United States District Court, S.D. New York
GEORG F. W. SCHAEFFLER et al., Petitioners,
UNITED STATES OF AMERICA., Respondent
[Copyrighted Material Omitted]
[Copyrighted Material Omitted]
Justin Kattan, M. Todd Welty, Mark P. Thomas, Dentons U.S. LLP, New York, New York, for petitioners.
Rebecca S. Tinio, Assistant United States Attorney, Preet Bharara, United States Attorney, New York, New York, for respondent.
OPINION AND ORDER
GABRIEL W. GORENSTEIN, United States Magistrate Judge.
As part of its investigation into the federal tax liability of Georg F.W. Schaeffler, the Internal Revenue Service (" IRS" ) served an administrative summons on Schaeffler's accountant, Ernst & Young. Schaeffler, together with a number of entities he controls, have now petitioned to quash the summons on the ground that it calls for privileged materials The United States Government has opposed the petition. The parties consented to disposition of this matter by a United States Magistrate Judge pursuant to 28 U.S.C. § 636(c). For the reasons stated below, we deny the petition to quash.
A. Schaeffler's Acquisition of Continental AG
Schaeffler owns 80% of INA-Holding Schaeffler GmbH & Co. KG (" IHO" ), which is itself an indirect owner of Schaeffler Holding GmbH & Co. KG (" SH-KG" ), and is also the sole owner of Schaeffler Holding, LP (" Schaeffler LP" ) (collectively the " Schaeffler Group" ). See Declaration of Georg F. W. Schaeffler in Support of Schaeffler's Petition to Quash Summons, dated May 16, 2013 (annexed as Ex. B to Petition to Quash Internal Revenue Service Summons, filed July 12, 2013 (Docket #1) (" Pet." )) (" Schaeffler Decl." ), ¶ 4. The Schaeffler Group is headquartered in Herzogenaurach, Germany, and is involved in the business of manufacturing and distributing bearings and other automotive and industrial components.
On July 30, 2008, the Schaeffler Group made a tender offer to buy shares of Continental AG (" Conti" ), a German supplier of automotive and industrial parts. Id. ¶ ¶ 5-6. The Schaeffler Group had expected to limit its acquisition to less than 50% of Conti's outstanding shares. Id. ¶ 6. However, as a result of the stock market downturn in September 2008, a majority of Conti shareholders accepted the tender offer for € 70-75 per share, and the Schaeffler Group ended up amassing 89.9% of Conti's outstanding shares. Id. The cost of this acquisition was € 11 billion. Id. ¶ 7. From August 27, 2008, to February 24, 2009, the market value of Conti shares plummeted from approximately € 74 to € 11. Id. ¶ 6.
The Schaeffler Group's acquisition was funded by a consortium of banks (the " Bank Consortium" ), which had pledged to finance the Schaeffler tender offer pursuant to a July 12, 2008 loan agreement. Id. ¶ 7; Declaration of Klaus Rosenfeld in Support of Schaeffler's Petition to Quash Summons, dated May 16, 2013 (annexed as Ex. C to Pet.) (" Rosenfeld Decl." ), ¶ 5. Given the unexpected result of the tender offer and the dire economic conditions at that time, the Schaeffler Group had " significant solvency concerns" about its ability to service the debt to the Bank Consortium. See Schaeffler Decl. ¶ 7. Accordingly, the Schaeffler Group recognized the
need to undertake substantial debt refinancing and corporate restructuring measures. Id. ¶ 5; Rosenfeld Decl. ¶ 5.
B. Ernst & Young and Dentons' Representation of Schaeffler
Because the Schaeffler Group viewed the tax issues raised by the Conti acquisition and the planned refinancing and restructuring to be unusually complex, it did not use its internal tax department but instead hired outside tax and legal advisors at Dentons U.S. LLP (" Dentons" ) and Ernst & Young LLP. Schaeffler Decl. ¶ 10; Rosenfeld Decl. ¶ 9; Declaration of Harald Dewert in Support of Schaeffler's Petition to Quash Summons, dated May 13, 2013 (annexed as Ex. D to Pet.) (" Dewert Decl." ), ¶ 6. Schaeffler's corporate lawyers at Allen & Overy also advised the Schaeffler Group regarding these issues. Schaeffler Decl. ¶ 11. Ernst & Young provided tax advice " on the various U.S. tax implications of the Schaeffler Group's proposed refinancing and restructuring related to the unanticipated consequences resulting from the Schaeffler Group's acquisition of Continental AG." Declaration of John Martinkat in Support of Schaeffler's Petition to Quash Summons, dated May 16, 2013 (annexed as Ex. F to Pet.) (" Martinkat Decl." ), ¶ 3. Specifically, " EY prepared tax memoranda and other tax analysis that identified potential U.S. tax consequences of the refinancing and restructuring, and identified and analyzed possible IRS challenges to the Schaeffler Group's tax treatment of the transactions at issue." Id. ¶ 4. John Martinkat, a partner at Ernst & Young, describes one such document, which we will refer to as the " EY Tax Memo." He states that this memorandum contained " EY's analysis and advice concerning the U.S. federal tax treatment of various aspects of the Schaeffler Group's 2009 and 2010 restructuring and refinancing, including an analysis of the possible challenges by the IRS [discussing] in detail the statutory provisions, Treasury regulations, judicial decisions, and IRS rulings relevant to various aspects of the transactions." Id. ¶ 8. The Court has examined this document in camera as is discussed in section II.B.3 below.
Dentons similarly " provided Schaeffler with U.S. tax and legal advice . . . in oral and written form, to assist Schaeffler in evaluating the likely tax consequences of the refinancing and restructuring, to assess the arguments the IRS would likely make in any dispute of Schaeffler's tax treatment of the transactions, and to weigh the potential risks Schaeffler would face if the tax consequences of the transactions were litigated or otherwise challenged by the IRS." Declaration of Marc Teitelbaum in Support of Schaeffler's Petition to Quash Summons, dated May 17, 2013 (annexed as Ex. H to Pet.) (" Teitelbaum Decl." ), ¶ 12. Specifically, Dentons gave legal advice on the following issues: " controlled foreign corporation ('CFC') U.S. tax principles; significant troubled company issues; German bank regulatory issues; the Conti debt covenant restrictions; German creditors' rights, securities, and merger and acquisition laws; and the differences between U.S. and German legal forms and tax law." Id. ¶ 6.
Schaeffler sought the outside tax and legal advisors at Ernst & Young and Dentons because he believed that " (1) acquiring an indirect majority ownership interest in Conti, a large non-U.S. corporation, and (2) the obviously necessary refinancing of the Conti stock acquisition debt and associated corporate restructuring would have significant U.S. tax and reporting implications." Schaeffler Decl. ¶ 8. Furthermore, " [d]ue to the magnitude of the restructuring, the complexity of the U.S. tax issues, and the material amounts potentially at
issue, [Schaeffler] expected, from the earliest planning stages of the refinancing and restructuring, that an IRS audit and possible dispute over at least some of the tax consequences was very likely, if not inevitable." Id. ¶ 19. This view was shared by his employees, see Dewert Decl. ¶ 8; Declaration of Klaus Deissenberger in Support of Schaeffler's Petition to Quash Summons, dated May 14, 2013 (annexed as Ex. E to Pet.), ¶ 7, and his tax and legal advisors, see Martinkat Decl. ¶ 7; Teitelbaum Decl. ¶ 11.
Schaeffler asserts that " [b]ut for" this expectation that the refinancing and restructuring measures would have " significant U.S. tax and reporting implications" and that the IRS would " examine these events closely," neither Dentons nor Ernst & Young " would have been engaged" for their services. Schaeffler Decl. ¶ ¶ 8, 10. Schaeffler's belief that the IRS would challenge his 2009 and 2010 tax returns was reinforced by the fact that he had recently been subjected to IRS audits. See Schaeffler Decl. ¶ 25. Schaeffler's 2001 and 2004 amended U.S. federal income tax returns had been examined by the IRS in the 2007-08 time period. Id.; accord Declaration of M. Todd Welty in Support of Schaeffler's Petition to Quash Summons, dated July 7, 2013 (annexed as Ex. I to Pet.) (" Welty Decl." ), ¶ 5. In 2009, the IRS began examinations of Schaeffler's 2006, 2007, and 2008 returns. Schaeffler Decl. ¶ 25. Schaeffler believed that " audits of [his] 2009 and 2010 tax returns were essentially inevitable." Id.
Throughout 2008 and 2009, Dentons and Ernst & Young tax and legal advisors worked together with the Schaeffler Group both to " devise a viable debt refinancing and restructuring" plan, Teitelbaum Decl. ¶ 8, and to evaluate the likely tax implications of such measures, id. ¶ ¶ 9-13. Schaeffler treated the communications with Dentons and Ernst & Young as " confidential." See id. ¶ 15; see also Rosenfeld Decl. ¶ 10; Dewert Decl. ¶ 9. The advisors at Dentons and Ernst & Young have also asserted that they maintained the confidentiality of these communications. See Martinkat Decl. ¶ 12; Teitelbaum Decl. ¶ 12. Eventually, " [d]ue to the magnitude and complexity of the issues . . . and because of the anticipated audit and the potential controversy with the IRS," Schaeffler sought a private letter ruling from the IRS. Teitelbaum Decl. ¶ 14; see generally 26 C.F.R. § 601.201. On August 6, 2010, the IRS ruled in favor of Schaeffler's proposed core tax treatment of the refinancing and restructuring measures. See Welty Decl. ¶ 8.
C. Communications Between Schaeffler and the Bank Consortium
By all accounts, the Schaeffler Group, Ernst & Young, and Dentons worked closely with the Bank Consortium not only in effectuating the refinancing and restructuring but also in analyzing the tax consequences of the Conti acquisition. The Bank Consortium was represented by Linklaters LLP. See Declaration of Stephen B. Land in Support of Schaeffler's Petition to Quash Summons, dated May 17, 2013 (annexed as Ex. G to Pet.) (" Land Decl." ), ¶ 4. Stephen Land, a Linklaters partner who worked on the assignment, explained that the Bank Consortium " was concerned about the U.S. tax implications of any debt refinancing and restructuring plan, since the resulting tax consequences could materially affect the Schaeffler Group's net cash flow and assets that would otherwise be available to repay the [Consortium's] debt." Id. ¶ 5. Early in the refinancing negotiations, Schaeffler and the Bank Consortium reached an agreement, which they have referred to as the " Ringfencing provisions," under which the Bank Consortium subordinated its claims
for repayment of Schaeffler's debt to the payment of Schaeffler's personal tax liabilities. See Teitelbaum Decl. ¶ 16; Schaeffler Decl. ¶ 13. The Ringfencing provisions allowed Schaeffler to prioritize up to € 885 million of his personal tax liabilities over repayment of the debt owed to the Bank Consortium. Rosenfeld Decl. ¶ 8. The Bank Consortium also agreed to provide an additional line of credit to pay Schaeffler's tax liabilities up to € 250 million. Teitelbaum Decl. ¶ 19. The Ringfencing provisions required " Schaeffler to notify the Bank Consortium of a material audit or investigation" by the IRS and to " permit the Bank Consortium the opportunity to advise on any proposed action -- including contesting or settling the tax dispute -- before proceeding." Schaeffler Decl. ¶ 14.
The Schaeffler Group and the Bank Consortium agreed to share legal analyses addressing the potential tax implications regarding the restructuring and refinancing measures. Rosenfeld Decl. ¶ 12. To this end, they signed an agreement, referred to as the Attorney Client Privilege (" ACP" ) Agreement, in which they expressed their desire to " share privileged, protected, and confidential documents and their analyses without waiving those privileges, protections, or the confidentiality of the information." Id. ¶ ¶ 12-13. Rosenfeld states that " the ACP Agreement was an important prerequisite for sharing the tax advice with the Bank Consortium," id. ¶ 15, and that he has " no reason to believe that the parties to the ACP Agreement, in fact, have not maintained through the present time, the confidentiality of all information shared pursuant to the ACP Agreement," id. ¶ 16. Although the ACP Agreement has not been made part of the record, Teitelbaum asserts that it " provides that information exchanged or otherwise communicated pursuant to the ACP Agreement that is protected from disclosure by U.S. privileges or protection, including, but not limited to, the attorney-client privilege, work-product doctrine, and the tax practitioner privilege of I.R.C. § 7525, will remain privileged and protected under the common legal interest doctrine, joint defense doctrine, or other available privileges and protections." Teitelbaum Decl. ¶ 22.
Following execution of the ACP Agreement, the Schaeffler Group shared with the Bank Consortium certain documents containing tax advice. See Land Decl. ¶ 9; Teitelbaum Decl. ¶ 21. It is these documents, which were created by Ernst & Young and disclosed by Schaeffler to outside parties, that the Government has asked Ernst & Young to produce. See IRS Summons to Ernst & Young, dated June 25, 2013 (annexed as Ex. A to Pet.) (" IRS Summons" ). Out of the approximately 10,000 responsive Ernst & Young documents, petitioners have described only the EY Tax Memo, which they allege analyzed " numerous legal issues, cases, and tax authorities, discusse[d] theories the IRS may advance to challenge the transactions, and note[d] the strengths and weaknesses of Schaeffer's tax and legal positions." Teitelbaum Decl. ¶ 23.
D. The IRS Audit of Schaeffler's 2009 and 2010 Tax Returns
Notwithstanding the IRS's private letter ruling in 2010 approving Schaeffler's proposed core tax treatment of the restructuring and refinancing measures, see Welty Decl. ¶ 8, the IRS began to examine Schaeffler's 2009 and 2010 federal income tax returns in 2012, id. ¶ 11. On July 26, 2012, the IRS sent Schaeffler a letter stating it intended to audit Schaeffler's personal tax returns as well as the Schaeffler Group's returns for the 2009 and 2010 taxable years. Id. Official audit notices were then sent to Schaeffler and the
Schaeffler Group on August 15, 2012. Id. ¶ 12.
When the IRS issued an Information Document Request (" IDR" ) to Schaeffler in September 2012, Schaeffler invoked " all privileges and protections that exist under U.S. law -- including, but not limited to, the attorney-client privilege, the work product doctrine, 26 U.S.C. § 7525, and the common interest doctrine -- to prevent the disclosure of any privileged and protected information, including, but not limited to, tax opinions." Id. ¶ 13. On October 19, 2012, Schaeffler's counsel met with the IRS to discuss " the withdrawal or narrowing of the scope of [the IDR] . . . in order to avoid a costly and time-consuming privilege fight," but the " IRS refused to withdraw or narrow the scope of [the IDR]." Id. ¶ 15. On November 8, 2012, the IRS issued a second IDR requesting " [a]ll tax opinions and tax analysis that discuss the U.S. tax consequences of any and all steps of [Schaeffler's] restructuring." Id. ¶ 16.
Through July 2013, the IRS issued 86 IDRs requesting information regarding Schaeffler's 2009 and 2010 tax returns, and Schaeffler has in response produced tens of thousands of pages of documents. Id. ¶ 17. In petitioners' view, " Schaeffler has provided the IRS with voluminous factual and reporting information necessary to conduct the examinations of the 2009 and 2010 tax returns . . . [including] the operative refinancing and sales agreements, transaction documents and corporate chronologies related to the refinancing and restructuring, legal and tax organizational charts, detailed tax calculations with specific ...