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Firm Comments on Forthcoming Guidance on Taxability of Gift Card Sale Proceeds

NOV. 18, 2009

Firm Comments on Forthcoming Guidance on Taxability of Gift Card Sale Proceeds

DATED NOV. 18, 2009
DOCUMENT ATTRIBUTES
  • Authors
    Beller, Herbert N.
    Shah, Amish M.
  • Institutional Authors
    Sutherland Asbill & Brennan LLP
  • Cross-Reference
    For FAA 20093801F, see Doc 2009-20906 or 2009 TNT

    180-21 2009 TNT 180-21: IRS Field Attorney Advice.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2009-25920
  • Tax Analysts Electronic Citation
    2009 TNT 225-25

 

November 18, 2009

 

 

Mr. Brandon Carlton

 

Attorney-Advisor

 

Office of Tax Legislative Counsel

 

Department of Treasury

 

1500 Pennsylvania Avenue, NW

 

Washington, D.C. 20220

 

 

Re: Pending Gift Card Guidance

Dear Mr. Carlton:

This comment letter follows up on our prior telephone conversations regarding Treasury's pending guidance project on the taxability of gift card sale proceeds. We address, in particular, the impact upon such guidance of recently released Field Attorney Advice 20093801F (the "FAA"). That taxpayer-specific document concludes that neither of the administrative mechanisms for deferring the recognition of gift card income beyond the year of receipt -- Treas. Reg. § 1.451-5 (2 years) or Rev. Proc. 2004-34 (1 year) -- is available to a restaurant management company that receives and disburses gift card amounts ("Giftco"), but does not directly own or maintain inventories of the food and beverages served when the gift cards are redeemed at participating restaurants.

We believe that the result reached by the FAA -- immediate taxation of the gift card sale proceeds in the year received -- is incorrect. We therefore urge that any forthcoming published guidance not embrace either the conclusions or asserted legal principles of the FAA. More specifically, we submit that --

  • Gift card sale receipts should not be characterized as items of gross income where the Giftco is under a continuing legal obligation to repay such amounts to a related entity that ultimately honors the gift card when presented for redemption by its holder.

  • Even assuming initial characterization of gift card sale proceeds as "income", the absence of actual inventory ownership by the Giftco should not preclude deferral under Treas. Reg. § 1.451-5 or Rev. Proc. 2004-34 or otherwise dictate automatic "income" recognition in circumstances similar to those present in the FAA.

 

Factual Context of the FAA

The Giftco in the FAA is an "S" corporation that provides full-scale management services to numerous restaurants (the "Restaurants") and employs all persons who work at the Restaurants. Legal ownership of the Restaurants resides in separate partnerships, limited liability companies (taxed as partnerships) and other S corporations (the "Affiliate Entities"). The ownership interests in the Affiliate Entities are held primarily by Giftco and Giftco's shareholders.

Gift cards are sold by Giftco and most of the Restaurants, and may be redeemed at most of the Restaurants. All gift cards are issued under the Giftco name and are accepted by the Restaurants in payment of the gift card holder's full check (including food, beverage, tax and gratuity). The gift cards are not subject to any maintenance or non-usage fees, have no expiration dates and are not subject to state law escheat.

Cash proceeds from the sale of gift cards are received directly by Giftco, or transferred to Giftco by Restaurants at which the cards are sold. Giftco is under a continuing legal obligation to remit the amount of any redeemed gift card to the redeeming Restaurant in cash. We understand that, historically, all but a relatively small percentage of restaurant gift cards are eventually redeemed; and that while most cards are redeemed within 2 years after issuance, some are not redeemed for several or many years.

Failure to Address Threshold "Is It Income?" Question

The FAA assumes that the gift card sale proceeds are items of "income" in the first instance, thus focusing only upon the timing question -- i.e., when should such income be recognized for tax purposes. A number of decided cases are relevant in this regard, including the Supreme Court's decision in Indianapolis Power & Light Co. v. Commissioner, 493 U.S. 203 (1990) and the 7th Circuit's decision in Illinois Power Co. v. Commissioner, 792 F.2d 683 (7th Cir. 1086), aff'g and rev'g in part 83 T.C. 842 (1984). Both provide strong support for characterizing the gift card receipts in the FAA as non-income items.

Indianapolis Power. The taxpayer in Indianapolis Power ("IPL") obtained deposits from certain of its electricity customers. The deposits were returnable to the customer by cash payment or application against future bills after satisfaction of certain creditworthiness criteria. The Service asserted that the deposits were advance payments of income taxable in the year of receipt because they (i) served to secure the payment of future income; and (ii) were not placed in escrow or segregated from IPL's other funds. In concluding that the deposits were not income to IPL, the Court distinguished non-taxable "deposits" from taxable "advance payments," stating in pertinent part:

 

The key is whether the taxpayer has some guarantee that he will be allowed to keep the money. IPL's receipt of these deposits was accompanied by no such guarantee. . . . *** . . . . From the moment an advance payment is made, the seller is assured that, so long as it fulfills its contractual obligation, the money is its to keep. . . . IPL's right to keep money depends upon the customer's purchase of electricity, and upon his later decision to have the deposit applied to future bills, not merely upon the utility's adherence to its contractual duties. Under these circumstances, IPL's dominion over the fund[s] is far less complete than is ordinarily the case in an advance-payment situation. [ Id. at 210-211. (Emphasis supplied.)]

 

Thus, the essence of Indianapolis Power is that a receipt is not properly characterizable as a taxable advance payment where the taxpayer has (i) no guarantee that it will be entitled to permanently retain the payment and (ii) no control over whether it ultimately may do so. This "guarantee" test has since been recognized and applied in several decided cases and embraced by the IRS.1 Just as IPL's ability to retain customer deposit amounts depended on actions taken or not taken by its customers, Giftco's ability to retain any amounts received from gift card sales is subject solely to action or inaction on the part of the purchaser of the gift card or the purchaser's assignee -- i.e., Giftco has no guarantee that, or control over whether, it ultimately will be able to keep any portion of such receipts. Rather, just as IPL must apply or return customer deposits for the benefit of the customer if and when the requisite creditworthiness criteria are met, Giftco must pay over to the redeeming Restaurant the amount to be applied against the outstanding gift card balance if and when gift cards are redeemed.

Illinois Power. The Illinois Power decision provides another route to the non-income conclusion. In that case, a state regulatory authority (the "Commission") ordered the taxpayer utility to raise its electricity rates for certain commercial customers in order to encourage energy conservation. The taxpayer was not permitted to keep the additional revenues collected from customers; but it initially had no direction as to what had to be done with such amounts and was not required to segregate the funds in the meantime. The Commission eventually decided that the extra amounts should be disbursed via a credit to the utility bills of all of the taxpayer's customers, i.e., not only the commercial customers who had made the additional payments.

Reversing the "surprising result" of the Tax Court, i.e., that the additional revenues were includible as taxable income upon receipt, the 7th Circuit dismissed the government's reliance on the "claim of right" doctrine, finding that "[t]he taxpayer never made a formal claim of right to the [additional] revenues beyond a right to hold them as (in effect) a fiduciary of the ratepayers." [792 F.2d at 688.] In reaching its conclusion, the court stated:

 

[We] cannot see what difference it makes whether the money is placed in a formal trust or is merely ordered held for the benefit of others, which is how we interpret the Commission's order. . . . The company was to be a custodian, a tax collector, with no greater beneficial interest in the revenues collected than a bank has in the money deposited with it." [792 F.2d at 688-9. (Emphasis supplied.)]

 

Likewise, Giftco holds the gift card sale proceeds effectively as a mere custodian or trustee for the benefit of the Affiliate Entities, since it is under an unequivocal duty to pay over to the Restaurants all amounts redeemed against outstanding gift cards. It does not, and cannot, redeem gift cards directly, because it does not directly own or hold the food and beverage inventories used for meals sold to redeeming gift card holders. Thus, its possession of the gift card sale proceeds is merely temporary, pending the mandatory repayment of such amounts to the Affiliate Entities and the Restaurants that prepare and serve such meals.

The FAA curiously makes no mention of Indianapolis Power or Illinois Power. The Service has, however, rejected the Indianapolis Power rationale in other non-precedential gift card guidance,2 asserting that the guarantee test does not require nontaxable treatment of gift card sale proceeds because the taxpayer (i) has control of the funds and has not segregated them; and (ii) holds a claim of right with respect to such funds unless, and until, a subsequent event occurs that would require it to transfer amounts to retailers or refund amounts to a customer. These assertions, we submit, misread Indianapolis Power. The Court explicitly recognized that the customer deposits were commingled with other cash held by IPL and were subject at all times to IPL's "unfettered use and control" (which facts "cannot be dispositive"); and it further recognized that the "claim of right" doctrine did not apply because IPL's customer deposits did not in the first instance constitute "income."

In short, the Giftco in the FAA functions in much the same way as do banks or other depositories for cash assets. Banks accept cash deposits, commingle the deposits with other cash deposits, hold the deposits (often for decades), and remit cash to the depositor or her designee (e.g., persons holding checks written by the depositor). Similarly, Giftcos accept gift card sale proceeds, commingle those proceeds with other gift card sale proceeds, hold the proceeds and remit cash to the Restaurants for the benefit of the gift card purchaser. In both cases, the taxpayer is required to return all or a portion of its cash deposits when requested to do so. There is no question that banks are not required to treat deposits as income. The same treatment should be accorded similarly-situated Giftcos with respect to their receipt of gift card sale proceeds.

Attribution of Inventory Ownership to Giftco

The FAA simply assumes that gift card receipts are items of income in the first instance, and that only the timing of their recognition as taxable income needs to be determined. It appears to suggest that there are no circumstances in which the deferral rules of Treas. Reg. § 1.451-5 or Rev. Proc. 2004-34 can be availed of by non-inventory owning taxpayers. That conclusion, we submit, is not necessarily mandated by the express language of those administrative pronouncements and is especially harsh in factual contexts similar to those of the FAA. Moreover, even assuming that inventory ownership on the part of Giftco is legally necessary, we question the conclusion of the FAA that such "ownership" must necessarily be actual or direct. Deemed or imputed ownership would seem equally sufficient under the facts of the FAA; for all of the Affiliate Entities are "pass-through" entities and Giftco, through its shareholders and its own employees, is in the "business" of not only managing, but actually conducting, the day-to-day operations of Restaurants at which the gift cards may be redeemed (including all functions and decision-making involved in acquiring and maintaining sufficient supplies of food, beverages and other items sold to customers or otherwise used by the Restaurants).

The decision in Straight v. Commissioner, T.C. Memo 1997-569, as reversed on reconsideration in an unpublished order dated May 6, 1999, supports deemed ownership treatment. In that case, which also involved the application of Treas. Reg. § 1.451-5, the petitioner owned all the stock of Eagle, an "S" corporation that sold prefabricated houses manufactured by Timberline, another "S" corporation 50 percent owned by petitioner. Eagle maintained no inventories of timber, plywood products or other materials utilized in the manufacture of the house kits. Deposits received by Eagle were placed into a general bank account and used to pay current expenses. Eagle did not include in gross income deposits for house contracts that would close within 4 years; instead, such deposits were recorded as a liability. Petitioner claimed that these deferrals were appropriate under the general "advance payment" rules of Treas. Reg. § 1.451-5(a)(1).

The Tax Court initially held that the deferrals should not be permitted because Eagle neither held the house kits primarily for sale to customers in the ordinary course of business (as required by -5(a)(1)(i)), nor built, constructed, installed or manufactured the house kits (as required by -5(a)(1)(ii)). On reconsideration, however, the Tax Court concluded that Eagle did hold the house kits for sale to customers for purposes of -5(a)(1)(i), even though it never held legal title to, or physical possession of, any of the materials that comprised the house kits.3

Attribution of inventory ownership to Giftco would likewise be appropriate with respect to the Restaurants that are operated through related partnerships or LLCs. Both the Service and the courts have long recognized that "[f]or federal income tax purposes, the activities of a partnership are often considered to be the activities of the partners" [Rev. Rul. 98-15, 1998-1 C.B. 718]; and that "the business of a partnership is the business of its partners." [ Arens v. Commissioner, T.C. Memo 1990-241.] In such situations, absent explicit statutory direction to the contrary, the applicable Code provisions, regulations and other relevant tax rules and principles are applied based on the "aggregate" (as opposed to the "entity") theory of partnership taxation -- i.e., that "a partnership is simply an aggregation of individuals, each of whom should be treated as the owners of a direct undivided interest in partnership assets and operations." [McKee, Nelson & Whitmire, Federal Taxation of Partnership and Partners (2008 ed.), at ¶ 1.02.] For example, the aggregate theory has been adopted by the Service in at least one inventory-related context, involving computation of "the LIFO recapture tax" under section 1363(d); for that purpose, a "C" corporation converting to "S" corporation status is deemed (under Treas. Reg. § 1.1363-2(b)) to own a proportionate share of the LIFO inventory held by a partnership in which the corporation is a partner.

The business activities and assets of a partnership also are attributed to a corporate partner for purposes of applying (i) the non-statutory "continuity of business enterprise" requirements that must be satisfied in connection with tax-free "reorganizations" [Treas. Reg. § 1.368-1(d)]; and (ii) the "active business" requirements of section 355(b) in connection with the tax-free spin-off of a corporate subsidiary to parent company shareholders.4 The permitted attribution in these subchapter C contexts keys off of the corporate partner's "active and substantial management functions" for, and ownership of a "meaningful" or "significant" interest in, the partnership. Those criteria certainly are met by Giftco in the circumstances of the FAA, given again its pervasive involvement in, and control over the operations of the Restaurants that are legally owned by partnership/LLC Affiliate Entities. We respectfully submit that, if legally necessary, Treasury and the Service could reasonably decide to apply similar pass-through entity attribution principles that would enable non-inventory Giftcos to avail themselves of the administrative deferral rules under Treas. Reg. § 1.451-5 and Rev. Proc. 2004-34.

Important Business Reasons Dictate Use of Giftcos

From a tax policy perspective, large multiple entity restaurant companies that administer gift card programs through a separate non-inventory holding entity should not be treated differently than a single restaurant that issues gift cards for use only at its own restaurant. Treas. Reg. § 1.451-5 was promulgated almost 40 years ago. Since then, gift cards sales have increased exponentially and the U.S. economy has shifted dramatically from more localized, smaller operations to complex business structures with multiple brands and outlets. In such structures, centralized administration of gift card programs has become the norm for important business reasons -- in particular, to achieve substantial cost savings and otherwise minimize the financial and human resource burdens associated with such programs; and to increase customer choices and loyalty, and thereby sales, by selling and allowing the use of the same gift card across multiple brands and locations.5 While the "inventionable goods" exception may well be a clumsy fit in this changed business environment, Treasury and the Service should exercise maximum administrative flexibility in accommodating the real world business circumstances in which the affected taxpayers now operate. With all due respect, pronouncements such as the FAA do not further that objective and reach conclusions that are not clearly mandated by existing law.

IRS Cannot Have It Both Ways

The position advanced by the IRS in the FAA puts it on the horns of a dilemma. If Giftco does not own the food and beverages delivered to diners who redeem gift cards, then all that has happened is that Giftco has received cash which it is legally obligated to return to gift card holders through cash repayment to the redeeming restaurants. On the other hand, if Giftco is viewed as delivering meals to gift card holders, it cannot do that unless it is treated as owning and holding the underlying food and beverage inventories -- in which case it should be entitled to defer income recognition with respect to unredeemed gift cards under the "inventoriable goods" exception of the regulations. By attempting to tax Giftco on all gift card sale proceeds in the year of receipt, the FAA ignores these mutually exclusive transactional constructs and erroneously seeks to create a phantom category of immediately taxable "income" that simply does not exist. In the process, the important "matching" principle of tax accounting is also ignored; for it is known with certainty that, at any given point in time, substantial portions of outstanding gift cards will remain unredeemed well beyond the year in which they were sold.

We therefore urge that the pending guidance should either (i) confirm that gift card sale proceeds received by Giftcos are not "income" where there is a continuing legal obligation to repay such amounts when gift card redemptions occur; or (ii) treat Giftcos that administer gift card programs for related pass-through entities as holding inventories owned by such entities (thus satisfying the requirements for deferral under Treas. Reg. § 1.451-5 and Rev. Proc. 2004-34). If thought necessary, those administrative pronouncements should be revised accordingly with retroactive effect.

 

* * *

 

 

We appreciate your consideration of these comments and would be pleased to further discuss them with you. Please contact the undersigned at 202/383-0120 (Herb Beller) or 202/383-0456 (Amish Shah) if you think that such discussion might be useful.
Very truly yours,

 

 

Herbert N. Beller

 

Sutherland Asbill & Brennan LLP

 

Washington, DC

 

 

Amish M. Shah

 

Sutherland Asbill & Brennan LLP

 

Washington, DC

 

FOOTNOTES

 

 

1See, e.g., Herbel v. Commissioner, 106 T.C. 392, 413-14 (1996) ["[I]f the payor controls the conditions under which the money will be repaid or refunded, generally, the payment is not income to the recipient."]; 1997 FSA Lexis 346 (Jan. 27, 1997) [concluding that deposits received from country club members not taxable to club stressing "[i]t is very important to determine who controls the ultimate fate of the payment."].

2See NSAR 20082801F (March 26, 2007); TAM 200849015 (Aug. 22, 2008).

3 Other cases similarly have concluded that, for purposes of Treas. Reg. § 1.451-5, inventory is not limited to "goods on the taxpayer's shelves or in his warehouse." See City Gas Co. of Florida v. Commissioner, T.C. Memo 1984-44 ["inventoriable goods" exception applied notwithstanding unrelated supplier's direct delivery of gas to petitioner's customers]. See also, Epic Metals Corp. v. Commissioner, T.C. Memo 1984-382 [subsidiary sales corporation deemed, at Service's urging, to have momentary title to inventory produced and delivered by parent corporation].

4See Prop. Treas. Reg. § 1.355-3(b)(2)(v) (May 8, 2007); Rev. Rul. 2002-49, 2002-2 C.B. 288.

5 For gift cards that can be used for multiple brands and locations, each restaurant (or other retail outlet) would be required to undertake enormous administrative burdens, including: (i) tracking whether each gift card sold by it was used at its restaurant and/or one or more other participating restaurants and whether each gift card redeemed by it was sold by another participating restaurant; (ii) calculating the amount of gift card sale proceeds required to be remitted to, or entitled to be received from, each of the other participating restaurants on each settlement date (i.e., each month); and (iii) transferring proceeds to, and confirming receipt of proceeds from, the other participating restaurants. For example, if there are 20 participating restaurants, taken together they would be required to undertake hundreds of settlement transactions on each settlement date -- whereas, with the use of a Giftco, only 20 settlement transactions would be required.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Beller, Herbert N.
    Shah, Amish M.
  • Institutional Authors
    Sutherland Asbill & Brennan LLP
  • Cross-Reference
    For FAA 20093801F, see Doc 2009-20906 or 2009 TNT

    180-21 2009 TNT 180-21: IRS Field Attorney Advice.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2009-25920
  • Tax Analysts Electronic Citation
    2009 TNT 225-25
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