Airline costs allocable to vouchers issued are not deductible until vouchers are redeemed for tickets. (Expenses).

Taxpayer T is an accrual-basis commercial airline, providing passenger and cargo flight services within the U.S. To maintain customer goodwill, airlines routinely issue travel vouchers when a customer's experience has been unsatisfactory. For example, the airline may issue vouchers when customers are voluntarily or involuntarily denied boarding or when luggage is lost or damaged.

Vouchers are not tickets but are similar to discount coupons, issued in a customer's name, usually for a stated dollar amount. The customer may subsequently redeem the voucher to obtain a free ticket or to reduce its purchase price. However, there are certain restrictions on the use of vouchers; they:

* Are valid for one year from the date of issuance;

* Have no cash surrender value;

* Are not transferable;

* Are not replaceable if lost or stolen;

* Must be redeemed for a ticket;

* Must be redeemed at the airline's ticket office (and not with a travel agent); and

* May not be redeemed for tickets on certain "blackout" dates.

The use (or nonuse) of a voucher lies totally within the receiving customer's discretion, and a significant percentage of vouchers expire without being redeemed.

When T accounts for its voucher system, there are three significant events:

1. Issuance of the voucher: On issuance, T, in its financial books and records, debits the appropriate expense account an amount equal to a percentage of the voucher's face value, and credits its "travel voucher liability" expense account in the same amount.

For Federal income tax purposes, T claims a deduction equal to this percentage of face value, for the estimated incremental cost of providing the flight that will be obtained when the customer uses the voucher.

2. Redemption of voucher for ticket: On redemption, T debits the "travel voucher liability" account by the amount previously credited and credits its "air traffic liability" account in the same amount. T also credits its "air traffic liability" account by the remaining percentage of voucher face value, matched with a percentage-face-value debit in its "passenger revenue" account.

For Federal income tax purposes, T, in effect, deducts the remaining percentage face value of the voucher from gross income when the voucher is redeemed for a ticket.

3. Exchange of ticket for boarding pass: On the exchange of a ticket for a boarding pass (or when the ticket ages beyond 12 months), T recognizes the entire face value of the voucher as earned revenue. The taxpayer includes the face value in income (presumably based on Rev. Proc. 71-21) at this time.

If the customer does not use the voucher, T recognizes as earned revenue the previously deducted estimated incremental cost (e.g., the percentage of the face value) on expiration of the voucher (one year from issuance), and includes that amount in gross income for Federal income tax purposes.

T's financial accounting and tax treatment of travel vouchers differs from its treatment of tickets actually sold. T does not establish and deduct a reserve for the future expenses to be incurred in the provision of the future flight service when a customer purchases a ticket. Instead, it incurs and deducts the actual expenses for the flight service when actually performed and the related revenue is earned and recognized.

Analysis

Under Sec. 162(a), a taxpayer can deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. Sec. 461(a) provides that the amount of any valid deduction or credit can be taken for the proper tax year under the accounting method used in computing taxable income.

Under the accrual method, a liability is incurred (and generally is taken into account for Federal income tax purposes) in the tax year in which:

* All the events have occurred that establish the fact of the liability;

* The amount of the liability can be determined with reasonable accuracy; and

* Economic performance has occurred with respect to the liability.

Fact of liability. A taxpayer may not deduct an estimate of an anticipated expense--no matter how statistically certain--if the fact of the liability is based on conditional events that have not occurred by the close of the tax year. When further events must occur before a liability is fixed, an accrual amounts to nothing more than a non-deductible reserve (in the absence of specific statutory provisions providing otherwise).

Conversely, the fact of liability is fixed even if a condition subsequent exists that could later reduce or eliminate the payment obligation. Liability is fixed in situations in which an expense is certain to be incurred under relevant law.

Travel vouchers are subject to several conditions precedent on issuance. Until these conditions are met, there is no fixed liability. Similarly, a traveler's redemption of a voucher for a ticket does not establish the fact of liability; the ticket must be redeemed for a boarding pass before the traveler can receive the flight services.

Amount of liability. Even if T can establish that the liability was fixed on issuance of the voucher, it would still be prevented from accruing any expenses unless it could show that the amount of the liability could be determined with reasonable accuracy. Even if T can statistically forecast the number of vouchers that would be used and the applicable expenses in honoring them, this is not sufficient to satisfy the second prong of the all-events test. T treats a percentage of a voucher's face value as an estimate of its anticipated incremental flight-related costs (e.g., meals, fuel and baggage handling). T's method, however, fails to tie this figure to any actual costs (including costs that will not be incurred with respect to vouchers not redeemed for tickets).

Economic performance. Under Sec. 461(h)(1), in determining whether an amount has been incurred for an item during any tax year, the all-events test cannot be treated as met any earlier than when economic performance for such item occurs. Sec. 461(h)(2)(B) provides that, if a taxpayer's liability requires him to provide property or services, economic performance occurs as the taxpayer provides such property or services.

When an airline issues a travel voucher to a customer, economic performance does not occur until the customer receives flight service. It is only when the customer actually flies using the ticket acquired with the voucher that the airline incurs the incremental costs. Prior to this time, the only cost incurred by the airlines would be the actual administrative cost of issuing the travel voucher (e.g., paper, ink and ticket agent payroll). This cost is deductible as incurred and is not at question.

Sec. 461(h)(3) provides a "recurring item" exception to the economic-performance requirement. This exception applies if (1) the all-events test is otherwise satisfied for economic performance; (2) economic performance occurs on or before the earlier of the date the taxpayer files a timely return or within 8 1/2 months after the end of the tax year; (3) the item is recurring in nature; and (4) either the item is material or its accrual results in a more proper match: against income than if the item were accrued in the year of economic performance.

Because T failed to meet the all-events test, it fails the first part of the recurring-item exception. Turning to the second part, there will be numerous instances in which the economic performance will occur after the applicable time period (because the vouchers are valid for one year, and the flight services will be provided subsequently). Presumably the incremental expenses are, in fact, recurring in nature, thus satisfying the third part. As to materiality, Regs. Sec. 1.461-5(b)(4)(i) indicates that the size of the item must be considered in absolute terms and in relation to the taxpayer's income and other expenses. In the present case, the issue involved tax adjustments of more than $1 million.

Finally, T would not meet the final requirement of the economic-performance test, which provides that, even if the item is material, the recurring-item exception would be applicable if deduction of the expense in the tax year prior to economic performance results in a better match of the expense with the income to which it relates. However, this is clearly not met, as the taxpayer does not take into account any income related to these expenses until the flight services are performed.

LETTER RULING (FSA) 200203004 (9/20/01)