The IRS issued AOD 2016-03 to indicate that it will not follow the Third Circuit Court of Appeals decision in Giant Eagle, Inc. v. Commissioner, 822 F.3d 666 (3rd Cir. 2016), rev’g T.C. Memo 2014-146. The issue is whether costs for a rewards program are deductible in the year the rewards are earned by the taxpayer’s customer or in the year in which the rewards are redeemed by the taxpayer’s customer. This issue has generated a considerable amount of controversy between taxpayers and the IRS. Worse yet, these adjustments result in accounting method changes. So the IRS has the ability to make an adjustment in a current year for all of the deductions taken in all prior years. This will almost always result in the amount in dispute in the current year being extraordinarily large.
The taxpayer owned and operated supermarkets under the name “Giant Eagle” and gas stations under the name “GetGo.”
The taxpayer had a customer loyalty program by which customers making qualifying purchases at Giant Eagle could earn “fuelperks!” that were redeemable for a discount against the purchase price of gas at GetGo.
For every $50 in groceries purchased from Taxpayer, customers qualified for a reduction in price of ten cents per gallon on a future purchase of fuel. The discount coupons expired three months after the last day of the month in which they were issued and could not be redeemed in cash.
The taxpayer deducted the estimated costs of redeeming the discount coupons that were unexpired and unredeemed at the end of each year at issue based on the statistical likelihood that customers would use their discount coupons by purchasing fuel before the coupons automatically expired.
The IRS denied the deduction. It questioned whether the taxpayer properly accrued and deducted expenses for the unredeemed fuelperks! under the “all events” test of Section 461.
The Section 461 All Events Test
Cash-basis taxpayers are generally entitled to deduct expenses in the year they are incurred. Accrual-basis taxpayers are generally allowed to deduct expenses in the year in which the expense is incurred, regardless of the actual date of payment.
An expense is “incurred” for Federal income tax purposes in the year in which:
- all the events have occurred that 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.
If these elements are met, the accrual method taxpayer can deduct the expense in the current year.
The Giant Eagle Audit and Litigation
In the Giant Eagle case, the IRS argued that the first element was not satisfied because all the events had not occurred to establish petitioner’s liability for the outstanding fuelperks!
According to the IRS, the taxpayer’s liability for fuelperks! was fixed when they are redeemed. So the taxpayer should have deducted the expense when the fuelperks! were redeemed. The taxpayer argued that its liability for the fuelperks! was fixed when they are earned by the customers.
The U.S. Tax Court agreed with the IRS. It reasoned that “the purchase of gas was necessarily a condition precedent to the redemption of fuelperks!.” So the court concluded that the obligation to redeem fuelperks! was subject to a condition precedent that could be satisfied only after the close of the tax year.
On appeal, the Third Circuit Court of Appeal reversed the U.S. Tax Court. It did so by looking to state contract law. It reasoned that the taxpayer’s rewards program created a unilateral contract under Pennsylvania contract law with each customer upon the customer’s purchase of groceries. So the taxpayer was legally bound to honor unexpired discount coupons. This lead to the conclusion that the taxpayer’s liability for unredeemed discount coupons was fixed when a customer purchased groceries.
The IRS’s AOD and Its Impact
The IRS’s AOD indicates that it will not follow the Third Circuit Court’s decision outside of the Third Circuit. According to the AOD, the IRS intends to challenge rewards programs subject to the law in other circuits.
There are significant amounts at stake in these cases. Since the terms of reward programs are set out in contracts and most rewards programs are housed in a separate entity or subsidiary entity, it will be interesting to see if taxpayers who operate rewards programs outside of the third circuit’s jurisdiction will take steps to bring their rewards programs within the jurisdiction of the third circuit given this AOD.