Card reward liabilities are eligible for the recurring-item exception

Editor: Michael Wronsky, CPA, MST

In Chief Counsel Advice (CCA) 202417021, the IRS provided guidance on the timing for deducting credit card reward liabilities under the all-events and economic performance rules, including whether the taxpayer is eligible to use the recurring-item exception method of accounting. The IRS favorably concluded that the credit card reward liabilities are deductible when the rewards become redeemable for cash or a statement credit and that the taxpayer may use the recurring-item exception to accelerate deductions for its credit card reward liabilities. Given the prevalent and growing use of reward and loyalty programs to incentivize consumer spending across a broad array of industries (e.g., airlines, retailers, hotels, restaurants, and banks), the CCA provides useful guidelines to taxpayers on how to structure these programs to accelerate deductions of reward program liabilities.

Facts of the CCA

According to the CCA, the taxpayer is a federally chartered bank that issues credit cards that enable cardholders to earn rewards by accumulating miles, points, etc. that can then be redeemed for cash, statement credits, travel, gift cards, and other goods and services. Different quantities of reward points are earned based on the type of transaction and the credit card purchase amount. Notably, the taxpayer’s reward program does not have redemption thresholds, and rewards are immediately redeemable by cardholders at the close of their billing period without an additional purchase requirement. Cardholders may redeem their rewards by phone or via the bank’s website or mobile app by specifying the number of points to redeem and clicking a button to execute the redemption. The taxpayer then immediately makes the redemption payment by sending the cardholder a check, issuing a statement credit, or providing the cardholder with the selected reward.

Under its present method of accounting, the taxpayer deducts the credit card reward liability when the rewards are redeemed. The CCA was issued in response to a request for advice from the IRS Large Business and International Division regarding the taxpayer’s proposal to change its accounting method for its credit card reward liabilities to use the recurring-item exception. Under the recurring-item exception, the taxpayer will deduct the credit card reward liability expenses in the tax year in which the rewards are earned by its cardholders, provided that the rewards are redeemed within 8½ months after the end of the tax year.

Background

Regs. Sec. 1.461-1(a)(2) generally provides that, under an accrual method of accounting, a liability is incurred in the tax year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability (the all-events test).

Sec. 461(h) and Regs. Sec. 1.461-4(a)(2) provide that, for purposes of determining whether an accrualbasis taxpayer can treat the amount of any liability as incurred, the all-events test is not treated as met any earlier than the tax year in which economic performance occurs with respect to the liability.

Regs. Sec. 1.461-4(g)(3) provides that if the liability of a taxpayer is to pay a rebate, refund, or similar payment to another person (whether in property, money, or as a reduction in the price of goods or services that the taxpayer is to provide in the future), economic performance occurs when payment is made to the person to which the liability is owed (see also Regs. Sec. 1.461-4(g)(8), Example 2).

Sec. 461(h)(3) and Regs. Sec. 1.461-5 permit a taxpayer to treat a liability as incurred prior to economic performance occurring by adopting the recurring-item exception as a method of accounting. A liability is treated as incurred for a tax year under the recurring-item exception if (Regs. Sec. 1.461-5(b)(1)):

• As of the end of the tax year, all events have occurred that establish the fact of the liability and the amount of the liability can be determined with reasonable accuracy;
• Economic performance occurs on or before the earlier of the date the taxpayer files a timely (including extensions) income tax return or the 15th day of the ninth month after the close of that tax year;
• The liability is recurring in nature; and
• Either the amount of the liability is not material, or accrual of the liability for that tax year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the tax year in which economic performance occurs.

Regs. Sec. 1.461-5(b)(5)(ii) provides that, for certain payment liabilities including rebates, the “better matching” requirement in the last prong of the four-part test described above is deemed to be satisfied.

In Giant Eagle, Inc., 822 F.3d 666 (3d Cir. 2016), rev’g T.C. Memo. 2014-146, the Third Circuit addressed the tax treatment of reward payments and ruled that a taxpayer’s anticipated liability for unredeemed gasoline discounts was fixed in the year the rewards were earned for purposes of the allevents test. Giant Eagle operated a gasoline discount program that entitled a customer to receive a “discount coupon” for a 10-cents-per-gallon reduction in price for every $50 spent on groceries. However, the discount coupons required an additional purchase of gasoline, were valid only at certain gas stations, and expired three months after the last day of the month in which they were issued.

The IRS issued Action on Decision AOD-2016-03 disagreeing with the Third Circuit’s decision and restating its position that the “[t]axpayer’s liability for its unredeemed discount coupons is not fixed before the customer purchases fuel” because the additional purchase of gasoline is not a ministerial act and is, therefore, a condition precedent to the establishment of the liability, in accordance with General Dynamics.

In General Dynamics Corp., 481 U.S. 239 (1987), the Supreme Court agreed with the IRS that the taxpayer’s liability for incurred but not reported expenses accrued under a self-insured employee medical plan was not fixed until the employee filed a claim form. The Supreme Court found that the filing of the claim was not ministerial because beneficiaries might not file claims for covered expenses for various reasons.

All-events test met when rewards are redeemable for cash or statement credit

The CCA favorably concluded that the taxpayer’s credit card reward liabilities are fixed and determinable when they become redeemable for a predetermined amount of cash or a statement credit (even though the rewards may also be redeemed for goods or services) because, under the taxpayer’s rewards agreement, a cardholder’s right to redemption is fixed and determinable at that point and the redemption procedure is ministerial. Noting that this finding is consistent with its longstanding position that a liability is not fixed under the all-events test if there is a condition precedent that is not ministerial, the IRS further explained that “reward programs that do not provide redemption options that include cash or a statement credit but require an additional purchase to receive a partial or complete discount” are treated as containing nonministerial condition(s) precedent that prevent the reward liabilities from becoming fixed under the all-events test until the rewards are actually redeemed (rather than when they are redeemable).

The IRS found that the taxpayer’s credit card rewards agreement contains no such conditions and is therefore distinguishable from the situations described in General Dynamics and Giant Eagle. Unlike the credit card rewards program in the CCA, the arrangements in these two cases contained nonministerial condition(s) precedent that had to be satisfied in order for the taxpayer’s liability to become fixed and determinable under the all-events test. Specifically, the IRS cited the claims filing process in General Dynamics and the requirement to make an additional purchase of gasoline at specific locations within a limited time period in Giant Eagle as nonministerial conditions precedent that delayed the deductions for the liabilities in these two cases until after the conditions were satisfied.

Significantly, the CCA also reiterated the IRS’s disagreement with the Third Circuit’s decision in Giant Eagle and referred to AOD-2016-03, outlining its established position regarding the all-events test. Consequently, taxpayers outside the Third Circuit that have relied on that court’s holding to support a contrary stance should carefully evaluate whether to revise their rewards program or change their method of accounting to mitigate potential IRS exam and litigation risks.

Having determined the time when the taxpayer’s credit card reward liabilities become fixed and determinable, the IRS next addressed the economic performance requirement under the allevents test.

Economic performance and eligibility for the recurring-item exception

Under Regs. Sec. 1.461-4, the nature of the liability determines when economic performance occurs. Based on the taxpayer’s facts, the IRS determined that the credit card rewards described in the CCA are akin to a rebate or “similar payment” liability for which economic performance occurs when the redemption payment is made to the cardholder. In support of its conclusion, the IRS noted that, like a rebate, which is essentially “a return of an amount actually paid by a customer in a sale,” the taxpayer’s credit card reward program provides the cardholder with cash back and other rewards based on the price paid for purchases made using the credit card. Thus, the IRS reasoned that the credit card rewards are “sufficiently similar” to a rebate within the meaning of Regs. Sec. 1.461-4(g)(3), even though they are not “technically” rebates.

Furthermore, the IRS favorably concluded that the taxpayer may use the recurring-item exception to accelerate the deduction of its credit card reward liabilities that satisfy the four-part test under Regs. Sec. 1.461-5(b). Thus, the taxpayer may deduct reward liabilities incurred by year end that meet the recurring-item exception, even though actual economic performance (i.e., payment) has not occurred at that time.

Importantly, classification of the taxpayer’s credit card rewards as a rebate or “similar payment” means that the taxpayer’s reward liabilities are deemed to meet the “better matching” requirement of the four-part test pursuant to the special rule in Regs. Sec. 1.461-5(b) (5)(ii). This is fortunate because this condition has often been a source of controversy and a barrier to taxpayers’ attempts to apply the recurring-item exception to accelerate deductions for other types of liabilities not covered by the special rule (e.g., services and rent). See, for example, VECO Corp., 141 T.C. 440 (2013), and Rev. Rul. 2012-1.

Regs. Sec. 1.451-4 exception inapplicable

Finally, the IRS concluded in a footnote that the taxpayer’s credit card rewards are “hybrid coupons” because they allow a cardmember to receive a partial or full discount on the purchase of an item. (See AM 2017-002 for definitions of hybrid, discount, and premium coupons.) Consequently, the taxpayer’s reward liabilities are ineligible for the favorable exception to the all-events test and economic performance requirements provided in Regs. Sec. 1.451-4. Under this exception, a taxpayer that issues trading stamps or premium coupons with sales of merchandise is permitted to deduct the estimated cost of redeeming the trading stamps or premium coupons when the sale is made rather than when the trading stamps or coupons later become redeemable or are redeemed. See Legal Advice Issued by Field Attorneys 20180101F for details of a fuel rewards program that the IRS determined was eligible for this exception under Regs. Sec. 1.451-4.

Implications

Importantly, the CCA highlights the nuanced and fact-specific nature of the analysis required to determine the tax treatment of loyalty and reward program expenses. As illustrated in the CCA, seemingly minor variations in agreement terms can significantly affect the timing for deducting a taxpayer’s reward liabilities. Although it may not be cited as precedent and is directed to a particular credit card issuer, the CCA provides useful insight for taxpayers in other industries on how the IRS applies the all-events test in situations common to many types of reward and loyalty programs. For example, the CCA:

• Clarifies that lack of a cash rebate or statement credit reward option might trigger a condition precedent that delays the reward liability from becoming fixed and determinable until the rewards are redeemed. Similarly, the CCA’s facts imply that the existence of a redemption threshold could also constitute a condition precedent.
• Provides guidance to assist taxpayers in qualifying their reward program liabilities for the favorable recurring-item exception. In particular, like the taxpayer in the CCA, taxpayers might structure rewards as rebates or similar payments to automatically satisfy the “deemed better matching” provision of the four-part recurring-item exception test.
• Appears to interpret ministerial acts more broadly than the General Dynamics decision, which concluded that the employee claim filing requirement was a nonministerial condition precedent. In contrast, the IRS favorably determined that the cardholder redemption process described in the CCA was a ministerial act that did not prevent the reward liability from becoming fixed and determinable.
• Helpfully distinguishes the features and tax treatment for different coupon types (e.g., discount, hybrid), as well as notes the potential availability of the special exception to the all-events test under Regs. Sec. 1.451-4 for certain premium coupons.
• Serves as a reminder for taxpayers that may be improperly applying the Third Circuit’s decision in Giant Eagle to review their reward and loyalty programs and, if necessary, take action to mitigate potential IRS exam controversy and litigation risk.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.