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Retailers' increasing reliance on loyalty rewards programs can leave them with unforeseen sales tax risks, which are difficult to manage in a varied regulatory landscape. EY's Robin O'Brien, Michael Wasser and Grace Kyne say that often the issues from rewards programs result from ambiguity or a lack of relevant law and administrative guidance. Retailers can mitigate risks, the authors write, by carefully and meticulously analyzing and, where appropriate, modifying each loyalty program relative to the tax laws of the states in which they operate. But the first step toward an effective defense is fully assessing the risks associated with these loyalty programs.
By Robin O'Brien, Michael Wasserand Grace Kyne
Robin O'Brien is an executive director for indirect tax at EY in Boston. Michael Wasser is a senior manager in the National Tax department at EY in Washington. Grace Kyne is a tax manager with EY in Boston.
Retailers, large and small, increasingly rely on loyalty programs to boost customer appreciation, ensure repeat business, and distinguish themselves from competitors. However, all too often, the customer gets the rewards, the marketing department gets the credit, and the retailer is left with unforeseen sales tax risks. Tax departments are faced with the challenge of applying complex and disparate state tax laws and, at times, ambiguities in the interpretation of such laws, to constantly evolving, increasingly complex marketing strategies.
Loyalty programs vary widely from retailer to retailer. Understanding how each individual loyalty program operates is crucial in determining the potential state sales and use tax repercussions. Generally, these programs include a structured marketing effort designed to encourage customers to take actions such as, making purchases, referring friends, or writing reviews. A loyalty program may give a customer advanced access to new products, a special sales coupon or discount, free merchandise, or even cash value toward future purchases. The programs may be referred to in a variety of ways, including “rewards card,” “points card,” “advantage card,” or “club card” programs. Regardless of how it is represented by a marketing team, it is the substance of the underlying contractual rights, benefits, and mechanics of each program that drives tax implications and associated risks.
While many retailers administer these programs themselves, it is not unusual for retailers to partner with third-party program administrators. Likewise, an increasing number of retailers have partnered with third-party banks to offer customers branded credit cards, allowing customers to accrue “points” every time the card is used. The manner in which a customer earns and redeems rewards and the identity of the party or parties that actually bear the cost of the rewards are indispensable pieces of information in understanding the potential sales and use tax consequences.
In general, sales tax is imposed on the total “sales price” of a taxable transaction. Each state defines sales price slightly differently (some refer to “gross receipts”) but, in general, the term refers to the total amount of consideration, including cash, credit, property, and services, for which services or personal property are sold, leased, or rented, valued in money, whether received in money or otherwise . Most states have addressed how traditional discounts, coupons, and rebates factor into the taxable sales price. In many states, sales price does not include discounts, including cash, terms, or coupons that are not reimbursed by a third party . However, if the value of the discount or coupon is reimbursed by a third party, many states consider the value of such a discount or coupon to be part of the total consideration received by the seller and, therefore, part of the total taxable base. Reimbursement, unlike compensation, is not always clearly defined and can, therefore, be subject to interpretation. Therefore, it is important not only to consider the terms and conditions between the retailer and its customers, but also between the retailer and any relevant third parties (program administrators or banks).
Specific definitions and rules in each state must be analyzed to determine whether the value of a redeemed reward constitutes consideration includable in the taxable sales price. For example, if a customer redeems a $10 reward on a $30 purchase of taxable items, the customer only pays the retailer $20. Determining whether the proper taxable sales price is $20 or $30 requires an analysis of the underlying contractual rights and obligations associated with the loyalty program, as well as the state-specific tax rules and administrative enforcement policies.
Depending on the laws in each state and the specific terms of each loyalty program, the value of the loyalty rewards may or may not be subject to tax. Few states have released clear guidance about how to deal with such programs, and retailers are left to reconcile complex and sometimes outdated tax laws with the particulars of their respective loyalty programs. While some states simply apply their typical coupon or discount rules (which may or may not yield an intuitive result when applied to a loyalty program), other states have taken more complicated approaches. For example, a 2011 Missouri letter ruling ties the taxability of a loyalty points voucher to the taxability of the underlying purchases for which the points were earned. Contemplating the administrative burden of tracking and complying with such a rule is enough to make any tax director break a sweat. Finally, even if a state has issued guidance or a ruling about a specific taxpayer's loyalty program, the conclusions do not necessarily apply to other loyalty programs and, oftentimes, the analysis and conclusions would be completely different from those reached by another state. Retailers treating their loyalty program the same in every state carry a high probability of exposure to risk.
In addition to traditional audit exposure, retailers are at increased risk from qui tam suits (typically brought with respect to undercollections of tax) or class-action lawsuits (typically alleging overcollections of tax). The direct financial costs of these lawsuits continue to rise, increasing by a massive 25% between 2012 and 2013 . These can include direct tax, interest, and penalty costs, as well as significant awards for damages. Litigation costs to defend against qui tam or class-action suits alone can quickly eclipse the actual tax liability, and these costs are often incurred whether a taxpayer wins, loses, or settles the case. There are also less quantifiable costs, such as investor risk due to required financial reporting disclosures, and reputational risks that arise through media reports about retailers being named as defendants in class action and qui tam suits.
Qui tam actions are claims allowing a private party (a whistle-blower or “intervener”) to benefit financially from successfully suing on behalf of the government to recover damages for fraud or other wrongdoing that has wronged the government. The whistle-blower or intervener in such cases generally stands to receive some percentage of damages collected or amounts paid in settlement of such suits, thus attracting a number of would-be interveners to make careers of constantly looking for new, potential defendants. These actions are typically brought for undercollection of tax and can have an extended statute of limitations (10 years in New York and 6 years in Illinois).
Large retailers generally strive for 100% accuracy in tax compliance but despite best efforts, such a degree of accuracy is difficult to achieve. Rather than contend with protracted litigation and the costs and reputational risks that come with it, many large retailers far prefer to undergo regular audits by revenue agencies to address and rectify exceptions when they occur. Such examinations are generally conducted by highly trained tax enforcement personnel who are much better equipped than the courts to understand and work with taxpayers to rectify tax compliance issues.
In the face of a risk of significant audit assessments and increasing qui tam actions, some taxpayers, and even advisors, may attempt to err on the side of caution and set compliance systems “conservatively” to collect tax on the entire sales price, including any and all discounts. Although once a common compliance strategy, it may not always be an effective way to manage risk. In fact, the practice may exacerbate risk in some instances, as retailers are also being targeted in class action suits alleging overcollections of tax.
Class-action suits allow plaintiffs certified as a class to bring a single lawsuit to assert their collective claims that a retailer unlawfully overcollected sales tax. Any type of error resulting in an overcollection of sales tax, no matter how small, can produce significant class-action risk if it is repeated across multiple locations and transactions.
Retailer discounts and coupons have long provided fertile ground for class-action lawsuits, and the rise of loyalty and rewards programs has only increased the risk and uncertainty. For example, in two recent cases, a national retailer and a national grocery chain were both sued in claims alleging they overcharged customers sales tax on sales involving coupon redemptions in Illinois. In both cases, roughly 1% of each retailer's total annual revenue from each store in Illinois was at risk, amounting to a potential multimillion-dollar liability for both companies.
The potential consequences of arriving at the wrong taxability conclusions can be dire, regardless of whether they result in an overpayment or underpayment of tax.
For example, a Retailer with a loyalty program might offer its customers $10 off for every $100 spent. When a customer spends $100, and applies the $10 reduction, the Retailer must decide whether to collect sales tax on $100 ($7.00 at 7%) or $90 ($6.30 at 7%). The answer will depend on the structure of the loyalty program, and the laws in each state. If the Retailer collects the $6.30 in a state that treats the value of the loyalty redemption as part of the taxable sales price, they have undercollected $0.70 (audit, qui tam, and reputational risk). Conversely, if the Retailer collects the $7.00 in a state that treats the value of the loyalty redemption as a reduction to the taxable sales price, the retailer will have overcollected $0.70 (class-action and reputational risk).
These amounts may at first glance appear negligible, however if the Retailer has $100M in sales into the state, multiplied over a three year statute of limitations, the tax impact jumps to over $2M, not including interest and penalties that can near 30%, and potential punitive damages and litigation costs that can eclipse the tax liability. Duplicate the issue across a handful of additional states, and the costs of inaccuracy can escalate quickly.
Please note that this hypothetical is intended only to represent the historic and ongoing multistate compliance challenges posed by customer loyalty programs, and to highlight potential risk-mitigation that can be achieved by proactively addressing such risks.
While the issues in qui tam and class-action suits sometimes arise from gaps in the compliance process or from system errors, often the issues and risks around rewards programs simply stem from ambiguity or a lack of relevant law and administrative guidance. Retailers need not accept the risks of taking a single, multistate sales tax position with respect to their market-critical loyalty rewards programs, nor must they “pick their poison” in implementing compliance policies that either tend toward overcollection or undercollection of tax, both of which could subject them to a lawsuit. To the contrary, with deliberate forethought and a bit of effort, retailers can proactively manage the increasing risk of litigation, assessments, reputational, and financial disclosure risks by carefully and meticulously analyzing and, where appropriate, modifying the detailed mechanics of each loyalty program relative to the tax laws of the states in which they operate. Modern tax systems, software, and processes, when properly implemented, can be configured dynamically enough to accommodate even the most complex variations in multistate tax rules and requirements. Just as important, ambiguities in law can be addressed and resolved proactively and strategically in a manner that effectively inoculates a taxpayer against susceptibility to risks of qui tam or class-action lawsuits. The first step toward an effective defense is undertaking a full assessment of the risks associated with retailer loyalty rewards programs. This provides retailers with the insight necessary to allocate resources and response strategies appropriately to manage the risk using a mindset focused on practical risk versus materiality.
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