Retailer may estimate the goods share of unredeemed gift cards

Plain-English summary

A retailer sold gift cards redeemable for goods, integral services, unrelated services, warranties, and other items. The IRS concluded that gift cards do not fall outside the former section 1.451-5 deferral rule merely because they can be redeemed for both goods and services. Because the eventual use of any individual unredeemed card is unknown at year-end, the retailer could treat all outstanding cards from the year as a single agreement and estimate the portions allocable to goods, integral services, and non-integral services. The retailer could defer the estimated qualifying portion for up to two years, but the field examination team had to determine whether its estimation method was appropriate.

Ruling snapshot

• Question: Could the retailer defer income from unredeemed gift cards that were usable for both goods and services?
• Outcome: Advice given: yes, to the extent a supportable allocation estimates the portion qualifying under the former regulation.
• Key authorities: IRC §§ 446 and 451; former Treas. Reg. § 1.451-5

Full text (IRS public release)

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INTERNAL REVENUE SERVICE
NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                           August 28, 2015

Number: 201610017
Release Date: 3/4/2016

                                                     [Third Party Communication:
                                                     Date of Communication: <Month> DD, YYYY]

Index (UIL) No.: 451.13-04
CASE-MIS No.: TAM-107447-15

--------------------------

     Taxpayer’s Name:                            -----------------------------------------------------------
     Taxpayer’s Address:                         ---------------------------------------------------------
                                                 ------------------------------
     Taxpayer’s Identification No                ----------------
     Year(s) Involved:                           ----------------
     Date of Conference:                         ------------------

LEGEND:

Company = -------------
Country 1 = -------------------
Country 2 = -----------
Country 3 = --------
Year 1 = ----------------------------------
Year 2 = ----------------------------------
Term 1 = -------------
$o = --------
Term 2 = ----------
Division 1 = ------------------------------
Division 2 = -----------------
Division 3 = ---------------------------------
Division 4 = ---------------
TAM-107447-15 2

Division 5 = ------------
Division 6 = ---------
$a = -----------------
$b = -----------------
a% = ------
b% = ------
$c = -----------------
$d = -----------------
$e = -------------------
$f = ------------------
$g = ------------------
$h = -----------------
$i = -----------------
$j = -------------------
$k = ------------------
$l = ------------------
c% = ------
Period 1 = ---------------------------------
$m = ------------------
$n = ------------------
Year 3 = --------------------
d% = -----
Year 4 = -----------
Year 5 = -----------
$m = --------
$n = -------------
e% = ---------
f% = -------
g% = ---------
h% = -----
i% = -----

ISSUE:

  May Company defer for up to two years, under § 1.451-5 of the Internal Revenue

Regulations, the recognition of advance payment income received from the sale of
unredeemed gift cards that are redeemable for goods or services.

CONCLUSION:

  Income from the sale of unredeemed Company gift cards may be deferred under

§ 1.451-5, to the extent Company can make an appropriate estimate of the amounts
TAM-107447-15 3

that are deferrable under § 1.451-5 using an allocation similar to that found in § 1.451-
5(a)(3).

FACTS:

     Company is a multinational e-commerce and physical retailer of ----------------------

------------------- products with operations in Country 1, Country 2, and Country 3. During
the tax years at issue, Year 1 and Year 2, Company operated retail stores and
associated commercial websites under various brand names from which customers
could purchase its products including -------------------------------------------------------------------

---------------.

    Company also offers an assortment of related services including delivery,

installation, repair, and certain -----------------------------------. For example, if a customer
purchases a ------------- online or at its retail store, the customer can also pay an
additional fee to have Company deliver, install, or repair that -------------. These services
are related to its core businesses.

   Company sells services unrelated to its core business. For example, customers

can purchase repair services for --------------- not purchased from Company, can hire
Company to install new ---------------------------------that the customer did not purchase
from Company, or can hire Company to install ------------------------------------without
having purchased any of the ---------------------------------------from Company. These
services are unrelated to its core businesses.

     Company also sells extended warranties and service contracts, which generally

range in terms from Term 1 to Term 2, and are related to its core business. ----------------
---------------------------------------------. The warranty or service plans are sold on behalf of
a third party, ---------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------. During
Year 1 and Year 2 Company earned a commission for every extended warranty or
service contract it sold and recognized these commissions as commission revenue.
The third party determines whether to hire Company or another to perform the repair. If
Company performs the repair, the third party will reimburse Company for the cost of the
repair.1

   Company sells gift cards to customers, which can be purchased in increments of

$o up to any amount and do not have an expiration date. Company does not charge
customers any administrative fees to purchase or redeem a gift card. To redeem the

1
Beginning in Year 2, Company offered prepaid cards on behalf of unrelated retailers, -----------------------------------
----------------------------------------------------------------, which it treats as the sale of goods.
TAM-107447-15 4

gift card, customers need only present the card at the time of checkout. At redemption,
the gift card is treated as cash.2 The gift cards allow the holder to spend the value of
the gift card at Company retail stores or its website. Customers can use the gift cards
to purchase goods, services, or a combination of goods and services. There is no limit
on the number of gift cards a customer can use during a single purchase and gift cards
can be used in conjunction with any other type of tender. The gift cards are activated
and become available for immediate use at the time of purchase, at which time
Company is obligated to provide such goods or services as demanded from the gift card
holder at redemption.

  Company’s gift cards, regardless of amount, have the same stock keeping unit

(SKU), enabling Company to track when the gift cards are purchased. Gift card
balances and redemption data is tracked electronically by a third party. Company
suggests that customers generally buy the same proportion of goods, services, or both
goods and services with Company gift cards as they do with cash or credit cards.

    During Year 1 and Year 2 Company reported revenues in six product categories

or divisions: Division 1,3 Division 2,4 Division 3,5 Division 4,6 Division 5,7 and Division 6.8
In Year 1 and Year 2 Company reported total domestic gross revenue of $a and $b,
respectively. Tangible product sales accounted for a% and b% of domestic revenue in
Year 1 and Year 2, respectively. In contrast, services revenue accounted for h% and i%
of Company’s total domestic revenue in Year 1 and Year 2 respectfully.

  In Year 1 Company sold $c in gift cards. Of that amount, customers redeemed

and Company recognized $d in gift cards during Year 1. Of the Year 1 balance, $e
were redeemed and recognized in Year 2. Of the Year 1 remainder, $f of gift cards
were redeemed and recognized in Year 4. At the end of Year 4, $g of gift cards
purchased in Year 1, or d%, were unredeemed.

  Similarly, in Year 2 Company sold $h in gift cards. Of that amount, customers

redeemed and Company recognized $i in gift cards during Year 2. Of the Year 2
balance, $j were redeemed and recognized in Year 4. Of the Year 2 remainder, $k of

2
The gift cards cannot be redeemed for cash and customers cannot use the gift cards to make payments against their
Company credit card balances.
3
Division 1 consists of revenue from the sale of ----------------------------------
4
Division 2 includes revenue from the sale of ------------------------------------------------------------------------------------

5
Division 3 includes revenue from the sale of ------------------------------------------------------------------------------------

6
Division 4 includes revenue from the sale of ----------------------------------------------------------------
7
Division 5 includes revenue from the sale of ------------------------------------------------------------------------------------

8
Division 6 includes revenue from the sale of ---------------------------------------------------------------
TAM-107447-15 5

gift cards were redeemed and recognized in Year 5. At the end of Year 5, $l of gift
cards purchased in Year 2, or d%, were unredeemed.

    Historically, customers redeem c% of all Company gift cards within Period 1 of

being issued. Company determines its breakage rate, the amount of gift cards never
redeemed, using historical redemption patterns. After Period 1, for financial statement
purposes, Company recognizes breakage income for those gift cards for which the
likelihood of redemption is remote. For gift cards issued in Year 1, Company
recognized breakage income in the amount of $m in Year 4. For gift cards issued in
Year 2, Company recognized breakage income in the amount of $n in Year 5.

LAW AND ANALYSIS:

   Section 446(a) of the Internal Revenue Code provides that taxable income shall

be computed under the method of accounting on the basis of which the taxpayer
regularly computes its income in keeping its books. Section 446(b) provides that if the
method used does not clearly reflect income, the computation of taxable income shall
be made under such method as, in the opinion of the Secretary, does clearly reflect
income.

   Section 451(a) provides that the amount of any item of gross income shall be

included in the gross income for the tax year in which received by the taxpayer, unless,
under the method of accounting used in computing taxable income, such amount is to
be properly accounted for as of a different period.

   Section 1.451-1(a) provides that income is includible in gross income when all

the events have occurred which fix the right to receive such income and the amount
thereof can be determined with reasonable accuracy.

   Section 1.451-5(a)(1) provides that for purposes of § 1.451-5, the term “advance

payment” means any amount which is received in a tax year by a taxpayer using an
accrual method of accounting for purchases and sales, pursuant to, and to be applied
against an agreement for the sale or other disposition in a future tax year of goods held
by a taxpayer primarily for sale to customers in the ordinary course of his trade or
business.

    Section 1.451-5(a)(2)(i) provides that the term “agreement” includes a gift

certificate that can be redeemed for goods. The regulation also provides that the term
includes agreements which obligate a taxpayer to sell goods in a future taxable year
and which also contain an obligation to perform services that are to be performed as an
integral part of such sales.
TAM-107447-15 6

    Section 1.451-5(a)(3) provides that if an agreement for the sale of goods in a

future taxable year also obligates the taxpayer to perform services that are not to be
performed as an integral part of the sale of goods, then the amount received will only be
treated as an “advance payment” to the extent such amount is properly allocable to the
obligation to sell goods. The portion of the amount not so allocable will not be
considered an “advance payment” to which § 1.451-5 applies.

   Section § 1.451-5(a)(3) further provides that if the amount not so allocable is less

than 5 percent of the total contract price, such amount will be treated as so allocable to
the extent that such treatment does not result in delaying the time at which the taxpayer
would otherwise accrue the amounts.

    Section 1.451-5(b) provides that advance payments must be included in income

either in the tax year of receipt, or except as provided by § 1.451-5(c), in the tax year in
which properly accruable under the taxpayer’s method of accounting for tax purposes if
such method results in including advance payments in gross receipts no later than the
time such advance payments are included in gross receipts for purposes of all of the
taxpayer’s reports to shareholders, partners, beneficiaries, other proprietors, and for
credit purposes.

    Section 1.451-5(c)(1)(i) provides that if a taxpayer receives an advance payment

in a tax year with respect to an agreement for the sale of goods properly includible in his
inventory, or with respect to an agreement (such as a gift certificate) which can be
satisfied with goods or a type of goods that cannot be identified in such tax year, and on
the last day of such tax year the taxpayer in accounting for advance payments pursuant
to a method described in § 1.451-5(b)(1)(ii) for tax purposes, has received “substantial
advance payments” with respect to such agreement, and has on hand (or available to
him in such year through his normal source of supply) goods of substantially similar kind
and in sufficient quantity to satisfy the agreement in such year, then all advance
payments received with respect to such agreement by the last day of the second tax
year following the year in which such 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 such second tax year.

  Section 1.451-5(c)(3) provides that advance payments received in a tax year with

respect to an agreement (such as a gift certificate) under which the goods or type of
goods to be sold are not identifiable in such year shall be treated as “substantial
advance payments” when received.

   Sales of warranty contracts are generally treated as sales of services. See, Rev.

Proc. 97-38, 1997-2 C.B. 479.
TAM-107447-15 7

   This technical advice request presents the question of whether all or a portion of

the amounts received for gift cards which are redeemable for both merchandise and
services constitute advance payments under § 1.451-5(a).

    Company’s position is that amounts paid for its gift cards, including those

redeemable for services, are advance payments under § 1.451-5, which provides a two-
year deferral of such amounts if the exception under § 1.451-5(c) for inventoriable
goods applies. If the exception applies, then the amounts received for gift cards must
be included in gross income by the last day of the second tax year following the year
that payments are received.9 Since tax year ending Year 3, Company has deferred
recognition of revenue from the sale of gift cards until the earlier of (i) redemption of the
gift card, or (ii) the last day of the second taxable year after issuance of the gift card.

    If amounts received for gift card sales are not advance payments for purposes

of § 1.451-5, then the regulation will not apply and, under § 451(a), such amounts must
be included in gross income in the tax year of receipt.10 Thus, it is necessary to
consider whether the amounts the taxpayer receives for gift cards are advance
payments within the deferral rules of § 1.451-5(a).

   The regulations define the term “advance payment” to include any amount

received in a tax year pursuant to and to be applied against an agreement for the sale
or other disposition in a future tax year of goods held by a taxpayer primarily for sale to
customers.

         a. An advance payment requires “an agreement”

    First, is the payment an amount received pursuant to an “agreement?” Section

1.451-5(a)(2)(i) provides that the term “agreement” includes a gift certificate that can be
redeemed for goods. The amounts here were received for the sale of gift cards. If the
gift cards can be redeemed for goods they are similarly an agreement under the
regulation.11 Company’s gift cards are redeemable for goods, warranties, delivery and
installation, -------------------------and other services. The word “can” ordinarily means
may, not must. See, Random House Dictionary of the English Language (2d ed. 1987).
Reading “can” in § 1.451-5(a)(2)(i) to mean “must” would exclude from the regulation
any retailer whose gift cards could be redeemed for non-integral services or other items.
Given the ubiquitous sale of warranty and other services with goods purchased from
retailers, such a reading of the regulation is too restrictive. The regulation should be

9
For purposes of the inventoriable goods exception of § 1.451-5(c), we assume and therefore decline to discuss
whether the Company keeps on hand goods available for sale in the ordinary course of business because of its nature
as a retail merchant.
10
If properly elected, Company’s gift cards would appear to be deferrable under Revenue Procedure 2004-34, 2004-
1 C.B. 991.
11
Indeed, in Rev. Proc. 2011-18, 2011-1 C.B. 443, the Service treated gift cards and gift certificates as payments for
goods or services to be provided in the future.
TAM-107447-15 8

interpreted to apply to gift cards, like Company’s, that can be redeemed for goods but
can also be redeemed for other items, as well as to gift cards that can only be
redeemed for goods.

         b. The payment must be “applied against” the agreement

  Second, is the payment “applied against” such agreement? Because the

amounts are received for the gift cards the balance of which is applied against
purchases in future taxable years, this second requirement is satisfied.

         c. The agreement must be for the sale of goods

     Third, is the agreement for the sale of “goods held by the taxpayer primarily for

sale to customers in the ordinary course of his trade or business?” Thus, it is necessary
to determine whether a gift card which can be redeemed in part for services or other
items can still be considered an agreement for the sale of “goods.” That is, does the
ability to redeem the gift cards for services or other items render the gift cards outside of
the scope of § 1.451-5(a)?

  Section 1.451-5(a)(2)(i) provides in relevant part that an “agreement” includes

contracts that obligate a taxpayer to perform services that are integral to a sale of
goods.

   Section 1.451-5(a)(3) provides in relevant part that if a taxpayer receives an

amount pursuant to an agreement that not only obligates the taxpayer to provide goods,
but also obligates the taxpayer to perform non-integral services, such amount will be
treated as an “advance payment” only to the extent such amount is properly allocable to
the obligation to provide goods. If the amount not so allocable is less than 5 percent of
the total contract price, such amount will be treated as so allocable if such treatment
does not result in delaying the time at which the taxpayer would otherwise accrue the
amounts attributable to such activities (hereinafter referred to as “de minimis”).12

   Section 1.451-5(a)(3) is written in the present tense and contemplates a taxpayer

receiving an amount pursuant to an agreement to provide goods in the future where a
proper allocation can be made in the taxable year in which the advance payment is
received. Thus, the subparagraph applies to agreements with specific terms that
provide a basis for a proper allocation. Company’s gift cards, however, leave to the
discretion of the customer the choice of what items the gift card will be redeemed for
and preserves for the customer that discretion until the time when the gift card is
redeemed. Until Company’s gift cards are redeemed, for any individual gift card

12
Although not addressed in the submission, we proceed with our analysis under the assumption that the amount not
so allocable, if any, does not result in delaying the time at which the taxpayer would otherwise accrue the amounts
attributable to such activities.
TAM-107447-15 9

Company cannot know whether it will be redeemed for services and other items that are
not integral to a sale of goods by the company. These items may or may not be de
minimis in amount and thus, may or may not be properly allocable to a sale of goods
under the rules of § 1.451-5(a)(3), were it applicable. If not integral or properly allocable
to the sale of goods these items cannot be considered “goods” within the meaning of §
1.451-5(a), which is an exception to the general rule of income recognition and should
be narrowly interpreted. Thus, for a gift card outstanding at the end of the taxable year
in which it is purchased, an amount cannot be properly allocated to the provision of
goods under the language of § 1.451-5(a)(3) because what the card will be redeemed
for is unknown.

    The analysis, however, does not stop here. The inclusion in 1.451-5(a)(2)(i), that

gift cards “can” be redeemed for goods may only be given effect by inferring a process
similar to § 1.451-5(a)(3) and treating the totality of Company’s outstanding gift cards at
the end of the taxable year of their sale as if they represented a single agreement, and
then estimating amounts properly allocable to the sale of goods, integral services, and
the amount not so allocable for these gift cards representing a future sale13.
Accordingly, gift cards that can be redeemed for goods and non-integral services are
eligible to apply allocation rules similar to those described in § 1.451-5(a)(3) by treating
the total of the Company’s outstanding gift cards at the end of the taxable year of their
sale as a single agreement and allowing estimates to be used for the application of §
1.451-5(a)(3). Applying this approach to Company’s gift cards, it is eligible to defer
amounts received for its gift cards to the extent it can make an appropriate estimate of
the amounts that are deferrable under § 1.451-5.

   Company in its submission did not propose an estimation “methodology”, and

offered to work with the field to derive an acceptable method of estimation that is both
administrable and auditable. Whether Company's particular methods of estimating is
appropriate is a question of fact to be determined by the field. No opinion is expressed
on the issue of how this estimation is made or on any other issue not directly addressed
above.

CAVEAT(S):

  A copy of this technical advice memorandum is to be given to the taxpayer.

Section 6110(k)(3) provides that it may not be used or cited as precedent.

13
An advance payment is defined in § 1.451-5(a)(1)(i) as an amount received for the sale or other disposition in a
future taxable year of goods held by the taxpayer. Thus, for gift cards sold during a taxable year, the cards
outstanding at the end of the taxable year represent the only gift card amounts potentially deferrable under the
regulation.
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