In recent years, the sale of gift cards, as well as the issuance of gifts cards to customers in exchange for returned merchandise, has become a widespread business practice in consumer markets industries, especially the retail industry. This increasing use of gift cards and the disparity between federal tax accounting and financial accounting treatment of advance payments have led to inconsistency among taxpayers and confusion as to the proper timing of recognizing income from the sale of gift cards—particularly in situations when the gift cards may be redeemed by someone other than the taxpayer—and the proper treatment of gift cards issued to customers in exchange for returned merchandise. This item provides background information on the tax and accounting treatment of gift card income and discusses two revenue procedures that address these issues.
Gift Card Income
In general, Sec. 451 and the regulations thereunder require accrual-method taxpayers to include an item in gross income when the all-events test is met or, as interpreted by the courts, at the earliest of when it is received, due, or earned (Schlude, 372 U.S. 128 (1963); Rev. Rul. 84-31). Thus, when a taxpayer receives an advance payment for goods or services before the goods or services are provided, the payment must generally be included in gross income upon receipt; however, Regs. Sec. 1.451-5 and Rev. Proc. 2004-34 provide limited exceptions to the general rule, allowing deferral of advance payments.
Regs. Sec. 1.451-5 allows deferral of an “advance payment,” defined in relevant part as “any amount which is received . . . pursuant to, and to be applied against, an agreement . . . [f]or the sale or other disposition in a future taxable year of goods held by a taxpayer primarily for sale to customers in the ordinary course of his trade or business.” For this purpose, an “agreement” includes a gift card that can be redeemed for goods. The income related to the gift card can generally be deferred until the earlier of when a cardholder uses the card or the second tax year following the year of the card’s purchase.
Rev. Proc. 2004-34 also provides a deferral method but defines an advance payment differently than Regs. Sec. 1.451-5. Under the revenue procedure, a payment is an advance payment if:
- Including the payment in gross income for the year of receipt is a permissible method;
- The taxpayer recognizes the payment (in whole or in part) in revenues in its applicable financial statement for a subsequent tax year; and
- The payment is one of the specific items enumerated in the revenue procedure, which includes payments for services or the sale of goods (except when the taxpayer uses the Regs. Sec. 1.451-5 deferral method).
The taxpayer may defer an advance payment to the extent it is deferred for financial statement purposes in the year of receipt, but must include it in gross income in the succeeding tax year.
How retailers market, sell to customers, and redeem gift cards has evolved over time; cards are now commonly sold by one taxpayer and redeemed either by the selling taxpayer or by others, whether related or unrelated to the selling entity. Before issuing guidance (discussed below) that may allow deferral, the IRS had issued taxpayer-specific guidance taking the opposite position. (See, e.g., Technical Advice Memorandum (TAM) 200849015; Field Attorney Advice 20082801F.)
Rev. Proc. 2011-18
Rev. Proc. 2011-18 modifies Rev. Proc. 2004-34 in order to permit deferral in certain situations when gift cards are sold by one taxpayer and redeemed either by that taxpayer or by others, either related or unrelated to the selling taxpayer, under a gift card service agreement. Rev. Proc. 2011-18 provides the following examples of fact patterns that may be eligible for deferral:
- 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 geographic locations or with different trade names.
- 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.
The revenue procedure acknowledges that gift card entity structures and service agreements may vary widely but notes that it is common for a gift card entity to receive and hold the proceeds from gift card sales until a customer uses the card to purchase merchandise or services. If a customer uses a gift card to purchase merchandise or services from a participating merchant, that merchant is generally obligated to accept the gift card as payment for its goods or services, and the gift card entity is generally obligated to reimburse the participating merchant for the sales price of the goods or services purchased with the gift card. Under the terms of a typical gift card service agreement, the gift card entity is primarily liable to the customer for the value of the gift card until the card expires or is redeemed.
The revenue procedure goes on to say that the IRS and Treasury have concluded that—provided the other requirements of Rev. Proc. 2004-34 are met—when a taxpayer sells gift cards redeemable by other entities, the tax treatment should be the same as for gift cards redeemable only by the taxpayer. Accordingly, Rev. Proc. 2011-18 modifies the definition of advance payments in Rev. Proc. 2004-34 to allow deferral of advance payments received under additional types of gift card arrangements. Specifically, it adds payments for “an eligible gift card sale” to Section 4.01(3) of Rev. Proc. 2004-34. An eligible gift card sale is
the sale of a gift card (or gift certificate) if: (1) the taxpayer is primarily liable to the customer (or holder of the gift card) for the value of the card until redemption or expiration, and (2) the gift card is redeemable by the taxpayer or by any other entity that is legally obligated to the taxpayer to accept the gift card from a customer as payment for items listed in Sections 4.01(3)(a)–(j) of this revenue procedure.
Rev. Proc. 2011-18 adds three new examples to Rev. Proc. 2004-34 to illustrate how the deferral method applies to eligible gift card sales.
To meet the definition of “advance payment” in Rev. Proc. 2004-34, the taxpayer must recognize the payment, in whole or in part, in revenues in its applicable financial statement for a subsequent tax year. If a taxpayer is a member of an affiliated group of corporations that files a consolidated return for federal income tax purposes, Rev. Proc. 2011-18 considers the group’s financial statement to be a financial statement of the taxpayer. The revenue procedure does not, however, consider what happens if, for financial statement purposes, the gift card receipts are not reported as revenues when redeemed but rather, for example, as the reduction of a liability or a deposit. In this situation, there may be a question whether the payment qualifies for deferral. Also, because Rev. Proc. 2011-18 modifies Rev. Proc. 2004-34, but not Regs. Sec. 1.451-5, to allow deferral under additional gift card arrangements, the IRS may continue to assert that gift card income under these arrangements does not qualify for deferral under the regulation.
Change in Method of Accounting
Rev. Proc. 2011-18 generally allows a taxpayer to change its method of accounting to the Rev. Proc. 2004-34 deferral method for eligible gift card sales under the automatic method change procedures in Rev. Proc. 2008-52. However, shortly after the issuance of Rev. Proc. 2011-18, the IRS issued a new automatic change procedure, Rev. Proc. 2011-14, which amplifies, clarifies, modifies, and effectively supersedes Rev. Proc. 2008-52. Therefore, the change to the Rev. Proc. 2011-18 deferral method can now generally be made under the automatic change procedures pursuant to appendix Section 15.07 of Rev. Proc. 2011-14 (except in certain cases when a taxpayer is required to allocate the advance payment between qualifying and nonqualifying items, or when the taxpayer does not have an applicable financial statement and must determine the amount earned based on statistical data or on a nonratable basis, in which case the change must be requested under the nonautomatic procedures of Rev. Proc. 97-27).
The scope limitations in Section 4.02 of Rev. Proc. 2011-14 do not apply to this change in method of accounting for a taxpayer’s first or second tax year ending on or after December 31, 2010. However, if a taxpayer is under examination or appearing before an Appeals office or a federal court for any income tax issue when the taxpayer files the copy of Form 3115, Application for Change in Accounting Method, with the IRS National Office, the taxpayer must provide a copy of the form to the examining agent, Appeals officer, or counsel for the government, as appropriate, at the same time. The Form 3115 must contain the name(s) and telephone number(s) of the examining agent, Appeals officer, or counsel for the government, as appropriate.
Prior-Year Audit Protection
According to Rev. Proc. 2011-18, for tax years ending before December 31, 2010, the IRS will not raise on examination the issue of whether the Rev. Proc. 2004-34 deferral method can apply to eligible gift card sales. Moreover, if a taxpayer’s use of the deferral method for eligible gift card sales is an issue under consideration in examination, Appeals, or before the Tax Court in a tax year that ends before December 31, 2010, the IRS will not further pursue the issue.
Gift Cards Issued for Merchandise Returns
Typically, a taxpayer (merchant) will handle returns of inventoriable goods either by giving the customer a cash refund or by issuing a credit, for example, in the form of a gift card. Rev. Proc. 2011-17 provides a safe-harbor method of accounting for the treatment of gift cards in this situation. Under an accrual method of accounting, Sec. 461(a) and the regulations thereunder generally find that a liability has been incurred and take it into account in the tax year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred. When the liability is a refund liability, economic performance occurs when the refund is paid (whether in property, money, or a reduction in the price of goods or services to be provided in the future) pursuant to Regs. Sec. 1.461-4(g)(3).
Many commentators in the retail industry have contended that cash refunds and gift cards provided as refunds for returned goods should be treated the same and that issuing a gift card for returned goods is tantamount to making a cash refund that the customer immediately uses to purchase a gift card. However, the IRS’s position is that a taxpayer who issues a gift card in exchange for returned goods does not have a fixed liability under Sec. 461(a) because the liability is conditioned on the future redemption of the gift card.
Rev. Proc. 2011-17
Rev. Proc. 2001-17 establishes a safe-harbor method of accounting for the treatment of gift cards issued to customers in exchange for returned merchandise. The revenue procedure states that—to avoid disputes about the proper characterization of gift cards issued for returned goods, provide better matching of income and costs, and simplify recordkeeping—the IRS will permit a taxpayer to treat gift cards issued for returned goods as the payment of a cash refund and a sale of a gift card. The taxpayer must be within the scope of the revenue procedure—i.e., an accrual-method taxpayer engaged in the trade or business of selling goods at retail. The taxpayer may account for the amount deemed received for the sale of the gift card under either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34, if otherwise eligible. A taxpayer may use this method whether or not it is the taxpayer’s policy to provide a cash refund for returned goods.
For purposes of the safe harbor, a gift card is any evidence of a promise to provide a specific dollar amount of goods and/or services to a customer in a future sale, whether imprinted electronically on a plastic card, issued electronically with a special code, provided as a printed certificate, or recorded on a taxpayer’s books. A card or other evidence of a promise to provide a specific dollar amount of goods and/or services is not a gift card for purposes of the safe harbor if the customer must perform any act or service in addition to presenting the card, such as purchasing additional products, to obtain the goods and/or services.
Change in Method of Accounting
Rev. Proc. 2011-17 allows a taxpayer that wants to change its method of accounting to the safe-harbor method to generally do so under the automatic method change procedures in Rev. Proc. 2008-52. As explained above, Rev. Proc. 2008-52 has been superseded by Rev. Proc. 2011-14; thus, the change to the safe-harbor method can now generally be made under the automatic change procedures pursuant to appendix Section 19.10 of Rev. Proc. 2011-14.
A taxpayer may change its method to the safe-harbor method and a method of deferring the gift card income on the deemed gift card sale under Rev. Proc. 2004-34 on a single Form 3115. A taxpayer that wishes to change to the safe-harbor method and a deferral method under Regs. Sec. 1.451-5 may also file the change request on a single Form 3115; however, the change must be requested under the nonautomatic procedures of Rev. Proc. 97-27.
Like the Rev. Proc. 2011-18 accounting method change, the scope limitations in Section 4.02 of Rev. Proc. 2011-14 do not apply to this change in method of accounting for a taxpayer’s first or second tax year ending on or after December 31, 2010, and taxpayers under examination or appearing before an Appeals office or a federal court for any income tax issue must provide a copy of the Form 3115 to the examining agent, Appeals officer, or counsel for the government.
Prior-Year Audit Protection
If a taxpayer within the scope of Rev. Proc. 2011-17 used the safe-harbor method in a tax year ending before December 31, 2010, the IRS will not challenge the use of that method of accounting. Moreover, if a taxpayer’s use of the safe-harbor method is an issue under consideration in an examination, in Appeals, or before the Tax Court, the IRS will not further pursue the issue.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.