Mr. Andrew Keyso, Jr. Associate Chief Counsel (Income Tax & Accounting) Internal Revenue Service 1111 Constitution Avenue, N.W. Washington, D.C. 20224 RE: Recommendation for Modification of Rev. Proc. 2011-18 Concerning the Accounting Method for Income from Gift Card Receipts Dear Mr. Keyso: The American Institute of CPAs (AICPA) appreciates this opportunity to submit comments with respect to the application of Rev. Proc. 2011-18, in which the Service provided an administrative procedure allowing the use of the deferral method set forth in Rev. Proc. 2004-34 for income arising from the sale of gift cards that are issued by one taxpayer but redeemable at a third party s business. These comments were developed by the Gift Card Income Task Force of the AICPA s Tax Methods and Periods Technical Resource Panel, and approved by the AICPA Tax Executive Committee. The AICPA is the national professional organization of certified public accountants comprised of approximately 377,000 members. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America s largest businesses. Executive Summary This letter addresses an interpretive issue that we have identified in the application of Rev. Proc. 2011-18, and provides one potential suggestion for how the revenue procedure could be modified to avoid what we believe to be an unintended result.
Page 2 of 7 Background As a matter of background, Rev. Proc. 2004-34, which superseded and updated Rev. Proc. 71-21, allows taxpayers to use a limited deferral method for advance payments arising from, among other things, the provision of services or the sale of goods. 1 Under the deferral method allowed by Rev. Proc. 2004-34, a taxpayer that issues one of the types of financial statements that is considered an applicable financial statement must include an advance payment in its gross income for the tax year of receipt to the extent the advance payment is recognized in revenues in its applicable financial statement for that tax year, and include the remaining amount of the advance payment in gross income in the next succeeding tax year. If a taxpayer does not have an applicable financial statement or is unable to determine the extent to which an advance payment is recognized in financial statement revenues in the year of receipt, the taxpayer must include in its gross income in the year of receipt the amount of the advance payment that is earned in that year. The use of gift cards and gift certificates (hereinafter collectively referred to as gift cards ) to promote the sale of retail goods and services and enhance brand loyalty is a widespread business practice. It has also become commonplace for the owner of a retail brand to operate a gift card program through a common clearinghouse in order to facilitate their sale and redemption. Before this change in business practice, a single retailer would sell a gift card to a buyer, and would redeem the card itself by providing the goods or services to the holder. Such a retailer would have qualified for the deferral method under Rev. Proc. 2004-34. Now, however, gift cards are commonly sold by one retailer and redeemed either by that retailer or by others, some of which may be related and some unrelated to the selling entity. Prior to the issuance of Rev. Proc. 2011-18, the Internal Revenue Service (IRS) had informally taken the position that an entity that sells gift cards that may be redeemed by another entity (whether related or unrelated), or that may only be redeemed by another entity, as in the case of a gift card only clearinghouse, did not qualify for the deferral method under Rev. Proc. 2004-34 based in part on the contention that the gift card receipt to the selling entity was not an advance payment for goods or services to be provided by that entity. 2 The Service and Treasury Department determined that the deferral method in Rev. Proc. 2004-34 should be available to any entity that sells gift cards that can be redeemed by the holder for goods or services, whether or not by the same entity that sold the gift card. Specifically, Rev. Proc. 2011-18 acknowledges that in the current business environment, for example, it is common 1 Treasury Reg. 1.451-5 provides a more liberal deferral method, but is generally limited to advance payments for the sale of goods and integrally related services. If a taxpayer is eligible for and uses that method, the issue addressed in this letter does not appear to arise. 2 See 2009 IRS NSAR 3801; 2008 IRS NSAR 2801F; TAM 200849015. Arguably, if the gift card sales entity were primarily liable to the card holder, then the provision of services or goods could have appropriately been deemed to be provided by the taxpayer, albeit through a subcontract arrangement.
Page 3 of 7 for a gift card entity to operate a gift card program under a service agreement with participating merchants in one of the following formats: 1. 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; 2. 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; 3. A restaurant management company may sell gift cards that may be redeemed by participating restaurants in different geographic locations or with different trade names; or, 4. 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. 3 When one of the above gift card entity structures is used, it is common for the gift card entity to receive and hold the proceeds from gift card sales until a customer uses the card to purchase merchandise or services. When the customer uses the card, the participating merchant is obligated to honor the card, and the gift card entity is obligated to reimburse the participating merchant for the sales price of the goods or services. Under the terms of the 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. As noted above, the Service and Treasury concluded, as a policy matter, that a taxpayer that sells gift cards redeemable through other entities should be treated the same as a taxpayer that sells gift cards redeemable only by that taxpayer for purposes of qualifying for the deferral method of Rev. Proc. 2004-34. Rev. Proc. 2011-18 carries out this policy decision by modifying Section 4.01(3) of Rev. Proc. 2004-34 to add to the list of qualifying items, eligible gift card sales, which is defined by Rev. Proc. 2011-18 to mean the sale of a gift card 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 section 4.01(3)(a)-(j) of this revenue procedure. 3 See Section 2.06 of Rev. Proc. 2011-18.
Page 4 of 7 Issue An issue arises with respect to any gift card entity structure in which the arrangement is described in formats 2-4 above and in which the gift card may be redeemed by an entity whose financial results (specifically, financial statement revenues) are not consolidated with those of the entity that issues the gift card in the issuing entity s applicable financial statement, as that term is defined in Section 4.06 of Rev. Proc. 2004-34. In these situations, if the applicable financial statement is based on generally accepted accounting principles, the issuing gift card entity s accounting entries to account for the transaction are as follows: (1) To record the receipt of the proceeds: Debit (DR) Cash (balance sheet) Credit (CR) Gift card liability (balance sheet) (2) To record the redemption: DR Gift card liability (balance sheet) CR Cash (or, if a financially related entity, cash or intercompany (I/C) payable) (balance sheet) The issue comes into sharper focus when one examines the corresponding accounting entries to record the other side of the transaction: If the redeeming entity is financially related, the journal entry is as follows: (3) To record the redemption: DR Cash or I/C receivable (balance sheet) CR Revenue (income statement) If the redeeming entity is financially unrelated, the journal entry is virtually the same: (4) To record the redemption: DR Cash or account receivable (balance sheet) CR Revenue (income statement) The issue arises with respect to any redemption transaction that takes place at a financially unrelated entity. While, as noted above, Rev. Proc. 2011-18 modified Section 4.01(3) of Rev. Proc. 2004-34 to cover eligible gift card sales, it did not modify the language of Section 4.01(2).
Page 5 of 7 Section 4.01(2) sets forth a distinct and additional requirement for payments to be eligible for the deferral method. Specifically, Section 4.01(2) defines the term advance payment for which the deferral method is available as follows:.01 Advance payment. Except as provided in section 4.02 of this revenue procedure, a payment received by a taxpayer is an advance payment if ******* (2) The payment is recognized by the taxpayer (in whole or in part) in revenues in its applicable financial statement (as defined in section 4.06 of this revenue procedure) for a subsequent taxable year (or, for taxpayers without an applicable financial statement as defined in section 4.06 of this revenue procedure, the payment is earned by the taxpayer (in whole or in part) in a subsequent taxable year); and ******* As illustrated by the accounting entries above, if the redeeming entity is financially unrelated to the issuing entity, the issuing entity will never recognize any of the revenue from a gift card receipt (in whole or in part) in revenues in its applicable financial statement, because that revenue is accounted for solely by the unrelated redeeming entity upon the sale of the merchandise or services. This makes sense because two different entities cannot earn the same income. 4 Because Rev. Proc. 2011-18 is not a self-contained procedure for allowing the use of the deferral method, but only modifies Rev. Proc. 2004-34, presumably the requirements of Section 4.01(2) must be still be satisfied. As a result, any of those situations described above in Rev. Proc. 2011-18 that involve card receipts that may or inevitably will be redeemed by unrelated merchants will fail to meet the literal requirement of Section 4.01(2) of Rev. Proc. 2004-34, even though they now meet the requirements of Section 4.01(3) as modified by Rev. Proc. 2011-18. In contrast, a taxpayer that sells gift cards redeemable only by that taxpayer (or a related member of its financial reporting group) would always meet the requirement in Section 4.01(2) because the redemption transaction in that instance would always result in financial reporting revenues for the reporting group. 5 4 While we believe this tends to also demonstrate why the gift card sale arguably does not constitute gross income under section 61 but rather something more appropriately characterized as a deposit for the gift card purchaser/holder for federal income tax purposes i.e., because two different taxpayers conceptually cannot realize the same dollars of gross income the Service and Treasury have decided otherwise. 5 See, e.g., Section 3.02 of Rev. Proc. 2011-18, which adds new Section 4.08 to Rev. Proc. 2004-34 to provide that [i]f the taxpayer is a member of an affiliated group of corporations that files a consolidated return for federal income tax purposes, the group s financial statement (as defined in section 4.06 of this revenue procedure) is a financial statement of the taxpayer.
Page 6 of 7 Specific Recommendations Because the Service and Treasury have decided, as a policy matter, to treat a taxpayer that sells gift cards redeemable through other entities in the same manner as a taxpayer that sells gift cards redeemable only by that taxpayer for purposes of qualifying for the deferral method of Rev. Proc. 2004-34, it appears necessary for the Service and Treasury to make a further modification to Rev. Proc. 2004-34 to carry out the policy and prevent the former group of taxpayers from being ineligible for the deferral method in Rev. Proc. 2004-34. Accordingly, we suggest that Section 3 of Rev. Proc. 2011-18 be modified to add the following language to Rev. Proc. 2004-34: For purposes of section 5.02(1)(b) of this revenue procedure, a taxpayer that sells gift cards that are redeemable by entities whose financial results are not included in the taxpayer s applicable financial statement (as determined without regard to this section), will be treated as not having an applicable financial statement with respect to gift cards that are actually redeemed by unrelated entities or, for administrative convenience if the taxpayer so elects, with respect to all such gift card sales. Further, the taxable year in which a gift card is redeemed will be treated for this purpose as the tax year in which the gift card is earned. * * * * * We appreciate your consideration of our recommendation and believe it requires a minor, but important, change to fully carry out the objective of Rev. Proc. 2011-18. If you have any questions or would like to further discuss this issue or our recommendation, please contact Carol Conjura, Chair, AICPA Gift Card Income Task Force and Chair, AICPA Tax Methods and Periods Technical Resource Panel at (202) 533-3040, or cconjura@kpmg.com; David Auclair, Immediate Past-Chair, AICPA Tax Methods and Periods Technical Resource Panel at (202) 521-1515, or david.auclair@us.gt.com; or Michelle R. Koroghlanian, AICPA Technical Manager, at (202) 434-9268, or mkoroghlanian@aicpa.org. Respectfully submitted, Patricia A. Thompson, CPA Chair, AICPA Tax Executive Committee cc: Scott Dinwiddie, Special Counsel to the Associate Chief Counsel (Income Tax & Accounting), Internal Revenue Service
Page 7 of 7 Alexa Claybon, Attorney-Advisor, Department of the Treasury, Office of Tax Legislative Counsel Scott Mackay, Taxation Specialist, Department of the Treasury, Office of Tax Legislative Counsel