Rev. Proc. 2011-18: Implication on Media & Entertainment Industry and Consumers

By Michael H. Salama and Michelle L. Chung  

The Walt Disney Company, Burbank, CA 

I. Introduction  

This commentary piece addresses the evolving Internal Revenue Service (IRS) guidance in the area of gift cards and income recognition, with a particular focus on the Media & Entertainment industry. As most American consumers know, the use of gift cards offerings to induce spending has grown in popularity with retailers and various businesses, including brick-and-mortar video rental chains, on-line content distributors, motion picture theatres, and theme park operators. The prevalence of gift cards issuance is difficult to miss; they can be observed by the growing number of gift card malls and in-store kiosks that sell an assortment of cards from brand-name stores in various quantities and denominations.  The proliferation of gift card use by companies is coupled with a growth in the manner in which the programs are structured. In Rev. Proc. 2011-18,1  issued January 5, 2011, the IRS National Office provides the following examples of typical gift card structures that retailers may use to facilitate their respective programs:

  Members of an affiliated group of corporations may establish a gift card subsidiary to sell gift cards that may be redeemed for goods or services provided by the gift card subsidiary or other members of the affiliated group;

  A franchisor, purchasing cooperative, not-for-profit membership organization, or franchisee may sell gift cards that may be redeemed for goods or services provided by independently-owned franchisees or members;

  A restaurant management company may sell gift cards that may be redeemed by participating restaurants in different geographical locations or with different trade names; or

  A retailer may issue a gift card that may be redeemed for merchandise at the retailer's stores, retail stores operated by a related party, or retail stores operated by unrelated parties.

 

Rev. Proc. 2011-18 modifies and clarifies Rev. Proc. 2004-342  to allow retailers to defer income recognition for tax purposes for advance payments received from sale of gift cards redeemable for goods or services of the retailer or a third party.  It is effective for taxable years ending on or after December 31, 2010. However, it does not modify the Regs. §1.451-5 deferral provision. In order to qualify for this provision: (a) the taxpayer must be principally liable to the customer (or gift card holder) for the value of the card until expiration or redemption; and (b) the gift card must be redeemable by the taxpayer, or any other entity legally required to accept the card from the customer by way of payment for items enumerated in Rev. Proc. 2004-34.

II. Discussion  

A. General Framework  

Internal Revenue Code (IRC) §451 requires accrual method taxpayers to include in gross income advanced payments received in the year of receipt, unless the income is properly accounted for as of a different period under the taxpayer's accounting method.  Exceptions allow for the deferral of "advance payments" for one or up to two years based on the taxpayer's recognition of payments under its accounting method for financial reporting purposes.  Specifically, Rev. Proc. 2004-34 and Regs. §1.451-5 serve as exceptions to the general rule provided certain criteria are satisfied.

Rev. Proc. 2004-34 allows accrual method taxpayers to defer income recognized from advance payment received for merchandises and services to the succeeding tax year if they do not recognize the advance payment as income for financial statement purposes in the year of receipt. Regs. §1.451-5 permits deferral of income recognition for advance payments received by an accrual method taxpayer for goods held by the taxpayer primarily for sale to customers until the tax year the payments are recognized as income for financial reporting purposes.3  Under the regulations, if the taxpayer has received "substantial advance payments" at least equal to the inventory costs of the goods and goods sufficient to satisfy the taxpayer's contractual agreement are on hand or available through the taxpayer's normal source of supply, then all advance payments received "by the last day of the second taxable year following the year in which such substantial advance payments are received, and not previously included in income in accordance with the taxpayer's accrual method of accounting, must be included in income in such second taxable year."4  Unlike Rev. Proc. 2004-34, Regs. §1.451-5 does not apply to advance payments for services on its face.

Prior to Rev. Proc. 2011-18, various attorneys in the IRS National Office had challenged and denied the deferral in certain instances. Specifically, if the gift card management companies were separate wholly-owned subsidiaries that did not provide goods or services of their own, some took the position that the regulations did not allow either the maximum two-year deferral under Regs. §1.451-5 or the one-year deferral under Rev. Proc. 2004-34.5  These conclusions were based on the fact that neither of the deferral provisions applies where the group entity selling the gift card is not the same legal entity that will redeem the gift card with its own provision of goods and services. The IRS's approach to gift card subsidiaries reflected limited and restrictive applications of the regulations and Rev. Proc. 2004-34, which is inconsistent with the intended scope of the deferral provisions. The change of position under Rev. Proc. 2011-18 can be attributed to a combination of factors, including the recognition of the merits of the taxpayer's positions, evolving business patterns, administrative grace, and resolving controversy over a short-term timing item. In addition, taxpayer optimism regarding favorable resolutions at the IRS Appeals Division level or potential inability of the IRS's position to withstand judicial scrutiny could have also contributed to the change.

B. Quantifying the Deferral Benefit  

Under the deferral provisions, the economic benefit for the retailers with gift card sales is real and quantifiable.  The taxpayers who qualify under either the Rev. Proc. 2004-34 or Regs. §1.451-5 will benefit from liberalized income deferral rules. While much has been written on this topic, we have seen little financial analysis on it.

For illustration purposes, assume company X, a home video rental retailer, defers $1M of income from sale of gift cards under Rev. Proc. 2004-34. The cash-tax benefit may be computed as follows:

 

 

 

$1,000,000

x

35%

=

$350,000

x

0.51%

=

$1,785  

 

 

 

 

 

 

 

 

 

Gift Card Sales Revenue

 

Fed Corporate Tax Rate

 

Tax Liability

 

AFR Short Term Annual Rate 6 

 

One Year Deferral Benefit  

 

The interest rate used here was the short term annual rate. In reality the value of this benefit is having the tax monies in hand for an extra year. In determining one's own discount rate for this purpose, that rate typically will equal the one year Treasury rate plus the rate of return on a high performing equity (this rate should not be confused with the weighted average cost of capital which one would apply to longer term projects and initiatives).  However, one must be careful in this analysis to reflect upon other correlative impacts the income deferral might have on one's tax liability and income statement. For example, what if the income deferred also qualified for the §199 benefit as domestic production gross receipts? Then one would need to take into account the deferral impact on moving income to a later year. Where taxpayers were experiencing phase-in rate differences under §199, i.e. from 3% to 6% or from 6% to 9%7  deferring income to a year with a higher rate would also provide an increased permanent deduction and related income statement benefit. Although most taxpayers are fully phased-in for §199 purposes, they should also consider other areas where the movement of income from the current year to a future year (on a recurring basis – since the deferral is an accounting method) has an impact for Federal and state tax purposes.

C. Business & Economic Implications  

The tax treatment of advanced payments under the Rev. Proc. 2011-18 is a welcomed piece of guidance from the IRS and it reflects the business and economic realities underlying the gift card sales and redemptions. Many companies create subsidiaries or a single-member LLCs to manage their gift card programs for business and administrative purposes. A gift card management subsidiary can oversee an entire gift card program for a consolidated group, including the issuance and sale of gift cards used in stores operated by the group.

Without this guidance, companies might have needed to revert to issuing and selling separate and distinct store gift-value product for each of its businesses if they wanted absolute tax comfort. This would likely cause confusion and inconvenience for the consumers attempting to redeem the gift cards. The current trend seems to be for a gift card management entity on behalf of its affiliates and related companies to issue a single gift card that is redeemable at all of its business segments at various locations.  For example, a theme park company might issue a gift card that is available for sale not only at various locations throughout its business operations but also online and at third party grocery and drug stores throughout the U.S. Another common example is a theatre company that owns movie theatres throughout the U.S. A gift card that can be purchased on site or online and can be used at any of its theatres across the U.S. at the box office or concession stands is much more valuable to consumers and the business. Perhaps the consumers are the real beneficiaries of the liberalized income deferral rule for the gift cards? Centralized systems and national-use cards offer consumer versatility and convenience. The combination of accessibility, convenience, and diversity in use of cards likely signals continual growth for the gift card business models. The degree to which companies offer and consumers buy more universal-type gift cards and the overall impact on economic factors remains to be seen and would be an interesting item to track.

 For more information, in BNA's Tax Management Portfolios, see White and Salles, 570 T.M., Accounting Methods — General Principles, and Salama and Tilman, 599 T.M., Film Production: Basis Recovery and Federal Incentives,  and in Tax Practice Series, see ¶3540, Timing of Inclusion.


1 2011-5 I.R.B. 443 (1/5/11). 

2 2004-22 I.R.B. 991 (5/6/04). 

3 Regs. §1.451-5(c). 

4 Id

5 FAA 20093801F (1/16/09); FAA 20082801F (3/26/07); TAM 200849015 (8/22/08). 

6  Rev. Rul. 2011-4. This revenue ruling provides various prescribed rates for federal income tax purposes for February 2011. 

7 §199(a)(2); Regs, §1.199-1(a).