Opinion
8823-18
10-25-2021
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 section 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.
Unless otherwise indicated, all statutory references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Petitioner timely petitioned this Court in May 2018. In its petition and amended petition it challenged the negligence penalties, asserting that it "was not negligent and did not intentionally disregard any rules or regulations." Respondent seeks discovery concerning that defense, and this has prompted a vigorous dispute over discovery privileges. Currently before the Court is respondent's Motion to Compel Production of Documents, filed March 23, 2021. The parties have briefed this Motion extensively. We will grant the Motion in large part.
Background
In June 2012 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 I" Deloitte was to analyze petitioner's facts and circumstances with a view to determining whether it qualified for such deductions. Deloitte agreed to conduct an onsite visit, during which it would review petitioner's financial records and interview key personnel. At the conclusion of "phase I," Deloitte was to submit a report setting forth its analysis and preliminary recommendations.
"Phase II," petitioner says, "commenced sometime in late August or early September of 2012." Deloitte's work product during phase II included tax computation workpapers and related documents to support the section 199 deductions claimed on petitioner's tax returns. Deloitte also prepared a "Section 199 Revenue Qualification Memo" (Qualification Memo) for petitioner. The Qualification Memo was dated November 14, 2012, and was marked "Confidential." It contained a comprehensive discussion of section 199 and explained why petitioner (in Deloitte's view) could qualify for deductions under section 199. The preamble to the Qualification Memo stated that Deloitte's analysis was based in part on "representations made by * * * [petitioner] during an onsite visit." The Qualification Memo stated that it could not be used by petitioner "for the purpose of avoiding any penalties."
During the IRS examination and in response to respondent's discovery requests, petitioner has supplied most or all of the documents generated during phase II of Deloitte's work, including the Qualification Memo. However, petitioner has maintained claims of privilege--the attorney-client privilege, the section 7525 tax practitioner privilege, and the work product doctrine--with respect to most or all of the material generated during phase I of Deloitte's work. Petitioner has provided respondent with privilege logs detailing its claims of privilege.
Respondent has moved to compel production of documents. The parties' dispute focuses on 408 documents, described as follows:
--Of the 408 documents, 84 allegedly relate to petitioner's communications with Deloitte regarding the terms and scope of Deloitte's engagement (engagement documents). According to the privilege logs, the engagement documents contain "legal advice and information for purposes of obtaining tax advice of Deloitte * * * regarding [the] Section 199 claim." Respondent seeks to obtain these documents so that he can identify (among other things) "the instructions [petitioner] gave to Deloitte."
--Of the 408 documents, 266 allegedly relate to tax advice that Deloitte and petitioner's in-house advisers provided during phase I of Deloitte's work. According to the privilege logs, these include documents and emails pertaining to "tax advice regarding [petitioner's] Section 199 claim." Respondent seeks to obtain these
documents so that he can identify (among other things) "the correctness of facts [petitioner] gave to Deloitte."
--Of the 408 documents, 58 allegedly consist of documents prepared in response to Information Document Requests (IDRs) propounded by the IRS during the examination of petitioner's 2011 and 2012 returns. Because petitioner had not yet filed its return for 2013, respondent suggests that these documents may be relevant. Respondent seeks to obtain these documents so that he can identify "whether the inquiries made by the [IRS] had any effect on how petitioner's accountants viewed the [section] 199 issue at the time the 2013 [return] was filed."
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 II of Deloitte's work, has waived privileges as to material generated during phase I of Deloitte's work. Second, respondent contends that petitioner has implicitly waived privileges by raising an affirmative defense to the negligence penalties and thus putting its subjective state of mind in issue. Petitioner challenges both propositions.
Discussion
Petitioner engaged Deloitte to perform services in connection with its potential claim to section 199 deductions. Petitioner characterizes Deloitte's engagement as having two water-tight "phases," with all material generated during phase I being privileged. Because Deloitte's engagement appears in substance to have been a seamless one, this bifurcation strikes us as artificial. Petitioner seems to have adopted this characterization in the hopes of using Deloitte's ultimate work product--the Qualification Memo--to its advantage, while restricting respondent's access to the information that Deloitte used when preparing the Qualification Memo. We conclude that petitioner is improperly attempting to use the discovery privileges as both a sword and a shield.
A. Claims of Privilege
Proceedings in the Tax Court are conducted in accordance with the Federal Rules of Evidence. See sec. 7453; Rule 143. The Federal Rules of Evidence incorporate the common law rules of privilege. See AD Inv. 2000 Fund LLC v. Commissioner, 142 T.C. 248, 254 (2014); Fed.R.Evid. (FRE) 501, 1101(c). Petitioner has invoked two common law protections--the attorney-client privilege and the work product doctrine--as well as the section 7525 tax practitioner privilege.
These privileges may be waived under certain circumstances. If privileged material is disclosed "in a Federal proceeding or to a Federal office or agency * * * the waiver extends to an undisclosed communication" if three conditions are met. FRE 502(a). Those conditions are that (1) the waiver is intentional, (2) the disclosed and undisclosed communications concern the same subject matter, and (3) the two sets of communications "ought in fairness to be considered together."
B. Analysis
During the IRS examination and in response to respondent's discovery requests, petitioner supplied most or all of the documents generated during phase II of Deloitte's work. Respondent cites FRE 502(a) to support his contention that petitioner, by disclosing these communications, has waived privileges as to material generated during phase I of Deloitte's work. At the threshold, petitioner challenges the premise for respondent's argument, insisting that FRE 502(a) has no application here because the phase II communications were not privileged to begin with. According to petitioner, the phase II material was not privileged because it consisted of material backing up entries on petitioner's tax returns. The disclosure of non-privileged material, petitioner says, cannot be deemed to have waived any privilege.
We reject petitioner's threshold argument. The attorney-client privilege applies to communications made in confidence (1) by a client to an attorney for the purpose of obtaining legal advice and (2) by an attorney to a client, where the communication contains legal advice or reveals confidential information relating to such advice. Upjohn Co. v. United States, 449 U.S. 383, 390 (1981); Bernardo v. Commissioner, 104 T.C. 677, 682 (1995); Hartz Mountain Indus. v. Commissioner, 93 T.C. 521, 525 (1989). Section 7525 extends a similar privilege to certain communications between a taxpayer and a Federally authorized tax practitioner. The section 7525 privilege applies "to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney." Sec. 7525(a)(1).
Section 7525 does not protect "information generally gathered to facilitate the filing of a tax return." See Valero Energy Corp. v. United States, 569 F.3d 626, 631 (7th Cir. 2009). We assume for purposes of this Order that the phase I communications are privileged under section 7525.
The Qualification Memo that Deloitte prepared in November 2012--during what petitioner calls "phase II" of Deloitte's work--was clearly privileged. That document was prepared by a Federally authorized tax practitioner. See sec. 7525(a)(3). And petitioner cannot seriously dispute that this document, which was marked "Confidential," contains tax advice provided in confidence by a tax professional to a client. The Qualification Memo includes an eight-page "Overview of Section 199" in which Deloitte explains the legal requirements that a taxpayer must satisfy to obtain deductions under that section. Deloitte then analyzed petitioner's business and identified which of petitioner's revenue streams represented (in Deloitte's view) "domestic production gross receipts" within the meaning of the statute and regulations.
Petitioner contends that the Qualification Memo was never privileged because petitioner from the outset entertained the possibility of turning it over to the IRS in the event of an audit. Because petitioner thought it might eventually disclose the Qualification Memo, the document supposedly was never actually "confidential." Considering that Deloitte marked the memo "Confidential," we find this assertion quite wide of the mark. See New Phoenix Sunrise Corp. v. Commissioner, 408 Fed.Appx. 908, 919 (6th Cir. 2010) (holding that a memo marked "CONFIDENTIAL" was privileged even though the taxpayer intended to disclose it to auditors), aff'g 132 T.C. 161 (2009). The fact that a taxpayer might subsequently choose to waive a privilege does not retroactively convert a privileged document into a non-privileged one. The Qualification Memo was clearly privileged because it contained tax advice provided in confidence by a tax adviser (Deloitte) to a client (petitioner). See Upjohn Co., 449 U.S. at 390.
Petitioner urges that materials are not privileged if prepared "with the intent that the information will be transmitted to a third party" (e.g., if the information will be placed on a tax return). See United States v. Lawless, 709 F.2d 485, 487 (7th Cir. 1983). But taxpayers do not normally attach tax advisers' opinions to their tax returns, and petitioner did not attach the Qualification Memo to its tax return for any year. Indeed, there is no indication that petitioner would ever have turned this document over to the IRS if the IRS had not chosen to audit the returns on which the section 199 deductions were claimed. In its privilege log petitioner identified as privileged a PDF version of a "document reflecting tax advice" that Deloitte transmitted to petitioner on November 14, 2012. That date is the same date that is marked on the Qualification Memo.
Having concluded that the Qualification Memo was privileged, we consider next whether petitioner waived privileges by voluntarily disclosing that document to the IRS. "[I]t has been established law for a hundred years that when the client waives the privilege by testifying about what transpired between her and her attorney, she cannot thereafter insist that the mouth of the attorney be shut." In re von Bulow, 828 F.2d 94, 101 (2d Cir. 1987). This principle is now embodied in the Federal Rules of Evidence. FRE 502(a) provides that, if a party discloses privileged material to a Federal agency, then the party is deemed to have waived privi- leges as to undisclosed communications if "(1) the waiver is intentional; (2) the disclosed and undisclosed communications * * * concern the same subject matter; and (3) they ought in fairness to be considered together."
The first element is clearly met here. Petitioner voluntarily disclosed the Qualification Memo to the IRS (a Federal agency) during the examination of petitioner's 2011-2013 returns. The waiver was thus intentional.
With respect to most of the 408 documents at issue, the second element is likewise met. The disclosed communications (the Qualification Memo) and the undisclosed communications (the engagement documents and the "phase I" material) concern the same subject matter, viz., the process petitioner undertook with Deloitte to determine its entitlement to section 199 deductions.
The parties have concentrated their firepower on the third element: whether the disclosed and undisclosed communications "ought in fairness to be considered together." "Determining whether the undisclosed material ought to be considered with the disclosed material requires a case-specific analysis of the subject matter and adversaries." Appleton Papers, Inc. v. EPA, 702 F.3d 1018, 1026 (7th Cir. 2012). Undisclosed materials should in fairness be disclosed "to prevent a selective and misleading presentation of evidence to the disadvantage of the adversary." Judicial Conference Advisory Committee on Evidence Rules, Explanatory Note on Evidence Rule 502. We conclude that fairness dictates disclosure of the engagement documents and the "phase I" materials compiled by petitioner and Deloitte.
The waiver rule is designed to prevent a party from securing a tactical advantage by selectively disclosing information that would otherwise be privileged. Ibid. Petitioner disclosed the Qualification Memo during the IRS examination to show why "it believed [it was] entitled to take the § 199 deduction." But petitioner seeks to protect the phase I information on which Deloitte specifically relied when preparing the Qualification Memo. That information appears to include emails between petitioner's and Deloitte's personnel, information regarding Deloitte's onsite visit, and information gained during Deloitte's interviews of petitioner's employees.
We conclude that the Qualification Memo and the material on which Deloitte relied when preparing the Qualification Memo "ought in fairness to be considered together." FRE 502(a). See In re Pioneer Hi-Bred Int'l, Inc., 238 F.3d 1370, 1374-1375 (Fed. Cir. 2001) (finding that a client, by disclosing tax advice, had waived privileges "with respect to all documents which formed the basis for the advice, all documents considered by counsel in rendering that advice, and all reasonably contemporaneous documents reflecting discussions by counsel or others concerning that advice"). To allow petitioner to use the privilege as both a sword and shield would place respondent at a significant disadvantage. See Johnston v. Commissioner, 119 T.C. 27, 39 (2002).
Because we find that petitioner waived privileges under FRE 502(a), we need not reach respondent's alternative argument that petitioner implicitly waived privileges by raising an affirmative defense to the negligence penalties.
We reach the same conclusion regarding the engagement documents. According to petitioner's privilege logs, these documents contain "legal advice and information for purposes of obtaining tax advice of Deloitte * * * regarding [the] Section 199 claim." These documents may shed light upon the instructions petitioner gave Deloitte, the extent to which Deloitte was to rely on petitioner's representations, and other matters bearing upon the scope of Deloitte's engagement and the basis for the conclusions it reached in the Qualification Memo. We accordingly conclude that the Qualification Memo and the documents addressing the scope of Deloitte's engagement "ought in fairness to be considered together." FRE 502(a).
Petitioner asserts that it gained no unfair advantage by disclosing the Qualification Memo. Petitioner says that it intends to advance a "reasonable basis" defense to the negligence penalties and that this defense encompasses an objective inquiry--viz., whether petitioner's return position is supported by relevant legal authorities. Respondent disagrees with this characterization, urging that the reasonable basis defense requires a showing that petitioner actually relied on legal authority. See Wells Fargo & Co. v. United States, 957 F.3d 840 (8th Cir. 2020).
We need not resolve this question. The phrase "reasonable basis" is nowhere to be found in petitioner's petition or amended petition. In both pleadings it challenged the negligence penalties, asserting that it "was not negligent and did not intentionally disregard any rules or regulations." The phase I material may shed light upon whether petitioner acted negligently. These documents might show (for example) that petitioner failed to disclose all materially relevant facts or supplied Deloitte with incorrect or insufficient information. See sec. 1.6662-3(b)(1) and (2), Income Tax Regs.
More fundamentally, we reject the premise for petitioner's "no unfair advantage" argument. The premise for its argument seems to be that the phase I material is irrelevant to the "reasonable basis" defense that it intends to offer against the penalties. But the phase I material may shed light, not only upon the penalty issue, but also upon the substantive tax issue, namely, petitioner's entitlement to section 199 deductions.
For example, petitioner's employees may have made statements in emails or during interviews with Deloitte's personnel that are unhelpful to petitioner's position. By advancing claims of privilege to the phase I material, petitioner would prevent respondent from using such statements in depositions of petitioner's employees or for impeachment purposes at trial. It seems clear to us that petitioner would gain an unfair tactical advantage by disclosing the Qualification Memo during the examination--in the hope of securing a favorable settlement--while denying the IRS access, if no settlement were reached, to the information that Deloitte received when preparing the Qualification Memo.
For these reasons, we conclude that petitioner has waived privileges with respect to the phase I material and the engagement documents because the Qualification Memo and those documents "ought in fairness to be considered together." FRE 502(a). We reach the opposite conclusion regarding the 58 documents prepared in connection with petitioner's responses to the IDRs. These documents were prepared during the IRS examination, i.e., after Deloitte prepared the Qualification Memo and after petitioner filed the first two returns relevant to this case. Petitioner claims that these documents are privileged under section 7525 and the work product doctrine.
It does not appear to us that the disclosed communication (the Qualification Memo) and the undisclosed communications (the IDR-related material) "concern the same subject matter," viz., the process petitioner undertook with Deloitte to determine its entitlement to section 199 deductions. And we do not see why a legal memorandum prepared by petitioner's tax adviser "ought in fairness to be considered together" with responses to IDRs propounded during a subsequent examination.
Respondent contends that the IDR-related material may be relevant because petitioner had not yet filed its return for the last year at issue. Respondent suggests that these documents might reveal "how petitioner's accountants viewed the [section] 199 issue" and might be helpful in "determining what questions to ask petitioner's accountants." We find this line of reasoning insufficient to compel disclosure under FRE 502(a). To the extent there might be any connection between the Qualification Memo and the IDR-related documents, we think it is too speculative and attenuated to dictate that the two sets of documents must in fairness be considered together.
Accordingly, it is
ORDERED that respondent's Motion to Compel Production of Documents, filed March 23, 2021, is granted in part and denied in part.