The IRS audited Hyatt for the tax years 2009 – 2011 and found that it wasn’t paying tax on loyalty program revenue. It didn’t include the revenue received for what was then Gold Passport (now World of Hyatt) in income, and didn’t include payments from the program as expenses. It just ignored the program, even though it collected money and invested it earning a return.
The IRS wanted Hyatt to not only pay up for those years but to go all the way back to the beginning of the program in 1987, with a quarter of a billion dollars of income at issue and a tax deficiency of $65 million. (This period is prior to the introduction of a co-brand credit card, and Hyatt has had few partners buying points, so the money at issue is largely from accrued points balances on hotel stays that hadn’t yet been redeemed.)
Hyatt argued that
- it was merely a trustee of the fund on behalf of owners
- it should be able to offset revenue with estimated future expenses against the fund
The litigation has the side effect of being interesting for sharing details of historical program economics, such as increasing the cost of the program for full service hotels in 2012 (with the cost to hotels for program member stays going from 4% to 4.5%) and the amount of compensation hotels received for redemption stays falling in 2011. It also discusses the program’s 2011 devaluation but I assume this must actually refer to June 2010’s introduction of category 6 redemptions.
PricewaterhouseCoopers estimated redemption costs and breakage (points that would never be redeemed, even before poitns in the program expired) and Deloitte audited the rewards fund for the years at issue.
|Marketable Securities — Net Gain||7,214,521||7,510,716||7,208,255|
Expenses were as follows:
|Membership Acquisition & Enrollment/Fulfillment||3,679,263||4,749,127||13,607,160|
|Membership Communication & Marketing||—||—||7,121,477|
|Membership Statements & Processing||1,673,285||1,137,967||—|
|General & Administrative||17,763,862||18,555,852||8,195,723|
Future redemption estimates represented 46% to 61% of expenses, and Hyatt showed a loss each year as a result.
The fund is described as being owned by Hyatt-branded hotels, rather than by Hyatt, even though if a hotel left the chain it wouldn’t take any ownership stake with them – or even have access to the data that their expenses paid to maintain.
Hotels would pay into the fund when members stayed on property, and deduct those payments as an expense, even though they purportedly owned the bank accounts into which those funds were sent.
On Hyatt’s Form 1120, U.S. Corporation Income Tax Return, they reported the fund on Schedule L but didn’t include it in income or deductions. Its Schedule M3 allocated the fund reserves out to each domestic hotel and told hotel owners to consult their tax advisors on how to handle.
Hyatt claimed it did not directly benefit from the fund. The Tax Court ruled that Hyatt wasn’t merely a trustee of a fund that was beneficially owned by affiliated hotels.
To the extent that other chains are using similar accounting methods, one argument they may hang their hat on in continuing to do so is that Hyatt owns a disproportionately large share of its hotels and therefore directly benefited at the hotel level from advertising costs incurred by the fund. Hotels, for Hyatt, aren’t entirely a separate and arms-length entity. However that’s just one reason why Hyatt lost here. Indeed, the value of the program directly benefited Hyatt in other ways as well (though maybe this is not true for all hotel chains!):
Not only did customer goodwill generate repeat hotel stays and thus direct and indirect revenue for petitioner (as discussed above), but it also granted petitioner additional contractual leverage in its role as prospective franchisor or manager for hotel properties. Put another way, petitioner could rely on the increased goodwill associated with the Hyatt brand in negotiating higher royalties, management fees, and other fees in new agreements reached with existing or prospective TPHOs — a direct benefit to it.
The IRS argued that tax treatment of the rewards fund constituted a change in accounting treatment that allowed it to go back and assess taxes without respect to the statute of limitations for doing so. The IRS “lost on the retroactive inclusion of income.”
This decision has broad implications for rewards programs who aren’t recognizing income or losses on an annual basis for their rewards programs.