Frequent flyer mile price may exclude marketing portion

Plain-English summary

An airline sold frequent flyer miles to a credit card bank under a co-brand agreement that also provided marketing services, intellectual property rights, data, and administrative support. The agreement split the per-mile price into a taxable mile portion and a marketing portion, and the invoices stated the two components separately. Chief Counsel concluded that the airline and bank may exclude the marketing portion from the air transportation excise tax base if their allocation method is reasonable and accurately separates taxable transportation from nontaxable services. If they cannot support the allocation, the entire composite price is taxable. The memorandum did not decide whether the particular allocation methodology was reasonable. It also concluded that the tax attaches when the bank pays the airline for the miles, regardless of when or whether those miles are credited to customer accounts.

Ruling snapshot

• Question: May the parties exclude a marketing component from the frequent flyer mile tax base, and when does the tax attach?
• Outcome: The marketing portion may be excluded if properly allocated and substantiated; tax attaches when the bank pays for the miles.
• Key authorities: IRC §§ 4261, 4262, and 4263; Treas. Reg. §§ 49.4261-2, 49.4261-4, 49.4261-7, and 49.4261-8

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201606028
           Release Date: 2/5/2016
           CC:PSI:B07:MHBeker                                Third Party Communication: None
           POSTN-123192-15                                   Date of Communication: Not Applicable

 UILC:     4261.00-00, 4261.01-00

  date:    September 25, 2015

     to:   Julia Wahl
           Senior Attorney, CC:SB:2:PIT
           Office of the Division Counsel
           (Small Business/Self Employed)

  from:    Stephanie Bland
           Branch Chief, Branch 7
           Office of the Associate Chief Counsel
           (Passthroughs & Special Industries)


subject:   Bifurcation of Award Miles


           Airline               =      ---------------------------------------------

           Bank                  =      ------------------

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POSTN-123192-15                                  2

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Year                   =   ------

a%                     =   ------

b%                     =   ------

Composite Rate         =   ------------

Mile Portion           =   ------------

Marketing Portion      =   ------------


This Chief Counsel Advice responds to your request for assistance dated April 7, 2015.
This advice may not be used or cited as precedent.

ISSUES

        1. Whether, in the circumstances described below, a collector and taxpayer may
        exclude certain amounts from the tax base upon which tax is imposed by § 4261
        of the Internal Revenue Code (“air transportation excise tax”).

        2. Whether, in the circumstances described below, the air transportation excise tax
        attaches when an amount is paid for frequent flyer miles, rather than when the
        frequent flyer miles are deposited into (or credited to the benefit of) the
        taxpayer’s customer accounts.
POSTN-123192-15                               3

CONCLUSIONS

    1. In the circumstances described below, a collector and taxpayer may exclude
      certain amounts from the tax base upon which air transportation excise tax is
      imposed.

    2. Air transportation excise tax attaches when an amount is paid for frequent flyer
      miles, not when the frequent flyer miles are deposited into (or credited to the
      benefit of) the taxpayer’s customer accounts (and regardless if the frequent flyer
      miles are ever actually deposited into (or credited to the benefit of) a customer’s
      account).

FACTS

The facts in this case are complex; they are presented here in simplified form and only
to the extent necessary to address the specific legal issues discussed in this
memorandum.

Airline is a common carrier that provides scheduled, ticketed travel within the United
States. Airline operates a mileage award program that sells mileage awards (generally
referred to as frequent flyer miles) to its customers and to certain other entities. Airline’s
frequent flyer miles are redeemable for transportation beginning and ending in the
United States.

Bank, a credit card issuer, is one of the entities that purchases frequent flyer miles from
Airline. As an incentive for card holders, Bank distributes frequent flyer miles to the
card holder when the card holder engages in certain credit card usage behaviors.

Bank and Airline enter into a series of agreements, letters of understanding, and
licenses (referred to collectively as “the agreement”) to co-brand a credit card issued by
Bank and to engage in other mutually beneficial marketing efforts. The agreement
provides that Bank will purchase frequent flyer miles at a certain rate per mile. The
agreement also grants Bank the right to use (or benefit from) certain Airline proprietary
business information and data (including Airline’s customer lists); intellectual property,
including trademarks and trade names; brand-related goodwill; and administrative
services carried out by Airline’s employees assigned to Airline’s mileage award
program. In addition, the agreement grants Airline the right to use certain of Bank’s
proprietary business information and data to assist Airline in carrying out its obligations
under the agreement and to engage in mutually beneficial marketing efforts.

The agreement includes a “bifurcation” clause that provides that the rate paid by Bank
to Airline for each mile is a composite rate; that is, part of the rate per mile is designated
as the purchase price for a frequent flyer mile (referred to as the “mile portion”) and the
other part of the rate per mile is designated as compensation to Airline for the
proprietary business information, intellectual property rights, and administrative services
POSTN-123192-15                                       4

provided by Airline (referred to as the “marketing portion”). With regard to licenses and
intellectual property, Bank is not required to pay Airline any royalties or fees; Airline’s
compensation for the licenses is included in the rate per mile. Further, under the
bifurcation clause, Airline and Bank agree to use the number of frequent flyer miles
purchased by Bank to determine Airline’s compensation for the arrangement under the
theory that the volume of frequent flyer miles awarded to Bank’s card holders
corresponds to the amount of card holder credit card spending, and thus reflects the
success of the arrangement.

The following is an illustration of how the “bifurcation” clause works numerically1:

        Bank agrees to purchase a certain number of frequent flyer miles at Composite
        Rate, calculated using Allocation Method. The agreement states that for Year,
        a% of Composite Rate represents the purchase price for each frequent flyer mile
        purchased by Bank, and b% of Composite Rate represents compensation to
        Airline for the arrangement. Bank pays, and Airline collects, the 7.5% air
        transportation excise tax on the Mile Portion only, rather than on the full
        Composite Rate amount Bank pays Airline per mile. Bank does not pay, and
        Airline does not collect, the 7.5% air transportation excise tax on the Marketing
        Portion of the Composite Rate.

Bank pays, and Airline collects, air transportation excise tax when Bank distributes the
frequent flyer miles purchased from Airline to its card holders (that is, when the frequent
flyer miles are credited to the card holder’s frequent flyer account with Airline). Bank
does not pay, and Airline does not collect, air transportation excise tax at the time Bank
pays an amount to Airline for frequent flyer miles.

The invoices that Airline sends to Bank break out the amount due that is attributable to
the mile portion (i.e., Bank’s purchase of frequent flyer miles) as a separate line item
from the amount due that is attributable to the marketing portion (i.e., Airline’s
compensation for the co-brand arrangement).

LAW AND ANALYSIS

        Issue 1: “Bifurcation”

Section 4261(a) imposes a tax on the amount paid for taxable transportation (as defined
by § 4262) of any person by air. “Taxable transportation” generally includes air
transportation that begins and ends in the United States.

Section 4261(e)(3)(A) treats any amount paid (and the value of any other benefit
provided) to an air carrier for the right to provide mileage awards for (or other reductions

1
 This paragraph is not intended to describe an actual fact pattern or a particular transaction in this case.
This description is merely a simplified conceptual illustration of how the bifurcation clause applies to a
hypothetical purchase of frequent flyer miles.
POSTN-123192-15                              5

in the cost of) any transportation of persons by air as an amount subject to tax imposed
by § 4261(a).

Congress enacted § 4261(e)(3) as part of the Taxpayer Relief Act of 1997, P.L. 105-34,
to extend the § 4261(a) tax to certain payments to airlines. According to the
Conference Report, Report 105-220, at 555-6, those payments include “(1) payments
for frequent flier miles (including other rights to air transportation) purchased by credit
card companies, telephone companies, rental car companies, television networks,
restaurants and hotels, air carriers and related parties, and other businesses, and (2)
amounts received by air carriers (and related parties) pursuant to joint venture credit
card or other marketing arrangements.”

The General Explanation of Tax Legislation Enacted in 1997 (General Explanation),
prepared by the Joint Committee on Taxation, JCS-23-97, 230-231, generally repeats
the language of the Conference Report but changes the wording to state: “… and (2)
amounts received by airlines (whether paid in cash or in kind) pursuant to joint venture
credit card or other air transportation marketing arrangements as compensation for the
right to air travel.” (Emphasis added.)

The Conference Report indicates that Congress contemplated arrangements like those
at issue in this case and intended that, generally, all amounts paid to airlines under such
arrangements would be taxed. However, when read in conjunction with the language of
the General Explanation, it appears that Congress did not intend to tax all amounts paid
to an airline under such arrangements. Rather, Congress intended to tax only the
amounts paid as compensation for the right to air transportation (i.e. amounts paid that
would be taxable had the taxpayer purchased an airline ticket rather than frequent flyer
miles). Although we recognize that the General Explanation is not authoritative, we
believe that it represents persuasive evidence of Congress’s intent when it enacted
§ 4261(e)(3). Further, the General Explanation is consistent with the plain language of
§ 4261(e)(3)(A), which essentially equates the purchase of frequent flyer miles with the
purchase of an airline ticket.

In this case, Bank paid amounts to Airline for intellectual property rights and marketing
services provided by Airline. Just as an amount paid by Bank to an independent third-
party advertising firm for services related to promoting a credit card would not be
subject to air transportation excise tax, the mere fact that Bank purchases those
services (along with other rights and licenses) from the same company (Airline) from
which it also purchases frequent flyer miles should not change an otherwise nontaxable
amount into a taxable amount. Further, it is an important fact that Airline and Bank
agreed to use the number of frequent flyer miles purchased by Bank to determine
Airline’s compensation for the arrangement because it is a convenient measure of the
success of the arrangement, rather than directly linked to a payment for taxable air
transportation.
POSTN-123192-15                             6

Sections 49.4261-2(c), 49.4261-7(i), and 49.4261-8(f) of the Facilities and Services
Excise Tax Regulations (regulations) provide generally that if a payment covers charges
for nontransportation services, such as charges for meals, hotel accommodations, etc.,
as well as for transportation of a person, the charges for the nontransportation services
may be excluded in computing the tax payable for such payment, provided such
charges are separable and are shown in the exact amounts thereof in the records
pertaining to the transportation charge. If the charges for nontransportation services are
not separable, the tax must be computed upon the full amount of the payment.

In this case, the agreement covers the purchase of both transportation and
nontransportation services as contemplated by the regulations. More specifically, the
rate per mile under the agreement’s bifurcation clause is a composite rate that consists
of a mile portion and a marketing portion. While the mile portion of the composite rate is
attributable to taxable transportation, the marketing portion is not. Further, the invoices
associated with the agreement meet the “shown in the exact amounts” requirement set
forth in the regulations. Based on the foregoing, we conclude that in the circumstances
described above, Bank and Airline must include in the tax base upon which air
transportation excise tax is imposed amounts that represent the mile portion of the
composite rate paid by Bank to Airline pursuant to the agreement. However, Bank and
Airline may exclude amounts that represent the marketing portion of the composite rate
from the air transportation excise tax base.

Section 49.4261-4(a) of the regulations creates a presumption that the air transportation
excise tax applies to any amount paid within the United States for the transportation of
any person, unless the taxpayer (or collector, in this case) establishes in accordance
with the provisions of § 49.4261-4 that at the time of payment the transportation is not
transportation in respect of which tax is imposed by § 4261(a). Thus, Bank and Airline
bear the burden of demonstrating that the allocation between the mile portion and
marketing portion accurately reflects the split between amounts paid for taxable
transportation and amounts paid for nontaxable, nontransportation services. If Bank
and Airline do not meet this burden, the entire amount that represents the composite
rate under the agreement is subject to the air transportation excise tax.

The IRS has not issued regulations that addresses how a taxpayer (or collector)
“establishes in accordance with the provisions of § 49.4261-4” that a portion of the
amount paid for frequent flyer miles are properly allocable to nontaxable,
nontransportation services as described in the facts, above. In this regard, Notice 2002-
63, 2002-2 C.B. 644 (relating, in general, to the taxability of amounts paid for frequent
flyer miles that may be used for international travel), is instructive. Notice 2002-63
provides that an air carrier that purchases frequent flyer miles from a domestic air
carrier may use any reasonable method to allocate amounts paid (and the value of any
other benefits provided) between purchased frequent flyer miles that will be awarded in
connection with the purchase of taxable transportation and purchased frequent flyer
miles that will not be so awarded. The issue addressed in Notice 2002-63 is analogous
to the issue we address here because both deal with allocations between taxable and
POSTN-123192-15                              7

nontaxable payments with respect to frequent flyer miles. Applied to the instant case
and in the absence of any other IRS guidance, we conclude that Bank and Airline may
use any reasonable method to allocate a portion of the amount paid for the agreement
to nontaxable, nontransportation services (i.e., the marketing portion of the composite
rate).

In our view, the determination of whether a particular allocation methodology is
reasonable is not a legal issue. Rather, we believe that the IRS examination function is
better suited to make this determination based on the facts and circumstances of a
particular case. As a result, we express no opinion regarding whether Allocation
Methodology, or any of the rates or allocations based thereon, is reasonable or satisfies
the requirements of § 49.4261-4.

       Issue 2: Tax Collection Timing

In general, a collector must collect air transportation excise tax at the time payment is
made for taxable transportation. Section 4261(d) provides that except as provided in
§ 4263(a), the taxes imposed by § 4261 are paid by the person making the payment
subject to the tax.

Section 4263(a) provides that if the payment upon which the § 4261 tax is imposed is
made outside the United States, the person furnishing the initial transportation pursuant
to such order must collect the amount of the tax.

Section 4263(c) generally provides that where any tax imposed by § 4261 is not paid at
the time payment for transportation is made, then, under regulations prescribed by the
Secretary, to the extent that such tax is not collected under any other provision of this
subchapter such tax shall be paid by the carrier providing the initial segment of such
transportation which begins or ends in the United States.

Section 4263(d) provides that the tax imposed by § 4261 shall apply to any amount paid
within the United States for transportation of any person by air unless the taxpayer
establishes, pursuant to regulations prescribed by the Secretary, at the time of payment
for the transportation, that the transportation is not transportation in respect of which tax
is imposed by § 4261.

As discussed above, § 49.4261-4(a) provides that the tax imposed by § 4261 applies to
any amount paid within the United States for the transportation of any person, unless
the taxpayer establishes in accordance with the provisions of § 49.4261-4 that at the
time of payment the transportation is not transportation in respect of which tax is
imposed by § 4261(a).

In this case, air transportation excise tax attaches when Bank pays an amount to Airline
for frequent flyer miles pursuant to the terms of the agreement, not when the frequent
flyer miles are credited into (or credited to the benefit of) customer award miles
POSTN-123192-15                              8

accounts (and regardless if the frequent flyer miles are ever actually deposited into (or
credited to the benefit of) a customer’s account). Thus, Airline must collect air
transportation excise tax when Bank pays an amount for frequent flyer miles.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call Michael Beker at (202) 317-5258 if you have any further questions.