What would happen to the global customer loyalty business if taxing authorities declared the value of points received as ordinary income, triggering a taxable event?
In a word, devastation.
Will this happen anytime soon?
In two words, absolutely not.
Do we worry about this eventuality?
In three words, just a little.
Points and miles issued as a reward for spending on credit cards and with airlines, hotels, restaurants, and retailers possess many characteristics of a real currency, the definition of which is a “medium of exchange for goods and services”. While points and miles are not issued in the form of coin or paper items and aren’t issued by any government, they do pass other tests of the definition. These pseudo currencies can be exchanged for items of real value, in real time, even accepted as cash equivalents to reduce the amount a person pays for goods and services online and in physical stores.
Though most experts agree that making reward currencies subject to income tax is not going to happen anytime soon, the case of Konstantin Anikeev, an experimental physicist, pointed up how those consumers who become especially creative with how they accumulate and extract value from rewards currency can draw unwanted attention from taxing authorities.
Mr. Anikeev is apparently a very clever person who created a scheme that started with credit card spending and then spun the cash-back earned through a circle that included gift cards, money orders, and bank deposits. The arbitrage he earned on this spin cycle landed him over $300,000 and the US Internal Revenue Service took him to court challenging the taxable nature of that income.
You can take a deep breath knowing the judge presiding over the case issued a court opinion in February 2021 exonerating Mr. Anikeev of any tax liability. The process created by Mr. Anikeev had similarities to money laundering, and that activity was the principal reason the IRS became interested in his case. In layman’s terms, the court ruled that Mr. Anikeev was annoyingly clever in executing his plan but didn’t do anything wrong that created unreported income.
We think it is reasonable that rewards earned continue to be treated as discounts or rebates, as opposed to “income”. That said, this case brought unwanted attention on the status of points and miles, just as the Eye of Sauron once plagued Frodo Baggins and his companions in their Lord of the Rings quest.
The IRS has already ruled previously that rewards can be treated as taxable if they are earned without spending. Examples include a bonus for opening a bank account or winning an asset of value in a contest or sweepstakes.
What concerns us just a bit is that quiet whispers about the taxable nature of frequent flyer miles or reward points become louder each time consumers hijack the intended loyalty model for their own special benefit. Though we don’t propose the use of tactics known as the Loyalty Asterisk™ in your program structures, we do understand the need for careful consideration of program rules to head clever blokes off at the pass.
One gap that isn’t entirely closed is the perceived disconnect between, for example, the party that typically pays for airline travel and the one who benefits from the accumulated miles when they are cashed in for free flights. Business travel is the most potent example of this gap.
The vast majority of airfares, hotel fees, and restaurant visits (plus lots more charges that go on rewards rich credit cards) are treated as business expenses with the traveler reimbursed through expense report submission. Travelers spend as they make the rounds of client visits and conferences and eventually cash in points and miles for free flights they use for personal enjoyment. With more flexibility being added to currency utility, points can be treated like cash at the point of sale with retailers. Blockchain driven marketplaces enable the exchange of currencies, making their fungibility richer and more valuable to end users.
The perceived difference in who pays and who benefits could be interpreted as creating a stream of unearned income that would become taxable to the recipient. That’s an interesting theory to debate, and while we don’t think it will ever come to pass through tax legislation, we remain vigilant that the gap remains open to challenge.
Another reason we do not believe that rewards currency will ever be treated as taxable income is a practical one — the sheer weight of administration and accounting. We don’t believe that even the most aggressive of revenue agents would press the issue of taxability on points and miles. Why?
Just imagine the difficulty in tracking every credit card charge in an individual case to categorize as a personal expense versus one that is a reimbursed business expense. Next, try to match up points redeemed to travel or spending that can be proven to be personal in nature. The tax auditing process is already burdened by establishing proof of that same split on your vehicle mileage or the deductibility of your home office and might crash under its own weight in pursuit of taxability on rewards currency.
A byproduct of the effort by the IRS would make it the target of consumers and elected officials, essentially everyone, who would like to keep a bit of fun in the world. Even IRS agents might rebel against the idea when they consider the impact that would boomerang upon them.
We will always have a watchful eye on this topic. Does it make you lose any sleep at night? Have you anticipated the many games that loyalty program members can play to manipulate your well-intended program for unintended benefit? Where do you see the potential risks to the global loyalty industry?
Let’s talk about it, shall we?