Retailers must be mindful of gift card tax pitfalls
INSIGHT ARTICLE |
While it is widely accepted that a well-designed and executed gift card program can drive customer traffic, increase sales and build customer loyalty, retailers and restaurant operators must be mindful of the financial reporting and tax consequences of their gift card programs in order to manage them effectively. Understanding the various financial reporting and tax issues requires a closer look.
In nearly all cases, the sale of a gift card results in a liability recorded at the point of sale representing the obligation to deliver goods or services to the customer on redemption of the gift card. 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 guidance requiring uniform accounting treatment, some retailers elect a policy for unused gift cards for which amounts will not be escheatable to the state to allow the liability to remain on the balance sheet until such time that the gift card either has 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 in perpetuity (if no expiration date) or until such amounts are escheated to the state, if required by state law.
In response to this, many retailers have 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 1) when the likelihood of redemption of the gift card or portions thereof is considered remote or 2) over the period in which the remainder of the gift cards are expected to be used.
There are several key elements in such a policy that require data collection and analysis, diligence, and judgment. The first is estimating the amount of gifts cards that are expected to remain unused and/or determining at what point in time the likelihood of redemption is remote, and the second is determining whether or not a legal obligation exists to remit amounts to local jurisdictions.
In order to estimate the amount of gifts cards that are expected to remain unused and determine when the likelihood of redemption is remote, sufficient historical data must be available to assist management in making an accurate determination. For that reason, there is normally a period of multiple years before a company has enough information to reliably make such a determination.
In a retail environment in which sales are made not just through brick and mortar stores, but through multiple channels, including internet sales, determining whether or not amounts need to be remitted to local authorities can be difficult. Retailers need to determine factors such as the state of origin of the individual purchasing the card, the address of the last known owner of the card and the unique escheat laws in many different states.
New guidance for retailers
In May of 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which provides specific guidance to all entities, including retailers, regarding breakage, which would apply to gift cards. Based on ASU 2014-09, 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 ASU requires an entity to recognize revenue for the breakage they are entitled to proportionately as other gift card balances are redeemed. However, the ASU goes on to state that consideration received from a customer that must be remitted to a governmental entity (i.e., as a result of escheat laws) should not be recognized as revenue.
ASU 2014-09 will replace most existing revenue recognition guidance in Generally Accepted Accounting Principles when it becomes effective and permits the use of either a full retrospective or modified retrospective with cumulative effect transition method. ASU 2014-09 will be effective for annual reporting periods beginning after Dec. 15, 2017 for public reporting entities and for annual reporting periods beginning after Dec. 15, 2018 for non-public reporting entities.
ASU 2014-09 offers more specific guidance that must be applied with respect to breakage, but the burden of estimating the amount of gifts 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. While the standard is not yet effective, now is the time to consider the impact the new standard will have on accounting policies.
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.
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 of one year deferral for tax reporting). Alternatively, if the retailer does not have an AFS, they 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.
In general, sales tax can be a complicated area. Businesses have to deal with sales tax associated with gift cards as well as incentives such as coupons, loyalty programs and deal-of-the-day incentives. The rules can be state-specific related to all these different incentives which is why it is important to not just apply the sales tax rule for one type of incentive to another. With respect to gift cards, they are typically considered a cash equivalent and therefore no sales tax is charged at the time the gift card is purchased. Sales tax is applied to the transaction at the time a gift card is used to purchase taxable merchandise or services, with few exceptions.
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 which remain unredeemed then that 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 U.S., 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, states like Delaware have historically extrapolated liability back over 30 years during audits. However, Delaware is reviewing its voluntary disclosure agreement policies and expects to introduce legislation to address some of the issues raised in a recent court case when the General Assembly reconvenes in 2017.
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 and 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 percent 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 critically important to managing this exposure.
Finally, 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. In November 2015, the judge in the case issued a memorandum opinion on the defendants’ Motion to Dismiss. While the opinion is unfavorable for the defendants, the litigation is still ongoing.
Given ongoing litigation and ever-changing unclaimed property laws, retail organizations should take specific action steps to mitigate potential exposure, including:
- 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.
- 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.
- To the extent that your business model permits, consider adapting your gift card program to the company’s advantage, minimizing the administrative burden associated with a multi-state gift card escheatment program.
- Lastly, gift cards are only one type of unclaimed property. Retailers and restaurant operators are often targeted by states and their third-party auditors for full-blown unclaimed property audits, which typically encompass a complete general ledger review, including but not limited to, vendor checks, payroll checks, merchandise credits, etc. Understanding the regulations, assessing exposure and instituting proactive remediation can mitigate interest and penalty.
While trends in consumer spending play out at the cash register, they also make a real difference in the back-office through tax compliance and planning as well as financial reporting. Retailers need to be aware of how to treat gift card sales, redemptions and those that remain outstanding in the long term, and understand the complexities especially when operating in multiple states or obtaining new customers who live across state lines. Errors applied to a single transaction may seem inconsequential, but when multiplied across many gift card transactions and multiple states the potential for miscalculation and cash flow surprises is significant. Best practices recommend at minimum an annual review of gift card procedures including assessing reporting, sales tax, unclaimed property and more.
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