Loren Opper & Christie Galinski (Miller Canfield), Hyatt Tax Case Sets the Stage to Change Loyalty Reward Programs, Bloomberg Law

An appeals court last week said a case involving the IRS and Hyatt Hotels Corp.’s customer loyalty reward program should go back to the US Tax Court, whose eventual final ruling could have significant effects on how these programs are structured. Sponsors of loyalty programs should ensure their obligation to repay prepayments of loyalty rewards are clearly documented in agreements with their counterparties.

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In one of the tax years at issue in Hyatt Hotels Corp. v. Commissioner, $118 million of prepayments flowed into the fund. The provision for future award redemptions amounted to $72 million that year. Hyatt didn’t include the inflows as income or deduct the outflows as an expense. Its theory was that it didn’t have a claim of right to the fund.

The Seventh Circuit ruled in Hyatt that even if a taxpayer fails the exclusionary test of the trust fund doctrine for an item of income, the taxpayer may exclude the item from income if the taxpayer has no claim of right. The trust fund doctrine holds that trust funds are excludable from income when two requirements are met:

• The taxpayer must be obligated to spend the money for a specified purpose.
• The taxpayer may not receive any profit, gain, or other benefit in return unless it is incidental and secondary.

The Seventh Circuit opinion thus provides sponsors of loyalty reward programs with flexibility in use of funds remitted to pay loyalty program rewards. Hyatt made expenditures from the fund for advertising, which Hyatt asserted focused on the loyalty program.

The tax court previously ruled that the advertising expenditure benefited Hyatt directly. But the Seventh Circuit opinion avoids that issue by observing that a borrower generally can use borrowed funds for any purpose and doesn’t have to include the funds in income if the borrower has an obligation to repay the funds.

The Seventh Circuit remanded the case to determine if the claim of right doctrine applies. The tax court earlier decided only that Hyatt failed the trust fund doctrine because of the advertising and other benefits that it derived from the funds.

The central question now is whether the agreements between Hyatt, its franchisees, and the loyalty reward members require Hyatt to repay the amounts that are remitted to it as prepayments.

Additional Coverage:

Tristan Navera & Perry Cooper (Bloomberg Law): Hyatt’s $71 Million Tax Assessment Bounced Back to Tax Court