DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D. C. 20224
LMSB Control No.: LMSB-04-0507-039
Impacted IRM 4.51.2
May 23, 2007
MEMORANDUM FOR INDUSTRY DIRECTORS, LMSB
DIRECTOR, FIELD SPECIALISTS, LMSB
DIRECTOR, PRE-FILING & TECHNICAL GUIDANCE, LMSB
DEPUTY COMMISSIONER, LMSB
DEPUTY DIRECTOR, INTERNATIONAL, LMSB
DIVISION COUNSEL, LMSB
AREA COUNSEL, LMSB
DIRECTOR, EXAMINATION, SB/SE
CHIEF, APPEALS
FROM: John Risacher /s/ John Risacher
Industry Director
Retailers, Food, Pharmaceuticals & Healthcare Industry
SUBJECT: Tier II Industry Director’s Directive on the Planning and
Examination of Gift Card/Certificate Issues in the Retail
and Food & Beverage Industries
Introduction:
This memorandum is intended to provide direction to effectively utilize resources in the classification and examination of a taxpayer who is receiving gift card/certificate income. This Directive is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such.
Background:
The popularity of gift cards has increased at a remarkable rate in recent years. The sale of a gift card, however, is not immediately recognized as income for financial reporting purposes. Similarly, under certain circumstances, the sale of a gift card may be deferred from immediate income recognition for tax reporting purposes. Generally, unless an accrual-basis taxpayer follows the deferral rules under Treas. Reg. § 1.451-5, gift card/gift certificate income must be reported when received. (Rev. Proc. 2004-34, 2004-1 C.B. 991, allowing a one-year deferral, may also apply in certain circumstances). To the extent that a taxpayer is appropriately using the deferral rules of Reg. § 1.451-5, unredeemed gift card income may be deferred up to the last day of the second taxable year following the year of the sale. Deferral for tax purposes cannot be later than it is for financial accounting purposes, and the taxpayer must have on hand enough goods to satisfy the outstanding gift cards/certificates. The regulations generally provide deferral related to goods and not services. However, Rev. Proc. 2004-34 allowing a one-year deferral may be elected in certain circumstances and applies to the sale of goods, services, and mixtures of goods and services.
Planning and Examination Guidance:
The Technical Advisors for the Food & Beverage and Retail Industries have identified inconsistent tax accounting treatment for gift cards/certificates involving both revenue and expense recognition within their industries. Variations and problems encountered are numerous and fall into two main categories as outlined below in Parts A. and B. Should an examining agent identify a Part A gift card/gift certificate issue, the issue must be raised and contact must be made with either the Food & Beverage or Retail Technical Advisors for coordination of the issue.
Part A. The first category of issues pertains to: 1. Compliance with the Regulations, 2. Changes of Accounting Method, and 3. The Use of Estimates, as explained below.
1. Compliance with the Regulations - If the taxpayer receives an advance payment
under an agreement for sale of goods properly includible in inventory (such as a gift
certificate), or for goods that cannot be identified in that taxable year and on the
last day of the taxable year, the taxpayer:
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Is accounting for advance payments in accordance with §1.451-5(c).
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Has received substantial advance payments with respect to the
agreement.
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Has on hand goods of substantially similar kind and in sufficient quantity to satisfy the agreement in that year, then all advance payments received under the agreement by the last day of the second taxable year, after the year in which the substantial advance payments are received and not previously included in income in accordance with the taxpayer’s accrual method of accounting, must be included in income in that second taxable year.
Additionally, the taxpayer must attach to its income tax return for each taxable year to which such provisions apply, an annual information schedule reflecting the total amount of:
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Advance payments received in the taxable year.
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Advance payments received in prior taxable years which have not been included in gross income before the current taxable year.
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Such payments received in prior taxable years which have been included in gross income for the current taxable year.
QUESTION: Does the failure to include the information schedule required by
§1.451-5(d) with its tax returns prevent the taxpayer from treating the amounts received with respect to gift cards/certificates as advance payments as described in § 1.451-5(c)?
RESPONSE: Some taxpayers may claim income deferral based on § 1.451-5 as a defense when an examiner raises a gift card/certificate issue. For tax purposes, the general rule is gift card/certificate income is recognized when the gift card/certificate is sold. For financial purposes, gift card/certificate sales are income when redeemed. Recently, with the huge increase in gift card sales this issue has grown in significance. A taxpayer may not have paid close attention to the difference between book and tax accounting. Sometimes a taxpayer will state that they were not aware that the information schedule is required to be attached to its tax return. It is difficult to understand how a taxpayer would be familiar with the deferral provisions of § 1.451-5, without also being aware of its reporting requirements.
If a taxpayer inadvertently left off the information schedule on one tax return but otherwise meets the conditions under § 1.451-5, then the examiner should take this into account when considering whether to raise the issue. However, if the taxpayer consistently did not include the information schedule on the tax return and did not meet the other requirements of § 1.451-5, then the examiner should definitely pursue this issue. If an examiner is unsure whether to raise this issue in a particular case, consideration should be given to contacting Philip J. Hofmann, Food & Beverage Technical Advisor or David F. Moser, Retail Technical Advisor.
The Tax Court has consistently recognized the Commissioner's right to insist upon full compliance, when the regulatory requirements relate to the substance or essence of a statute. Courts have commonly employed five factors in determining whether to permit less than literal compliance with regulatory requirements, namely whether the:
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Taxpayer's failure to comply fully defeats the purpose of the statute.
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Taxpayer attempts to benefit from hindsight by adopting a position inconsistent with his original action or omission.
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Commissioner is prejudiced by the untimely election.
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Sanction imposed on the taxpayer for the failure is excessive and out of proportion to the default.
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Regulation provided with detailed specificity the manner in which an election was to be made. Substantial compliance, as opposed to strict compliance, should not be allowed to extend beyond cases in which the taxpayer has a compelling reason for its failure to comply. Where the examiner believes that a compelling reason may exist, the examiner should contact the Food & Beverage or Retail Technical Advisor.
2. Change in Accounting Method – Is a taxpayer required to file a Form 3115,
Application for Change in Accounting Method, in order to adopt and/or to switch
to the deferral method under § 1.451-5?
Scenario 1
A business owner may have issued "gift certificates," that is, paper documents in the past and deferred income from the sale of the certificates in accordance with § 1.451-5(b)(1)(ii). Now, however, the taxpayer no longer issues "gift certificates" but rather "gift cards," that is, plastic credit cards that can have a myriad of features, such as being reloadable lighting up like a video game, playing music like an MP3 player and even doubling as a DVD. If the taxpayer was in compliance with the deferral regulations relative to the "gift certificates," would the taxpayer have to file a Form 3115 to defer the income from the sale of the gift cards merely because he no longer issues gift certificates but gift cards?
RESPONSE: No. Gifts cards are treated the same as gift certificates. If the taxpayer had adopted a proper deferral method for gift certificates, the conversion to gift cards is a continuation of the program and the items should/may be accounted for consistently.
Scenario 2
Same facts as Scenario 1, except the taxpayer was not in compliance with the deferral regulations relative to the "gift certificates." The taxpayer would be on an impermissible method of accounting relative to the "gift certificates." Would a Form 3115 have to be filed for both the gift certificates and the gift cards?
RESPONSE: Yes. Because the gift cards are the same item, the taxpayer must file a Form 3115 to change their method of accounting. The change from gift certificates to gift cards is not a change in underlying facts that would permit the adoption of different accounting treatment without first obtaining consent via a Form 3115. In other words, if a taxpayer has accounted for gift cards in a manner that did not comply with § § 1.451-5(b)(1)(ii) and 1.451-5(d) and then changed its method of accounting to a method in compliance with these sections without first obtaining the consent of the Commissioner, that taxpayer has made an unauthorized change in accounting method. Even though the new method complies with the regulations the method is considered an impermissible method because it was adopted without proper consent. Note, however, that if a taxpayer is using a method that complies with the regulations an examiner does not normally question how/when the method was adopted unless there is evidence of a method change through inspection of prior year returns or records.
Scenario 3
Same facts as Scenario 1 except that the taxpayer does not defer income from the sale of gift certificates. For the first year the business owner issues gift cards (as described in Scenario 1), can the taxpayer adopt a deferral method for the gift cards without filing a Form 3115?
RESPONSE: No. See response to Scenario 2
Would the sale of gift cards vs. the sale of gift certificates constitute a material item (relative to the gift card) for which a change in accounting method via Form 3115 is required since the taxpayer had not previously deferred the sale of gift certificates from income?
RESPONSE: Yes. The sale of gift cards/certificates is a material item, any change in the accounting treatment affects the timing of taxable income for the taxpayer. Note that the Service position is that gift certificates and gift cards are the same type of item. Once the taxpayer has adopted a method of accounting for the sale of gift cards/certificates, it must obtain consent via filing a Form 3115, before it changes its accounting method for that item.
Additional commentary and background:
A taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for the taxable year covered by such return. Moreover, a taxpayer may adopt any permissible method of accounting for an item in the first year in which the item is accounted for without the need to file a Form 3115. See § 1.446-1(e)(1).
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Once a method of accounting is adopted for an item, the taxpayer must secure the consent of the Commissioner before changing a method of accounting for federal income tax purposes. See § 1.446-1(e)(2).
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A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions, or a change in the treatment of any material item. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of the item as a deduction. Although a method of accounting may exist under this definition without a pattern of consistent treatment of an item, a method of accounting is not adopted in most instances without consistent treatment. The treatment of a material item is the same way in determining the gross income or deductions in two or more consecutively filed tax returns.
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Without regard to any change in status of the method as permissible or impermissible represents consistent treatment of that item for purposes of § 1.446-1(e)(2)(ii)(a). See also Rev. Rul. 90-38, 1990-1 C.B. 57.
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In order to obtain the Commissioner's consent to a method change, a taxpayer must file a Form 3115, Application for Change in Accounting Method, pursuant to the applicable revenue procedure. See § 1.446-1(e)(3)(i).
The Commissioner may require a taxpayer that has changed its method of accounting without the Commissioner's consent to change back to its former method. The Commissioner may do so even when the taxpayer changed from an impermissible to a permissible method. The change back to the former method may be made in the taxable year the taxpayer changed without consent, or if that year is closed by the running of the period of limitations, in the earliest open year. See Commissioner v. O. Liquidating Corp., 292 F.2d 225 (3rd Cir.), cert. denied, 368 U.S. 898 (1961); Wright Contracting Co. v. Commissioner, 316 F.2d 249 (5th Cir., 1963), cert. denied 375 U.S. 879 (1963), reh'g denied 375 U.S. 981 (1964), acq. 1966-2 C.B. 7; Daktronics, Inc. v. Commissioner, T.C. Memo. 1991-60; Handy Andy T.V. and Appliances, Inc. v. Commissioner, T.C. Memo. 1983- 713.
3. The Use of Estimates (estimated gift cards/certificates outstanding) – May a
taxpayer use estimates to determine the amount of unredeemed gift cards?
RESPONSE: No. When computing the amount of gift cards/certificates outstanding, some taxpayers use estimates of outstanding balances. For example; they make an assumption that 50% of the gift cards sold will be redeemed in the first year, 25% in the second year, 15% in the third year and 10% will never be redeemed. The redeemed percentages are estimated and make it easier for the taxpayer to determine the amount of gift cards outstanding. We do not believe that these estimates meet the requirements of the regulations.
Treas. Reg. § 1.451-5(d) states: Information schedule. If a taxpayer accounts for advance payments pursuant to paragraph (b)(1)(ii) of this section, he must attach to his income tax return for each taxable year to which such provision applies an annual information schedule reflecting the total amount of advance payments received in the taxable year, the total amount of advance payments received in prior taxable years which has not been included in gross income before the current taxable year, and the total amount of such payments received in prior taxable years which has been included in gross income for the current taxable year. A taxpayer adopting the more favorable income deferral method must specifically comply with the regulations. Implicit in § 1.451-5(d) is that the amounts identified and included on the information schedule are accurate and based on supporting documentation. Consequently, a taxpayer must specifically track gift cards/certificates as to the year sold. A taxpayer cannot attest to the accuracy of estimated statements because outstanding gift cards/ certificates are not tracked.
Therefore, estimates are not allowed in the determination of gift cards/certificates outstanding.
Part B. The second category of issues may include the following:
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Separate gift card companies
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Gift cards versus gift certificates
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Reloadable gift cards
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Deposits
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Gift cards as refunds
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Dormancy fees
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Escheatment to states
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Bulk sales discounts
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Promotional gift cards (advertising)
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Charitable contribution of gift cards
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Estimated cost of goods sold
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Franchise/franchisor gift cards
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Expiration date
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Rev. Proc. 2004-34
While the second category of issues constitutes all the significant issues involving gift cards/certificates that the Technical Advisors are currently aware, there may be new issues arising which involve gift cards/certificates and which are also potentially significant. Any such circumstances should also be brought to the attention of the Technical Advisors so they can evaluate whether or not the foregoing list should be expanded. Issue tracking codes for this issue are: UIL - 451.13-04, with a primary SAIN of 221 and a secondary SAIN of 310.
If you have any questions, please contact Phil Hofmann, LMSB Food & Beverage Technical Advisor at 316-352-7434, Dave Moser, LMSB Retail Technical Advisor at 636-255-1246 or Jim Johnston, Senior Program Analyst at 630-493-5948.
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