A few years ago, during the oil crisis and back when gasoline was $4.00 a gallon, a supermarket in our town offered gasoline discounts based on certain items that you bought and how much you spent in their store. My wife and I would get as many points as we could so we could get a free tank of gas. It was simple to do because we had to eat anyway, so why not shop at a store that was providing us a loyalty discount?

Giant Eagle, a company in Pennsylvania, had a similar program in 2006 and 2007. However, to delve into this case, we need a little background information:

“Under IRC § 461(a), a deduction or credit must be taken for the tax year that is the proper tax year under the accounting method used by the taxpayer to compute its taxable income. Under Reg. § 1.461-1(a)(2)(i), a liability is generally incurred and taken into account under an accrual accounting method in the tax year in which: (1) all the events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability under IRC §461(h).

“If the taxpayer’s liability is to pay a rebate, refund, or similar payment to another person (whether paid in property, money, or as a reduction in the price of goods or services to be provided in the future by the taxpayer), economic performance generally occurs as payment is made to the person to which the liability is owed. (Reg. § 1.461-4(g)(3))

“However, under the IRC §461(h)(3) recurring item exception, certain recurring items can be deducted for a tax year, even if economic performance has not been met, if:

• at the end of the tax year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (Reg. § 1.461-5(b)(1)(i))

• economic performance occurs on or before the earlier of (i) the date that the taxpayer files a return (including extensions) for the tax year, or (ii) the 15th day of the ninth calendar month after the close of the tax year; (Reg. § 1.461-5(b)(1)(ii))

• the liability is recurring in nature; (Reg. § 1.461-5(b)(1)(iii)) and

• either the amount of the liability is not material or accrual of the liability in the tax year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the tax year in which economic performance occurs. (Reg. § 1.461-5(b)(1)(iv))”

Giant Eagle operates supermarkets, pharmacies and gas stations. During 2006 and 2007, Giant Eagle had a customer loyalty program like the supermarket in my hometown, but with a couple of differences. Under this program, customers of Giant Eagle would present a customer loyalty card when purchasing qualifying groceries, just like the supermarket we went to. The program worked like this: for every $50 spent, a customer would earn a 10¢ per-gallon price reduction for gasoline purchased in one transaction. The discounts were aggregated so they could potentially reduce the per-gallon gas price to zero. However, these discounts were described in a program brochure as expiring three months after the last day of the month in which they were earned, but Giant Eagle did not revoke any accumulated discounts during 2006 or 2007.

On its corporate income tax returns for 2006 and 2007, Giant Eagle claimed a deduction for the discounts its customers had accumulated but at year’s end had not yet applied to fuel purchases, amounting to $3.4 million for 2006 and $313,490 for 2007. The way that Giant Eagle computed the deductions were by:

• ascertaining the total dollar amount spent at its supermarkets on discount-qualifying items,

• dividing that figure by 50 to determine the number of outstanding accumulated discounts, and

• multiplying the quotient by 10¢ to determine the face value of the discounts.

Next, Giant Eagle multiplied the discounts’ face value by the historical redemption rate of discounts in their expiring month and multiplied that product by the average number of gallons purchased in a discounted fuel sale.

Upon audit, the IRS disallowed these deductions and Giant Eagle appealed all the way to the United States Tax Court. The court sided with the Commissioner. Giant Eagle argued that the discounts accumulated but not applied by year’s end satisfied the “all events” test under the recurring items exception because Giant Eagle’s liability became fixed upon issuance of the discounts, and the amount of that liability was reasonably ascertainable. The Tax Court, however, found the claimed deductions did not satisfy the “all events” test because the program was structured as a discount against the purchase price of gas, so the purchase of gas was necessarily a condition precedent before Giant Eagle could claim a deduction.

Giant Eagle appealed the Tax Court decision to the Third Circuit Court of Appeals, where it won the decision 2-1 on a three-judge panel. The only unresolved issue on appeal was whether, before the end of the tax year, Giant Eagle had become liable to pay the discount to its customers, who had purchased qualifying groceries under the program.

The Third Circuit found that Giant Eagle’s liability in this case attached to them, when a customer made qualifying purchases under the program. It applied the Pennsylvania Superior Court’s 1989 decision in Cobaugh v. Klick-Lewis, Inc. to show Giant Eagle entered into a unilateral contract with each shopper at checkout, thereby incurring liability to provide discounted gas at that time.

Overall, the Third Circuit was convinced Giant Eagle demonstrated the existence as of year’s end of both an absolute liability and a near-certainty the liability would soon be discharged by payment. The court found Giant Eagle’s method for calculating the deduction reasonably considered the chance of non-redemption with “reasonable accuracy.” It noted this is all that is required to satisfy Reg. § 1.461-5(b)(1)(i)’s all events test and Giant Eagle was therefore entitled to deduct its program-related liabilities incurred during the years at issue.

The IRS has now announced its nonacquiescence with the Third Circuit’s holding that all events fixing a liability for federal income tax purposes occurred when the discount fuel purchase coupons were issued to a customer for retail grocery purchases. Nonacquiescence is the intentional failure by one branch of the government to comply with the decision of another to some degree.

The Service said the case is controlled by the Supreme Court’s opinion in a 1987 case involving General Dynamics Corp., which held that a taxpayer may not “deduct an estimate of an anticipated expense, no matter how statistically certain, if it is based on events that have not occurred by the close of the taxable year.” Thus, the IRS stated, although a customer’s purchase of $50 worth of groceries obligated Giant Eagle to provide a 10¢-per-gallon discount on a future purchase of gasoline, the discount itself was not absolute until the customer actually purchased gasoline.

This is heating up to be a showdown and will probably end up in the Supreme Court.

Craig W. Smalley, MST, EA, has been admitted to practice before the Internal Revenue Service. He has a Masters in Taxation from UCLA, and is the founder and CEO of CWSEAPA, LLP, and Tax Crisis Center, LLC, with locations in Florida, Delaware, and Nevada. He has been in practice for 22 years.