Income tax treatment of loyalty point programs

Editor: Alexander J. Brosseau, CPA

Taxpayers administering funds for loyalty point programs on behalf of multiple parties are often perplexed about the appropriate federal income tax treatment accorded such funds. Does the fund result in nonrecognition of revenue under a conduit theory or in deferred revenue recognition as an eligible advance payment? Or does it generate current income with (1) a current offset under the trading stamp regulations; (2) a current expense under Giant Eagle, 822 F.3d 666 (3d Cir. 2016); or (3) merely a deduction at the time of future redemption? Hyatt Hotels Corp., T.C. Memo. 2023-122, is the latest development in this area and provides additional guidance for taxpayers struggling to determine the proper federal income tax treatment relative to the administration of their loyalty point programs.

In Hyatt Hotels, Hyatt operated a customer rewards program that provided customers with reward points redeemable for free stays at Hyatt hotels. Hyatt-branded hotels comprise both Hyatt-owned hotels and locations operated by third-party hotel operators. When a customer received reward points for a stay at a Hyatt hotel, Hyatt required the hotel owner to make a payment into an operating fund. When a customer redeemed rewards points for a stay at a Hyatt hotel, Hyatt made a compensation payment to the hotel owner out of the fund.

The fund was held and managed by Hyatt, which retained significant control over the fund in several ways:

• It could unilaterally adjust the program assessment fee that was contributed to the fund;
• It directed the fund’s general investment strategy;
• The fund accrued interest and realized investment gains, which Hyatt could direct the use of;
• It was the sole recipient of quarterly statements regarding the fund’s investment activities;
• It controlled fund disbursements by creating the compensation formula used to pay third-party hotel operators for customer redemptions; and
• It used the fund to pay some of its own advertising and administration costs.

Additionally, Hyatt maintained exclusive unlimited access to the program’s member database and directly benefited from the goodwill generated by the program.

For federal income tax purposes, Hyatt excluded the revenue from its gross income and claimed no deductions for expenses paid, in accordance with its belief that it was merely a trustee, agent, or conduit for the hotel owners instead of a true owner of the fund.

The Tax Court held that: (1) the amounts received related to the customer reward program were revenue includible in Hyatt’s gross income; (2) the treatment of the revenue was not a method of accounting subject to a Sec. 481(a) adjustment; and (3) Hyatt could not employ the trading stamp method of accounting.

Revenue includible in gross income

Generally, Sec. 61 broadly defines gross income as all income from whatever source derived. However, several exclusions from gross income exist, including under the trust fund doctrine, which Hyatt asserted as a justification for the exclusion of the fund from federal income tax.

The Tax Court recognized the trust fund doctrine in Seven-Up Co., 14 T.C. 965 (1950), which allows a taxpayer to exclude trust funds from gross income when a taxpayer (1) receives funds in trust, subject to a legally enforceable restriction that they be spent in their entirety for a specific purpose, and (2) does not profit, gain, or benefit from spending the funds for that purpose. In Seven-Up, the taxpayer, which provided third-party bottlers with 7 Up extract to bottle and sell the product to consumers, created and contributed to an advertising fund. The third-party bottlers also voluntarily contributed to the advertising fund, which was used to promote consumer purchases of 7 Up. As the taxpayer was a wholesaler, its business was focused solely on selling the extract to the bottlers. Therefore, the advertising was a direct benefit to the bottlers, as they sold directly to consumers and the taxpayer received only an indirect benefit based on the third parties’ increased need of extract to serve consumer demand. The Tax Court highlighted that in Seven-Up, the payments were not includible in gross income because the taxpayer did not gain or profit because of the fully offsetting restriction on its use of the funds and the fact that the benefit flowed directly to third parties and only indirectly to 7 Up.

The Tax Court distinguished Hyatt’s situation from that of the taxpayer in Seven-Up because Hyatt mandated that the third-party hotel operators participate in the program and pay into the fund, controlled the amounts of program payments into and compensation payments out of the fund, decided how to invest the fund, directed use of the accrued interest and realized investment gains recognized by the fund, and determined whether particular advertising or administrative costs would be paid for by the fund — all without oversight or input from the third-party hotel operators. Hyatt’s significant control indicated a beneficial interest instead of a legally enforceable restriction.

Regarding the second portion of the trust fund doctrine, Hyatt directly benefited from the fund because the fund benefited Hyatt-owned hotels, compensated Hyatt for advertising costs, and ultimately generated goodwill among customers, leading to increased bookings as well as increases in royalties and other fees that third-party hotel operators would provide to Hyatt as a result of the increased goodwill and bookings. As such, the Tax Court concluded that the trust fund doctrine exception did not apply to Hyatt’s situation and the fund revenue was includible in gross income.

Taxpayers maintaining a fund to account for loyalty program revenue and expense need to determine whether their situation is (1) more analogous to that of the taxpayer in Seven-Up and ultimately excludable from gross income as a trustee, agent, or conduit of such funds, or (2) substantially similar to Hyatt, where the fund receipts generate current taxable revenue due to the taxpayer’s control over, and benefits derived from, the fund. Whether a taxpayer is more akin to the taxpayer in Hyatt or the one in Seven-Up is a highly factual question requiring extensive development and analysis of a taxpayer’s circumstances. While no particular fact is controlling, taxpayers are more likely to have a current revenue recognition event when there is little restriction on their ability to direct fund activities and when they directly benefit from the fund’s operation.

Method of accounting

The second item of contention between Hyatt and the IRS was whether Hyatt’s treatment of fund revenue and expense was a method of accounting subject to a Sec. 481(a) adjustment. Under Regs. Sec. 1.446-1, a change in method of accounting includes a change in the overall method of accounting for gross income or deductions, or a change in the treatment of a material item, which is any item that involves the proper time for the inclusion of the income or the taking of a deduction. Hyatt asserted that the treatment of the fund did not involve material items since the fund revenue and expenses were permanently excluded on prior returns. In an attempt to reach the revenue the fund had received in closed years, the IRS took a more results-based view whereby both Hyatt’s prior and current treatment of the fund as a whole (revenue and expense) resulted in zero aggregate lifetime taxable income, thus implicating questions of timing. The Tax Court concluded that Hyatt’s approach was correct because its consistent, total exclusion of both program revenue and expense did not involve timing. Hyatt never intended to recognize income and expense and therefore had no method of accounting subject to a Sec. 481(a) adjustment.

Hyatt reported a zero fund impact on its federal income tax returns. Hyatt’s intention to never recognize fund income or expense was a significant impediment to classifying its treatment of the fund as a method of accounting. However, if Hyatt had alternatively recognized fund income and expense in equal amounts (netting to zero) simultaneously at the point of customer redemption, the court might have concluded that a method of accounting did exist.

Trading stamp method

The last issue in the case focused on an exception to the all-events test. Pursuant to the all-events test in Regs. Sec. 1.461-1(a)(2), a liability is incurred for the tax year when (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 with respect to the liability. Hyatt attempted to assert the trading stamp method under Regs. Sec. 1.451-4 as an exception to the all-events test applicable to its fact pattern. The trading stamp method allows taxpayers to accelerate deductions to the point in time when trading stamps or premium coupons are dispensed instead of when they are redeemed for merchandise, cash, or other property in a future period.

For Hyatt, the trading stamp method would allow fund gross receipts to be offset by both the current-year reward redemptions and the estimated cost of future tax year reward redemptions. However, the Tax Court denied this argument on the grounds that a hotel stay, which is characterized either as a license or a leasehold, would not qualify as merchandise, cash, or other property as required under the trading stamp method. The Tax Court clarified that “other property” should be construed only as property similar to merchandise or cash. Proper application of the trading stamp method requires a specific set of taxpayer facts. As such, many taxpayers find it difficult to claim the benefits afforded under this provision.

Consideration of the Tax Court’s holdings in the case are essential when evaluating tax planning opportunities associated with the administration of loyalty programs among multiple taxpayers. The most important takeaway is that taxpayers relying on the trust fund doctrine will want to ensure that their fact pattern more closely aligns with Seven-Up. Failure to do so will likely create complexities for taxpayers attempting to avoid revenue recognition by establishing themselves as an agent or conduit.

Editor Notes

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. For additional information about these items, contact Brosseau at abrosseau@deloitte.com. Unless otherwise noted, contributors are associated with Deloitte Tax LLP.

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