Gift Cards: Opportunity and Issues for Retailers

The growth of gift cards has been nothing less than phenomenal. But while gift cards have come to provide a critical source of earnings, they also face an intensifying regulatory environment, including tax and financial reporting for gift cards, that has become increasingly complex.


Gift cards can be instrumental to improving a retailer’s cash flow and managing inventory. Perhaps the greatest benefit to retailers is that a sizable number of consumer gift card purchases are never redeemed. Estimates of the percentage of gift card balances that remain unredeemed — otherwise known as breakage — range from 10% to 19%.


But as gift card sales continue to surge, financial executives in the retail industry must carefully keep track of ever-changing tax, regulatory and financial reporting that can affect their bottom line. There is an uptick in scrutiny and regulation, especially within the past year. For consumers, there is increased protection under Title IV of the Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD Act), which went into effect in early 2010. The CARD Act restricts gift card issuers from charging fees on cards for 12 months and extends card expiration until five years after purchase. In addition, the Federal Reserve Board (FRB) and the IRS have recently issued new rules for companies with gift card programs, providing much-needed guidance.


Key issues for retailers to consider include:


State tax nexus issues for retailers: For gift card issuers to be subject to state taxation, the issuer must have nexus — a physical or economic presence sufficient to establish jurisdiction to tax — in that state. It is important for companies to understand what establishes nexus in the various states in which their gift cards are sold, since each state’s rules differ.


State escheat rules: The increasing popularity of gift cards also makes the management of escheat, or unclaimed property, liabilities an important issue. All U.S. states and the District of Columbia, as well as Puerto Rico, Guam, the U.S. Virgin Islands and certain other foreign jurisdictions, have explicit unclaimed property reporting requirements. Unclaimed property liability is not a tax, but rather a liability under state succession laws relating to property rights.


Breakage and GAAP accounting: Retailers routinely sell gift cards to individuals with the expectation that a certain portion of these cards will never be used, called “breakage,” which mostly results from lost cards. Gift card breakage has certain accounting and state escheat implications, since it affects income recognition. These unredeemed dollars can have a significant influence on many companies’ bottom lines. If the card does not fall under specific state escheat rules, the question arises as to when companies can recognize income from breakage for financial statement purposes under GAAP.


The popularity of gift cards shows no sign of abating and will likely continue to grow as more consumers begin to use gift cards via convenient new mobile applications and to enjoy heightened consumer protections under the CARD Act. The benefits to gift card issuers remain numerous: increased sales, improved inventory management, better cash flow and higher profitability.


While there is also more scrutiny of gift cards from the IRS and the FRB, the new rules mean more clarity for gift card issuers with respect to federal tax accounting rules and the financial accounting treatment of advance payments. Companies have done a significant amount of work in the past to ensure that they are able to recognize gift card breakage income, but they must continue to evaluate and monitor the legislative changes in the various states in which they operate. The last thing retailers want is to have a financial restatement that is due to lack of awareness of changes in state regulations.


Giles Sutton is a state and local tax partner and the national retail tax practice leader for global accounting firm Grant Thornton ([email protected]); Mark Wuller is an audit partner and the national retail practice leader for the same firm ([email protected]).