What is the tax impact on retailers’ response to consumer spending trends?
Discounts and gift cards can affect accounting methods, sales tax and more
INSIGHT ARTICLE |
As the days turn cooler and fall is upon us, consumer product companies shift attention to the holiday season, which seems to get longer each year. Consumer spending increases sharply from the days leading up to Halloween right through Thanksgiving and the many December holidays. This increased spending also comes with increased discounting.
Discounting impacts taxes as well as top line revenue. As we have discussed previously, the shift to earlier discounting has caused retailers and suppliers to alter their purchasing and inventory management processes, changing everything from promotional programs to supply-chain management. If this practice of early discounting continues, retailers will need to interpret the impact of the early discounting from a results and a margin perspective. An unintended consequence of early discounting is that consumers no longer expect to pay full price. As retailers prepare for this and either work together to increase prices or be prepared to settle for lower margins it is prudent to consider how discounting may impact your corporate taxes. From the sales tax implications on gift cards to the impact on income taxes from changes in inventory levels at year-end, there are tax considerations worth reviewing as we move into the holiday season.
Discounted inventory and accounting methods
Many issues can come to light when taxpayers are considering discounting goods. Thought should be given to the tax accounting methods that the taxpayer is currently on, how to change methods if the taxpayer desires to do so, the effect of using the new method(s) going forward and the impact on the tax side of the varied choices that are available.
Retailers that apply heavy discounts to their goods during sale season may reduce the cost of their inventory that is recorded on their books by making a "market adjustment." For financial statement purposes this market adjustment, or discount, may take on many faces. In some cases, retailers may pick certain lots of inventory that will be marked down to what the retailer expects will be the ultimate sale price. In other cases, taxpayers may mark down all of their inventory, or a portion of it, by simply taking a percentage of the inventory as a reduction. And still in other cases, taxpayers may get more specific and mark down each item of inventory to the price they believe they can sell it for.
Lower of cost of market
The inventory rules for federal tax generally do not permit retailers to reduce their inventory value for a general allowance for expected sales during the holiday season, yet there is some ability to recognize a reduction in inventory valuation. For tax purposes, there are many rules that must be followed when taking market adjustments, also known as "lower of cost or market" (LCM). In the case of LCM, in order for a taxpayer to take a write-down and reduce the carrying value of their inventory for tax purposes they must value the inventory at the current bid price for the goods at the time of the inventory count. By definition, the bid price is the replacement cost. This concept is very different than discounting the inventory for the sales price or the price the taxpayer expects to sell the goods for.
For consumer products companies, many times the cost to replace the goods is very close in cost to the original carrying value of the inventory so there would generally not be a significant, if any, market adjustment on the tax value of the inventory. However, exceptions to the valuation of the inventory at replacement cost include write-downs for abnormal goods or goods that are unique and unusual design (i.e., custom produced items). In such instances a taxpayer must provide proof of sales or purchases of such items within the timeframe around the inventory valuation date and if it can be shown that the sales price or purchase price of like items is lower than cost, then the taxpayer may be able to justify an inventory write-down for federal income tax purposes.
Another option available for taxpayers to discount inventory for federal income tax purposes is under the rules for subnormal goods. Subnormal goods are goods that a taxpayer has an inability to sell or use because the goods are damaged, have imperfections, have shop wear, have had changes of style, odd or broken lots or other similar causes. When goods meet the definition of subnormal goods, then a taxpayer may value these goods at net realizable value (NRV), which is generally equivalent to the selling price less costs to dispose of the goods. Unfortunately, the discounting for financial statement purposes simply to sell these goods faster, provide a deal, or because too many were ordered are generally not situations where the subnormal goods rules apply. The most likely application of the subnormal goods rule is for retailers to show that a change of style occurred for the item. For example, clothing or shoes are no longer in style and therefore warrant a reduction in the inventory value for tax purposes. In addition to value the goods at NRV, the taxpayer must also offer the goods for sale within 30 days of the year-end inventory date.
Uniform capitalization (UNICAP)
Another issue that may arise for federal income tax purposes as a result of discounting inventories is the impact on the section 263A calculation (also known as UNICAP) for a taxpayer. Under the UNICAP rules, taxpayers are required to look at their costs that are involved in manufacturing or distributing inventory and capitalize certain expenses into ending inventory at year-end resulting in increased taxable income and a corresponding negative impact to cash flow. If a discount is taken for financial statement purposes but cannot be taken for tax purposes to the same extent, the absorption (capitalization) of costs under UNICAP will be determined based on the higher tax valuation of the inventory. To the extent not already considered, this could lead to an unexpected adjustment if tax and cash flow planning is based on the lower financial statement value of the inventory. Additionally, reducing inventory levels at year-end will help to reduce the UNICAP adjustment that would otherwise increase taxable income.
Gift cards: The Importance of tracking in order to defer taxable income
Another consideration for the holiday season is the sale of gift cards. In 2014, $124 billion was loaded on gift cards, and this amount is expected to increase for the foreseeable future. Under the right circumstances retailers have a limited ability to defer the recognition of income for federal income tax purposes for the sale of gift cards (including issuing refunds on a gift card) from the year of sale into the subsequent tax year.
Under Rev. Proc. 2004-34, retailers can defer the recognition of income from the sale of gift cards that are not redeemed in the current tax year to the subsequent tax year if they have an Applicable Financial Statement (AFS), generally an audited financial statement, to the extent the retailer's AFS also defers the revenue. However, under Rev. Proc. 2004-34, the retailer must recognize taxable income in year 2 for any income that is deferred from the year of cash receipt even if the AFS defers beyond the subsequent tax year (i.e., a maximum of 1 year deferral for tax reporting). Alternatively, if the taxpayer does not have an AFS, the taxpayer must recognize all cash received on the sale of the gift card in the year received to the extent such income is earned in that year (i.e., to the extent the gift cards are redeemed in that year) with the remaining amount deferred to the next tax year. This may or may not result in the same tax position as if there was an AFS depending on how revenue, including gift card breakage, is being recorded for financial accounting purposes.
The IRS has extended the use of this method to gift cards redeemable by members of a consolidated group or even unrelated third parties (whether the gift card program is operated by a gift card subsidiary, franchisor, franchisee, management company, etc.). To qualify for the treatment under Rev. Proc. 2004-34, the retailer must carefully track its gift card revenue and redemptions.
Potential accounting method change request(s) required
Changes to the taxpayer's use of LCM, subnormal goods, UNICAP, and the deferring advance payments under Rev. Proc. 2004-34, are considered methods of accounting and have additional rules and intricacies that must be followed. If a taxpayer is not currently using these methods, then a change in method of accounting must be requested (i.e., through the filing of a Form 3115, Request for Change in Accounting Method) in order to adopt these methodologies. Depending on the situation of the taxpayer, these method changes should be considered before year-end in the event that any filings may need to be completed by the end of the tax year.
Gift cards and rewards programs: Sales tax considerations
As consumers seek to make the most of their holiday spending, many will use gift cards or customer loyalty points to help defray their out of pocket costs. Retailers must pay close attention to the different guidance for the treatment of sales tax in each state and for each type of gift card or reward program. The rules are no different during the holiday season, however the frequency with which they must be applied typically increases, bringing with it the potential for customer inquiries.
At a high level, sales tax calculations related to the consumer spending trends associated with discounts can be addressed through four main categories: coupons or direct discounts, gift cards, loyalty programs and deal of the day incentives.
Coupons and discounts
Store coupons or in-store discounts effectively lower the amount the retailer receives for the item being purchased, therefore the sales tax generally is calculated on the customer's lower final price after the discount.
Manufacturing coupons lower the amount being charged to the customer, but do not change the total sales price from the seller perspective as the seller will be reimbursed by a third party (the manufacturer). In most cases, the sales tax is therefore calculated on the sales price before application of manufacturing coupon discounts.
Gift cards typically are considered a cash equivalent and therefore no sales tax is charged at the time the gift card is purchased. Sales tax is applied at the time a gift card is used to purchase merchandise, with few exceptions.
Loyalty or reward programs
In this area, the states are continuing to develop guidance. Some states treat loyalty point redemptions as consideration paid by the customer whereas some jurisdictions may treat the points as a true reduction in sales price. Sales tax implications vary greatly by state so a full review of the state tax requirements is recommended for those retailers using loyalty or reward based programs.
Deal of the day incentives
States have generally determined their approaches to deal of the day incentives, which typically offer discounted pricing for products and services via prepaid vouchers (with the deal promotion company and the seller each receiving a share of the voucher fee). Streamlined Sales Tax (SST) member states generally calculate sales tax based on the price paid for the voucher while nonmember states have more flexibility.
Domestic production activities (section 199): Driving production but impacts margin
Consumer product companies increase production to meet year-end demands—demands which may be artificially increased by consumer expectations of buying more for less. These operational changes can impact a taxpayer's domestic production activity deduction (section 199 or DPAD) either increasing or decreasing overall taxes owed. This can also have a state tax impact, however some states have decoupled from section 199 and have their own domestic production activities deduction that may be more narrow or broad than the federal DPAD.
The DPAD was put in place by Congress in part to incent manufacturing and other production activities in the United States. The calculations are quite complex but in simple terms a company may be able to obtain a tax benefit effectively equal to a 3 percent income tax rate reduction based on a 9 percent tax deduction on its domestic production activity (manufacturing) taxable income.
Although manufacturers of consumer products are well aware of the benefit of the DPAD, there are many complexities to the computation, and traps for the unwary, making it easy to get it wrong without a thorough analysis. Understating the DPAD results in leaving money on the table, while overstating it increases IRS and state audit exposure.
Discounting will impact a company's DPAD amount. A reduction in a company's taxable income resulting from discounted pricing may also result in a reduction of the DPAD and loss of some tax benefit. A company that normally sells its manufactured products for a profit of $1,000 would have claimed a $90 DPAD but that DPAD is reduced to $81 if the product is discounted by $100.
While trends in consumer spending play out at the cash register they also make a real difference in the back office through tax planning and bottom line results. Retailers and suppliers need to recognize how the nickels and dimes customers seek should be treated for tax purposes. Errors applied to a single transaction may seem inconsequential, but when multiplied across year-end purchases and multiple states the potential for miscalculation and missed tax planning opportunities is significant. Best practices recommend at minimum an annual review of sales tax processes and inventory accounting methods to make sure that processes and methods align with current guidance across all jurisdictions.