The Tax Court ruled that the credit card “interchange” fees received by subsidiaries of the Capital One credit card issuer resembled interest that increased or created an initial issue discount (OID ) related to the Company’s pool of credit card receivables. As an OID, a daily amount was correctly included in income over the term of the credit card obligation, the court said. The court also found that the accounting method used by the taxpayer to calculate the daily inclusion of OID related to over limit fees and interchange fees was generally reasonable; however, he revised three components of the calculation, claiming that they did not comply with IRC § 1272.
Taxpayers holding debt instruments with an OID, defined as the excess of the stated redemption price of an instrument at maturity over its issue price, must accumulate and include in gross income the OID on a daily basis. during the life of the instrument. For a pool of credit card receivables, the IRS estimated that the annual fee does not create or increase the OID, but admitted that late fees, cash advance fees, and overdue fees limit do. While principal payments of a debt instrument may be accelerated due to prepayments, as in the case of credit card loans, the life of the instrument is unknown, making it difficult to calculate the amount. ‘Daily OID. For such instruments, section 1272 (a) (6) provides guidance on calculating the daily OID, and section 1272 (a) (6) (B) (iii) requires the use of a ” early repayment assumption determined in the manner prescribed by the regulations. “However, these regulations have not yet been published.
Capital One Financial Corp., through its subsidiaries, Capital One Bank (COB) and Capital One FSB (FSB), has issued credit cards to consumers. Under credit card agreements, cardholders have promised to pay businesses the amount charged using the cards plus any applicable finance charges, late fees, or the like. When consumers used their Capital One cards, the Visa or MasterCard card systems, as part of their agreements with Capital One, would withdraw from the Capital One account an amount equal to the consumer’s purchase price minus an amount called a charge. interchange. Visa or MasterCard would remit the remainder to an intermediary bank which, after deducting a smaller amount, would pay the merchant. The COB and FSB treated this exchange as creating or adding to the OID of its pool of credit card receivables and recognized the amount of the exchange over time, using a method developed by the accounting firm KPMG .
After reviewing Capital One’s tax returns for 1995-1999, the IRS imposed additional taxes and penalties of approximately $ 295 million and $ 24 million, respectively. The IRS argued that (1) interchange fees were not OID; (2) The FSB could not retroactively allocate interchange fees and over limit fees for 1998 and 1999 because it previously used the current inclusion method and did not file Form 3115 , Request for change in accounting method; and (3) the KPMG model was an unreasonable methodology that did not clearly reflect income. Capital One sought relief from the Tax Court.
The IRS argued that the interchange was fee-for-service, since its amount was meant to encourage banks to issue credit cards and merchants to accept them. The Service also argued that Capital One did not obtain a discounted loan from the cardholder, since an intermediary bank was paying the interchange to Capital One, not the cardholder.
The court ruled, however, that the swap looked like interest, as it compensated Capital One for the costs of abandoning the use of its funds from the time the cardholders made a purchase until the end of their grace period. Another way the swap resembled interest was that the amount of interest increased as the amount of a cardholder’s purchase (the loan) increased. The court also said it didn’t matter if an intermediary bank paid the exchange to Capital One, because under Treas. Reg. § 1.1273-2 (g), these third party payments reduce the issue price, thereby creating or increasing the OID.
The Tax Court agreed with the IRS that the FSB could not change its accounting method and begin to prorate OID over limit fees and interchange fees for the 1998 tax years. and 1999. The tribunal relied on its previous decision in Capital One Financial Corp. and subsidiaries c. Commissioner, 130 TC 147, in which he denied the company’s attempt to retroactively allocate the OID resulting in late fees over time, since the company had not obtained IRS consent. (For previous coverage, see “Tax Matters: Their Wallet?” JofA, Sep 08, page 89.)
The IRS argued that the COB should calculate the daily OID inclusion amount using the same approach used for a fixed pool of mortgages. However, this argument was rejected by the court, as the company’s credit card pool was a dynamic loan pool with constantly fluctuating account balances. Overall, the court found that the KPMG method for recognizing the interchange as OID was reasonable, except that it incorrectly included new customer purchases when determining the method’s payout rate (needed to calculate yield to maturity) and the initial issue price of the debt instrument. Also, when calculating the payout rate, the method incorrectly applied the first payouts to accrued but unbilled finance charges, the court said.
In an issue unrelated to the OID, the court also ruled that the company could not deduct in 1999 more than $ 34 million for its increase in the estimated future cost of reward points (redeemable for airline tickets ) Earned by cardholders that year. The court rejected the company’s argument that the points were coupons issued with sales and redeemable in the property that Treas. Reg. § 1.451-4 allows for a common deduction, asserting that redemption fees could only be recognized under the all events test.
Capital One Financial Corp. and subsidiaries c. Commissioner
, 133 TC no. 8
Charles J. Reichert, CPA, professor of accounting, University of Wisconsin-Superior.