis" defense to the negligence penalties. The parties' dispute focuses on 408 documents generated during phase 1 of Deloitte's work, as to which petitioner claims privilege. Respondent advances two arguments in support of his contention that petitioner has waived privileges. First, he urges that petitioner, by disclosing material generated during phase 2 of Deloitte's work, has implicitly waived privileges as to material generated during phase 1 of Deloitte's work. That is so, respondent contends, because the two sets of documents "ought in fairness to be considered together." Fed.R.Evid. (FRE) 502(a)(3).
Second, citing Wells Fargo & Co. v. United States, 957 F.3d 840 (8th Cir. 2020), respondent contends that petitioner "must establish that it actually relied on legal authority" to claim its penalty defense successfully. According to respondent, the "reasonable basis" defense entails a subjective, not an objective, inquiry. Material generated during phase 1 of Deloitte's work, respondent urges, may thus be relevant in determining whether petitioner actually relied on legal authority. By injecting a "reasonable basis" defense into the case, therefore, petitioner has assertedly waived privilege with respect to documents bearing on that matter.
Respondent has moved to compel production of the material generated during phase 1 of Deloitte's work, and petitioner has responded to that motion. We will direct respondent to file a reply. In his reply, the Court would find it helpful if respondent would address (among other items he deems important) the following:
(1) Respondent apparently seeks 408 documents as to which petitioner has claimed privilege. Petitioner represents that 142 of these documents have little or nothing to do with its "reasonable basis" defense, so that the waiver arguments advanced by respondent have no application to these documents. Eighty-four of the documents allegedly consist of back-and forth between Deloitte and petitioner's in-house counsel concerning negotiation of Deloitte's engagement letter. Fifty-eight of the documents allegedly consist of communications between Deloitte and petitioner's personnel regarding information document requests (IDRs) that the IRS exam team propounded during the audit. Petitioner contends that these communications are protected by the attorney-client privilege and work product doctrine, respectively, and that neither privilege has been waived.
(2) Petitioner advances two arguments as to why, by disclosing phase 2 Deloitte-related material, it has not waived privilege regarding the phase 1 material. The phase 2 material, petitioner says, was not privileged to begin with because it consisted of material backing up the entries on its tax returns. Disclosure of non-privileged material does not waive any privilege.
In any event, even if some phase 2 material was privileged, FRE 502(a)(3) finds an implicit waiver only if (among other things) the two sets of documents "ought in fairness to be considered together." This Rule is designed to prevent a party from selectively disclosing privileged documents in an effort to gain an unfair tactical advantage. See, e.g., Appleton Papers, Inc. v. EPA, 702 F.3d 1018, 1026 (7th Cir. 2012) (stating that FRE 502(a) governs situations "where a party unfairly discloses only a portion of privileged material"). In his Motion to Compel respondent does not explain how petitioner, by disclosing the phase 2 material during the IRS audit, has acted unfairly or attempted to secure an inappropriate tactical advantage. Nor has respondent otherwise explained why the phase 1 and phase 2 material "ought in fairness to be considered together."
(3) Respondent contends that the "reasonable basis" defense to the negligence penalty entails a subjective inquiry, urging us to adopt the Eighth Circuit's reasoning in Wells Fargo. (This case would normally be appealable to the Seventh Circuit.) Petitioner contends that this defense entails an objective inquiry, viz., whether the authorities upon which it relies supply a "reasonable basis" for its return position in an objective sense (sometimes viewed by practitioners as equating to about a 20% likelihood of success). Petitioner urges that the Eighth Circuit misapprehended the statute and regulations and asks us to reject the Wells Fargo analysis.
It is not clear to us that we need to reach that question. The Wells Fargo case did not involve a discovery dispute or any question about waiver of privileges. Rather, the Eighth Circuit affirmed a district court decision holding that (1) the "reasonable basis" defense requires the taxpayer to show actual reliance on the relevant legal authority and (2) the taxpayer failed to submit such evidence at trial. As the appellate court concluded: "We agree with the government that the reasonable-basis defense requires evidence of actual reliance on the relevant authority on the part of the taxpayer." 957 F.3d at 852.
In a response to informal discovery petitioner identified the legal authorities on which it relies for its penalty defenses. Significantly, it did not list any Deloitte-related material among those authorities. Indeed, the regulations explicitly bar the use of a tax professional's opinion as support for a "reasonable basis" or "substantial authority" defense. See § 1.6662-4(d)(3)(iii), Income Tax Regs. Petitioner has offered "to produce a document that establishes" actual reliance on relevant legal authority. And it has offered to make available for an interview--on the condition that this would not waive any privilege--its former chief accounting officer, who signed its 2011-2013 tax returns and commissioned the Deloitte engagement. During such an interview respondent could investigate the question of petitioner's "actual reliance" on legal authority.
For these reasons, it appears to us that the phase 1 Deloitte-related material--in particular, any opinion letters or memoranda that Deloitte may have prepared--may be irrelevant to petitioner's penalty defense. The regulations preclude use of such documents to support a "reasonable basis" defense, and petitioner has identified the legal authorities upon which it does rely. If we reject the Wells Fargo "actual reliance" test, petitioner may prevail at trial by showing that these authorities supply, in an objective sense, a reasonable basis for its return position. On the other hand, if we rule that the "actual reliance" test applies, petitioner may be able to satisfy that test at trial without any reference to the phase 1 Deloitte-related material. In either event, petitioner's raising of the "reasonable basis" defense does not put the phase 1 Deloitte-related material into issue and therefore does not waive any privileges with respect to it.
In his Motion to Compel respondent emphasizes that petitioner "has reserved the right to use all evidence in order to make its reasonable basis argument." But if petitioner agrees to forgo use of phase 1 Deloitte-related material for that purpose, and to demonstrate at trial (if required to do so) actual reliance on the legal authorities it has identified, it is hard to see how its penalty defense amounts to the implied waiver of any privilege.
Accordingly, it is
ORDERED that respondent shall file with the Court, on or before July 30, 2021, a response to this Order addressing the questions set forth above and any other matter he deems appropriate. It is further
ORDERED that petitioner may file by August 30, 2021, if it wishes, a response to respondent's filing.