Mileage Award Buyers, Sellers Comment on Excise Tax Exclusion

In Notice 2015-76, the Treasury Department and the IRS requested comments regarding the excise tax on amounts paid for the right to provide mileage awards. In particular, the Notice requested comments concerning a possible safe harbor methodology that could be used to more accurately determine the excise tax base to account for mileage awards that are used other than for domestic air transportation.

Section 3 of the Notice provides a detailed description of the safe harbor methodology, it provides a formula under which a reduction in the excise tax base is determined by calculating the ratio of mileage awards redeemed other than for taxable transportation during a historical period to total redemptions of mileage awards during the same period. Except for the need to more specifically address redemptions for transportation to and from Alaska and Hawaii as discussed below, we believe the methodology detailed in the Notice is the correct general approach.

As an initial matter, the Notice contains a potential inconsistency with respect to the taxation of mileage sales to individuals. These sales are distinguishable from amounts paid "for the right to provide mileage awards" (e.g., amounts paid by credit card and other commercial companies to airlines) in that, unlike with mileage sales to commercial partners, individuals are the end users of those miles. Section 3 of the Notice provides, among other things, that the collector will multiply the amount paid "for the right to provide frequent flyer miles" by the Exclusion Ratio and will reduce the § 4261(a) tax base by this amount. On the other hand, Section 4.01 of the Notice provides that an election to apply an Exclusion Ratio would be irrevocable for "all frequent flyer miles purchased" from the collector during the applicable period the election is in effect, thus making it applicable to the miles purchased by individuals even though those sales are not amounts paid for the right to provide mileage awards, Clarification regarding the taxability of mileage sales to individuals is warranted, and we strongly urge the Treasury Department and the IRS to consider a prospective exemption from the excise tax under § 4261(e)(3) on those sales for the reasons discussed below.

Specifically, applying an Exclusion Ratio to miles purchased by individuals is likely to give rise to significant administrability concerns. One of the possible procedures in Section 4 of the Notice for a collector adopting an Exclusion Ratio is that the collector would provide notification of the adoption of the Exclusion Ratio and specify the ratio in program literature available to taxpayers. It is not clear what notification would be required in addition to specifying the ratio in program literature. Nevertheless, the Air Carriers are generally reluctant to undertake notification requirements and/or publication of Exclusion Ratios. The information the Exclusion Ratio represents (i.e., redemption information) has not historically been made public by airlines. Most importantly, while the commercial partners of airlines can readily understand why the Exclusion Ratio and the related effective tax rate applicable to their payments may vary from airline to airline (and from year to year), varying tax rates would introduce unwanted and, arguably, unnecessary confusion for individual purchasers. Also, collection and enforcement issues would be far more complicated in the case of large numbers of individuals who make very small purchases.

For the reasons discussed above, we believe that there are strong policy arguments for excluding from the tax mileage sales to individual purchasers. A decision by the Treasury Department and the IRS to exclude mileage sales to individuals from the excise tax would greatly simplify the application of the safe harbor for both the IRS and airlines and would have a modest impact on the amount of tax that would otherwise be collected. Further, it would avoid creating unnecessary confusion for individual purchasers in frequent flyer programs. Limiting the tax to commercial (i.e., business to business) transactions would also eliminate the need for carriers to make the Exclusion Ratios public in program literature since that information would be provided to commercial purchasers as part of the normal contractual process, subject to the customary confidentiality and nondisclosure agreements, Issues related to how to deal with potential errors in the computation of the Exclusion Ratio would also be simplified if purchases of frequent flyer miles by individuals are exempted.

In addition to the policy reasons for excluding the sales of miles to individuals from the excise tax, we believe there is a compelling statutory basis for such an exclusion. Section 4261(e)(3) applies to amounts paid "for the right to provide mileage awards for (or other reductions in the cost of) any transportation of persons by air. . . ." Amounts paid for frequent flier miles by commercial enterprises, such as credit card issuers, are "amounts paid for the right to provide mileage awards" to customers of the commercial enterprise. In contrast, payments made by individuals are not payments for the right to provide mileage awards.

As stated above, we believe that an exemption from tax for all purchases of frequent flyer miles by individuals would result in only a modest reduction in the amount of excise tax currently collected. For the airlines submitting these comments, purchases of miles by individuals constituted less than 5 percent of total mileage purchases during 2015.

Specific Requests for Comments

Section 6 of the Notice requests comments on a number of specific issues. Our responses to these requests follow:

Whether the methodology in Section 3 of this notice, if adopted, is workable for taxpayers, airlines, and other stakeholders: As noted above, we believe the methodology described in the Notice is the correct general approach. With the exception of our caveat regarding the application of the rules to individuals purchasing frequent flyer miles and our comments below regarding transportation to and from Alaska and Hawaii, we believe the methodology is workable for both the Air Carriers and the Mileage Award Purchasers. Although we cannot speak for other purchasers, carriers, or stakeholders, we can think of no reason others would find the methodology unworkable.

For purposes of computing the Exclusion Ratio, the guidance should specifically address redemptions for flights between the continental United States (or the 225-mile zone) and Alaska or Hawaii. In the case of a purchase of transportation between the continental United States (or the 225-mile zone) and Alaska or Hawaii, the portion of the flight that is over Canadian territory or over international waters is exempt from the tax imposed under § 4261(a). See Rev. Rul. 75-166. Consistent with this partial exemption, a portion of the miles (or preferably all miles, as discussed below) redeemed for transportation between the continental United States (or the 225-mile zone) and Alaska or Hawaii should be treated as redeemed for other than taxable transportation for purposes of computing the Exclusion Ratio.

The most precise approach (but, as discussed below, not the best approach for either the airlines or the IRS) would be to separately compute the taxable and nontaxable portion for each redemption of miles for Alaska/Hawaii transportation. For each trip, the proportion of the total miles redeemed which the mileage of the nontaxable portion of the transportation bears to the mileage of the entire trip would be included in the numerator of the Exclusion Ratio. However, we believe that the precision that would be obtained by these separate computations would be far outweighed by the administrative burden they would impose on both the airlines and the IRS. Moreover, it is not practically possible for airlines to determine, for each redemption, the proportion of the total miles redeemed which the mileage of the non-taxable portion of the transportation bears to the mileage of the entire trip. Accordingly, we respectfully request that the IRS consider treating all miles redeemed for transportation between the continental United States (or the 225-mile zone) and Alaska or Hawaii as redemptions for other than taxable transportation. Overall, we expect the nontaxable portion of this transportation to far exceed the taxable portion. If the potential revenue loss from this approach is considered to be problematic, we respectfully request that a carrier be allowed, at its election, to use the "Most Frequent Route" method described in Exhibit A of this document to determine the taxable and nontaxable portion of each redemption of miles for transportation involving Alaska or Hawaii. Additionally, at its option, a carrier may be allowed to treat all miles redeemed for transportation involving Alaska or Hawaii as redemptions for taxable transportation (for instance, if the carrier has a relatively small number of routes to Alaska or Hawaii),

Whether the methodology in Section 3 of this notice, if adopted, should be adopted as a rule of general applicability instead of as a safe harbor provision: We believe the flexibility afforded by an elective safe harbor is preferable to a mandatory rule and therefore, the methodology in Section 3 of the Notice should not be mandatory.

Whether the methodology in Section 3 of this notice should be modified to take into account a longer or shorter period of historical data: We believe the one-year period prescribed in the Notice is appropriate and should not be modified. Such a period takes into account seasonal variations. Moreover, in our experience, redemption data is relatively stable from year to year.

Whether airlines (or airline mileage award programs) are willing to share historical data with taxpayers so that taxpayers can verify the tax base upon which the § 4261(a) tax is applied when a taxpayer purchases frequent flyer miles: The Air Carriers and the Mileage Award Purchasers do not support a regulatory requirement that historical redemption data be shared with taxpayers in order to allow taxpayers to verify the tax base upon which the § 4261(a) tax is applied. The information that would be required to verify the tax base is sensitive and confidential business information, and while the IRS would have the right to audit/verify this information, the Air Carriers expect that this information would be subject to the same confidentiality protections afforded all other taxpayer information. Furthermore, we believe that any such data would be of limited use to the taxpayers. The Mileage Award Purchasers, as taxpayers that would be most directly affected by the data sharing, do not see any rationale for a regulatory data sharing requirement. Instead, they expect to obtain all the information needed to comply with their tax obligations through their contractual relationships with the Air Carriers. We recognize that different considerations could arise if the excise tax and the related Exclusion Ratio are made applicable to purchases of frequent flyer miles by individuals. We view the resulting complications as providing an additional policy rationale for an exemption from the tax for purchases of frequent flyer miles by individuals.

Whether in lieu of the methodology in Section 3 of this notice, the Treasury Department and the IRS should provide an allocation percentage that can be applied on an airline industry-wide basis, which the Treasury Department and the IRS would calculate using industry-provided data: In a previous submission, the Mileage Award Purchasers and Airlines for America suggested that the IRS explore the feasibility of an industry-wide safe harbor and offered to work with the IRS on such an approach. After considerable study, we now believe that an industry-wide safe harbor, if adopted in lieu of the airline specific safe harbor described in the Notice, would be unworkable and would produce unfair and inaccurate results. We believe it would be very difficult to develop a system under which industry data would be provided to the IRS in a reliable, consistent, verifiable and comprehensive manner. It is unlikely, year to year, that the industry could find a consistent methodology for collecting data from all airlines, and it is unclear whether the IRS and the carriers could agree on the appropriate party to collect and aggregate such data. We are also concerned that the resolution of the issues surrounding the mechanism to accomplish an industry-wide safe harbor will inevitably lead to unnecessary delays in the issuance of long-awaited guidance. This would be particularly unfortunate as the IRS and Treasury have already identified a workable methodology.

How often an industry-wide allocation percentage, if adopted, should be updated to reflect current industry data and what is the best method for the Treasury Department and the IRS to collect the necessary data: See our response to the preceding request.

Whether the Treasury Department and the IRS should adopt a methodology that is not described in this notice and recommendations for alternative methodologies: As noted above, we believe the methodology described in the Notice is the correct general approach, subject to addressing service to Alaska and Hawaii and the sale of frequent flyer miles to individuals as discussed above.

Whether the Treasury Department and the IRS should provide a mechanism for collectors to make adjustments to the Exclusion Ratio to correct computational and typographical errors after the collector reports the Exclusion Ratio to the IRS, and how such a mechanism should work: We believe errors relating to the Exclusion Ratio should be addressed prospectively only. If an error in the Exclusion Ratio is discovered during the year in which it applies, the airline should be permitted to file an amended Exclusion Ratio with the IRS and use the amended Exclusion Ratio for the remainder of the Election Year.

Whether the procedures in Sections 4 and 5 of this notice would be workable from the collector and the taxpayer's perspectives: While we cannot speak for every collector and every taxpayer, from our perspective the procedures in Sections 4 and 5 are generally workable. We do, however, have two concerns:

• The timeline proposed in Section 4, which requires airlines to compute the Exclusion Ratio by February 1, will likely be difficult to meet. We recommend that the beginning of the Election Year, which under the Notice is April 1, be moved to July 1. The Base Period would continue to be the calendar year immediately preceding the calendar year in which the Election Year begins. The collector would begin reflecting the Exclusion Ratio for a particular Election Year on a Form 720 filed for the third calendar quarter of the calendar year in which the Election Year begins. We believe this change will not materially alter the amount or timing of excise tax collected because of the relative stability of the redemption experience from year to year.

• Section 4 requires airlines to include various details relating to the safe harbor in their program literature. For the reasons stated above in our discussion of an exemption for individuals, we believe these requirements are problematic. Moreover, if the safe harbor is limited to frequent flyer miles acquired in commercial transactions, such requirements are unnecessary as the information will be conveyed as part of the business relationship between the airline and the purchaser alleviating any concerns arising from the public disclosure of confidential business data.

If, however, the Treasury Department and the IRS believe that tax adjustments should be made for such errors, we strongly believe that a collector that has acted in good faith in reliance on what is determined to be an erroneous Exclusion Ratio should not be responsible for any resulting underpayments. At most, a collector should be made responsible for any such underpayments only to the extent that it is able to timely recover that amount from the purchaser of frequent flyer miles (other than individual purchasers, to whom we believe the Safe Harbor should not apply), since currently a collector has no such responsibility (i.e., currently all amounts paid for frequent flyer miles are subject to the tax). In the event a collector is unable to recover an underpayment after reasonable efforts, the collector could be required to notify the IRS of its inability to collect the tax, similar to procedures already required by the IRS (see Reg. § 49.4291-1, requiring an "Uncollected Tax Report" to be filed by collecting agents of air transportation taxes if the person from whom the tax is required to be collected (the taxpayer) refuses to pay the tax or it is impossible for the collecting agent to collect the tax). Any deadline for filing such a report under the procedures of this Notice (if required) would need to take into account a reasonable period of time after discovery of the error (and after a reasonable period of time to attempt to collect the tax, if the IRS will require the collector to attempt to collect the tax retroactively).

In the event that an error in the Exclusion Ratio results in an overpayment of tax for a prior period that the Treasury Department and the IRS believe should be adjusted, we believe that, consistent with current tax law and procedures, a carrier should have the option (but not be required) to repay the overpaid tax to the taxpayer and claim a credit or refund of the overpayment from the IRS.

Conclusion

The Mileage Award Purchasers and the Air Carriers are appreciative and supportive of the efforts by the Treasury Department and the IRS to create a more appropriate tax base on which to impose the excise tax on the right to provide mileage awards. The safe harbor mechanism included in the Notice, with the additional modifications suggested in this submission, would provide a very workable approach to achieve this result. We urge the Treasury Department and the IRS to move forward this year to issue guidance embodying this thoughtful and equitable proposal.

Please contact Elena Romanova of Citigroup (at elena.romanova@citi.com) and Laurie Davies of Alaska Airlines (at laurie.davies@alaskaair.com) if you have any questions regarding this submission.

The number of frequent flyer mites redeemed for nontaxable transportation in the case of mileage redeemed for transportation to or from Alaska or Hawaii could be determined by reference to the nontaxable portion of an amount paid by a passenger for a flight ticket on the airline's most frequently flown route to or from Alaska or Hawaii. The nontaxable portion of a flight to or from Alaska or Hawaii is generally the portion of the flight that is over Canadian territory or international waters. The number of miles redeemed for transportation to or from Alaska or Hawaii that corresponds to the nontaxable portion of the airline's most frequently flown route to or from those states would then be treated as redeemed for nontaxable purposes. The following examples illustrate this computation.