Tax considerations in an omnichannel environment
Successful brands find ways to personalize their relationships with customers in many ways, which is what makes omnichannel strategies one of today's top trends in the consumer products industry.
An omnichannel strategy puts the customer, not the company, at the center and recognizes that online tools have enabled customers to use channels simultaneously. For example, customers can check out product reviews on their mobile device while evaluating a product on the retail store shelf. Omnichannel marketing recognizes that customers engage with their favorite brands in many different ways-across multiple platforms. In fact, it is believed that consumers spend four times as much through multiple channels as through a single one. Retailers must look at customer interactions across all channels which require strategies to both capture and interpret data.
Integrating traditional and online sales strategies provides great opportunity for retailers and can create both opportunities and issues in the world of taxation. In this article we will discuss how omnichannel strategies can affect a company's treatment of sales tax, gift cards, unclaimed property, website development costs, online or store expansion, product returns and even domestic production activities.
Selling through multiple channels creates sales tax complexities across the 12,000+ taxing jurisdictions in the United States. Manual approaches to sales tax compliance can create exposure due to human error while slowing down the effort of a successful omnichannel strategy.
In the current economy, sales tax audits are increasing as state and local jurisdictions face budget shortfalls and are seeking to rebuild their revenue streams. In addition, states continue to enact legislation imposing sales tax on services as a measure to increase the tax base. Out of state retailers are especially prone to audit given the nuances associated with nexus creating activities which results in a related sales tax collection and filing responsibility.
Each channel requires an understanding of the sales tax rules that apply as nexus-creating activities are more prevalent as additional sales channels are introduced, such as affiliate programs, click-through nexus via websites, sales representative activities and other solicitation methods. Given the complexities associated with the issues referenced above, companies are recognizing the need to automate the sales tax collection and compliance function. To ensure that omnichannel strategies are successful, companies need to proactively consider many factors including:
- Address verification
- Sales tax calculations
- Shipping costs
- Taxable versus tax exempt transactions
- Management of exemption documentation
There is a national effort to tax online sales. Recently a bipartisan group of lawmakers teamed up to introduce new legislation to make it easier for states and localities to collect sales taxes on online purchases and other remote transactions. Similar to its predecessor bill, the Marketplace Fairness Act (MFA), the Remote Transactions Parity Act (RTPA) relies on the Streamlined Sales and Use Tax Agreement. The RTPA represents the type of compromise bill many were calling for when the MFA first cleared the Senate, but it still has to clear the House Judiciary Committee and the full House in an environment where both parties are very reluctant to pass legislation. The new bill, if passed, aims to promote states' rights and to bring sales tax parity to online retailers and brick-and-mortar stores.
Companies should stay tuned to legislative developments around sales tax and regularly review their sales tax procedures across all channels to ensure proper application of current nexus principles.
Gift cards and unclaimed property
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 has become an increasing source of revenue for states; accordingly, jurisdictions are increasing audit efforts (including through third-party contract audit firms) which result in increased assessments. Gift cards, which can be purchased through one channel or location and redeemed through a different channel or location, are a source of concern for states and companies alike.
Unclaimed property is sourced to the state of the owner's last known name and address. If the last known address of the owner is unknown or if the state of the last known name and address does not provide for escheat of the property, then a holder's state of incorporation or organization may lay claim to the property. Numerous states have statutory exemptions from escheat related to gift cards, stored value cards, etc. in line with each state's specific requirements. However, many sellers of gift cards do not obtain owner name and address information. Accordingly, such property is generally escheatable to the company's state of incorporation or organization.
Recently, litigation has been increasing with respect to various unclaimed property matters, including gift cards. In 2014, Delaware unsealed a qui tam (e.g., whistleblower) civil action filed in June 2013 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 Delaware ex rel. French v. Card Compliant LLC, Case No. N13C-06-289 FSS (Del. Super. Ct. June 28, 2013), the suit alleges that the retailers knowingly and willfully violated the Delaware False Claims and Reporting Act by failing to file required reports and making false reports to Delaware "to conceal, avoid, or decrease their obligations to the State of Delaware."
Given ongoing litigation and ever-changing unclaimed property laws, companies can take specific action steps to mitigate potential exposure, including:
- Reviewing 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.
- To the extent potential liabilities are identified, consider entering into voluntary disclosure agreements. Benefits of a voluntary disclosure agreement generally may include a limited lookback period and abatement of interest and penalties.
Website development costs
Omnichannel approaches are dependent on strong websites that include fundamental consumer information (hours of operation, contact numbers and product descriptions) and a streamlined approach to attract and sell to consumers. The treatment of website development costs can become complex due to the various components that make up website design and content within the website.
Website development costs generally include software, content and design components:
- Software costs may be deductible or capitalizable depending on whether such costs are for the development or acquisition of software
- Content costs may be treated as deductible advertising costs or may be subject to capitalization and amortization if such content is copyrighted
- Graphic design costs may be made up of both software elements (i.e., those that are integral to the website's design) and content elements
Revenue Procedure 2000-50 provides guidance for both developed and acquired software costs:
- Internally developed software costs may be: (1) currently deducted similar to research and experimental costs; (2) capitalized and amortized over 60 months from the date of completion (similar to rules for research and experimental costs under section 174); or (3) capitalized and amortized over 36 months from the date the software is placed into service under section 167
- Taxpayers that contract out website software development costs may be able to treat such costs as internally developed software costs as long as the taxpayer maintains the benefits and burdens of development (e.g., the risks of development)
- Acquired software costs generally must be capitalize and amortized over 36 months from the date the software is placed into service.
Website content, on the other hand, may be deductible or capitalizable depending on the type of content:
- If the content is for advertising purposes, content costs may generally be currently deducted as an advertising expense under section 162
- If the content includes copyrighted material, the costs associated with acquiring (or developing) the copyright may be capitalizable and amortizable over its useful life (or over a 15-year safe harbor) under section 167 or over 15 years under section 197
The determination of whether section 167 or section 197 applies to the costs of copyrighted material depends on whether the copyright is self-created or acquired either separate from or as part of the acquisition of a trade or business.
Expansion versus startup costs for brick and mortar operations moving to online retailing
As brick and mortar companies move to online retailing, tax planning becomes increasingly important. The initial structuring of the expanded channel can significantly impact cash flow due to differing tax treatments.
Generally, a taxpayer must capitalize costs incurred to start a new business. Under regulations, start-up costs may be deductible up to a certain limit, with any excess amortized over 180 months, beginning with the month the trade or business begins. However, costs incurred to expand an existing business may be currently deductible as an ordinary and necessary business expense when incurred. The determination of whether costs are incurred to start a new business or expand an existing one has caused controversy in the past and can affect taxpayers incurring costs to move from brick and mortar to online operations.
Briarcliff Candy Corp. is a leading case in the area of start-up versus expansion. In this case, the taxpayer was a manufacturer and seller of candy products that, in order to combat falling sales, incurred costs to solicit and enter into franchise agreements with drugstores in a different geographical area, providing for the drugstores to sell the taxpayer's product. The taxpayer incurred promotional and advertising costs, which it treated as currently deductible. The IRS argued that such costs should be capitalized since they created a benefit for future years (i.e., increased revenue). The Court of Appeals for the second circuit, however, held that the costs were currently deductible since they were incurred to protect and expand the taxpayer's existing business and not to create a separate and distinct intangible asset.
Alternatively, in Specialty Restaurant Corp, the Tax Court held that amounts incurred by a restaurant operator to open new restaurant locations must be capitalized as start-up costs. In this case, although the opening of each new restaurant would normally be considered an expansion of the existing business, because the taxpayer created a new subsidiary (i.e., a separate tax entity) to hold each new restaurant that was opened, each new subsidiary was treated as a new trade or business. Therefore, costs incurred for the start-up of each new trade or business were required to be capitalized.
In Rev. Rul. 2003-38, the IRS ruled that a taxpayer engaged in the retail shoe store business was expanding its business when it created an internet website for the online sales of its shoes. The IRS ruled that although the operation of an online sales business requires some knowledge apart from that required to operate a brick and mortar store (e.g., different marketing approaches and technical operations, etc.), the website's operations depended significantly on the taxpayer's existing experience, knowledge and goodwill. Additionally, the principal business activity of the two operations was the same. As such, the move to online sales was properly treated as an expansion of the existing business rather than the creation of a new trade or business.
Consumer product companies continue moving to online operations (either exclusively or in addition to brick and mortar operations) as they focus on their omnichannel strategy. It is important to do upfront planning to determine the appropriate treatment of otherwise deductible costs associated with creating and opening online operations. Fortunately, case law and rulings generally provide that such costs should be treated as costs incurred to expand an existing business (and thus are not required to be capitalized as start-up costs). However, if companies choose to open their online operation in a separate entity (which may be advantageous for liability reasons), the costs associated with these are likely treated as start-up costs requiring capitalization and a lengthy amortization period for tax purposes notwithstanding that such costs may otherwise be treated as currently deductible expansion costs.
Product returns, including gift cards in exchange for returns
Omnichannel approaches are meant to put the consumer convenience factor at the forefront. As such, online retailers are making returning products increasingly simple for the consumer by providing free returns and prepared packaging slips that can be printed out directly from the retailer's website or allowing online purchases to be returned at the store.
There's no doubt that this convenience factor increases consumer purchasing, but as a result, many companies with online operations have to deal with a correspondingly increased number of returns. For instance, consumers purchasing clothing from an online retailer may purchase multiple sizes of one item in order to find the best fit, intending to return remaining items. Consumers are also more willing to take a chance on an item they have not inspected personally, knowing they can easily return it if the item does not meet expectations. In light of this, taxpayers may be netting returns against gross receipts in a taxable year prior to the year when such returns should be properly recognized for federal income tax purposes.
Retailers using an accrual method of accounting must generally recognize a liability in the taxable year in which:
- all the events have occurred to establish the fact of the liability;
- the amount of the liability can be determined with reasonable accuracy; and
- economic performance has occurred with respect to the liability.
Thus, a liability may generally not be taken into account until economic performance occurs with respect to such liability. For liabilities to provide a refund to a customer, economic performance (the third test) occurs as the refund is paid. Thus, even if a taxpayer is notified that a return is being made (for instance, when a consumer requests a return slip), the liability related to the return may not be recognized until the associated refund is provided to the consumer, which may be in the subsequent tax year.
However, an exception may apply to allow acceleration of an otherwise fixed and determinable liability into the year the liability becomes fixed, even if economic performance (payment of the refund) occurs after year end. Under the recurring item exception of Reg. section 1.461-5 (sometimes referred to as the "8.5 month rule"), a liability is treated as incurred for a taxable year if:
- as of the end of the taxable year, the liability has become fixed and determinable;
- economic performance with respect to the liability occurs on or before the earlier of 8.5 months after the close of the taxable year or the date the taxpayer files a timely (including extensions) return for that taxable year;
- the liability is recurring in nature; and
- either the amount of the liability is not material or the accrual of the liability for that taxable year results in a better matching of the liability with the income to which it relates than would result from accruing the liability for the taxable year in which economic performance occurs (the "matching requirement").
In the case of liabilities to provide refunds, the matching requirement is deemed satisfied. Thus, taxpayers may be able to accelerate the recognition of refund liabilities into the year prior to when the refund is actually made and paid out to the consumer.
Additionally, retailers that use the overall accrual method of accounting and issue credits (or gift cards) in exchange for returned goods may treat such transactions as (1) the payment of cash refund in an amount equal to the gift card, and (2) the sale of the gift card in an amount equal to the gift card (Rev. Proc. 2011-17). By using this treatment, the taxpayer can recognize the full amount of the refund (e.g., as a reduction to gross receipts) either in the year the refund is issued or in the preceding year under the recurring item exception, and the taxpayer can defer the income inclusion related to the deemed sale of the gift card for up to one year (Rev. Proc. 2004-34) or up to two years (Reg. section 1.451-5).
Section 199 domestic production activities deductions
There are several issues under the section 199 domestic production activities deduction (DPAD) regarding software that may affect taxpayers in the consumer products industry as they expand into omnichannel operations. For instance, in a recent general legal memorandum (AM 2014-008), the IRS determined that a banking industry taxpayer's provision of a free, downloadable computer software application (the App) to its customers did not meet the requirements for treatment as a qualifying disposition for purposes of section 199.
The IRS found that the App fell within the definition of online software and thus downloads of the App would not be considered a qualifying disposition. In analyzing the App, the IRS focused on a couple of factors. First, it noted that the App did not function unless the user was connected to the Internet. Second, it noted that the App did not provide the user with any benefit other than access to the taxpayer's banking services.
The IRS also analyzed whether the download of the App could qualify as a disposition under the self-comparable or third-party comparable exceptions. Online software qualifies for the self-comparable exception if a taxpayer also derives gross receipts from software that
- has only minor or immaterial differences from the online software;
- was produced by the taxpayer in whole or in significant part within the United States; and
- has been provided to such customers affixed to a tangible medium…or by allowing them to download the computer software from the Internet.
Online software qualifies for the third-party comparable exception if "another person derives, on a regular and ongoing basis in its business, gross receipts from the lease, rental, license, sale, exchange, or other disposition of substantially identical software…(as compared to the taxpayer's online software) to its customers," either affixed to a tangible medium or by allowing them to download it.
Since the taxpayer did not produce any software comparable to the App, it did not meet the requirements for the self-comparable exception. Additionally, the taxpayer was unable satisfy the third-party comparable exception because, although similar software was produced by another company, such software was not substantially identical to the App.
In today's online sales environment, where many retailers offer apps for online purchasing and related services, the determination of whether the download of such apps meet the definition of a qualifying disposition under section 199 is increasingly difficult. In determining whether gross receipts from online software qualify for inclusion in domestic production gross receipts (DPGR), it is crucial to examine
- the software's relationship to any services being offered by the taxpayer,
- whether the same (or immaterially different) software is being sold on a tangible medium or via online download, and
- whether a taxpayer's competitor sells substantially identical software on a tangible medium or via online download.
Examples of software developed by consumer products companies that could qualify for the DPAD include:
- Computer games that customers can either purchase in a store in disc form, download from the internet or access online
- Subscriptions to Netflix, Amazon Prime, iTunes and other similar entertainment software that be downloaded onto a computer, iPad or similar device
Another common issue with software is that although section 199 allows software developed by a taxpayer to be treated as qualified production property and licensing revenue from such software to be treated as DPGR, in the current software as a service (SaaS) and cloud computing environment, it is often difficult to distinguish between the licensing of software (DPGR) and the sale of services (non-DPGR). The IRS National Office recently addressed this issue in a Technical Advice Memorandum (TAM 201445010).
Under the facts evaluated in the TAM, the taxpayer developed and licensed custom software to a contracting party, which used the software to manipulate its own data. An end user would then enter into a subscriber agreement with both taxpayer and the contracting party whereby the contracting party used the licensed software to compute certain results that are provided to the user. The IRS treated this transaction as occurring in two steps: (1) taxpayer produces software and licenses it to the contracting party, and then (2) the contracting party uses the software to provide services to the end user. It is important to note in this case that the contracting party used its own data to perform the service and the license did not indicate that the taxpayer was providing any services to the end user. Accordingly, The IRS ruled that the revenue from the software license may be treated as DPGR.
Companies wishing to claim the DPAD for software should consider contracting separately for the licensing of software and the provision of any services.
The above are six areas where business strategy affects tax planning in an omnichannel consumer products world. As demonstrated, the answers are not black and white and depend greatly upon the business facts of any situation. As consumer products companies embrace a variety of communication and selling channels to reach an increasingly-demanding and location-agnostic audience, it will be important to regularly review the tax treatment of product sales and business investments. In doing this, companies should make sure to work with their tax advisers to monitor developments, evaluate the related implications and take the necessary steps to remain in compliance and proactively manage risk.
Contact our consumer products team to learn more about how an omnichannel approach may affect your tax strategy.