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Income tax treatment of client loyalty programme transactions

17 October 2014   (0 Comments)
Posted by: Author: Sophia Brink
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Author: Sophia Brink (University of Stellenbosch)

This article highlights principles that might be used for the tax treatment of client loyalty programme transactions in the hands of the supplier. 

Function and types of client loyalty programmes

A client loyalty programme is a programme through which the clientele and loyalty of members is retained by awarding them points or miles (usually accumulated on membership cards) as reward for the acquisition of goods or services from qualifying suppliers participating in the loyalty programme. These points or miles can accumulate on a membership card or a cash back reward is issued for a predetermined number of points or miles. The points, miles or cash back rewards are linked to a specific rand value and may later be exchanged for goods, services or a discounton the future acquisition of goods or services from the same qualifying suppliers. The supplier will incur an expense in supplying benefits (goods, services or a discount on the transaction) in exchange for points or miles or cash back rewards.

Various types of client loyalty programmes exist in the South African market each with their own unique terms and conditions. A single-company program is the most popular programme in South Africa and is characterized by the fact that a single owner (the supplier) operates and manages the program. This single owner is therefore responsible for the granting of points or miles and for eventually supplying the benefits in exchange for points or miles. Examples of single-company programmes include Pick ‘n Pay’s Smart Shopper programme, the Edgars Thank You card, the Dis-chem Benefit Programme and the Clicks Club Card. A single-company program is the most popular model and therefore this article will only focus on the income tax treatment of a client loyalty programme transaction in the hands of a single-company programme supplier.

Current situation in South Africa

The popularity of client loyalty programmes has increased drastically over the past few years and more than one hundred suppliers in South Africa are already making use of these programmes. Despite the fact that client loyalty programmes have been prevalent in South Africa since the 1980s, the South African Revenue Service (SARS) has issued no specific guidelines on the income tax treatment of client loyalty programme transactions. Given the popularity of client loyalty programmes in South Africa, together with the extremely high rand value associated with it, it is important to correctly account for client loyalty programme transactions for income tax purposes. 

Client loyalty programme expenditure meets all the requirements of section 11(a), namely expenditure or a loss not of a capital nature, actually incurred and in the production of income (for carrying on a trade). Therefore in practice client loyalty programme suppliers succeed in deducting the expenditure incurred in terms of section 11 (a). The question arises whether the deduction is claimed in the correct year of assessment. The component of section 11(a) ‘actually incurred’ will determine the timing of the deduction.

Section 11(a) – Actually Incurred

Once the merchant supplies benefits in exchange for points, miles or cash back rewards, the expense will be actually incurred. In most cases members will accumulate enough points or miles in a given year to qualify for a cash back reward. Where members exchange points or miles earned or cash back rewards received in a given year, in that same year of assessment, it means that the ‘actually incurred’ requirement is met, seeing as the supplier supplied the benefits. However, it is questionable whether a liability for the supplier will arise if members do not accumulate enough points or miles to qualify for a cash back reward in a given year or if points or miles earned or cash back rewards received during a given tax year are not exchanged for benefits in the same year of assessment.

In the Caltex Oil (SA) Pty Ltd v SIR [1975] 37 SATC 1 case it was determined that ‘expenses actually incurred’ does not mean expenditure actually paid during the year of assessment, but instead refers to ‘all expenditure for which a liability has been incurred during the year, whether the liability has been discharged during that year or not’. In a client loyalty programme transaction a liability will arise in the hands of the supplier. It is uncertain exactly when the obligation arises. To address these uncertainties the two different forms in which points or miles are awarded are considered. Points or miles can be granted in two different forms by a single-company program supplier. These are through cash back rewards that are issued or points or miles that are accumulated on a membership card.

Client loyalty programmes that issue cash back rewards for accumulated points or miles 

For client loyalty programmes that issue cash back rewards a predetermined number of accumulated points or miles are required before the member qualifies for a cash back reward. Consequently, members have limited access to accumulated points or miles and an obligation in the hands of the supplier will only occur when a cash back reward is issued.

Client loyalty programmes where points or miles accumulate on the membership card

For client loyalty programmes where points or miles accumulate on membership cards, the member has free access to use these points or miles at any given time. The supplier's obligation to supply benefits will arise when granting points, miles or when issuing cash back rewards and not during the eventual exchange thereof. If points, miles or cash back rewards are issued during a year of assessment, it means in effect that the supplier actually incurred the expenditure in that year of assessment, whether the benefits were supplied in that year, or not.

The situation may occur where the supplier has no further obligation at the end of the year of assessment in respect of points or miles or cash back rewards that were previously granted or issued. The following examples are relevant:

- Client loyalty programmes where the points or miles are not subject to an expiry date and the member fails to exchange the points or miles for benefits;

- Client loyalty programmes where the points or miles are subject to an expiry date and the member fails to exchange the points or miles earned in time (before the expiry date);

- Client loyalty programmes where a cash back reward is issued and the member fails to exchange the cash back reward received in time, in other words before the expiry date. (In all client loyalty programmes investigated where a cash back reward is issued, the cash back reward is subject to an expiry date.)

Points or miles not subject to an expiry date - member fails to exchange points or miles 

The possibility exist that points or miles granted will never be exchanged, but it is impossible for the supplier to determine whether the member will exchange points or miles or not. The supplier will always have an obligation to supply benefits in terms of points or miles that were previously granted and will meet the requirement ‘actually incurred’ when points or miles are granted.

Points, miles or cash back rewards subject to an expiry date - member fails to exchange points or miles before the expiry date 

If the member fails to exchange the points, miles or cash back rewards earned in time (before the expiry date), the supplier will have no further obligation to supply benefits to the member after the expiry date. At the end of the year of assessment, the supplier will, with reference to expired points or miles, be able to determine whether a liability exists or not. Points or miles granted will no longer meet the ‘actually incurred’ requirement after the expiry date.

Other considerations – Section 8(4)(a) 

For client loyalty programmes, if a deduction is claimed during year one in respect of points or miles granted or cash back rewards issued subject to an expiry date, and if during year two the expiry date lapsed without the member exchanging the points or miles or cash back rewards, it means in effect that the supplier was previously entitled to a deduction in respect of an expenditure that it never actually incurred. Accordingly, in year one the supplier's taxable income will be less because of the deduction granted. The fact that no expenditure was actually incurred in respect of a deduction already allowed during year one will result in a recovery. With the lapsing of the expiry date the value of the points or miles or cash back rewards must be included in the supplier’s gross income.

Conclusion and Recommendations 

It was found that for client loyalty programmes where the points, miles or cash back rewards are not subject to an expiry date, the expenditure incurred will be deductible under section 11(a) once the points or miles are granted or the cash back rewards are issued. For client loyalty programmes where the points, miles or cash back rewards are subject to an expiry date, the expenditure incurred will be deductible under section 11(a) at the end of the year of assessment only if the expiry date has not lapsed and the points or miles or cash back rewards have not yet been exchanged. For client loyalty programmes, if a deduction is claimed during year one in respect of points, miles or cash back rewards issued subject to an expiry date, and in year two the expiry date lapses without the member exchanging the points or miles or cash back rewards, then the supplier must include the value of those points or miles or cash back rewards in gross income (in terms of special inclusion paragraph (n)).

The ‘actually incurred’ component of section 11(a) can easily be misinterpreted and incorrectly applied. In Concentra (Pty) Ltd v CIR [1942] 12 SATC 95 it was held that deductible expenditure is restricted to that incurred in the year of assessment. The general rule is that no expenditure incurred in a particular year of assessment may be deducted in subsequent years of assessment. It is therefore crucial that the supplier claim the section 11(a) deduction once the expenditure is ‘actually incurred’ to prevent possible financial loss. The alternative is for the taxpayer to open, correct and re-submit a previous year's income tax return. If a client loyalty programme supplier incorrectly interprets and applies the Income Tax Act, it might lead to an understatement of its total income tax liability and penalties might follow.

It is recommended that to ensure the correct and consistent interpretation and application of the Income Tax Act No. 58 of 1962, the South African Revenue Service (SARS) should formulate guidelines regarding the tax treatment of client loyalty programme transactions in the hands of the supplier (the supplier granting points or miles to members).

This article first appeared on the September/October edition on Tax Talk.


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