It has been estimated that annual gift card sales have reached approximately $110 billion as a result of an increase in gift card offerings from financial services firms (for example, American Express, Visa, MasterCard and Discover, with revenue estimated at $40 billion); restaurants (revenues estimated at $19 billion); and retail and wholesale companies (revenue estimated to be $36 billion).1 Last year, it was estimated that 85 percent of the U.S. population would exchange gift cards.2 Moreover, the gift card market is expected to continue to grow, topping $130 billion in sales by 2015, with electronic gifting growing from $3 billion annually to $16 billion by 2015.3 With the significance of gift cards, it is not surprising that the Internal Revenue Service (the “Service”) continues to focus its efforts on the income tax treatment of gift card income.
A number of issues have been identified by the Service regarding the tax treatment of gift card income in general and the deferral of gift card income in particular. Many companies defer recognition of gift card income until the gift card is redeemed for financial accounting purposes. However, for tax purposes, gift card income is generally recognized upon receipt (that is, when the gift card is purchased) unless the taxpayer has taken advantage of the deferral provisions allowed for advance payments. Because of the disparate financial and tax accounting treatment for gift cards, the Service identified the tax treatment of gift card income as a significant compliance risk as part of its tiered examination initiative.4 Following a rash of IRS examinations involving gift card income, a number of issues were resolved with the publication of administrative guidance in 2011.5 Although this guidance addressed numerous issues, several issues remained outstanding6 and the Service recently released new guidance, Revenue Procedure 2013-29,7 which further clarifies the treatment of gift card income.
The new administrative procedure modifies and clarifies the guidance previously issued under Revenue Procedures 2011-18 and 2004-34. Importantly, it allows deferral for payments received in connection with the sale of gift cards redeemable by unrelated entities.
As a general rule, when an accrual-basis taxpayer receives a payment for goods or services that are to be provided in the future, income is recognized in the year of receipt.8 However, under the deferral method of accounting available in Revenue Procedure 2004-34,9 a taxpayer receiving advance payments for goods and services may defer income recognition to a later year (no more than two years’ deferral) as long as the income is recognized consistent with the taxpayer’s applicable financial statement. For taxpayers without an applicable financial statement, the advance payments must be included in gross income to the extent earned in the year of receipt.
Revenue Procedure 2011-18 expanded the definition of an “advance payment” in Revenue Procedure 2004-34 to include eligible gift card sales. As a result of the clarification, taxpayers selling gift cards redeemable by the taxpayer were permitted to use the deferral method of income recognition provided in Revenue Procedure 2004-34. When a gift card is redeemed by an entity whose financial statement revenues are not consolidated with the taxpayer’s, Revenue Procedure 2011-18 provided no mechanism for deferral. The Service may have concluded that there was no reason to address the issue, as the taxpayer would not generally recognize income because the revenue was earned, and thus, accounted for only by the unrelated entity. However, with the proliferation of gift card companies responsible for administering gift cards, questions arose regarding whether deferral was appropriate for such companies that are not consolidated with the taxpayers for financial accounting purposes.
As a result of the shortcoming in Revenue Procedure 2011-18, the Service issued Revenue Procedure 2013-29 to clarify the treatment for certain advance payments. This revenue procedure provides that if a gift card is redeemable by an entity whose financial results are not included in the taxpayer’s applicable financial statement, a payment will be treated as recognized by the taxpayer in revenues in its applicable financial statement to the extent the gift card is redeemed during the taxable year.10 For taxpayers without an applicable financial statement, if a gift card is redeemable by an entity whose financial results are not included in the taxpayer’s financial statement, a payment will be treated as earned by the taxpayer to the extent the gift card is redeemed during the taxable year. In substance, the modification results in the deferral of income recognition provided under Rev. Proc. 2004-34, for taxpayers receiving advance payments from the sale of gift cards redeemable by an entity whose results are not included in the taxpayer’s financial results.
As noted above, Revenue Procedure 2013-29 is read in conjunction with, and serves to modify and clarify Rev. Procs. 2004-34 and 2011-18. As such, this revenue procedure is retroactive in application and is given the earlier effective date (i.e., tax years ending on or after December 31, 2010). Further, accounting method changes made in compliance with the new guidance received audit protection.
Revenue Procedure 2013-29 provides enhanced flexibility in allowing taxpayers to defer revenue associated with gift card income, which many taxpayers will appreciate. For example, a taxpayer that has established a gift card company whose financial results are not included in the taxpayer’s financial statements, may nonetheless take advantage of the deferral method provided in Revenue Procedure 2004-34. Even though the guidance will be appreciated by some, it could potentially be used as a sword by the Service to argue in certain circumstances that companies should be recognizing gift card income. Further, additional issues associated with gift card income remain to be addressed by the Service (e.g., reloadable cards). With the significance of gift card income, the Service may provide additional guidance to address the outstanding issues.
1 Press release from CEB TowersGroup, “Gift Card Sales To Top $110 Billion As Card Spillage Declines 20 Percent,” Dec 17, 2012.
4 The Large & Midsize Business Division of the Internal Revenue Service created an Industry Issue Focus (IIF) program in order to properly focus audit resources on specific areas of noncompliance. The IIF program created three tiers of issues based on concern to the IRS, with Tier 1 consisting of the most significant compliance risks. Gift card treatment is focused within Tier 2, representing those issues that are of potentially high compliance risk. As part of addressing the treatment of gift card sales, the Service issued an Industry Director Directive in May 2007 alerting agents of the complexities and concern of advance payments received as a result of gift card sales. The directive divides the gift card issue into subcomponents requiring agents to examine certain areas in order to ensure: 1) proper statements as to the method of deferral are appropriately attached to the return; 2) proper consent of the IRS has been obtained; and 3) the redemption of gift cards has been tracked separately and does not rely on estimates. Other considerations in the directive involve examination of the taxpayer’s ability to properly address issues of reloadable gift cards, gift cards being issued as refunds, and also gift cards being redeemed by unrelated third parties.
5 See Rev. Proc. 2011-17, 2011-5 I.R.B. 441 (providing safe-harbor method of accounting for gift cards issued to customers in exchange for returned merchandise); Rev. Proc. 2011-18, 2011-5 I.R.B. 443 (clarifying and modifying Rev. Proc. 2004-34 to include gift card sales redeemable by the taxpayer or third parties within the category of advance payments specifically allowed to be deferred).
6 Specifically remaining to be addressed was the recognition of income associated with the advance payments received from gift card sales in which the taxpayer redeeming the card is financially unrelated to the taxpayer issuing the gift card. The requirements provided under Rev. Proc. 2004-34 remained applicable despite the issuance of Rev. Proc. 2011-18. As a result, taxpayers could still only defer income to the extent the revenue was included in the taxpayer’s applicable financial statement in the subsequent year, or in the case of a taxpayer without an applicable financial statement, only to the extent earned in the subsequent year. The party issuing the gift card would never recognize the revenue in its applicable financial statement, and thus deferral of income recognition provided in Rev. Proc. 2004-34 would not be available.
7 Rev. Proc. 2013-29, 2013-33 I.R.B.
8 I.R.C. § 451. See also Treas. Reg. § 1.451-1(a) (“income is includable in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.”)
9 Rev. Proc. 2004-34, 2004-1 C.B. 991.
10 Rev. Proc. 2004-34 defines an “applicable financial statement” to include: (1) a financial statement required to be filed with the Securities and Exchange Commission (SEC); (2) a certified, audited financial statement that is accompanied by the report of an independent CPA and that is used for credit purposes, for purposes of reporting to shareholders, or for any other substantial non-tax purpose; or (3) a financial statement (other than in a tax return) required to be provided to the federal or a state government or to any federal agency (other than the SEC or IRS).
Ellen McElroy and Clayton Garrett