In Chief Counsel Advice 201606028 (the CCA), the Service determined that amounts paid for frequent flyer miles, to the extent properly allocable to nontransportation services, are not subject to the aviation excise tax imposed by Section 4261 in certain circumstances. The Service also ruled that the tax applies to a payment for frequent flyer miles at the time of the payment, rather than when the frequent flyer miles are credited to the traveler's account.

Background

Section 4261 of the Code imposes an excise tax on amounts paid for domestic air transportation (generally, air transportation that begins and ends in the United States). The tax equals 7.5% of the amount paid for the transportation, plus an additional fixed charge for each transportation segment (i.e., each combination of one takeoff and one landing). Frequent flyer miles awarded in connection with air transportation are not subject to this tax. If an air carrier sells frequent flyer miles, however, Section 4261(e)(3) imposes a 7.5% tax on the amount paid for the right to provide the awards. Purchasers of frequent flyer miles include credit card issuers that award frequent flyer miles as part of their loyalty programs, hotels, rental car companies, other airlines and individuals. Credit card issuers generally purchase frequent flyer miles as part of a co-branding program in which they receive, in addition to the right to provide mileage awards, other commercial rights and services.¹

The treatment of amounts paid under these co-branding programs has been a frequent issue in the audits of both airlines and credit card issuers. The IRS audit guidelines include a statement prohibiting the "bifurcation or division of amounts paid between the frequent flyer miles and costs such as marketing ... " As a result, IRS examiners frequently challenge the allocation of any portion of the amount paid under a co-branding program to the other commercial rights and services provided under the program.

Bifurcation permitted

The CCA describes a co-branding agreement between a bank and an airline under which the bank purchases frequent flyer miles at a specified rate per mile. The agreement also provides the bank with other commercial rights and services. The agreement includes a bifurcation formula under which a specified percentage of the amount paid for each mile is designated as the purchase price of the frequent flyer mile and the remainder is designated as compensation for the other commercial rights and services (the marketing portion). The invoices the airline sends to the bank separately state the amount attributable to frequent flyer miles and the amount attributable to the marketing portion.

On these facts, the Service concluded that the marketing portion of the amounts paid under the agreement is not subject to the air transportation excise tax. This conclusion is based on multiple lines of analysis. First, the CCA cites the Joint Committee on Taxation's explanation of Section 4261(e)(3), which states that the tax on frequent flyer miles applies to "amounts received by airlines ... pursuant to a joint venture credit card or other transportation marketing arrangements as compensation for the right to air travel." The emphasized language is cited as evidence that Congress contemplated arrangements like the agreement described in the CCA and intended to tax only the amounts paid as compensation for the right to air transportation. The CCA notes that this is consistent with the plain language of Section 4261(e)(3)(A), which equates the purchase of frequent flyer miles with the purchase of an airline ticket.

Second, the CCA analogizes the marketing portion of the amounts paid under the agreement to amounts a bank pays to an independent third-party advertising firm for services relating to promoting the credit card. Just as those amounts are not subject to the air transportation excise tax, amounts paid for similar services should not become taxable merely because they are paid to an airline from which the bank also purchases frequent flyer miles.

Finally, the CCA cites various provisions of the regulations, providing generally that, if a payment covers charges for nontransportation services, such as charges for meals, hotel accommodations, etc., as well as air transportation, the charges for the nontransportation services may be excluded in computing the air transportation excise tax, provided such charges are severable and are shown in the exact amounts thereof in the records pertaining to the transportation charge. Although the marketing services provided in the agreement are not among those described in the regulations, the Service concluded that the agreement covers the purchase of both transportation and nontransportation services as contemplated by the regulations. Furthermore, the invoices sent to the bank meet the "shown-in-the-exact-amounts" requirement of the regulations.

Allocation required

The CCA states that the bank and the airline bear the burden of demonstrating that the allocation of the amount paid between the frequent flyer mile portion and the marketing portion accurately reflects the split between the amounts paid for taxable transportation and the amounts paid for nontransportation services. If this burden is not met, the entire amount paid is subject to the air transportation excise tax. Note that an erroneous or unsupported allocation is not corrected; instead, it is completely disregarded and the entire payment is taxed.

The CCA notes that the IRS has not issued regulations addressing the manner in which a taxpayer may establish that a portion of the amount paid is properly allocable to nontransportation services. It notes, however, that, in Notice 2002-63. 2002-2C.B. 644, an air carrier was permitted to use any reasonable method to allocate amounts paid for frequent flyer miles between those that will be awarded in connection with taxable transportation and those that will not be awarded in connection with taxable transportation. In the absence of any other IRS guidance, the CCA concludes that the bank and the airline may similarly use any reasonable method to allocate a portion of the amount paid to the marketing portion of the agreement.

The CCA concludes that the determination of reasonableness is not a legal issue and that the IRS examination function is better suited to make the determination based on the facts and circumstances of the particular case. Although the examination function is given the authority to determine whether the method chosen by the taxpayers is reasonable, it is not empowered to pick and choose among multiple reasonable methods. It seems clear under the CCA that any such choice belongs to the bank and the airline.

Tax collection timing

A bank may pay for frequent flyer miles either before or after those miles are credited to the accounts of its credit card customers. The CCA concludes that, regardless of when the miles are credited to customers' accounts, the tax attaches when the bank pays for the frequent flyer miles pursuant to the terms of the agreement.

Implications

While Chief Counsel Advice may not be used or cited as precedent, it does represent the views of the Office of Chief Counsel in a particular factual situation, and its views in situations similar to that described in the CCA are likely to be consistent

Banks and airlines entering into new co-branding agreements may want to use the fact pattern in the CCA as a guide. Four factual elements seem to be of particular importance: (1) identification of the commercial rights and services included in the marketing portion of the agreement; (2) inclusion of an allocation formula in the agreement; (3) the separate statement on invoices of the amount attributable to frequent flyer miles and the amount attributable to marketing; and (4) the ability to prove that the allocation in the agreement is accurate and based on a reasonable method. Taxpayers should be particularly aware of the drastic consequences of a failure to make an accurate allocation — that is, the entire amount paid under the agreement will be treated as taxable.

Existing arrangements that do not correspond in all respects to the arrangement described in the CCA should nevertheless take some comfort from the explicit endorsement of bifurcations in co-branding agreements. The CCA does not remove the audit guidelines statement prohibiting bifurcation, and is not the vehicle for effecting such a removal. Nevertheless, it is clear that the statement in the audit guidelines does not reflect the views of Chief Counsel and this should be pointed out early in any audit in which the statement is an issue.

In a separate, but related, development, the IRS and Treasury are working on a guidance project addressing the application of the excise tax to purchased miles. In Notice 2015-76, the IRS requested comments on issues that should be addressed in guidance on excluding from the air transportation excise tax amounts attributable to mileage awards that are redeemed for other than taxable transportation (e.g., to pay for hotel rooms, restaurant gift cards and merchandise). Publication of the CCA may provide an opportunity for the bifurcation issue to be addressed in the guidance developed in response to Notice 2015-76. The deadline for submitting comments is March 15, 2016.

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ENDNOTES

¹ The other commercial rights and services provided under the co-branding program described in the CCA include the right to use (or benefit from) certain airline proprietary business information and data (including the airline's customer lists); intellectual property, including trademarks and brand names; brand-related goodwill; and administrative services carried out by the airline's employees assigned to the mileage award program.