01 November 2023 Tax Court holds taxpayer must include revenue from loyalty rewards program in gross income and casts uncertainty on the conduit approach
In Hyatt Hotel Corporation & Subsidiaries v. Commissioner of Internal Revenue, T.C. Memo. 2023-122 (October 2, 2023), the Tax Court held a taxpayer must include revenue from its loyalty rewards program in gross income. Hyatt Hotels Corp. and Subsidiaries (Hyatt) operate the Gold Passport Program, which gives participating travelers who stay at Hyatt-branded hotels reward points that may be redeemed for a future free stay. In lieu of receiving points for hotel stays, participating travelers may receive travel miles, which may be redeemed with one of Hyatt's travel partners. The program began in 1987, and only Hyatt could change the program, including the points needed for member redemptions. In 2009, 2010 and 2011 (the years at issue), Hyatt owned approximately 25% of Hyatt-branded hotels; the remainder were owned by third parties that contracted with Hyatt for hotel management services, its brand name and other intellectual property. Hyatt required hotel owners to pay 4% (4.5% for 2012 and onwards) of the revenue from a traveler's stay to an operating fund, the Gold Passport Fund, held by a Hyatt subsidiary, when a traveler received reward points for staying at a Hyatt-branded hotel. When a traveler redeemed points for a stay at a Hyatt-branded hotel, Hyatt compensated the hotel owner from the fund. If a traveler chose to receive miles, instead of points, hotel owners had to pay Hyatt the actual cost of the miles (miles payments) as negotiated between Hyatt and the third-party travel partners. Additionally, Hyatt sold rewards directly to customers, hotel owners, Hyatt Vacation Club and certain car rental companies; the proceeds from those sales were put in the same bank accounts as the 4% payments and miles payments. Those payments were collectively known as the Gold Passport Fund, and Hyatt owned the bank accounts into which those payments were deposited. Hyatt also paid administrative and advertising expenses for the program from the fund. It invested unused portions of the fund in marketable securities, which resulted in realized gains and accrued interest. For the years at issue, Hyatt filed consolidated Form 1120, US Corporate Income Tax Return, and reported the fund's assets and liabilities in the totals on Schedules L, Balance Sheet per Books. Hyatt treated the program revenue and expenses in two different ways. As an agent for the hotel owners, Hyatt did not include the program's revenue in its gross income or claim deductions for the program's expenses. As a hotel owner, Hyatt included compensation it received or was owed from the fund in its gross income and claimed deductions for its share of program expenses for the tax year in which the compensation payments were made from the fund. It did not use the trading stamp method or include statements under Treas. Reg. Section 1.451-4. The IRS determined Hyatt's tax treatment of the program's revenue was an improper method of accounting for income recognition. Therefore, Hyatt was required to "include in income as a transitional adjustment its net revenue from the [p]rogram since 1987." The IRS issued a notice of deficiency and Hyatt filed a petition with the Tax Court. IRC Section 61 requires taxpayers to include all income derived from whatever sources in their gross income. The Tax Court observed that it "narrowly construe[s] any exclusions from [that] sweeping definition." The court, however, pointed out that it recognized the trust fund doctrine in Seven-Up Co. v. Commissioner, 14 T.C. 965, 979 (1950), as one exclusion from gross income. In Seven-Up, the taxpayer created a collective fund to pay for advertising. Certain third-party bottlers of Seven-Up voluntarily contributed to the fund. The court characterized the payments from the bottlers "as neither 'for services rendered or to be rendered' by the taxpayer nor 'part of the purchase price of the extract.'" Therefore, the court ruled that the payments were not includible in the taxpayer's gross income because "the taxpayer did not gain or profit because of the fully offsetting restriction on its use of the fund." The court, in its analysis, stated that the doctrine has been refined since the decision in Seven-Up. Now, the trust fund doctrine allows a taxpayer to exclude funds from gross income if it "(1) receives funds in trust, subject to a legally enforceable restriction that they be spent in their entirety for a specific purpose and (2) does not profit, gain, or benefit from spending the funds for that purpose." If both elements of the doctrine are present, the taxpayer may be recognized as a "conduit or custodian of funds and not the beneficial owner for federal income tax purposes." Further, the court stated, any benefit inuring to the taxpayer from use of a purported trust fund cannot be more than "incidental and secondary," citing Angelus Funeral Home, 47 T.C. at 396, 398 (concluding that a taxpayer's contractual option to use a purported trust fund to pay for capital improvements to its facilities or to acquire real estate was "of sole benefit to the [taxpayer] and of no conceivable benefit to the [the trust fund contributors]"). The court found Hyatt (1) controlled the program, (2) determined how the fund amounts would be invested, (3) accrued interest and realized investment gains and (4) determined that advertising and administrative costs would be paid by the fund. The third-party hotel owners had no input into how the funds were spent or how the program was run. It also found that Hyatt benefitted from exercising control over the program and fund. The court observed that Hyatt directly benefitted from the program advertising and asserted it increased customer goodwill. Because Hyatt "had a sufficient beneficial economic interest," the court held the trust fund doctrine did not apply and Hyatt "should have included the [p]rogram revenue in gross income for the years at issue." The IRS may make an IRC Section 481 adjustment if omitted or duplicated income results from a change to the taxpayer's accounting method. Treas. Reg. Section 1.481-1(a)(1) states that a change in accounting method to which IRC Section 481 applies includes a change to (1) the overall accounting method for gross income or deductions, or (2) the proper time for including the item in income or taking a deduction. To determine whether the taxpayer's treatment impacts timing, courts have applied the lifetime income test, under which they examine whether the taxpayer's treatment would have allowed the taxpayer to permanently avoid reporting the income over the taxpayer's lifetime income or would have postponed the reporting. If the taxpayer's treatment only postpones the reporting of the income, the court then considers whether a change to the "taxpayer's treatment … would result in no more or less income to the taxpayer over the course of its lifetime." If the taxpayer's lifetime income is not affected, timing is implicated and the change to the treatment is a change in accounting method. Hyatt argued that "its prior return treatment permanently excluded the [p]rogram revenue and [it] never claimed deductions with respect to [p]rogram expenses," so "timing issues were not implicated." The IRS contended the change in Hyatt's tax treatment of the fund "would not affect the aggregate amount of petitioner's lifetime taxable income." The court rejected the IRS's argument, finding that Hyatt consistently excluded the program revenue and did not take deductions for the program expenses. Thus, timing was not involved. The court further found that Hyatt would continue to exclude the amounts in the fund, even if the program terminated. Accordingly, the court held that Hyatt's "prior treatment of the [p]rogram revenue was not … a method of accounting." Therefore, the court did not sustain the IRS's IRC Section 481 adjustment. The trading stamp method is an exception to the all events test. That method applies to an accrual-method taxpayer that (1) issues trading stamps or premium coupons with sales, and (2) redeems those stamps or coupons with merchandise, cash or other property. If both conditions apply, Treas. Reg. Section 1.451-4(a)(1) allows the taxpayer to offset against gross receipts from sales "an amount equal to '[t]he cost to the taxpayer of merchandise, cash, and other property used for redemptions in the [tax] year' plus 'the net addition to the provision for future redemptions during the [tax] year.'" In determining the meaning of "merchandise, cash or other property," the court applied the interpretive canon of "ejusdem generis." Under that canon, a general term following specific terms should be understood as embracing objects that are similar to the specific terms. After defining merchandise and cash, the court turned to "other property" and, after applying "ejusdem generis," found that "other property" is limited to property that is similar to merchandise and cash. To support this finding, the court considered Treas. Reg. Section 1.451-4(b)(1)(iii), which "repeatedly contemplates 'other property' in tangible terms, speaking of physical possession, transportation, and storage." Based on its reading of Treas. Reg. Section 1.451-4(b)(1)(iii), the court found "that a common characteristic of the three categories is tangibility," and "other property" should be similar to merchandise and cash. Therefore, the court held that the trading stamp method did not apply, so Hyatt "must defer its cost recovery until the [tax] year for which compensation payments give rise to a deductible expense." Regarding Hyatt's assertion that the claim-of-right doctrine provided an additional basis for excluding the amounts at issue from income, the court stated: We do not understand [the claim-of-right] doctrine to provide an independent basis for exclusion of the Program revenue in these circumstances. The trust fund doctrine is best understood as a more tailored application of claim of right principles; if a taxpayer holds funds in trust subject to a use restriction and for the primary benefit of others, it naturally follows that such funds are not "received and treated by a taxpayer as belonging to [it]" — i.e., without a claim of right. Whether an amount represents income, and the timing associated with that determination, continue to be pervasive issues for taxpayers across industries, practitioners, and the Internal Revenue Service. While the modifications made to IRC Section 451 by the Tax Cuts and Jobs Act, which were further detailed in Treas. Reg. Sections 1.451-3 and 1.451-8, added enhanced scrutiny to income recognition generally, the Hyatt case highlights that income recognition issues arose well before these modifications came into play. Rewards programs have become a common tool used by companies to build brand loyalty and can take on many forms. The specific facts and circumstances surrounding a given rewards program, however, will ultimately determine how a respective rewards program is treated for Federal income tax purposes; thus, the holding in Hyatt does not necessarily determine how another entity operating a rewards program should account for that program. The court's discussion also is much broader in impact than simply an analysis of customer reward programs, as it focuses on broad concepts, such as income realization and recognition. With that said, the Hyatt case is instructive in its discussion of income recognition generally and its specific discussion and delineation between the facts at issue before the court and those before the court in Seven-Up and/or found in scenarios in which the trust fund doctrine applies. By pursuing a decision in Hyatt, the IRS signaled its intent to challenge taxpayers applying a conduit approach to the receipt and disbursement of amounts in certain scenarios. Through its decision in Hyatt, the court has at the very least cast doubt on the applicability and/or viability of a conduit approach to the receipt and disbursement of amounts in scenarios where the taxpayer responsible for collecting and disbursing amounts retains some benefit from the program operated. In addition, the court's analysis of the applicability of the trading stamp method in Treas. Reg. Section 1.451-4 limits the type of property, and fact pattern, to which the provision may apply. Finally, the court's holding that a method of accounting was not at issue resulted, in part, from the court's conclusion that the determination was one of "whether" amounts were income and/or deductions, not "when" those amounts are to be recognized as income and/or deductions. The significance of the court's determination was to preclude an IRC Section 481(a) adjustment. As the court's own analysis indicated, this area of the law is nuanced; as such, the facts and circumstances of a given scenario must be carefully analyzed to determine whether a method of accounting is at play.
Document ID: 2023-1821 | ||||||||||
