The popularity of gift cards and gift certificates (collectively referred to as gift cards) has increased dramatically in recent years. For state escheat and unclaimed property reasons, a common business model is for gift cards to be sold and managed by a separate gift card company (Giftco) and redeemed by either an affiliated party or an unrelated third party under a gift card service agreement. Since 2007, the IRS has taken a position in informal guidance that deferral is not permitted under either Rev. Proc. 2004-34 or Regs. Sec. 1.451-5 in situations where the entity selling the gift card is not the one ultimately providing the goods or services in redemption of the gift card. Controversy has also arisen relating to the tax treatment of gift cards issued for returns of merchandise.
On January 5, 2011, the IRS issued two taxpayer-favorable revenue procedures addressing the treatment of payments received for gift cards. The first (Rev. Proc. 2011-17) provides a safe-harbor method of accounting for gift cards issued in exchange for returned merchandise, while the second (Rev. Proc. 2011-18) involves income deferral for gift cards that can be redeemed by a third party.
For tax purposes, amounts received by an accrual-method taxpayer for goods or services it will provide in the future must generally be included in gross income in the tax year of receipt. However, deferral is permitted under either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34. Regs. Sec. 1.451-5 generally allows accrual-method taxpayers to defer recognition of the advance payment for goods until the tax year that the payments are recognized in revenues under the taxpayer’s method of accounting for financial reporting purposes. However, Regs. Sec. 1.451-5(c) provides that a taxpayer generally may not defer advance payments for inventoriable goods beyond the end of the second tax year following the year the taxpayer receives a substantial advance payment such as a gift card sale (hence, a two-year deferral).
The second exception, Rev. Proc. 2004-34, is broader but provides a shorter deferral period. Under this revenue procedure, an accrual-method taxpayer may defer all or part of certain advance payments for services and/or the sale of goods in gross income until the tax year following the tax year in which payment is received (hence, a one-year deferral).
Rev. Proc. 2011-17
Rev. Proc. 2011-17 provides a safe-harbor method of accounting for the treatment of gift cards issued to customers in exchange for returned merchandise. According to the revenue procedure, retail taxpayers handle returns of goods by either giving the customer a cash refund or issuing the customer a gift card. The IRS concludes that a retailer may treat the issuance of a gift card in exchange for returned merchandise as if it had paid the customer an immediate cash refund, which the customer then used to purchase the gift card. Under this safe harbor, the retailer can recognize the liability for the refund immediately and defer the income arising from the advance payment for the gift card under either Regs. Sec. 1.451-5 or Rev. Proc. 2004-34, if otherwise eligible. A taxpayer may use this method regardless of whether it is the taxpayer’s policy to provide a cash refund for returned goods.
Taxpayers may file an automatic consent Form 3115, Application for Change in Accounting Method, under Rev. Proc. 2011-14 to request a change to the one-year deferral method of Rev. Proc. 2004-34 and the Rev. Proc. 2011-17 safe harbor. However, a change to the two-year deferral of Regs. Sec. 1.451-5(c) and the Rev. Proc. 2011-17 safe harbor requires an advance (i.e., nonautomatic) consent Form 3115 under Rev. Proc. 97-27. For taxpayers already using the permitted method in a tax year ending before December 31, 2010, the IRS will not raise the issue on audit; if it has already raised the issue, the issue will not be pursued further. Rev. Proc. 2011-17 is effective for tax years ending on or after December 31, 2010.
Rev. Proc. 2011-18
Rev. Proc. 2011-18 applies to an accrual-method taxpayer that receives an advance payment for an eligible gift card sale. The term “eligible gift card sale” means the sale of a gift card if 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 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 goods or services.
In order to reduce controversy, the IRS and Treasury have concluded that a taxpayer that sells gift cards redeemable through other entities in an eligible gift card sale should be treated in the same manner as a taxpayer that sells gift cards redeemable only by that entity. Accordingly, Rev. Proc. 2011-18 expands the scope of Rev. Proc. 2004-34 to allow taxpayers to use the one-year deferral even when the gift cards will be redeemed by a third party, related or unrelated to the selling entity, under a gift card service agreement. The IRS acknowledges several types of gift card arrangements, including:
- Members of an affiliated group using a gift card subsidiary to sell gift cards that may be redeemed for goods and services provided by the gift card subsidiary or by other members of the group;
- A franchisor or franchisee selling gift cards that may be redeemed for goods or services provided by other independently owned franchisees;
- A restaurant management company selling gift cards that may be redeemed by participating restaurants in different geographic locations or with different trade names; and
- A retailer issuing 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.
Taxpayers may file an automatic consent Form 3115 under Rev. Proc. 2011-14 to request a change to the one-year deferral method of Rev. Proc. 2004-34 if otherwise eligible. For taxpayers already using the permitted method in a tax year ending before December 31, 2010, the IRS will not raise the issue on audit; if it has already raised the issue, the issue will not be pursued further. Rev. Proc. 2011-18 is effective for tax years ending on or after December 31, 2010.
Limitations on Scope of Relief
Although it expanded the scope of Rev. Proc. 2004-34, Rev. Proc. 2011-18 does not modify Regs. Sec. 1.451-5 to allow deferral of advance payments where the entity issuing the gift card is not the party that redeems the gift card. In the IRS’s view, Regs. Sec. 1.451-5 applies only to “an agreement for the sale or other disposition in a future taxable year of goods held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business” (Regs. Sec. 1.451-5(a)(1)). Therefore, according to the IRS, goods provided by entities other than the taxpayer issuing the gift card are not held by the taxpayer for sale. In light of this recent guidance, affected taxpayers with such eligible gift card sales should evaluate their policies and methods of accounting for gift card sales and implement changes where necessary.
Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.