Hedge funds and other investment funds are emerging as sophisticated litigators, viewing litigation as an asset, which can create value and mitigate risk, rather than something to be avoided or feared. As a consequence, both the market and various legal systems are being disciplined and developed. How and why is this happening? Willing to litigate relentlessly and fearlessly, hedge funds will seek out and find gaps in documents and uncertainties in the law, and exploit them with ruthless efficiency, entering new legal territory and pushing the boundary of legal theories.
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Imagine you’ve been on an out-of-town business trip. Your employer paid for your airfare, but allowed you to keep the frequent flyer points generated by the trip. Some time later, you redeem the points (perhaps along with additional points generated by other business trips) for a free flight to a vacation destination. You might wonder, “Do I have taxable income, either when the points are credited to my account or when I redeem the points for personal travel?”
Under the US federal income tax, it is reasonably clear that there is taxable income in this story, although there is plenty of room to argue about the timing of the taxable event, or that the fair market value (of either the points or the later reward) should be included in income.
Despite the technical “taxability” of employees who benefit from frequent flyer programs, the Internal Revenue Service (IRS) announced a “don’t-ask-don’t-tell policy” in 2002, which stated that “the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles … attributable to the taxpayer’s business travel.”
Seemingly faced with problems of valuation, enforcement, and taxpayer understanding, the IRS simply declared that it had no intention of enforcing the law, rather than dealing with the issues that would have been created by a serious attempt to administer the taxation of frequent flyer benefits.
“Seemingly faced with problems of valuation, enforcement, and taxpayer understanding, the IRS simply declared that it had no intention of enforcing the law.”
Twelve years later, the 2002 announcement still accurately reflects the supine position of the IRS. Regardless of one’s views on the merits of either taxing or not taxing employee-retained frequent flyer benefits, from a rule-of-law perspective, it is troubling that this question has been resolved by a statutorily unauthorized de facto administrative exemption, rather than by a legislative enactment.
The IRS is far from alone among tax administrators in having performed poorly with respect to frequent flyer benefits, despite having had more than three decades to grapple with the problem since frequent-flyer schemes were introduced in the 1980s. The efforts of the Canada Revenue Agency and of the Australian Taxation Office have differed from those of the IRS, but today, all three countries retain the same bottom line: virtually no tax on frequent flyer benefits is collected anywhere, and respect for the rule-of-law (on the part of both taxpayers and the tax agencies themselves) has been eroded.
So what ought to be done? A tax policy purist would suggest that either the tax administrator or the legislature should develop workable rules for valuation, and for third-party information reporting of that value (by either employers or airlines). The development of workable rules would not be easy, but it could be done. If such rules were adopted, the tax administrator could and should enforce the taxation of frequent flyer benefits. It is unlikely, however, that either an agency or a legislature would take on the difficult and thankless task of developing and adopting the necessary rules. If neither the tax agency nor the legislature is willing to get serious about the taxation of frequent flyer benefits, the second-best approach would be for the legislature to solve the agency-as-scofflaw problem by turning the IRS’ de facto administrative exclusion into an explicit statutory exclusion.
Featured image credit: Airplane flight. Photo by Robert S. Donovan. CC BY-NC 2.0 via booleansplit Flickr.
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