Retailers must be mindful of gift card tax pitfalls

Nov 21, 2019
Business tax Restaurant Retail Grocery

While it is widely accepted that a well-designed and well-executed gift card program can drive customer traffic, increase sales and build customer loyalty, retailers and restaurant operators must be mindful of the ASC 606 financial reporting and tax consequences of their gift card programs in order to manage them effectively. Note the following key considerations. 

Financial reporting considerations

The sale of a gift card results in a liability recorded at the time of the sale representing the obligation to deliver goods or services to the customer on redemption of the gift card at some point in the future. However, the method by which the liability is relieved and revenue is recognized is where we see some diversity in practice.

Given the absence of previous guidance requiring uniform accounting treatment, some retailers and restaurant operators elected a policy for unused gift cards to allow the liability to remain on the balance sheet until the gift card had either been redeemed for goods or services, or expired. This approach, however, can lead to significant liabilities on the balance sheet for the obligation to deliver future goods or services that may never be fulfilled. For example, in an attempt to use the entire gift card, consumers often redeem their cards for goods and services that are close to the full value of the card, but leave behind small balances on the cards. This can result in a consistent pattern of small, unredeemed amounts outstanding on gift cards sold. With enough volume, this approach can lead to significant liabilities that would remain on the balance sheet of the retailer and restaurant operators in perpetuity (if the gift cards have no expiration date).

Previously many retailers adopted accounting policies to derecognize these liabilities earlier based on “breakage.” The concept of breakage for gift cards relates to estimating the portion of gifts cards that are expected to remain unused. Applying this concept would allow a retailer to derecognize the estimated breakage liabilities and record revenue in circumstances in which there is no obligation to remit amounts to the local jurisdiction either (a) when the likelihood of redemption of the gift card or portions thereof is considered remote or (b) over the period in which the remainder of the gift card is expected to be used. 

ASC 606 provides specific guidance to all entities, including retailers and restaurant operators, regarding breakage, which would apply to gift cards. Per ASC 606, revenue should be recognized when the card is presented for redemption and the goods or services are transferred to the customer. However, if there is a portion of a gift card sold that is not expected to be redeemed for goods or services (i.e., breakage), the new guidance requires an entity to recognize revenue for the breakage they expect to be entitled to proportionately as other gift card balances are redeemed. However, the company will need to apply the variable consideration constraint and conclude it is probable that a significant reversal in cumulative revenue recognized will not occur as a result of proportionately recognizing breakage as revenue as the other performance obligations in the contract are satisfied.  

ASC 606 replaces most existing revenue recognition guidance in U.S. generally accepted accounting principles and permits the use of either a full retrospective transition method or a modified retrospective transition method with a cumulative effect adjustment to the opening balance of retained earnings as of the date of initial application. Management will need to (a) document its accounting considerations and conclusions through internal memos and (b) evaluate historical data to make an accurate determination of the impact of adopting the new guidance and the best transition method for adoption.

Management also should consider the impact of internal controls and the reliance on third-party service providers to ensure accurate and timely financial reporting. Implementation of internal controls over the adoption of the new guidance will need to be considered by management, and the ongoing accounting for gift card revenue likely will result in additional controls or the modification of existing controls. Companies will want to ensure that control objectives and key attributes of the controls have been updated to address the accounting and reporting implications of the new guidance. Additionally, many companies use third-party service providers to maintain gift card records. Ensuring that the company has access to all historical information and the necessary details of each gift card transaction will be important to the application of the new guidance and the ongoing accounting and disclosure.

One lesson learned from public companies’ adoption of the new guidance includes the evaluation of historical data and methods by which gift cards are sold, either through the retail and/or restaurant location, online or through third-parties. Having access to accurate and complete historical information will allow companies to establish a pattern for recognizing breakage proportionate to the patterns of rights exercised by the customer. Having a clear understanding of the various business operations that result in the sale of gift cards will ensure the new guidance is properly evaluated by management. While the new guidance is not expected to significantly change the way retail and restaurant operators recognize revenue from gift cards, management still needs to adequately evaluate the potential impacts of the new guidance and make changes to company accounting polices based on historical accounting under legacy GAAP compared to the new guidance. Additionally, the new guidance requires private companies to include additional disclosures, although certain quantitative and qualitative disclosure requirements are more limited than those required of public companies.

While ASC 606 replaces most existing revenue guidance, the impact is most likely more significant for franchisors. Specific to gift cards, ASC 606 offers more guidance that must be applied with respect to breakage, but the burden of estimating the amount of gift cards that are expected to remain unused and determining whether or not amounts are escheatable to a government entity will still fall on the retailer and restaurant operator. 

Tax considerations

The importance of tracking in order to defer taxable income

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.

In December 2017, Congress amended section 451 of the Internal Revenue Code. The amendments included a new section 451(c), which allows certain accrual-method taxpayers to elect a limited deferral of the inclusion of income associated with certain advance payments. The rules in new section 451(c) generally mirror the approach in Rev. Proc. 2004-34. Notice 2018-18 indicated that the Internal Revenue Service expects “to issue future guidance regarding the treatment of advance payments to implement this legislative change. Taxpayers, with or without applicable financial statements, receiving advance payments may continue to rely on Rev. Proc. 2004-34 until future guidance is effective.”

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 defined as an audited financial statement, to the extent the retailer's AFS also defers the revenue as discussed in the financial reporting section. However, under Rev. Proc. 2004-34, retailers must recognize taxable income in year two 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 one-year deferral for tax reporting). Alternatively, if the retailer does not have an AFS, it 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 were 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 or management company). To qualify for the treatment under Rev. Proc. 2004-34, retailers must carefully track gift card revenue and redemptions.

Unclaimed property

Gift cards are generally subject to abandoned and unclaimed property rules. Abandoned and unclaimed property is not actually a tax, although many think it is. Thus, traditional nexus standards do not apply. It is, in fact, an unpaid contractual liability. Many companies don’t believe they have unclaimed property. However, if a company sells gift cards that remain unredeemed, the company likely has some sort of unclaimed property, but what does that mean?

All states have unclaimed property laws requiring companies with tangible or intangible personal property owed to a third party to escheat the property or its value to the respective state after a period of inactivity, known as the dormancy period. Unclaimed property laws vary by state and no two sets of laws are exactly alike. In the United States, there are 54 jurisdictions (50 states, the District of Columbia, Guam, Puerto Rico and the U.S. Virgin Islands) to consider if you are issuing gift cards.

Unclaimed property has become an increasing source of revenue for states; accordingly, jurisdictions have increased audit efforts, including through third-party contract audit firms. They often exercise their ability to estimate the liability for years where accounting records no longer exist, which can result in significantly increased assessments. For example, most states extrapolate liability back over a 10- to 15-year period, a practice that can be very damaging to a company’s bottom line.

For most types of unclaimed property, the escheatment process can be fairly straightforward, but for gift cards it is a bit more complex since gift cards can be purchased through one channel or location and redeemed through a different channel or location. Some states exempt gift cards from unclaimed property laws and others require only some or a portion of the unredeemed gift card to be escheated, so, again, what does that mean?

Broadly speaking, unclaimed property is sourced to the state of the owner's last known address. If the last known address of the owner is unknown or if the state of the last known owner does not provide for escheatment of the property, then a holder's state of incorporation or organization may lay claim to the property. Said another way, if the purchaser is unknown, it is the issuer’s state of incorporation that may make claim to the property. 

Since many sellers of gift cards do not obtain owner name and address information, frequently such property is escheatable to the company's state of incorporation or organization. This is very important to understand thoroughly. The rules around last known owner can have a significant impact on whether the unclaimed property, or gift card breakage, must be remitted to a state, and if so, which state and at what value. At one extreme, an issuer company could keep the unclaimed property and record 100% as income, and at the other extreme the issuer may be required to remit all or some of the unclaimed property to multiple jurisdictions, which can be a heavy burden to track and remit accurately. Accordingly, understanding the regulations, developing a program that considers those regulations and maintaining complete and accurate records is key to managing this exposure.

It is important to note that litigation has been increasing with respect to various unclaimed property matters across the country, including gift cards. In 2014, Delaware unsealed a qui tam (e.g., whistleblower) civil action claiming that numerous Delaware incorporated entities failed to escheat the value of unredeemed gift cards by engaging in improper practices to escape their obligations to report unclaimed property to the state of Delaware. Just this past year, many of the cases were settled with Overstock paying over $7 million after the judge held the retailer liable under the Delaware False Claims Act. Finally, many states are changing their gift card laws in accordance with the 2016 Revised Uniform Unclaimed Property Act. While some states are taking an unfavorable position, other states are clarifying existing positions. Others are simply modernizing the language in their statutes to account for changes in the instrument and categories of cards (i.e., stored-value card, loyalty card, payroll card).

Action steps

Given ongoing litigation and ever-changing unclaimed property laws, retail organizations should take specific action steps to mitigate potential exposure, including:

  1. Review existing gift card programs and practices to confirm compliance with state escheat laws. To the extent programs are administered through gift card management companies, perform an examination of the related form and substance of the entities and the level of information they retain on gift card purchasers and holders.
  2. To the extent potential liabilities are identified, consider entering into voluntary disclosure agreements. Benefits of a voluntary disclosure agreement generally may include a limited look-back period and abatement of interest and penalties.

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