Cleaning Up After The Elephants – A Practical Reminder On Document Preservation Policies and Litigation Holds In Tax Disputes
Any corporate tax executive who has ever been involved in contesting an audit adjustment knows all too well how unfavorable documents relating to the subject of the adjustment – particularly improvident comments reflected in email correspondences – can be an ongoing impediment to resolving a tax dispute from the audit phase right up to and through litigation with the IRS or Department of Justice. When such documents exist, even where taken out of context, the government will zealously sink its teeth into them like a junkyard dog, making the prospects of reaching a reasonable settlement or gaining an IRS concession all the more difficult. One can’t fault the government for taking a hardline position. Precedent reflects that this is a good strategy, particularly in economic substance cases, as demonstrated by the numerous times these unfavorable documents work their way into the text of court opinions as the factual underpinning for an adverse finding against the taxpayer. Like a Dickensian character, they will come back to haunt you again and again.
The solution, of course (conveniently ignoring the practical realities of many understaffed and overburdened tax departments), is for the tax function to do a better job of policing both document production and retention policies, particularly outside of its own direct jurisdiction and normal supervision. Non-tax business justifications pervade so many tax disputes that it is incumbent on the tax executives to ensure that these justifications are not only well-documented, but consistently followed in practice after the transaction is put into place. The tax folks are, after all, the ones ultimately on the front lines defending the non-tax business justification. As they say, it’s like cleaning up after the elephants in the circus parade – unpleasant but necessary.
In the course of this process, it is important to remain mindful that once documents are created, particularly in connection with a transaction where future litigation may reasonably be anticipated, a duty to preserve via a litigation hold may override a company’s normal document destruction policies. See e.g., Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir.2001) (duty to preserve evidence “arises not only during litigation but also extends to the period before the litigation when a party reasonably should know that the evidence may be relevant to anticipated litigation.”) Indeed, the failure to put a litigation hold in place can have deleterious consequences, from waiver of attorney work product protection (see e.g., Samsung Electronics Co., Ltd.. v. Rambus, Inc., 439 F. Supp. 2d 525 (ED Va. 2006) (rev’d on other grounds, 523 F.3d. 1374 (Fed. Cir. 2008)), to IRS challenges regarding the completeness of a taxpayer’s Schedule UTP disclosures (which does not require reserves to be recorded for positions “expected to be litigated”), a topic I have written about before. Simply put, it is difficult to persuasively argue that an issue was reasonably anticipated to be litigated (e.g., for work product protection or UTP purposes), where there is a failure to implement a litigation hold predicated on that very anticipation.
Earlier this month, U.S. District Judge Shira Scheindlin (S.D.N.Y.), author of the landmark Zubulake opinion on electronic discovery, raised the stakes further when she ruled, in Sekisui American Corp. v. Hart, 2013 WL 4116322 (S.D.N.Y. Aug. 15, 2013), that a party who failed to preserve electronically stored information (ESI) by not implementing an adequate litigation hold was subject to an adverse inference about the content of such evidence. The ruling was notable because it bucked the trend of courts to overlook a party’s destruction of ESI in the normal course of its business practices, notwithstanding the obligation the party may have had to implement a litigation hold to preserve such documents. (See Fed. R. Civ. P. 37(e), requiring “exceptional circumstances” to impose sanctions.) In Sekisui, Judge Scheindlin imposed the adverse inference sanction (in addition to monetary damages) even without finding any malevolent intent or substantial prejudice to the opposing party. The court simply ruled that the failure to implement a litigation hold was enough to constitute a willful intent to destroy documents.
It doesn’t take a great deal of imagination to appreciate that a ruling invoking an adverse influence as a result of the failure to preserve documents can be fatal, an even more likely outcome in a bench trial where the judge making the ruling is also the trier of fact. At the very least, being slapped with such a sanction will preclude any benefit of the doubt that documents interpreted negatively by the IRS may be accorded a more favorable interpretation by the trier of fact.
I have heard – certainly more than once – government counsel advocate to a court words to the effect that “memories fade but documents never lie.” It is true that the odds of prevailing in a tax dispute are not helped by poor recordkeeping practices, by which I include both shoddy documentation as well as carelessly policed documentation containing ill-conceived content readily subject to misinterpretation and misuse.
If nothing else, the ruling of an influential jurist like Judge Scheindlin should heighten tax departments’ sensitivities about monitoring company recordkeeping practices from the outset of a transaction. These efforts should be quantitative in terms of fully apprehending the documents to be generated and maintained, and qualitative to reduce the risk that problematic documents are generated carelessly and maintained thoughtlessly. No less thought should be put into the timely implementation of litigation holds to ensure that company records – hopefully those that will help it carry the day in a tax dispute – are adequately preserved, particularly when the ramifications of their destruction can exponentially increase the likelihood of an unfavorable outcome.Explore posts in the same categories: Administrative, Appeal, Audit, Corporate, Court Cases, Economic Substance, Litigation
Tags: Audit, business purpose, document preservation, economic substance, ESI, IRS Audits, litigation hold, Privilege, recordkeeping, records retention policy, Sekisui, Shira Scheindlin, spoliation, Tax Litigation, Work Product, ZubalakeYou can comment below, or link to this permanent URL from your own site.