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By James E. Connor, J.D., Jennifer D. Kennedy, CPA, George A. Manousos, CPA, and Dennis L. Tingey, J.D., CPA
PricewaterhouseCoopers LLP, Washington, DC, and Phoenix, AZ
Certain federal tax issues follow a predictable cycle. Issues in this category (referred to in this article as "mega-issues") typically are those that impact a large number of taxpayers, often in one or more industries, in a similar manner. The cycle of the issue generally begins when one IRS exam agent, or one IRS National Office specialist, decides that a particular position taken by taxpayers is subject to challenge. The issue is raised in the examination of one, or a few, taxpayers. Because of how well connected the IRS is internally, and because of how well connected many taxpayers are, particularly those with strong industry groups, word of the IRS challenge spreads. Within months, the subject becomes a topic at ABA, AICPA, and TEI meetings. The IRS National Office then commits to study the issue. At this point things often slow down, because studying the issue generally involves several individuals within the IRS and Treasury, and reaching consensus takes time. Also, senior level personnel at the IRS and Treasury are very busy, and it takes time to get their input on the issue. After studying the issue, the IRS sometimes decides that it can issue guidance that will make all of the constituent parties (internal IRS personnel, IRS leadership, taxpayer groups, and individual taxpayers) sufficiently happy that there won't be a reason for ongoing controversy. In other situations, the IRS digs in to support its position, and forces the issue into litigation. If the IRS loses in litigation, it then must decide whether to accept the court's decision, look for a middle ground solution or to continue to fight the issue.1
The gift card issue is a good example with which to illustrate the typical life cycle of a mega-issue. It has its roots in the "trilogy" of Supreme Court cases from the late 1950s and early 1960s addressing the federal income tax treatment of advance payments. The trilogy is made up of three 5-4 decisions2 that seem to hold (although this is subject to much debate) that the receipt of cash in advance of performing services or providing goods is taxable upon receipt for accrual method taxpayers. This extreme view that the receipt of cash always required immediate taxation for accrual method taxpayers was perceived at the time as going too far. As a result, this led to the creation of regulatory and administrative exceptions, the first of which was issued in 1971 and the last of which was issued in 2011.
The first exception to immediate inclusion of advance payments that is relevant to the gift card issue is the promulgation of Regs. §1.451-5 in 1971. It is indisputable that such regulation permitted up to a two-year deferral of the inclusion in income of advance payments received for "gift certificates"3 (for readers under 30 years of age, gift certificates are the paper-based predecessor of gift cards).
From the time Regs. §1.451-5 was issued until about 2006, things were quiet on this issue. However, various changes in how retailers did business, and how gift certificates/gift cards were used, created the seeds for the mega-issue that existed between 2006 and the issuance of two revenue procedures (discussed below) early in 2011. By 2000, because of the great strides in technology, gift certificates evolved into gift cards.4 The convenience of gift cards, and their benefit to retailers in increasing sales, made gift cards much more common than gift certificates. Further, the desire on the part of retailers to limit liability by creating multiple legal entities, generally in the same affiliated group filing a consolidated return for tax purposes, necessitated, for business purposes, cross-redemption5 among related legal entities.
Another development was state tax planning, which led to the creation of gift card subsidiaries to minimize the impact of unclaimed property statutes. With this planning, multiple operating legal entities of retailers arranged with a gift card subsidiary6 to issue gifts cards that could be redeemed at any such operating entity. This approach may also be used with franchise arrangements (that is, franchisees, not otherwise related to one another, honor gift cards issued by the franchisor or a gift card entity formed for the benefit of the franchise arrangement).
One more development that eventually played a part in the mega-issue is the fact that, in certain circumstances, when consumers return previously purchased merchandise, they are given gift cards rather than cash or a credit on their credit card account. From a practical perspective, the retailer treats these gift cards issued for returned merchandise in the same manner as gift cards purchased directly by a customer.
In the majority of situations, the above developments did not cause retailers to treat gift cards any differently than they had historically treated gift certificates - that is, they were applying the rules of Regs. §1.451-5(c).
Specifically, most retailers were including advance payments in income at the time the gift cards were redeemed, except to the extent the gift cards were still outstanding at the end of the second taxable year after they were issued, in which case any unredeemed amounts were included in taxable income. Because most gift cards are redeemed relatively soon after they are issued, only a small amount of advance payments for gift cards remains outstanding at the end of the second tax year after the year in which the gift cards were issued.
Against this backdrop,7 by around 2006 the IRS began to question retailers' treatment of gift cards. Some of the challenges were for routine matters such as failure to observe the two-year rule of Regs. §1.451-5(c) or failure to include the information statement required by Regs. §1.451-5(d). However, within a few months, these challenges evolved into what was the beginning of the mega-issue - the "cross-redemption" issue and the "returned merchandise" issue.
The IRS' basis for concern about cross-redemption was the literal wording of Regs. §1.451-5(a)(1), which arguably limits the deferral under Regs. §1.451-5 to receipt of an advance payment "by the taxpayer" for the sale of goods "held by the taxpayer" in a future taxable year.8 In the case of cross-redemption between operating retailers, this concern seemed hyper-technical because all parties involved held inventory for sale. However, gift card subsidiaries created for state tax planning purposes typically had no inventory and thus could not literally satisfy the requirements under Regs. §1.451-5(a)(1). Further, the use of gift cards in the franchise context presented additional concerns to the IRS because the cards were redeemed by unrelated parties.
In the case of returned merchandise, some at the IRS viewed this as a timing of deduction issue under IRC §461, rather than a timing of income issue. Regs. §1.461-4(g)(3) provides that refunds as a result of returns are not deductible until payment, and the IRS's position was that giving the customer a gift card was not payment until the gift card was redeemed (i.e., the retailer "paid" the refund with the merchandise selected by the consumer when the gift card was redeemed).9
Within a year or so of the first IRS exam challenges, the issues of cross-redemption of gift cards and the use of gift cards for returned merchandise were mega-issues. Most retailers issue gift cards, and, of those that did, most have either the cross-redemption issue or the returned merchandise issue or both. The IRS made the gift card issue a Tier 2 issue,10 which effectively mandated that agents raise the issue and precluded agents from settling the issue. In response to the IRS posture, some retailers settled in for a long battle on these issues, while others, depending on their examination posture, filed accounting method change requests to use alternative methods of accounting, effectively conceding the issues to the IRS. This issue was added to the IRS and Treasury Priority Guidance Plan in 2008, and was regularly discussed at length at the regular tax meetings (ABA, AICPA, TEI, and various other tax conferences). At such meetings between 2008 and late 2010, the IRS promised guidance. While the guidance was being drafted and reviewed, the large number of cases in controversy generally remained in a holding pattern - some were held at examination, while in other cases taxpayers filed protests to move the issue to the IRS Appeals division. In summary, what was ongoing was very characteristic of a mega-issue - lots of talk by all involved, many very similar cases pending in controversy, and the sense by some that the mega-issue would continue indefinitely, perhaps until there was a court test.
All of a sudden, in January 2011, the mega-issue effectively came to an end. The development that ended the mega-issue was the issuance of two "Solomon-like" revenue procedures, Rev. Proc. 2011-1711 and Rev. Proc. 2011-18,12 which offered a compromise on the mega-issue. As background to this compromise, Rev. Proc. 2004-3413 offers a one-year14 deferral (in contrast to the two-year deferral provided by Regs. §1.451-5(c)) of advance payments in a much broader set of circumstances than Regs. §1.451-5. While the gift card mega-issue was ongoing, the IRS issued a TAM taking the position that Rev. Proc. 2004-34 didn't apply to gift cards any more broadly than Regs. 1.451-5(c) does.15
However, because Rev. Proc. 2004-34 is entirely the product of IRS discretion, it is subject to change. The IRS effectively resolved16 the gift card mega-issue by explicitly adding advance payments received in connection with the issuance of gift cards to the list of circumstances eligible for the one-year deferral under Rev. Proc. 2004-34. Rev. Proc. 2011-18 permits the deferral of advance payments received when gift cards are sold to customers; Rev. Proc. 2011-17 allows retailers to treat returned merchandise transactions as if the merchandise was returned for cash (thus disposing of the deduction timing issue) and the cash was used to purchase a gift card, which was subject to deferral under Rev. Proc. 2011-18. The revenue procedures each provided guidance as to how taxpayers could change from their current method of accounting for gift cards to the method permitted by such revenue procedures.17
In conclusion, several points are worth considering. First, while mega-issues are pending, there is never certainty as to what the outcome will be. This uncertainty as to the outcome tends to create a significant amount of unease among tax personnel within companies. Second, as a result of the first point, taxpayers faced with mega-issues must defend their position vigorously while the issue is still pending. This involves staying on top of the ongoing developments with respect to the mega-issue while it is still a mega-issue (before issuing the compromise document, the IRS often issues documents taking a hard-line stance on the mega-issue) and making strategic decisions as to what steps to take while the issue remains pending (e.g., go to Appeals, file a request for an accounting method change if possible, etc.). Third, while in the vast majority of cases a compromise similar to that offered by the IRS in the gift card mega-issue is palatable to all parties, and thus the ongoing controversies cease, there are times when one or more taxpayers choose to litigate the issue. Should such a taxpayer prevail, the mega-issue has the potential to begin again as the IRS and taxpayers react to the new situation.
For more information, in the Tax Management Portfolios, see White, 570 T.M., Accounting Methods - General Principles, and Connor, Kennedy, Tingey, and Carlone, 572 T.M., Accounting Methods - Adoption and Changes, and in Tax Practice Series, see ¶3540, Timing of Inclusion, and ¶3560, Timing of Deductions.
1 See, e.g., RJR Nabisco v. U.S., 955 F.2d 1457 (11th Cir. 1992), in which the taxpayer successfully challenged the IRS position on package design, and U.S. Freightways v. Comr., 270 F.3d 1137, 1143-44 (7th Cir. 2001), in which the taxpayer successfully challenged the position on the IRS on one-year prepaid expenses. In both situations the IRS ultimately accepted the court opinions and conceded the mega-issue.
2 Automobile Club of Michigan v. Comr., 353 U.S. 180, 184 (1957), American Automobile Assn. v. U.S., 367 U.S. 687, 697-698 (1961), Schlude v. Comr., 372 U.S. 128 (1963).
3 See Regs. §1.451-5(c)(1)(iii).
4 In IRS Large and Mid-Size Business Division Industry Director Directive on the Planning and Examination of Gift Card/Certificate Issues in the Retail, Food & Beverage Industries, 2007 ARD 108-2 (6/4/07), the IRS took the position that a taxpayer's method of accounting for gift certificates applied to gift cards issued by the taxpayer.
5 The term "cross-redemption," in this context, refers to the ability of a gift card holder to redeem the gift card at any legal entity designated on the gift card, and not merely at the legal entity from which the gift card was purchased.
6 Generally, the gift card subsidiary is either a subsidiary of an entity that is part of the consolidated group or is a disregarded entity of an operating legal entity.
7 The above list of circumstances that led to the mega-issue is not intended to be comprehensive. See IRS Industry Director Directive dated May 23, 2007, for a list of other developments.
8 See TAM 200849015.
9 The recurring item exception would allow the retailer to claim the deduction in a particular taxable year if the gift card was redeemed within eight and one-half months of the end of that taxable year.
10 See Industry Director Directive dated May 23, 2007 and IRM Section 4.43.1, Retail Industry (7/23/09).
11 2011-5 I.R.B. 441.
12 2011-5 I.R.B. 443.
13 2004-22 I.R.B. 991.
14 More specifically, taxpayers using the deferral method of Rev. Proc. 2004-34 include in taxable income in the year of receipt of the advance payment the amount included in income for financial statement purposes, and include in taxable income the remaining portion of the advance payment in the following year.
15 See TAM 200849015.
16 After the issuance of the revenue procedures, the issue of what to do with pending cases needed to be resolved, and in certain cases this took several months. Nevertheless, the debate over the impact of cross-redemption and returned merchandise on the treatment of advance payments received in connection with gift cards effectively ended.
17 See 572 T.M., Accounting Methods-Adoption and Changes, Worksheets, for additional information concerning these two accounting method changes relating to gift cards.
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