Capital One Financial Corporation and Subsidiaries v. Commissioner , 133 T.C. No. 8 ( 2009 )

133 T.C. No. 8UNITED STATES TAX COURT
CAPITAL ONE FINANCIAL CORPORATION AND SUBSIDIARIES,
Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 19519-05, 24260-05. Filed September 21, 2009.
P’s subsidiaries, COB and FSB, issued Visa and
MasterCard credit cards. Among the various revenues
received from the credit card business, COB and FSB
earned interchange. Interchange is income earned by an
issuer of Visa and MasterCard credit cards which
accrues to the issuer each time a cardholder uses a
credit card for a purchase. It is almost always
calculated as a percentage of the total purchase plus,
in some instances, a small fixed amount.
When a cardholder used a credit card to purchase
an item from a merchant, the cardholder agreed to pay
COB or FSB the full purchase price of the item.
However, because of the way the Visa and MasterCard
systems operated, COB and FSB authorized Visa and
MasterCard to withdraw a lesser amount from Capital
One’s account which eventually was delivered to the
merchant. The difference between the purchase price
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and the amount Visa or MasterCard withdrew from Capital
One’s account was the interchange on the transaction.
COB and FSB treated interchange as creating or
increasing original issue discount (OID) on the pool of
loans to which the interchange related under sec.
1272(a)(6)(C)(iii), I.R.C. R argues that interchange
is a fee for a service paid by the merchant or the
merchant’s bank, and not by the borrower. Furthermore,
R argues that interchange is not economically
equivalent to interest and therefore may not be treated
as OID under sec. 1272(a)(6)(C)(iii), I.R.C. Ps argue
that COB and FSB acquired the credit card loans at a
discount, the discount being the amount of interchange,
and therefore interchange was properly treated as OID.
In our previous Opinion in this case, Capital One
Fin. Corp. v. Commissioner, 130 T.C. 147 (2008), we
held that a taxpayer was required to follow all
procedures put in place by the Commissioner to change
its method of accounting in accordance with sec.
1272(a)(6)(C)(iii), I.R.C. FSB did not request to
change its method of accounting by filing Form 3115,
Application for Change in Accounting Method, with its
return.
Sec. 1272(a)(6)(C)(iii), I.R.C., provides a
specific formula by which OID accruals should be
calculated on a debt instrument subject to prepayment
such as a pool of credit card loans. Sec.
1272(a)(6)(C)(iii), I.R.C. requires the use of a
prepayment assumption. COB used a formula developed by
the accounting firm KPMG (KPMG model). R raises
several issues with respect to the KPMG model, arguing
that it did not comply with sec. 1272(a)(6)(C)(iii),
I.R.C., and that the results produced by the model were
unreasonable.
COB and FSB issued certain Visa and MasterCard
credit cards known as Milesone cards which allowed
cardholders to earn 1 mile for every dollar used for a
purchase transaction, with certain limitations. A
cardholder earned no miles for fees or finance charges
incurred. When a cardholder reached a certain number
of miles, they could be redeemed for airline tickets.
COB and FSB deducted the estimated future cost of
redeeming the miles under sec. 1.451-4, Income Tax
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Regs., which allows a taxpayer to deduct from sales
revenues an estimate of the expenses associated with
redeeming coupons that were issued with sales.
Held: Interchange is not a fee for any service
other than the lending of money. The issue price of a
credit card loan is the price paid for the loan, which
is the amount withdrawn from COB’s and FSB’s account
and deposited with the merchant’s bank. Therefore,
interchange is properly treated as OID under sec.
1272(a)(6)(C)(iii), I.R.C.
Held, further: FSB did not follow the required
procedures to change its method of accounting in
accordance with sec. 1272(a)(6)(C)(iii), I.R.C.
Therefore, FSB may not treat interchange and overlimit
fees as OID.
Held, further: The KPMG model did not comply with
sec. 1272(a)(6), I.R.C., in that: (1) The model
included in the beginning issue price of the debt
instrument additions to principal which occurred after
the first day of the accrual period; (2) the model
incorrectly calculated the payment rate by including
additions to principal which occurred after the first
day of the accrual period; and (3) the model
incorrectly calculated the payment rate by applying
payments to finance charges which accrued during the
period. Payments should first be applied to the prior
month’s accrued finance charges, and not the current
month’s finance charges. In all other respects, the
KPMG model was reasonable.
Held, further: The miles issued by COB and FSB
were not issued with sales, and COB and FSB did not
have gross receipts with respect to sales within the
meaning of sec. 1.451-4, Income Tax Regs. Therefore,
they may not deduct the estimated costs of redeeming
the miles pursuant to sec. 1.451-4, Income Tax Regs.,
but must do so under the all events test as to those
amounts that are fixed and known and for which economic
performance has occurred.
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Jean Ann Pawlow, Elizabeth A. Erickson, Holly K. Hemphill,
Kevin Spencer, and Robin L. Greenhouse, for petitioners.
Gary D. Kallevang, James D. Hill, and Alan R. Peregoy, for
respondent.
CONTENTS
Issue 1: Interchange . . . . . . . . . . . . . . . . . . . 8
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 8
A. An Introduction to Interchange . . . . . . . . . . 8
B. The Historical Roots of the Credit Card
Industry and Interchange . . . . . . . . . . . 9
C. Interchange Fees and the Visa and
MasterCard Systems . . . . . . . . . . . . . . 12
D. The Parties to a Typical Credit Card Purchase
Transaction . . . . . . . . . . . . . . . . . . 12
1. The Issuing Bank (Capital One) . . . . . . . 12
2. The Cardholder . . . . . . . . . . . . . . . 13
3. The Acquiring Bank. . . . . . . . . . . . . . 14
4. The Merchant . . . . . . . . . . . . . . . . 15
5. The Association (Visa or MasterCard) . . . . 15
E. A Typical Credit Card Purchase Transaction . . . . 15
F. The Clearing Process . . . . . . . . . . . . . . . 19
G. Net Settlement . . . . . . . . . . . . . . . . . . 20
H. Cardholder Payments . . . . . . . . . . . . . . . 23
I. Merchant Discount in Detail . . . . . . . . . . . 25
J. Interchange in Detail . . . . . . . . . . . . . . 26
1. Factors Influencing Interchange Rates . . . . 26
2. Capital One’s Costs and Interchange . . . . . 28
3. Debit Cards and Interchange . . . . . . . . . 29
4. Capital One’s Accounting Treatment of
Credit Card Purchases and Associated
Interchange Income . . . . . . . . . . . . 30
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . 33
A. An Overview of the Issue and the Law . . . . . . . 33
B. The SRPM of a Credit Card Loan . . . . . . . . . . 34
C. The Issue Price of a Credit Card Loan . . . . . . 35
1. Whether Interchange Is a Fee for a Service
(and If So, What Service) or Economically
Equivalent to Interest . . . . . . . . . . 36
2. Whether the Cardholder, the Merchant, or
the Acquiring Bank Pays Interchange . . . 48
D. Conclusion With Respect to the Interchange Issue . 52
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Issue 2: The Calculation of OID Under Section
1272(a)(6)(C) . . . . . . . . . . . . . . . . . 53
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . 53
A. Accounting Methods . . . . . . . . . . . . . 53
B. Income and OID Accruals of Overlimit Fees
and Interchange . . . . . . . . . . . . . 54
OPINION . . . . . . . . . . . . . . . . . . . . . . . . 55
A. Accounting Methods . . . . . . . . . . . . . 55
B. The Standard of Review . . . . . . . . . . . 57
C. Section 1272(a)(6)(C) . . . . . . . . . . . . 59
D. The KPMG Model . . . . . . . . . . . . . . . 62
1. The Payment Rate or Prepayment
Assumption . . . . . . . . . . . . . 62
2. The Weighted Average Maturity . . . . . 64
3. The Yield to Maturity . . . . . . . . . 65
4. OID Accrual . . . . . . . . . . . . . . 66
5. An Adjustment for Writeoffs . . . . . . . 67
6. The Mid-Month Convention . . . . . . . . 67
7. The KPMG Model Table . . . . . . . . . . 67
E. Respondent’s Arguments With Respect to the
KPMG Model . . . . . . . . . . . . . . . . 69
1. The Monthly Retirement and Reissuance
of the Pooled Debt Instrument . . . . 69
a. COB’s Reasons for Adopting the
“Retired and Reissued” Approach. 71
b. Respondent’s Alternative to the
“Retired and Reissued” Approach. 72
2. The Inclusion of New Additions in the
Beginning Issue Price . . . . . . . . 78
3. Payment Rate Issues . . . . . . . . . . 82
a. The Denominator . . . . . . . . . . 82
b. The Numerator . . . . . . . . . . . 84
c. Other Published Payment Rates . . . 86
4. Dr. Hakala’s Default Rate Adjustment
for Overlimit Fees . . . . . . . . . 87
5. Dr. Hakala’s Seasonality and
Trend Adjustment . . . . . . . . . . 90
F. Conclusion With Respect to the
Calculation of OID . . . . . . . . . . . . 91
Issue 3: Milesone Rewards . . . . . . . . . . . . . . . . . 91
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . 91
A. The Milesone Reward Program . . . . . . . . . 91
B. Milesone Program Costs and Accounting . . . . 93
OPINION . . . . . . . . . . . . . . . . . . . . . . . . 95
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A. The History of Accounting for the
Redemption of Trading Stamps and
Coupons . . . . . . . . . . . . . . . . . 95
B. The “With Sales” Requirement . . . . . . . . 98
C. Gross Receipts With Respect to Sales . . . . 102
D. Conclusion With Respect to the Milesone
Rewards Issue . . . . . . . . . . . . . . 104
HAINES, Judge: Respondent determined deficiencies in, and
penalties with respect to, petitioners’ Federal income taxes as
follows:1
Penalty
Year Deficiency Sec. 6662(a)
1995 $1,459,146 N/A
1996 7,162,060 N/A
1997 37,656,474 $5,487,734
1998 72,995,902 5,220,381
1999 175,286,436 13,194,525
Capital One Financial Corp., through its principal
subsidiaries Capital One Bank (COB) and Capital One, F.S.B. (FSB)
(collectively Capital One),2 is among the world’s largest issuers
of Visa and MasterCard credit cards. Its headquarters is in
Virginia. After concessions,3 three issues remain for our
decision, all of which are issues of first impression and relate
1
Unless otherwise indicated, section references are to the
Internal Revenue Code (Code), as amended. Rule references are to
the Tax Court Rules of Practice and Procedure.
2
We refer to COB and FSB individually only when the
difference is material to our analysis.
3
The parties were able to settle many issues, including all
issues with respect to petitioners’ 1995 and 1996 tax years.
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to the proper tax treatment of Capital One’s income and expenses
from its credit card business.
The first issue is whether certain credit card income, known
as interchange, is properly recognized at the time the
interchange accrues under the all events test (when the
cardholder’s credit card purchase is settled through either the
Visa or MasterCard system) or whether it is properly recognized
over the anticipated life of the pool of credit card loans to
which the interchange relates under section 1272(a)(6)(C)(iii).
We hold that interchange may be recognized over time as original
issue discount (OID) under section 1272(a)(6)(C)(iii).
The second issue is whether COB and FSB properly calculated
the amount of OID for interchange and overlimit fees.4 We hold
that the formula COB used to calculate OID, with modifications
required by the OID rules generally and section 1272(a)(6)
specifically, as set forth infra, is reasonable.
The third issue is whether Capital One may deduct under
section 1.451-4, Income Tax Regs., the estimated cost of future
redemptions of “miles” it issued to certain cardholders which
could be redeemed for airline tickets. We hold that Capital One
4
Subsumed in this issue is whether FSB is precluded from
treating interchange and overlimit fees as creating or increasing
OID on the pool of loans to which it relates because it did not
request to change its method of accounting. We hold that FSB did
not request to change its method of accounting and may not treat
interchange or overlimit fees as OID.
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may not deduct those costs pursuant to section 1.451-4, Income
Tax Regs., but must do so under the all events test as to those
amounts that are fixed and known and for which economic
performance has occurred.
The parties have stipulated many of the facts and they are
so found. The stipulations of facts and the exhibits attached
thereto are incorporated herein. For the most part the three
issues are discrete, and for convenience we have set forth below
separately our Findings of Fact and Opinion for each issue.
Issue 1: Interchange
FINDINGS OF FACT
A. An Introduction to Interchange
Interchange is income earned by an issuer of MasterCard or
Visa credit cards which accrues to the issuer every time a
cardholder uses a card for a purchase. Interchange is typically
calculated as a percentage of the total amount of the purchase
plus, in most but not all instances, a small fixed fee.
To better understand interchange, respondent suggests we
review how and why interchange developed and the contractual
relationships between the multiple parties in a credit card
transaction, as well as the interchange systems in other payment
card systems such as signature debit cards and personal
identification number (PIN) debit cards. Petitioners, on the
other hand, would have us focus on the economics of the credit
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card transaction, specifically the cashflows. In making our
determination, we do not limit our analysis to one aspect or one
viewpoint of the interchange system.
B. The Historical Roots of the Credit Card Industry and
Interchange
Payment card systems, like those of Visa and MasterCard,
facilitate transactions between merchants and cardholders. They
allow consumers a convenient way to purchase goods without having
to carry cash or use a check. Merchants also benefit from
payment card systems because they open themselves up to more
potential consumers and they receive some assurance of payment
and protection from fraud.
Hotels, gas companies, and department stores began issuing
payment cards to some of their customers in the early 20th
century. Such a card was usually accepted only by the merchant
who issued the card. Some of the payment cards offered their
cardholders a line of credit, while others required the
cardholder to pay the balance in full by a fixed date, for
example 30 days after a monthly statement was issued.5
In the 1950s a new type of payment card system was created,
Diner’s Club, and shortly thereafter American Express created a
similar system. Unlike previous cards issued by a single
5
Cards that require full payment and do not allow
cardholders to carry a balance from month to month are known in
the banking industry as charge cards.
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merchant, Diner’s Club and American Express cards were accepted
by many different merchants if the merchant had joined the
respective system. Diner’s Club adopted the following price
structure, known by some in the payment card industry as a
“merchant’s pay” structure: cardholders paid a $3 annual fee and
the merchants received 93 percent of the cardholder’s total
charge.6 The difference between the amount of the cardholder’s
charge and the amount the merchant received was retained by the
issuer and was known as merchant discount. American Express set
a slightly higher annual fee and smaller merchant discount than
Diner’s Club.
The Diner’s Club and American Express systems involved three
parties: the cardholder, the merchant, and the card issuer. In
these systems the card issuers not only issued cards to
cardholders; they also recruited merchants to join the system and
processed the card transactions. Of the various payment card
systems, this three-party system is known as the “go it alone”
system because the card issuer performed the various functions
necessary to operate the system.
In 1958 Bank of America also chose to go it alone and began
issuing its own payment cards, called BankAmericards, which were
credit cards in that cardholders could carry a balance from month
6
As we will see, respondent argues that the merchant has
paid 7 percent of the charge to the bank, and petitioners argue
that the bank has received funds net of a 7-percent discount.
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to month. Later on, in an effort to compete with Diner’s Club
and American Express, Bank of America franchised its cards to
selected banks across the country. Each franchisee operated the
program independently using the BankAmericard name, and
participating merchants accepted all cards carrying the name
whether they were issued by Bank of America or one of the
franchisees. Franchisees paid Bank of America .5 percent of
purchase volume plus a franchise entry fee. This was known as
the franchise model.
A third model developed in the 1960s, the bank association.
The idea was that banks would cooperate at the card system level
by setting operational standards and fees. Each bank would
compete for cardholders as well as merchants. The association
members agreed that a cardholder carrying a card issued by any
member bank could use the card at a merchant signed up by any
member bank. The banks also cooperated in promoting the card
brand name which involved making the association’s name more
prominent on the card than the individual bank’s name. Several
associations developed in the 1960s, the most enduring of which
was the Interbank Association, which issued Master Charge cards.
By the late 1960s banks were rushing to become either
BankAmericard franchisees or Interbank Association members.
Ultimately, most banks preferred being members of an association
rather than franchisees. Bowing to this pressure, in 1970 Bank
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of America converted its franchise system into an association,
National BankAmericard, Inc. National BankAmericard, Inc.,
became Visa in 1976 and the Interbank Card Association became
MasterCard in 1979.
C. Interchange Fees and the Visa and MasterCard Systems
A credit card transaction in the Visa and MasterCard (the
associations) systems included five parties.7 In the three-party
go it alone model, the card issuer, for example American Express,
would set a merchant discount rate acceptable to both parties,
maximizing the bank’s profits. In the five-party association
model the bank that issued the card was usually not the bank that
recruited the merchant, and each sought to maximize profits,
often at the other’s expense. The interchange system was created
to solve that problem.
D. The Parties to a Typical Credit Card Purchase Transaction
To explain how interchange works, we begin with a
description of the five parties to a typical credit card purchase
transaction under either the Visa or MasterCard system.
1. The Issuing Bank (Capital One)
During the years at issue Capital One was an issuing bank,
in that it issued cards to cardholders, but it did not recruit
merchants to join the system. The issuing bank’s primary service
7
The association model is sometimes referred to as a four-
party system because the association, either Visa or MasterCard,
is not counted.
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was lending money to its cardholders with whom it had a
contractual relationship as spelled out in the cardholder
agreement. All issuing banks operated under the rules provided
by the respective associations, either Visa’s By-Laws and
Operating Regulations (Visa rules) or MasterCard’s By-Laws and
Rules and Operating Manuals (MasterCard rules).
2. The Cardholder
The cardholder received a card from the issuing bank. The
credit card evidenced a line of credit that had been established
by the issuing bank upon which the cardholder could draw to
purchase goods or services and in some cases transfer a balance
or obtain a cash advance. The amount of the line of credit and
the terms and conditions for use of the line of credit were
provided in the cardholder agreement. The relationship between
the cardholder and Capital One was also described in solicitation
materials sent to the cardholder and the application filled out
by the cardholder when applying for a Capital One credit card.
Under the terms and conditions of Capital One’s cardholder
agreements, Capital One promised to extend credit on a revolving
basis to the cardholder in exchange for the cardholder’s promise
to pay Capital One the total price of the goods and services
purchased by the cardholder using the Capital One card, along
with any finance charges and fees as provided under the terms of
the cardholder agreement. If a cardholder failed to pay an
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amount owed, Capital One could not look for payment of the
liability from the association, the merchant, or the acquiring
bank.
3. The Acquiring Bank8
An acquiring bank recruited, screened, and accepted
merchants into the associations’ credit card systems. An
acquiring bank entered into agreements with merchants regarding
the merchants’ acceptance of credit cards (merchant agreement).
The acquiring bank’s contractual relationship with the merchant
was separate and distinct from the acquiring bank’s relationship
with the association. Neither Capital One, the cardholder, nor
the association was a party to the agreement between the
acquiring bank and the merchant.
An acquiring bank processed credit card transactions on
behalf of its merchants and carried out the settlement process
for them within the respective credit card systems. An acquiring
bank also typically provided services to the merchant including
deployment of credit card terminals at the point of sale, back-
end customer service, risk management, and marketing activities.
8
Acquiring banks are sometimes referred to as merchant’s
banks.
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4. The Merchant
The merchant sold goods or services to the cardholder. With
respect to a credit card purchase transaction, the merchant had
no contract with the issuing bank.
5. The Association (Visa or MasterCard)
Visa and MasterCard provided the infrastructure which
enabled credit card transactions to take place. They processed
transactions between acquiring and issuing banks, allowing
purchases to be authorized. Further, the associations provided
the infrastructure which allowed the parties to clear and settle
millions of credit card transactions. These processes are
described below.
E. A Typical Credit Card Purchase Transaction
Credit card purchase transactions typically included (1) an
authorization process to enable the merchant to obtain the
issuing bank’s authorization for the cardholder’s purchase and
(2) a clearance process to transmit information regarding credit
card transactions among the merchant, the acquiring bank, and the
issuing bank as required under the association’s operating
rules.9 Credit card purchase transactions also included a
separate flow of funds for settling accounts between issuing
banks, acquiring banks, and merchants. Visa and MasterCard each
9
In 1998 and 1999 Capital One cardholders participated in
211,152,400 and 335,188,370 credit card transactions,
respectively.
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operated electronic network systems to process their respective
card transactions, including approval, consolidation, and
settlement. These systems are referred to as interchange
systems. MasterCard’s interchange system is known as BankNet,
and Visa’s is known as VisaNet.
A typical credit card purchase transaction is initiated by a
cardholder who wants to make a purchase from a merchant. The
cardholder presents the card to the merchant in payment for
goods or services. The merchant swipes the cardholder’s card in
a credit card terminal, and data (including the purchase amount,
cardholder identifying information, and merchant identity) flows
from the merchant to the acquiring bank and then from the
acquiring bank through the association to the issuing bank.
Approval or denial of the transaction then flows from the issuing
bank back through the association to the acquiring bank and then
to the merchant. This flow of information typically takes place
in a matter of seconds.
The process by which Visa and MasterCard credit card
purchases were generally authorized is depicted in the chart
below. In this hypothetical transaction:
(a) A cardholder purchases a lamp for a total price of $100
from a merchant using a Visa or MasterCard credit card issued by
Capital One. The card is swiped through an electronic terminal
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at the merchant’s location. The terminal is linked through the
acquiring bank to the Visa or MasterCard network. See step 1.
(b) The amount of the transaction and the cardholder
information is routed from the merchant to the acquiring bank.
See step 2.
(c) The transaction information is routed from the
acquiring bank through VisaNet or BankNet to Capital One. See
steps 3 and 4.
(d) Capital One either authorizes or declines the
transaction, and a message is routed electronically through
VisaNet or BankNet to the acquiring bank, and then to the
merchant. See steps 5, 6, and 7. (The example assumes Capital
One authorizes the purchase.)
(e) Once the merchant receives approval of the transaction,
the cardholder provides the merchant with a signed transaction
receipt, the merchant issues a receipt to the cardholder (sales
receipt), and the cardholder departs with the lamp. See steps 8,
9, and 10.
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By signing the transaction receipt, the cardholder promises
to pay Capital One the total price shown thereon sometime in the
future. The cardholder may pay more than the total price shown
on the transaction receipt. For example, the cardholder may
incur finance charges, late fees, or overlimit fees.
With respect to a credit card purchase transaction, the
amount Capital One authorized to be charged (the total purchase
price) was equal to the amount it expected to be paid by the
cardholder. However, as discussed below, Capital One did not
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authorize Visa or MasterCard to withdraw the total purchase price
from its bank account as part of the net settlement process.
F. The Clearing Process
For each credit card purchase transaction, the merchant
furnished (either electronically or on paper) a detailed record
to its acquiring bank that contained specific information about
the transaction including the total price, the date of the
purchase, the cardholder’s account number, the brand and type of
credit card used, the merchant’s identifying information, the
type of merchant (e.g., a grocery store or an airline), the type
of transaction (e.g., a face-to-face purchase or an Internet
transaction), and the issuing bank’s authorization code, if
obtained. The merchant had to transmit this information to its
acquiring bank to receive payment for the purchase. In turn, the
acquiring bank was required to accept and pay all properly
presented transaction receipts from its merchant.
The acquiring bank consolidated and compiled information
from all its merchants, calculated the applicable merchant
discount (see section I, infra) for those merchants’ transactions
on the basis of the applicable merchant codes and other factors,
and then transmitted that information to the applicable
association for settlement. The association then sorted and
provided the relevant cardholder transaction information from all
the acquiring banks, along with the association’s interchange fee
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computation, to each of its issuing banks for the respective
issuing bank’s cardholder transactions via a transaction record.
MasterCard and Visa computed the interchange fees on a
transaction-by-transaction basis for every credit card
transaction submitted. The transaction records were compiled and
reported daily to the issuing bank.
G. Net Settlement
Capital One maintained a bank account with the Federal
Reserve Bank of Richmond. In accordance with their respective
rules, the associations were authorized to withdraw/debit and/or
deposit/credit funds into Capital One’s bank account to settle
Capital One’s credit card transactions each day. For credit card
purchase transactions, the associations withdrew funds from
Capital One’s account and deposited funds in the corresponding
acquiring bank’s account. Both MasterCard and Visa were
authorized to withdraw only the total price less the applicable
interchange fee from Capital One’s Federal Reserve Bank account.
The process through which credit card purchase transactions
were settled during the years at issue is shown in the
illustration below. This is an example of a single credit card
purchase transaction, using a total price of $100, a hypothetical
2-percent interchange fee, and a hypothetical merchant discount
of 2.5 percent. The example assumes that no other transactions
occurred for the cardholder, the merchant, the acquiring bank, or
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the issuing bank. In settlement of this hypothetical
transaction:
a. The association withdraws $98 from the issuing bank’s
account, representing the $100 total price less the 2-percent
interchange fee.
b. The association deposits $98 into the acquiring bank’s
account, also representing the $100 total price less the 2-
percent interchange fee.
c. The acquiring bank deposits $97.50 into the merchant’s
bank account, representing the $100 total price less the 2.5-
percent merchant discount.
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Although the chart above illustrates the settlement of a
single discrete cardholder credit card purchase transaction,
transactions were not typically settled individually. Rather,
credit card transactions were aggregated and processed in large
batches. The associations’ settlement systems consolidated all
batched transactions for a given period, usually daily, and
settled accounts among the various members through a process
known as direct net settlement. Direct net settlement resulted
in the netting of all cash due to, from, and between the
associations’ respective members. Association members were
required to net settle their transactions unless two members
agreed otherwise.10
The association calculated the aggregate settlement position
for each of its members. The association then withdrew funds
from a member with a negative aggregate settlement position;
i.e., a member who owed funds. With respect to credit card
purchase transactions, the association withdrew funds from the
issuing bank and deposited the net amount owed in the account of
the acquiring bank. The amount deposited by the association with
the acquiring bank in these circumstances would equal the total
credit card purchases made at all of that acquiring bank’s
10
Members could, but rarely did, negotiate agreements among
themselves to settle the transactions, in what were known as
bilateral agreements. Capital One did not enter into any
bilateral agreements.
-23-
merchants by all the issuing bank’s cardholders less the total
amount of interchange fees determined by the association with
respect to those transactions. Typically, the net settlement
position determined by the association included any chargebacks11
(reversed or canceled purchases initiated by issuing banks)
processed that day, credits (initiated by merchants), and any
other fees owed between issuing banks and acquiring banks.
To complete the process, the acquiring bank determined the
amount of funds, net of the applicable merchant discount, due
each of its merchants with respect to that merchant’s aggregate
settled credit card transactions. However, this was not part of
the associations’ net settlement processes.
H. Cardholder Payments
When a Capital One cardholder signed a transaction receipt,
the cardholder promised to pay Capital One the full purchase
price in accordance with the terms of the cardholder agreement.
Capital One sent its cardholders monthly statements containing
detailed purchase transaction entries reflecting the amounts owed
by the cardholders. The monthly statements also listed fees
Capital One charged the cardholders, such as overlimit fees or
11
When a chargeback was processed through MasterCard’s
interchange system, the interchange rate applied to the reversal
of the transaction was not necessarily the same rate that applied
when the original transaction was settled.
-24-
late fees. The monthly statements did not list the amount of
interchange applicable to the transactions.
Under the terms of the cardholder agreement, a cardholder
was obligated to pay Capital One at least a certain amount
(minimum payment) by the due date specified in the statement.
The minimum payment was typically 2 or 3 percent of the
cardholder’s outstanding balance with at least $10 or $15 due.
The cardholder agreement did not specify a date by which the
charge would have to be paid in full.
The cardholder agreement provided for a grace period with
respect to purchase transactions in which finance charges on new
purchases could be avoided if the total outstanding balance was
paid in full before the due date specified on the statement. The
cardholder agreement explained:
You may avoid finance charge[s] on new purchases and on
other new charges by paying the total new balance in
full prior to the date payment is due (this is the
grace period on new purchases). If you do not pay the
entire new balance from the previous statement, finance
charges will accrue on the entire previous new balance
from the first date of the new billing period. Finance
charges, when applicable, will be assessed as follows:
• Transactions made during the current billing
period from transaction date.
• Undated transactions and transactions made
with convenience checks: from the date the
transaction is processed to your account.
• Transactions made prior to the current
billing period: from the first calendar day
of the current billing period.
-25-
Capital One provided its cardholders with a grace period that
approximated 30 days. Because Capital One’s billing cycles
approximated 30 days and the grace period approximated 30 days, a
cardholder could have up to 60 days between the date a credit
card purchase was made and the date payment was due.
Cardholders who routinely pay their balance in full every
month are known in the credit card industry as transactors.
Cardholders who routinely carry a balance on their card are known
as revolvers. Of Capital One’s total credit card purchase volume
(in dollars), approximately 50 percent was attributable to
transactors and 50 percent to revolvers.
I. Merchant Discount in Detail
The difference between the total price of the goods or
services sold to cardholders and the amount remitted to the
merchant by the acquiring bank is known as the merchant discount
or gross merchant discount. The merchant discount was typically
a fixed percentage of the total price of the goods or services
sold and compensated acquiring banks for the services they
provided the merchant. Unlike interchange, the merchant discount
was not determined by the association. Rather, merchant
discounts were negotiated between acquiring banks and their
respective merchants. The difference between the amount the
acquiring bank receives from the issuing bank and the amount the
acquiring bank sends to the merchant is generally known as the
-26-
net merchant discount; i.e., the difference between the gross
merchant discount and the interchange fee.
J. Interchange in Detail
MasterCard and Visa set the interchange rates on their
respective systems but did not publish them during the years at
issue. At some point later, they began publishing their
interchange rates. Both MasterCard and Visa used the interchange
system to maximize system participation through increased
issuance of cards and increased acceptance by merchants. If
interchange rates were set too high, acquiring banks would raise
the merchant discount, and merchants would be less likely to
accept MasterCard or Visa cards. If interchange rates were set
too low, issuing banks were less likely to issue MasterCard or
Visa cards because they might not have been able to cover their
costs and make a sufficient profit.
1. Factors Influencing Interchange Rates
To balance the interests of the various parties to a credit
card purchase transaction and to maximize system participation,
both Visa and MasterCard have implemented a variety of
interchange rates. The rates were based on a number of factors
including: (1) The method of the purchase (e.g., in person or on
line); (2) the type of merchant; (3) the geographical area of the
merchant (e.g., domestic or international); (4) the type of
cardholder (e.g., individual/personal or corporate/business); (5)
-27-
in some instances the size of the transaction (e.g., a “large
ticket” purchase over a certain threshold amount); and (6) the
type of purchase (e.g., corporate travel and entertainment
expense).
The associations also set lower interchange rates to better
compete with other payment systems or methods. For example,
supermarkets typically operated on low gross profit margins and
were reluctant to accept Visa and MasterCard cards because of the
merchant discount. Both Visa and MasterCard implemented lower
interchange rates for supermarkets, resulting in lower merchant
discounts, thereby incentivizing card acceptance. The
associations also implemented lower interchange rates to better
penetrate other markets including automated fuel dispensers.
MasterCard’s interchange rates included the following
categories:
Program Name 1997-1998 Rates 1998-1999 Rates 1999-2000 Rates
Consumer 2.15% + $0.10 2.35% + $0.10 2.65% + $0.10
Standard
Travel 1.35% + $0.10 1.43% + $0.10 1.58% + $0.10
Industries
Petroleum 1.35% + $0.05 1.40% + $0.05 1.50% + $0.05
Terminal
Supermarket 1.10% 1.15% 1.15%
Corporate 2.25% 2.52% + 0.10 2.65% + 0.10
Standard
-28-
Visa’s interchange rates included the following categories:
Program Name 9/27/97-3/27/98 3/28/98-4/9/99
Rates Rates
Standard Commercial 2.00% + $0.11 2.09% + $0.10
(Other than Certain
Travel-Related Charges)
CPS/Retail1 Commercial 1.25% 1.31%
(Other than Certain
Travel-Related Charges)
CPS/Hotel and Car 1.93% + $0.06 2.02% + $0.10
Rental
Supermarket Incentive 1.10% 1.15%
Program, Non-Commercial
1
CPS refers to “custom payment service”, Visa’s term for
card transactions that are processed a certain way.
2. Capital One’s Costs and Interchange
The costs of issuing banks, such as Capital One, were one
factor associations considered when they set interchange rates.
Both Visa and MasterCard studied issuing banks’ costs.
MasterCard hired Edgar, Dunn & Co. (Edgar Dunn), a consulting
firm, to study issuing banks’ costs as part of MasterCard’s
process for setting interchange rates. The costs studied
included the grace period cost of funds for transactors, risk
costs for credit card transactions generally (credit and fraud
risks), and processing costs for credit card transactions. These
studies did not address the cost of funds for revolvers; that is,
cardholders who carry a balance on their card and therefore pay
monthly finance charges. Edgar Dunn’s composite issuing bank
cost figures were as follows:
-29-
Year Issuing Banks’ Costs1
1997 2.52 percent + $0.10 per transaction
1998 2.92 percent + $0.10 per transaction
1999 2.97 percent + $0.10 per transaction
1
Edgar Dunn broke the total cost down into components. The
issuing bank’s cost of lending money, i.e., the financial
carrying costs during the grace period, were .20 percent, .22
percent, and .20 percent of the total purchase price during 1997,
1998, and 1999, respectively. For 1997, 1998, and 1999, 2.32
percent, 2.70 percent, and 2.77 percent of the total purchase
price represented the total risk costs. Edgar Dunn calculated
the issuing bank’s processing costs to be 10 cents per
transaction.
For 1997 Visa estimated that the average processing cost per
transaction was 8.4 cents, with the actual costs ranging between
4.8 cents and 11.4 cents. For 2000 the average cost was 6.6
cents per transaction, with the actual costs ranging between 3.8
cents and 9.7 cents per transaction. For 1998 and 1999 Capital
One’s cost of processing a credit card transaction was likely
between 4.6 cents and 8.2 cents per transaction.
3. Debit Cards and Interchange
During the years at issue Capital One did not issue
signature debit cards.12 A signature debit card is linked to the
12
Capital One also did not issue PIN debit cards which are
linked to a cardholder’s checking account issued by the
cardholder’s bank. Unlike signature debit cards, the systems are
not operated by Visa or MasterCard; these systems are operated by
a number of other systems, including Plus and Cirrus. Rather
than signing her name, the cardholder enters her PIN. A PIN
debit transaction is processed through an electronic funds
transfer network and effects an immediate withdrawal from the
(continued...)
-30-
cardholder’s deposit account, from which the purchase price of
the goods or services purchased is withdrawn, as opposed to a
credit card which evidences a line of credit. However, other
issuing banks which were members of the associations did offer
debit cards. Both Visa and MasterCard set interchange rates for
their debit cards. MasterCard’s interchange rates for credit
card transactions were identical to those for debit card
transactions for each of MasterCard’s consumer interchange
programs. In a number of instances, Visa’s debit card
interchange rates were equal to the interchange rates for its
credit card transactions. Data published by the Federal Reserve
System in a report to Congress shows that until 2002, the
interchange rate on signature debit card transactions was only
slightly lower than the interchange rate on credit card
transactions.
4. Capital One’s Accounting Treatment of Credit Card
Purchases and Associated Interchange Income
Capital One kept track of all its cardholders’ charges in
what is known as its cardholder account system (CAS). The CAS
reflected the amount of each purchase made with a Capital One
card which was the same as the total purchase price of whatever
the cardholder purchased in that particular transaction. The CAS
12
(...continued)
cardholder’s account to satisfy the purchase amount. There can
be interchange and a merchant discount in these transactions as
well, either a percentage or a flat fee.
-31-
did not reflect any detail with respect to the amount of
interchange received. Capital One maintained so called “310
reports”, which were monthly summaries aggregating transaction
data and financial accruals. The 310 reports did not include any
information about interchange either on an individual cardholder
basis or on an aggregate basis.
For financial accounting purposes, Capital One accounted for
credit card purchase amounts and interchange fees through
separate systems. Capital One used daily summary reports from
Visa and MasterCard for purposes of booking interchange income.
Using the example of a $100 purchase transaction with a $2
interchange fee, Capital One would enter the purchase amount as
“credit card outstanding” (an account receivable). The $2
interchange fee would be credited as “interchange income”. For
financial accounting purposes, Capital One reported interchange
income as “noninterest income”.
Before 1998 Capital One recognized income from late fees and
overlimit fees for both financial accounting purposes and Federal
income tax purposes at the time the fees were charged to the
cardholder. Before 1998 Capital One recognized interchange
income for both financial accounting and Federal income tax
purposes at the time its cardholders’ transactions were net
settled under the Visa and MasterCard rules. For financial
-32-
accounting and regulatory reporting purposes,13 Capital One
differentiated between interest and noninterest income according
to whether the particular income was attributable to an activity
of the cardholder. For example, Capital One treated cash advance
fees as noninterest income because a cardholder would have
withdrawn cash at an ATM or a bank.14 Similarly Capital One
treated interchange as noninterest income for financial
accounting and regulatory reporting purposes because it is
triggered by the cardholder’s purchase.
On their Federal income tax returns for 1998 and 1999,
petitioners recognized Capital One’s income from overlimit fees,
cash advance fees, and interchange fees as creating or increasing
the amount of OID on Capital One’s pool of credit card loans,
thereby deferring the recognition of income and reducing their
Federal income tax liabilities. Respondent challenges
petitioners’ treatment of Capital One’s interchange income as
creating or increasing OID under section 1272(a)(6)(C)(iii).
13
The regulatory reports were filed with the Office of the
Comptroller of Currency.
14
For Federal income tax purposes Capital One treated cash
advance fees as creating or increasing OID before 1998 as well as
after 1998. Respondent has conceded this treatment is proper.
-33-
OPINION
A. An Overview of the Issue and the Law
Under section 1272(a)(6)(C)(iii) taxpayers that issue credit
cards and lend money to their cardholders are required to treat
certain credit card receivables as creating or increasing OID on
the pool of credit card loans to which the receivables relate.
See Capital One Fin. Corp. v. Commissioner, 130 T.C. 147, 150
(2008). The issue is whether Capital One’s interchange income is
properly recognized over time under section 1272(a)(6)(C)(iii),
or whether interchange income is properly recognized at the time
the cardholders’ charge is settled under the respective
associations’ systems. In our prior Opinion, Capital One Fin.
Corp. v. Commissioner, supra at 150-151, we described in general
terms the OID rules and section 1272(a)(6)(C)(iii):
The holder of a debt instrument with OID generally
accrues and includes in gross income, as interest, the
OID over the life of the obligation, even though the
interest may not be received until the maturity of the
instrument. Sec. 1272(a)(1). The amount of OID with
respect to a debt instrument is the excess of the
stated redemption price at maturity (SRPM) over the
issue price of the debt instrument. Sec. 1273(a)(1).
The SRPM includes all amounts payable at maturity.
Sec. 1273(a)(2). In order to compute the amount of OID
and the portion of OID allocable to a period, the SRPM
and the time of maturity must be known. This presents
a problem for debts such as credit card loans and real
estate mortgages that may be satisfied over a very
short or a very long period, thus making the time of
maturity an unknown at the inception of the debt.
-34-
For this reason, special rules were created for
determining the amount of OID allocated to a period for
certain instruments that may be subject to prepayment.
In the case of (1) any regular interest in a real
estate mortgage investment conduit (REMIC), (2)
qualified mortgages held by a REMIC, or (3) any other
debt instrument if payments under the instrument may be
accelerated by reason of prepayments of other
obligations securing the instrument, the daily portions
of the OID on such debt instruments are determined by
taking into account an assumption regarding the
prepayment of principal for such instruments. Sec.
1272(a)(6)(C)(i) and (ii).
Section 1272(a)(6)(C)(iii) applies this special
OID rule to any pool of debt instruments the payments
on which may be accelerated by reason of prepayments.
It is clear that section 1272(a)(6)(C)(iii) was
intended to apply to credit card loans and the related
receivables. See H. Conf. Rept. 105-220, at 522
(1997), 1997-4 C.B. (Vol. 2) 1457, 1992. What was
unclear at the time of enactment and is still not fully
resolved is which credit card receivables increase OID
under section 1272(a)(6)(C) and which do not.
[Fn. ref. omitted.]
Respondent has conceded that as a general proposition cash
advance fees, overlimit fees, and late fees may be treated as
creating or increasing OID on the pool of loans to which such
income relates. See id. at 153-154.
B. The SRPM of a Credit Card Loan
The parties agree that the SRPM of a credit card loan is the
sum of all payments provided by the debt instrument other than
finance charges. See sec. 1.1273-1(b), Income Tax Regs. In the
example of a $100 purchase of goods or services from the
merchant, the SRPM is equal to $100 because the cardholder, if
-35-
she lived up to her agreement, would have paid at least $100 to
Capital One. The starting point for the SRPM is the total price
of the goods or services the cardholder purchases. The SRPM may
increase if the cardholder incurs a late fee or an overlimit fee,
but the SRPM is not increased by any finance charges, i.e.,
qualified stated interest,15 incurred.
C. The Issue Price of a Credit Card Loan
The parties dispute the calculation of the issue price of a
credit card loan. Section 1273(b)(2) defines the issue price of
an instrument issued for money and not publicly offered as “the
price paid by the first buyer of such debt instrument.” The
regulations expand on this definition:
if an issue consists of a single debt instrument that
is issued for money, the issue price of the debt
instrument is the amount paid for the debt instrument.
For example, in the case of a debt instrument
evidencing a loan to a natural person, the issue price
of the instrument is the amount loaned. * * *
Sec. 1.1273-2(a)(1), Income Tax Regs. If X Bank lends $1,000 to
A, an individual, the issue price of the loan would be $1,000.
However, a credit card loan is part of a multiparty
transaction where the funds lent are sent to the merchant via the
15
Qualified stated interest is defined as the “stated
interest that is unconditionally payable in cash or in property
(other than debt instruments of the issuer), or that will be
constructively received under section 451, at least annually at a
single fixed rate”. Sec. 1.1273-1(c)(1)(i), Income Tax Regs.
-36-
acquiring bank. The cardholder never receives the funds, and the
funds received by the merchant are always less than the amount
the cardholder must repay. The issue price of a credit card loan
is the price paid for the debt instrument.16 Sec. 1273(b)(2).
Petitioners argue that Capital One acquired the loan at a
discount from the price at which the cardholder purchased goods
or services from the merchant, with the discount being the amount
of interchange, i.e., $2 for a $100 purchase, where Capital One
actually advanced $98 to the acquiring bank. Respondent argues
that Capital One cannot have acquired the loan at a discount
because the acquiring bank, and not the cardholder, paid
interchange to Capital One during the net settlement process.
Further, respondent argues that interchange was a fee for
services rendered by the issuing bank, not economically
equivalent to interest, and therefore not OID.
1. Whether Interchange Is a Fee for a Service (and If So,
What Service) or Economically Equivalent to Interest
16
If the issue price was the “amount loaned”, see sec.
1.1273-2(a)(1), Income Tax Regs., the parties would still dispute
the amount loaned to the cardholder. Using the $100 purchase
example, the amount loaned could be $98 or $100, depending on
whether interchange is viewed as a fee for a service as
respondent contends or as a discount as petitioners contend. In
this way, determining the issue price by determining the “amount
loaned” would require the same analysis as determining the “price
paid” for the credit card loan, and our conclusion would be the
same.
-37-
Respondent argues that interchange is a fee for a service,
and that Capital One acquired a credit card loan for an amount
equal to the full price at which the cardholder purchased goods
or services from the merchant, but that Capital One
simultaneously received a payment from the acquiring bank equal
to the interchange amount. Thus in respondent’s view the issue
price paid by Capital One to acquire the loan would be the total
purchase price of the goods or services which would in turn equal
the SRPM resulting in no OID.
In determining whether interchange is a service fee or
economically equivalent to interest, we draw on other areas of
the tax law where distinctions between fees and interest have
been made. Courts, including this Court, have held that fees
earned by a lender relating to the lending of money are properly
treated as interest unless the fee is for a specific service.
Although courts look to all the facts and circumstances to
determine whether an item of income is a service fee or interest,
the primary inquiry is whether the charge compensates the lender
for specifically stated services it provided to and for the
benefit of the borrower beyond the lending of money. In W.
Credit Co. v. Commissioner, 38 T.C. 979, 980 (1962), affd. 325
F.2d 1022 (9th Cir. 1963), a lender in the business of making
small loans to individuals levied a “contract charge” and a
“carrying charge” on each loan. The contract charge was $10 if
-38-
the loan was $100 or less, and was the greater of $15 or 3
percent of the loan if the loan exceeded $100. Id. It was not
related to the duration of the loan and was not allocated to
specific services. Id. at 987. The carrying charge was 1
percent per month of the principal sum of the loan if the loan
was for $100 or more. Id. at 980. The lender also charged fees
for filing and recording chattel mortgages and life insurance
premiums on the borrower’s life. Id. The issue we faced was
whether the contract charge constituted interest. We held:
We do not think the mere fact that the contract
designates certain uses to which the funds will be put
makes the charge any less a fee paid by the borrower
for use of the lender’s money, unless it is shown that
the charge was actually used for such purposes and the
charge is justifiably a charge to the borrower separate
from interest. Unless such can be shown, we believe
the service charges made by small loan companies must
be considered interest because basically the nature of
the small loan company business is to make a profit in
the form of interest on money loaned and the borrower
is interested only in obtaining the loan and pays
whatever is required of him to get the use of the
lender’s money. * * *
Id. at 987-988; see Noteman v. Welch, 108 F.2d 206, 213 (1st Cir.
1939) (3-percent fee charged to all borrowers was interest
because the only consideration the borrower received was the use
of the money lent); Seaboard Loan & Sav. Association v.
Commissioner, 45 B.T.A. 510, 516 (1941) (service fees charged by
a loan company ostensibly for investigating, closing, and
servicing loans were interest because “all the services charged
for were for the benefit of the lender and not for the benefit of
-39-
the borrower, and the only consideration received for the amounts
paid by the borrower was the money loaned”).
On direct examination by respondent, MasterCard’s Steven
Jonas, the senior business leader for financial analysis with
MasterCard Worldwide,17 was asked whether interchange compensated
an issuing bank for a specific service. He testified:
I don’t think directly. I think the issuers are
providing a service to the cardholders, enabling them
to go out and transact. Not directly - I mean, to some
extent, the issuer does provide value to a merchant
because they now have enabled the cardholder to go out
and make purchases, and the acquirer makes money by
processing transactions. And the merchant makes money
by selling goods and services. But I think I view the
transaction, the service being provided is to the
cardholder who is borrowing money and, therefore, going
out and making purchases.
Similarly, when asked about his statement that “Interchange rates
are not a fee for any specific service provided by issuing
banks”, William Sheedy, the president of Visa, Inc.,18 explained:
We’re not looking at any particular service. We’re
considering the product in general, the premium credit
product. We want the issuers to invest in that
product, to choose to do business with Visa, as
compared to our competitors. And we also want the
product and rate structure to be configured in a way
that the issuers will prioritize that within their
business and market it and promote it and put resources
against it, because our experience is when that
happens, it grows our business.
17
Mr. Jonas was responsible for, among other things, the
development and implementation of MasterCard’s interchange rate
programs in the United States.
18
Mr. Sheedy had previously been employed as the executive
vice president of interchange strategy for Visa, U.S.A., Inc.
-40-
Respondent’s expert witness, Dr. Richard Schmalensee,19
testified that the service provided “is putting customers on the
streets with cards eager to use them to buy from merchants.”
Credit cards evidence a line of credit on which cardholders can
draw, and providing credit cards that can be used to make
purchases is the lending of money. Certainly the lending of
money benefits cardholders, merchants, and acquiring banks, but
the receipt of a benefit does not mean that those parties have
been provided a service other than the lending of money to the
cardholder.
In arguing that interchange is a fee for a service,
respondent focuses on the purpose of interchange, which is to
balance the two sides of the credit card business to encourage
the overall growth of the respective systems. If interchange
rates are set too high, acquiring bank and merchant participation
are disincentivized. If interchange is set too low, card issuing
is disincentivized. Respondent makes much of MasterCard’s and
Visa’s desire to use optimal interchange rates to increase their
business. However, using interchange to balance the two sides of
the credit card business is entirely consistent with petitioners’
19
Dr. Schmalensee is the Howard W. Johnson Professor of
Management and Economics at the Massachusetts Institute of
Technology and the John C. Head III Dean Emeritus of the
Massachusetts Institute of Technology Sloan School of Management.
He is the coauthor of two editions of Paying with Plastic (1999 &
2005), a text on the economics of payment card systems.
-41-
position that interchange compensates issuing banks for the cost
of lending money.
We agree that setting interchange rates is a balancing act,
but we ask: what are the associations balancing? MasterCard and
Visa balance the issuing banks’ and the acquiring banks’ needs to
profit on credit card transactions. Profit is the excess of
revenues over costs. When lending money to its cardholders,
Capital One incurs the cost of processing transactions, financial
carrying costs, and the risk costs associated with credit card
transactions, for example, the risk that fraud was committed
(fraud risk) and the risk that the cardholder will be unable to
repay the loan (credit risk). In short, interchange compensates
banks for the costs of lending money.
Respondent argues that interchange has little to do with the
costs of lending money, specifically the time value of Capital
One’s money lent to the cardholders. In respondent’s view if
interchange is not akin to interest, it must be a fee for a
service. Respondent’s argument presupposes that for interchange
to be treated as creating or increasing OID, it must be
economically equivalent to interest.
OID “serves the same function as stated interest * * *; it
is simply ‘compensation for the use or forbearance of money.’”
United States v. Midland-Ross Corp., 381 U.S. 54, 57 (1965)
(citations omitted). Under section 1273(a)(2) an amount payable
-42-
at the maturity of a debt instrument need not bear all the
characteristics of interest to be included in the SRPM, and thus
increase the amount of OID on the instrument. Section 1273(a)(2)
defines the SRPM as:
the amount fixed by the last modification of the
purchase agreement and includes interest and other
amounts payable at that time (other than any interest
based on a fixed rate, and payable unconditionally at
fixed periodic intervals of 1 year or less during the
entire term of the debt instrument). [Emphasis added.]
If Capital One acquired the loan for less than the SRPM, there
was OID on the transaction regardless of whether amounts included
in the SRPM and not included in the issue price were equivalent
to interest. Nevertheless, interchange resembles interest in
many ways.
For many transactors interchange would be the only revenue
Capital One receives.20 The length of Capital One’s loan to a
transactor may be as little as a day or two (if the cardholder
pays Capital One immediately upon making a charge) or as long as
60 days (if the cardholder makes a charge on the first day of the
billing cycle and pays the statement balance on the last day of
the grace period). Whether for 1 day or 60, Capital One has
forgone the use of those funds, and payments for such use
resemble interest. If interchange is not payment for the use of
20
The exception would be a cardholder who paid an annual fee
for the privilege of having a Capital One card or a cardholder
who incurred another fee such as an overlimit fee.
-43-
the funds Capital One has lent, then Capital One would not have
received compensation for the use of approximately half the funds
lent to its cardholders. With respect to transactors,
interchange compensates Capital One for the expenses and costs
associated with lending money to cardholders, including financial
carrying costs and credit and fraud risks.
MasterCard’s rules explain the relationship between
interchange fees and issuing banks’ costs of lending:
Purpose of Fees. The interchange fee * * * [is]
designed to compensate a member for particular expenses
that it incurs as the result of interchange
transactions. For sale transactions, various elements
of expense make up the interchange fee, including costs
of processing, costs of money, and increased risk due
to the use of MasterCard cards in interchange
transactions.
Respondent’s expert witness, Dr. Schmalensee, testified that
“[interchange is] a revenue stream that serves to compensate
banks for all the costs involved in credit card and other payment
card programs.”
In determining interchange rates, Visa and MasterCard
studied and considered issuing banks’ costs of lending. The
Edgar Dunn studies break down an issuing bank’s costs into three
of the largest categories: Risk costs, financial carrying costs,
and processing costs. Risk costs include credit and fraud risks.
The financial carrying costs are the “imputed interest cost to
the issuing member of carrying the interchange transactions from
-44-
the time of account posting to the receipt of funds or accruing
of cardholder interest by the issuing member.”
Petitioners’ expert witness, Dr. Peter Tufano,21 explained
that when interchange is viewed as an “economic” interest rate,
the average annualized rate is “similar to those of interest
rates for unsecured consumer loans during 1998 and 1999.” The
speed at which the cardholder loan is paid off can dramatically
affect this rate, returning seemingly exorbitant interest rates
of over 100 percent in situations where the cardholder pays the
loan off within a few days. However, very high interest rates
are not uncommon in numerous forms of unsecured consumer lending,
such as so-called payday loans where the effective interest rate
can be between 390 and 500 percent depending on when the loan is
repaid. That the effective interest rate varies depending on
when the cardholder pays off the loan does not affect the
function of interchange, which is to compensate issuing banks for
the cost of lending money.
Respondent also invites our attention to signature debit
cards, which involve little or no lending, just a “float” of at
21
Dr. Tufano is the Sylvan C. Coleman Professor of Financial
Management and Senior Associate Dean at Harvard Business School.
He has taught courses in finance, capital markets, financial
engineering, and consumer finance in the MBA and Executive
Programs at Harvard Business School.
-45-
most 1 or 2 days.22 Visa’s and MasterCard’s interchange rates for
signature debit cards were often identical to the interchange
rates for credit cards during the years at issue. Until 2002
interchange rates on debit card transactions were only slightly
lower than the rates on credit card transactions. Respondent
concludes that interchange is not equivalent to interest because
similar interchange rates were used for debit cards, which
involve little to no lending. Just as the associations
considered several factors in setting credit card interchange
rates, we assume they considered similar factors in setting debit
card interchange rates. The similarity between the rates during
the years at issue does not negate our conclusion that
interchange compensates Capital One for its costs of lending
money.
Revolvers, as opposed to transactors, pay finance charges
which are stated separately on the cardholder’s monthly
statements. Stated finance charges compensate Capital One for
the use of the money lent, and revolvers do not have the benefit
of a grace period during which they receive the use of funds
interest free. Dr. Tufano testified that, with respect to
revolvers, interchange is viewed as additional compensation for
the use of the money lent. Dr. Tufano analyzed the effective
22
Capital One did not issue signature debit cards during the
years at issue. See paragraph J.3., supra.
-46-
interests rate of interchange fees on a revolving account and
determined that, on average, interchange raises the annual
percentage rate by about 1.7 percent, which was still comparable
with other types of consumer loans.
Credit and fraud risks are also costs associated with
lending money. Interest, including OID, compensates lenders for
the time value of their money, the risk that the borrower may not
repay principal, and the expenses of pursuing delinquent debtors.
Noteman v. Welch, 108 F.2d at 212-213; Bank of Am. v. United
States, 230 Ct. Cl. 679, 680 F.2d 142, 148 (1982) (“interest
typically covers credit risk, credit administration, and cost of
funds.”).
Interchange resembles interest in other ways as well. In
almost all instances, it is expressed as a percentage of the
amount lent, usually with an additional nominal fee.23 Thus, as
the amount of the loan increases, the amount of interchange
increases, just as the amount of interest increases as the amount
of the loan increases. As we said in Fort Howard Corp. & Subs.
v. Commissioner, 103 T.C. 345, 374 (1994), modified on another
issue 107 T.C. 187 (1996): “Crucial in establishing whether a
particular payment constitutes interest is whether the payment
23
The nominal fee portion of interchange transactions is
usually between $.05 and $.10. In 1999 the average interchange
fee for a Visa credit card transaction was $1.62. Therefore, the
nominal fee accounted for between 3 and 6 percent of the total
fee.
-47-
bears some relationship to the amount borrowed”. See also Sharp
v. Commissioner, 75 T.C. 21, 32 (1980), affd. 689 F.2d 87 (6th
Cir. 1982); Lay v. Commissioner, 69 T.C. 421, 438 (1977).
Respondent argues that interchange rates were not driven by
movements in market interest rates. For example, between 1999
and 2004 the prime rate fell from 8 percent to 4 percent, yet
average interchange rates rose slightly, from 1.62 percent to
1.71 percent. Petitioners’ expert witness, David Boucher,
counters that certain interest rates are “sticky” in that they do
not often change, and that sticky interest rates are not uncommon
in consumer lending. For example, the interest rate for payday
loans has not changed in at least 10 years. Furthermore,
interchange rates take into account various other factors such as
credit and fraud risk, processing costs, and Visa’s and
MasterCard’s efforts to maximize their business by competing with
other payment systems and balancing the competing sides of the
credit card business.
That interchange did not cover all of Capital One’s costs of
lending does not make it less “interestlike”. Interchange rates
were not set by Capital One but were set by VISA and MasterCard
to increase their business, compete with other payment card
systems, and penetrate new markets. To continue issuing Visa and
MasterCard credit cards Capital One was required to accept those
rates. Whether interchange covered all of Capital One’s costs,
-48-
or covered just a small fraction of them for certain types of
credit card transactions is not dispositive of our determination
of whether interchange is a fee for a service or economically
equivalent to interest.24
We conclude that interchange is not a fee for any service
other than lending money to cardholders, income from which is
generally treated as interest. Petitioners have shown that
interchange fees are a form of interest compensating Capital One
for the costs of lending money.
2. Whether the Cardholder, the Merchant, or the Acquiring
Bank Pays Interchange
The parties present two competing views of a credit card
purchase transaction. Petitioners argue that Capital One
acquired the credit card receivable, i.e., the transaction
receipt, from the acquiring bank. This would suggest that
Capital One acquired the debt instrument at a discount.
Returning to the $100 purchase with 2-percent interchange
example, Capital One authorized the cardholder to make a $100
purchase, but Capital One did not authorize MasterCard or Visa to
withdraw $100 from its account. It authorized only a $98
withdrawal, the purchase price less interchange. Respondent
24
Petitioners argue that a credit card purchase transaction
is like a factoring transaction. However, the record is devoid
of any evidence that Capital One engaged in factoring; that is to
say, Capital One did not purchase debts owed to another, stepping
into the lender’s shoes, but is itself the lender ab initio.
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contends that Capital One lends the cardholder $100 for the
cardholder’s promise to pay $100, and that the acquiring bank
paid Capital One $2. In this scenario, $2 would be a fee for
services and not OID.
Neither the Code nor the regulations define the term “paid”,
but courts have generally defined it as the paying out of cash or
its equivalent. See United States v. Clardy, 612 F.2d 1139, 1151
(9th Cir. 1980) (“The classic definition of ‘paid’ * * * [in the
context of interest deductions under section 163(a)] is ‘a
payment (of) cash or its equivalent’.”). In a credit card
transaction cash flows as an initial matter from the issuing
bank, not to the issuing bank; therefore petitioners argue that
the cashflow from the issuing bank to the acquiring bank was the
amount paid for the debt instrument.
But the debate about who really bears the cost of
interchange is largely academic, and we need not, and do not,
base our decision on its outcome. Whether merchants, acquiring
banks, or cardholders ultimately pay interchange is not
determinative of the tax treatment of interchange. If we accept
respondent’s argument that acquiring banks pay interchange to
issuing banks, we would still conclude that interchange is
properly treated as creating or increasing OID on the pool of
loans to which it relates.
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Section 1.1273-2(g)(4), Income Tax Regs., provides:
If, as part of a lending transaction, a party other
than the borrower (the third party) makes a payment to
the lender, the payment is treated in appropriate
circumstances as made from the third party to the
borrower followed by a payment in the same amount from
the borrower to the lender and governed by the
provisions of paragraph (g)(2) of this section. * * *
Section 1.1273-2(g)(2)(i), Income Tax Regs., provides:
a payment from the borrower to the lender (other than a
payment for property or for services provided by the
lender, such as commitment fees or loan processing
costs) reduces the issue price of the debt instrument
evidencing the loan. * * *
Respondent argues that interchange is not a part of a
lending transaction because the purpose of interchange is to
balance the competing interests of the issuing and acquiring
banks. As discussed earlier interchange compensates issuing
banks for the costs of lending money, and but for the lending of
money, Capital One would not earn any interchange. In short,
interchange is part of a lending transaction.25
Under respondent’s theory, a third party, the acquiring
bank, pays interchange to the lender, Capital One. As discussed
above, that payment is not for property or services provided by
the lender other than the service of lending of money to the
25
At trial, Dr. Schmalensee, respondent’s expert, was asked:
“you would agree with me, wouldn’t you, Dr. Schmalensee, that
interchange in a Visa or MasterCard credit card transaction is
part of a lending transaction, isn’t that correct?” Dr.
Schmalensee replied: “It’s part of a lending transaction.”
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cardholder.26 Therefore, under section 1.1273-2(g)(4), Income Tax
Regs., that payment may, in appropriate circumstances, be treated
as a payment from the cardholder to the lender. The question is:
what are appropriate circumstances?
The regulations provide an example of a situation in which a
payment from a third party to a lender results in OID. Section
1.1273-2(g)(5), Example (3), Income Tax Regs., describes a
situation where a real property seller pays the buyer’s “points”
to facilitate the buyer’s loan to purchase property:
(i) Facts. A sells real property to B for
$500,000 in a transaction that is not a potentially
abusive situation (within the meaning of §1.1274-3). B
makes a cash down payment of $100,000 and borrows
$400,000 of the purchase price from a lender, L,
repayable in annual installments over a term of 15
years calling for interest at a rate of 9 percent,
compounded annually. As part of the transaction, A
makes a payment of $8,000 to L to facilitate the loan
to B.
(ii) * * * Under the provisions of paragraphs
(g)(2)(i) and (g)(4) of this section, B is treated as
having made an $8,000 payment directly to L and a
payment of only $492,000 to A for the property. * * *
The payment to L reduces the issue price of B’s debt
instrument to $392,000, resulting in $8,000 of OID
($400,000 - $392,000). * * *
26
Respondent argues that in exchange for paying interchange
merchants receive substantial services from Capital One including
protection from fraud and credit risk, the reduced costs of
handling cash, reduced employee costs, increased sales, and
access to new markets. Merchants certainly receive benefits from
consumers’ use of credit cards, but Capital One does not provide
merchants a service simply because merchants receive a benefit.
As discussed above, the service provided is the lending of money,
which benefits all the parties in a credit card purchase
transaction.
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A credit card loan is not a “potentially abusive situation”
under section 1.1274-3(a), Income Tax Regs. In this example the
seller pays the purchaser’s points in order to facilitate the
loan. Mr. Sheedy, Mr. Jonas, Dr. Schmalensee, and Dr. Tufano all
testified that interchange encourages issuing banks to lend money
to cardholders so that the cardholders can make purchases.
Under these circumstances, we conclude that even if
respondent is correct that the acquiring bank pays interchange to
the issuing bank, that amount is considered a payment between a
third party and a lender which reduces the issue price of the
debt instrument under section 1.1273-2(g)(2)(i) and (4), Income
Tax Regs.
D. Conclusion With Respect to the Interchange Issue
The SRPM of a credit card loan is the purchase price of the
goods and services financed by the loan. The issue price of a
credit card loan is the amount the issuing bank pays for the
loan. Because Capital One authorized MasterCard and Visa to
withdraw the purchase price less the applicable interchange
amount for every credit card purchase transaction, Capital One
paid an amount less than the SRPM for the credit card loan. The
difference between the SRPM and the issue price, the interchange
on the transaction, is therefore properly treated as OID.
-53-
Issue 2: The Calculation of OID Under Section 1272(a)(6)(C)
FINDINGS OF FACT
A. Accounting Methods
On August 5, 1997, Congress enacted the Taxpayer Relief Act
of 1997 (TRA), Pub. L. 105-34, sec. 1004, 111 Stat. 911, which
added section 1272(a)(6)(C)(iii) to the Code. On September 15,
1999, COB submitted Form 3115, Application for Change in
Accounting Method, by attaching it to petitioners’ consolidated
Federal income tax return for 1998. Capital One Fin. Corp. v.
Commissioner, 130 T.C. at 149. COB stated on the Form 3115:
Capital One Bank (COB), a domestic corporation,
requests permission under Section 12.02 of Rev. Proc.
98-60 to change its method of accounting for interest
and original issue discount that are subject to the
provisions of Section 1004 of the Tax Relief Act of
1997.
FSB did not submit Form 3115 to respondent requesting permission
to change its accounting method to conform to the requirements of
section 1272(a)(6)(C)(iii) and TRA section 1004.
Nevertheless, FSB as well as COB treated overlimit fees and
interchange as creating or increasing OID under section
1272(a)(6)(C)(iii) on petitioners’ consolidated 1998 and 1999
returns. To calculate the proper amount of OID includable on
their returns, COB and FSB used a complex formula developed by
the accounting firm KPMG (KPMG model). After discussing section
1272(a)(6) and the principles behind calculating OID under that
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section for a pool of loans, we will discuss the KPMG model in
detail.
B. Income and OID Accruals of Overlimit Fees and Interchange
The following chart shows the fees COB27 earned for book
purposes (when the fee was charged to the cardholder in the case
of overlimit fees and when the cardholder’s purchase was settled
by the associations in the case of fees for interchange), the
amount of COB’s related OID included on petitioners’ consolidated
income tax return, the difference between them, and the amount of
accrued but unrecognized OID carrying over to the following year.
Overlimit Fees
Overlimit Income
Fee Income Recognized Difference: Unamortized
Taxable for book per KPMG Book v. OID Bal. at
Year purposes Model KPMG Model End of Year
1995 $62,492,312 $21,823,631 $40,668,680 $40,668,681
1996 147,929,903 71,177,420 76,752,482 117,421,163
1997 288,906,382 192,694,592 96,211,790 213,632,953
1998 436,215,910 323,714,900 112,501,010 326,133,963
1999 539,618,976 488,702,655 50,916,321 377,050,283
27
We include data with respect to COB only because of our
holding, infra par. A, that FSB did not request permission to
change its method of accounting for overlimit fee and interchange
income and therefore may not treat such income as increasing or
creating OID.
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Interchange Fees
Income
Recognized Difference: Unamortized
Taxable Interchange per KPMG Book v. OID Bal. at
Year Book Income Model KPMG Model End of Year
1995 $76,425,718 $26,786,819 $49,638,899 $49,638,899
1996 97,892,344 68,308,342 29,584,002 79,222,901
1997 109,487,559 94,175,860 15,311,699 94,534,599
1998 168,336,313 126,972,006 41,364,307 135,898,906
1999 298,347,199 223,016,501 75,330,698 211,229,604
OPINION
A. Accounting Methods
In 1997 Congress added section 1272(a)(6)(C)(iii) to allow
taxpayers to change their method of accounting to accrue original
issue discount on a pool of credit card receivables. TRA sec.
1004. Rev. Proc. 98-60, app. sec. 12, 1998-2 C.B. 759, 786,
provided procedures by which taxpayers could receive “automatic
consent” to change their method of accounting for pools of credit
card receivables in accordance with section 1272(a)(6)(C). Under
the revenue procedure, automatic consent was achieved by filing
Form 3115 with a taxpayer’s return. Id. sec. 6.02, app. sec. 12,
1998-2 C.B. at 765, 786.
Our previous Opinion addressed the parties’ cross-motions
for partial summary judgment on the issue of whether COB and FSB
were permitted to change their treatment of 1998 and 1999 late-
fee income to the method called for by section
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1272(a)(6)(C)(iii). We held that COB, which submitted Form 3115
but did not change its method of accounting for late fees in 1998
or 1999, and FSB, which did not submit Form 3115 or change its
method of accounting for late fees, could not retroactively
change their methods of accounting for late fees under section
446(e). Capital One Fin. Corp. v. Commissioner, supra at 156-
170.
Respondent argues that because FSB did not submit Form 3115
in 1998 or 1999, requesting to change its method of accounting
for interchange or overlimit fees, it may not now treat those
fees as creating or increasing OID under section
1272(a)(6)(C)(iii). As we stated in our prior Opinion:
In the light of the purposes for requiring
notification to the Commissioner of a taxpayer’s change
in method of accounting, the Court holds that
petitioners were required to follow all applicable
procedures put in place by respondent in order to
receive consent to change their method of accounting
to comply with section 1272(a)(6)(C)(iii). See Rev.
Proc. 98-60, 1998-2 C.B. 759. Failure to follow those
procedures would negate automatic consent to the
proposed change.
Capital One Fin. Corp. v. Commissioner, supra at 158. FSB did
not follow the applicable procedures to receive consent to change
its method of accounting. Therefore, it may not treat its
relevant credit card receivables as creating or increasing OID
under section 1272(a)(6)(C)(iii) in 1998 or 1999.
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B. The Standard of Review
No specific precedent articulates the standard to apply in
determining whether a taxpayer’s assumptions used to calculate
the proper amount of OID included in gross income in a given year
are proper. Although section 1.1272-1(b)(1)(ii) and (4)(iii),
Income Tax Regs., provides reasonableness standards for computing
the length of accrual periods and the amount of OID allocable to
the initial accrual periods, section 1.1272-1(b)(2)(i), Income
Tax Regs., provides that paragraph (b)(1) does not apply to debt
instruments subject to section 1272(a)(6). However, section
1.671-5(g)(1)(iv)(A)(2), Income Tax Regs., provides that in
calculating OID under section 1272(a)(6)(C), the trustee of a
widely held mortgage trust in certain circumstances “may use any
reasonable prepayment assumption to calculate OID”.28
Section 1272(a)(6)(B)(iii) requires taxpayers to use a
prepayment assumption as prescribed by regulations. No such
regulations have been issued. The models developed by KPMG and
by respondent’s expert call for the use of estimates. Under
these circumstances, COB’s assumptions and calculations used to
determine the amount of OID included in its gross income will be
respected so long as the assumptions and calculations are
28
The regulation provides trustees of widely held mortgage
trusts a safe harbor for reporting OID before the issuance of
final regulations under sec. 1272(a)(6)(C)(iii). No final
regulations have been issued.
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reasonable. Petitioners and respondent, in their briefs, agree
that a reasonableness standard is appropriate. However, the KPMG
model may not run afoul of the statutory scheme for calculating
the accrual of OID in general nor run afoul of section 1272(a)(6)
in particular.
Respondent also notes his authority to require a certain
method of tax accounting when the taxpayer’s method of accounting
fails to reflect the taxpayer’s income clearly. Thor Power Tool
Co. v. Commissioner, 439 U.S. 522, 532 (1979); Commissioner v.
Hansen, 360 U.S. 446, 467 (1959); see also sec. 1.446-1(a)(2),
Income Tax Regs. Section 446 provides in part:
SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.
(a) General Rule.--Taxable income shall be
computed under the method of accounting on the basis of
which the taxpayer regularly computes his income in
keeping his books.
(b) Exceptions.--If no method of accounting has
been regularly used by the taxpayer, or if the method
used does not clearly reflect income, the computation
of taxable income shall be made under such method as,
in the opinion of the Secretary, does clearly reflect
income.
We generally give deference to the Commissioner’s determination
that a taxpayer’s method of accounting does not clearly reflect
income. However, if a taxpayer uses a method of accounting which
clearly reflects income, the Commissioner is not authorized to
adjust a taxpayer’s method of accounting to a method that may
more clearly reflect income.
-59-
Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371
(1995); Bay States Gas Co. v. Commissioner, 75 T.C. 410, 422
(1980), affd. 689 F.2d 1 (1st Cir. 1982); Garth v. Commissioner,
56 T.C. 610, 623 (1971).
Where a taxpayer is required to use assumptions and
estimates to compute the accrual of OID, a reasonableness
standard is appropriate. Further, a reasonable method of
calculating the accrual of OID under section 1272(a)(6)(C)(iii)
will generally clearly reflect income within the meaning of
section 446.
As described below, we find that in some respects the KPMG
model does not comply with the OID rules and regulations. The
methods used for calculating the accrual of OID must comply with
those rules and regulations.
C. Section 1272(a)(6)(C)
In the case of (1) any regular interest in a real estate
mortgage investment conduit (REMIC), (2) qualified mortgages held
by a REMIC, or (3) any other debt instrument if payments under
the instrument may be accelerated by reason of prepayments of
other obligations securing the instrument, the daily portion of
the OID on such debt instruments is determined by taking into
account an assumption regarding the prepayment of such
instruments. Sec. 1272(a)(6).
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Section 1272(a)(6)(A) provides:
(A) In general.--In the case of any debt
instrument to which this paragraph applies, the daily
portion of the original issue discount shall be
determined by allocating to each day in any accrual
period its ratable portion of the excess (if any) of--
(i) the sum of (I) the present value
determined under subparagraph (B) of all remaining
payments under the debt instrument as of the close
of such period, and (II) the payments during the
accrual period of amounts included in the stated
redemption price of the debt instrument, over
(ii) the adjusted issue price of such debt
instrument at the beginning of such period.
The computation is represented by the following mathematical
equation: OIDn = [Cashflown + AIPn] - AIPn-1.
Where: OIDn = OID for the period.
Cashflown = amounts included in the SRPM received in the
current accrual period.
AIPn = present value of all remaining payments as of the
end of the period or adjusted issue price at the end of
the period.
AIPn-1 = adjusted issue price at the beginning of the
period.
Section 1272(a)(6)(A) requires COB to compute the present
value of all payments remaining to be made on its pool of credit
card receivables at the end of the accrual period. Section
1272(a)(6)(B) provides guidance with respect to determining the
present value:
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(B) Determination of present value.--For purposes
of subparagraph (A), the present value shall be
determined on the basis of--
(i) the original yield to maturity
(determined on the basis of compounding at the
close of each accrual period and properly adjusted
for the length of the accrual period),
(ii) events which have occurred before the
close of the accrual period, and
(iii) a prepayment assumption determined in
the manner prescribed by regulations.
No regulations have been promulgated with respect to the
prepayment assumption that must be made in valuing credit card
receivables. The legislative history of the TRA provides some
guidance as to how taxpayers are to calculate OID on a pool of
credit card receivables:
if a taxpayer holds a pool of credit card receivables
that require interest to be paid if the borrowers do
not pay their accounts by a specified date, the
taxpayer would be required to accrue interest or OID on
such a pool based on a reasonable assumption regarding
the timing of the payments of the accounts in the
pool. * * *
H. Conf. Rept. 105-220, at 522 (1997), 1997-4 C.B. (Vol.2)
1457, 1992.
The “timing of the payments of the accounts in the pool” is
critical because the present value of a future payment decreases
as the payment date becomes more distant, hence the adage “a
dollar today is worth more than a dollar in the future.” For
example, assuming a 10-percent interest rate, the present value
of $100 to be received in 1 year is $90.91. The present value of
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$100 to be received in 2 years is $82.65, and so forth. The
present value of a payment to be received in the future is
represented by the following formula:
Present Value = Future Value
(1 + R)n
Where: n = the number of periods until the payment is received.
R = interest rate.
D. The KPMG Model
1. The Payment Rate or Prepayment Assumption
With respect to credit card loans, there is no fixed date by
which a loan needs to be paid off. Therefore, a prepayment
assumption under section 1272(a)(6)(B)(iii) is simply a payment
rate. There is a direct correlation between the payment rate and
the amount of OID to be recognized. The higher the payment rate,
the more quickly COB recognizes OID; the lower the payment rate,
the more slowly COB recognizes OID. The KPMG model assumes that
the actual cash collected during each period is the best evidence
of the expected future payment rate.
Under the KPMG model, the payment rate is a fraction where
the numerator is cash collections net of finance charges and the
denominator is the beginning credit card receivable balance plus
that month’s new additions (excluding finance charges). For
purposes of computing OID, COB treats stated finance charges as
“stated interest” and recognizes such interest as income
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currently as it is billed to the cardholder. Therefore stated
finance charges are not included in either the numerator or the
denominator of the payment rate.29 The payment rate is calculated
using the following formula:
Payments - Stated Finance Charges
Outstanding Balance + New Additions
The KPMG model uses a constant monthly payment rate. For
example, on a $100 debt with a 10-percent payment rate, after 1
month the outstanding debt will be $90, after 2 months it will be
$81, after 3 months it will be $72.90, and so forth. In this way
the payments continue forever with the debt becoming
infinitesimally small. Assuming a 10-percent payment rate, 72
percent of the balance will be paid in 12 months, 92 percent in
24 months, and 98 percent in 36 months.
From 1995 to 1999 the payment rate for COB’s pool of credit
card receivables was calculated under the KPMG model to be an
average of 8.91 percent.
29
Although they dispute the manner in which it should be
done, the parties agree that stated finance charges are stated
interest and should be excluded from the payment rate
calculation.
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COB’S MONTHLY AND AVERAGE PAYMENT RATES
1 2 3 4 5 6 7 8 9 10 11 12 AVG
1995 9.07 9.05 9.73 8.03 8.67 8.35 8.46 8.02 7.21 8.90 8.47 7.66 8.47
1996 9.43 9.51 9.36 9.26 8.34 7.75 8.65 7.58 7.66 7.96 7.34 7.62 8.37
1997 8.16 8.23 8.82 8.01 8.77 8.92 8.59 8.00 8.20 8.58 8.22 8.53 8.42
1998 8.97 8.64 10.02 9.13 8.85 8.92 8.71 9.00 8.35 9.55 8.80 8.30 8.94
1999 8.85 9.39 11.01 9.94 10.72 9.87 10.70 10.54 10.77 10.98 10.68 10.70 10.35
8.91
The payment rate is critical to the calculation of OID
because it is used to calculate the weighted average maturity
(WAM) and the yield to maturity (YTM), both of which enter into
the calculation of the present value of future expected payments.
2. The Weighted Average Maturity
In the KPMG model the WAM is the inverse of the payment rate
and is expressed in months. For example, the WAM of a pool of
debt instruments with an expected payment rate of 10 percent is
10 months (1 divided by .1 = 10). If the payment rate is 20
percent, the WAM is 5 months (1 divided by .2 = 5).
The calculation of the WAM is a simplifying assumption in
the present value calculations. In reality some cardholders make
payments on their loan earlier and some later. The WAM is a
mathematical assumption of a single point at which on average all
cardholders will pay off their debt.
Rather than calculating the present value of each of a
series of unequal periodic payments of the pool every month, the
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KPMG model simplifies the process by using the WAM to limit the
calculation to the present value of one payment (equal to the
relevant balance of the entire pool) at the WAM. Specifically,
the WAM is the number of periods, or “n” in the present value
formula used in the KPMG model.
Present Value = Future Value or Future Value
(1 + R)n (1 + R)WAM
From 1995 to 1999 the WAM of COB’s pool of credit card
receivables was calculated to be on average 11.35 months and the
average WAM for 1998 and 1999 was 10.46 months.
Monthly and Average WAM
1 2 3 4 5 6 7 8 9 10 11 12 AVG
1995 11.02 11.05 10.28 12.45 11.54 11.98 11.82 12.47 13.87 11.24 11.81 13.06 11.88
1996 10.61 10.51 10.68 10.80 11.99 12.90 11.56 13.20 13.05 12.56 13.63 13.12 12.05
1997 12.25 12.14 11.34 12.48 11.40 11.21 11.64 12.50 12.20 11.65 12.17 11.72 11.89
1998 11.15 11.58 9.98 10.96 11.29 11.21 11.48 11.12 11.98 10.48 11.36 12.05 11.22
1999 11.29 10.65 9.08 10.06 9.33 10.13 9.34 9.49 9.29 9.11 9.36 9.34 9.71
11.35
3. The Yield to Maturity
In the KPMG model, the YTM is calculated using a formula in
a Microsoft Excel worksheet to derive the interest rate at which
the sum of the net present values of all of the future payments
is equal to the issue price of the debt pool. The issue price is
the amount of cash advanced by COB as the issuing bank to acquire
the debt. Specifically, the YTM is calculated using the RATE
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function in Excel, which is expressed as follows: RATE = (Nper,
Pmt, PV, FV).
In this formula: (1) Nper is the total number of payment
periods for the loan and Nper is equal to the WAM; (2) Pmt is the
payment made each period and Pmt equals zero for purposes of this
calculation (there are no monthly payments assumed but rather the
entire SRPM (FV)) is considered collected at the WAM; (3) PV is
the present value, the total amount that a series of future
payments is worth at that point and PV equals Beginning Issue
Price (including new additions)/SRPM (including new additions);
and (4) FV is the future value, or a cash balance you wish to
attain after the last payment is made and FV equals 1.
Calculating the YTM assuming payment of the SRPM at the WAM
is the mathematical equivalent of any combination of prepayment
assumptions that pays off the SRPM over various other periods
with the same WAM.
With a YTM and a WAM, the KPMG model then calculates the
present value of the future payment stream.
4. OID Accrual
Having determined a payment rate, a WAM, and a YTM, the KPMG
model then uses a beginning issue price, an ending issue price,
and principal payments for every month, which are derived from
COB’s financial accounting reports. The beginning issue price is
the issue price of the pool at the beginning of the month (the
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SRPM less OID accrued for prior periods) plus new additions
during the month (new principal). The ending issue price is the
present value of the future cashflow. The principal payments are
the actual principal payments received during the month. The
KPMG model then determines the unadjusted OID accrual for a given
month using the formula: OIDn = [Cash flown + AIPn] - AIPn-1.
5. An Adjustment for Writeoffs
The KPMG model incorporates a section 166 Schedule M-1
adjustment for book/tax basis differences in receivables written
off by recognizing an additional and proportional amount of
income to offset the portion of the writeoff expense that had not
been previously accrued in income.
6. The Mid-Month Convention
The KPMG model assumes that all charges or lending
transactions creating the monthly pool occur on the 15th of the
month. The model therefore allocates fourteen-thirtieths of the
OID for each monthly period to the calendar month of the
calculation and sixteen-thirtieths to the following calendar
month.
7. The KPMG Model Table
The following chart shows the KPMG model’s calculations of
OID for overlimit fees for the first 3 months of 1999.30
30
Figures are taken directly from Exhibit 11-J and have not
been adjusted for mathematical errors.
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KPMG/Rolling Balance OID Calculator
Capital One Financial Corporation (COB)
1999 - Overlimit Fees
Credit Card Fee Pool for Month 1 2 3
OID Created:
(A) Unamortized OID At Beginning of Period (overlimit 311,048,903 325,983,582 331,054,419
fees)
(B) Total New Additions of OID (overlimit fees) 48,238,609 41,029,513 43,915,549
(C) Total OID Before Current Month Amortization 359,287,512 367,013,095 374,969,968
(A+B)
SRPM
(D) SRPM At Beginning of Month 15,572,919,690 15,602,686,253 15,243,211,562
(E) Monthly Principal Addition 1,545,483,606 1,220,461,154 1,844,061,105
(F) Total SRPM After New Addition (D+E) 17,118,403,196 16,823,147,407 17,087,272,667
(G) Total SRPM at End of Month (F-I) 15,602,686,253 15,243,211,562 15,205,183,121
Adjusted Issue Price
(H) Beginning Issue Price (Incl. New Addition (F-C)) 16,759,115,684 16,456,134,312 16,712,302,699
Constant Yield (Monthly) 0.1879921% 0.2073659% 0.2446986%
(I) Principal Payment 1,515,716,943 1,579,935,845 1,882,089,546
(J) Ending Issue Price (PV of Future Cash Flow) 15,275,211,181 14,910,666,283 14,871,514,481
Reversal of Unamortized OID On Write Offs
(K) Ending Issue Price /SRPM (J/G) 97.90% 97.82% 97.81%
(L) Basis Adjustment Percentage (I-K) 2.10% 2.18% 2.19%
(M) Gross Write Offs 71,062,684 68,338,064 76,530,491
(N) Reversal of Unamortized OID on Write Offs (Basis 1,491,490 1,490,860 1,679,416
Adjustment)
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1 2 3
OID Amortization
(O) OID Amortization (I+J-H) 31,812,440 34,467,816 41,301,328
(P) Reversal of Unamortized OID on Write Offs (Basis 1,491,490 1,490,860 1,679,416
Adjustment)
(Q) Unamortized OID at Ent of Period (C-O-P) 325,983,582 331,054,419 331,989,224
OID Amortization on Calendar Month Basis
(R) Prior Period OID Recognized in Current Calendar 15,085,059 16,966,634 18,382,835
Month
(S) Current Period OID to be Recognized in Next Calendar 16,966,634 18,382,835 22,027,375
Month
(T) Adjusted OID Amor. for Calendar Month (O+R-S) 29,930,865 33,051,615 37,656,788
(U) Unamortized OID at End of Calendar Month (Q+S) 342,950,217 349,437,254 354,016,599
(V) Tax Adj. Inc. Recognized Per Calendar Month (T+P) 31,422,355 34,542,475 39,336,204
E. Respondent’s Arguments With Respect to the KPMG Model
Respondent argues that the results produced by the KPMG
model are unreasonable and do not clearly reflect COB’s income.
Respondent raises a number of specific issues with respect to the
KPMG model and proposes corrections and adjustments which
respondent argues are necessary for COB’s income to be clearly
reflected.
1. The Monthly Retirement and Reissuance of the Pooled
Debt Instrument
Respondent argues that the formulas and concepts originally
used for accruing OID on REMICs should apply in some reasonable
fashion to accruals of OID on a pool of revolving credit card
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debt. A REMIC is a fixed pool of mortgages that pays down as the
underlying mortgages are themselves paid down. OID accruals with
respect to a REMIC are typically computed according to the speed
at which the REMIC’s entire pool of mortgages pays down over
time. See sec. 1272(a)(6)(A) and (B). Unlike a REMIC, COB’s
credit card loan pool is dynamic, with cardholders making
payments and incurring new principal additions each month, and
with some cardholder accounts terminating as others enter the
pool.
Respondent concedes that COB’s revolving pool of credit card
loans does not fit comfortably into the fixed-pool REMIC model.
Respondent also concedes that the KPMG model seeks to apply
fixed-pool accounting to a dynamic pool of credit card loans by
using a 1-month instrument that is retired and reissued, referred
to as the “rolling balance” method. However, respondent argues
that “this notion of a ‘retired’ and ‘reissued’ debt is the
antithesis of a fixed pool of self-amortizing debt like that of a
REMIC.” Petitioners find themselves in a difficult situation.
Under respondent’s theory, COB should use the fixed-pool
accounting rules applicable to REMICs. However, COB’s pool of
loans is not fixed. To try to apply fixed-pool accounting to the
dynamic pool of credit card loans, COB uses a 1-month fixed pool
that is retired and reissued at the end of each month.
Respondent argues that this method is unreasonable.
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We ask two questions. First, what authority did COB rely
upon when adopting the retired and reissued approach? Second,
what alternative does respondent suggest?
a. COB’s Reasons for Adopting the “Retired and
Reissued” Approach
To solve the problem of how to apply fixed-pool accounting
to a dynamic pool of loans, Dennis Nelson, the KPMG partner
responsible for developing the KPMG model, looked to the OID
regulations to determine how OID is calculated when a debt
instrument is modified or there is a change in circumstance.
Section 1.1272-1(c), Income Tax Regs., provides rules to
determine the yield and maturity of certain debt instruments that
provide for an alternative payment schedule applicable upon the
occurrence of a contingency. “If a contingency * * * actually
occurs or does not occur, contrary to the assumption made * * *
[by the taxpayer] then * * * the debt instrument is treated as
retired and then reissued on the date of the change in
circumstances for an amount equal to its adjusted issue price on
that date.” Sec. 1.1272-1(c)(6), Income Tax Regs. Section
1.1275-2(h), Income Tax Regs., provides rules for debt
instruments subject to remote and incidental contingencies. If a
change in circumstance occurs, “the debt instrument is treated as
retired and then reissued on the date of the change in
circumstances for an amount equal to the instrument’s adjusted
issue price on that date.” Sec. 1.1275-2(h)(6)(ii), Income Tax
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Regs. Similarly, section 1.1275-2(j), Income Tax Regs., provides
that
If the terms of a debt instrument are modified to defer
one or more payments, and the modification does not
cause an exchange under section 1001, then, solely for
purposes of sections 1272 and 1273, the debt instrument
is treated as retired and then reissued on the date of
the modification for an amount equal to the
instrument’s adjusted issue price on that date. * * *
None of the above-quoted regulations apply directly to a
pool of credit card loans. In fact, none of the OID regulations
apply directly to the issue at hand. However, petitioners argue
that these regulations provide an apt analogy, and we agree.
A pool of credit card loans, the debt instrument, is
constantly modified as cardholders make principal payments,
charge additional purchases, transfer balances, and incur various
types of fees, many of which are contingent and cannot be
anticipated at the time the loan is made. The retirement of a
debt instrument under the regulations generally results in no
gain or loss but requires the rolling of unamortized OID into a
newly issued debt instrument to be taken into account over the
new debt instrument’s anticipated life.
b. Respondent’s Alternative to the “Retired and
Reissued” Approach
There are significant practical difficulties in developing a
model without the retired and reissued approach, in other words a
model with static pools. Mr. Nelson testified:
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in the end, it was an absolute nightmare. They
couldn’t reconcile the results. They didn’t know how
to allocate the payments. Because in the end, it all
came down to what payments should we assign to these
static pools that we created. And they didn’t have a
good way of being able to assign that. Their results
were totally dependent on how to assume the payments
were spread among these static pools. So they created
mountains of work for the client and ourselves.
Respondent maintains that the most accurate way to calculate
OID would be cardholder by cardholder, but concedes that the
sheer number of cardholders would make such calculations
burdensome. More importantly, section 1272(a)(6)(C)(iii) applies
the OID rules to a pool of loans, and there is no authority
suggesting that COB was required to calculate OID individually
for each of its millions of cardholders.
Under the KPMG model an accrual of a single item of OID can
extend beyond the underlying indebtedness to which the OID
relates because the KPMG model applies payments proportionally
across all outstanding debt. Respondent argues that COB must
track or trace its cardholder accounts on a first-in, first-out
(FIFO) basis so as to match the OID earned with the particular
loan transaction that gives rise to the OID. Respondent
describes the difference between the parties’ positions:
Petitioners contend that the credit card fees
attributable to specific cardholder accounts and
accrual periods should be treated, instead, as OID
arising in the aggregate on the constantly changing
balance of that pool. Petitioners are not troubled by
the prospect that, under the KPMG model, a cardholder
could close his account and transfer his balance to
another lender, yet leave unamortized OID on
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petitioners’ books. Nor are petitioners troubled by
the fact that, under the KPMG model, cardholders can
transfer balances to petitioner from other lenders as
to which no OID exists, even though such transactions,
when commingled with petitioners’ cardholder loans on
which there is OID, will dramatically slow the rate at
which OID is accrued on those older accounts and
balances that do not have OID.
Respondent demonstrates the problem by providing an
illustration of a single cardholder who makes a $600 purchase and
incurs a $40 overlimit fee in month 1, then makes principal
payments and charges new purchases in the following months.
Month 1 2 3 4 5 6 7 8
Balance 0 640 600 600 600 600 600 600
Purchases 600 56 90 90 90 90 90 90
Overlimit 40
Total with 640 696 690 690 690 690 690 690
New Charges
Payments 96 90 90 90 90 90 94
Payment 0% 15% 15% 15% 15% 15% 15% 15.67%
Rate
Amortized 0 6 5.10 4.34 3.68 3.13 2.66 2.36
OID
Unamortized 40 34 28.90 24.57 20.88 17.75 15.09 12.72
OID
Respondent argues that because the cardholder paid a total
of $640 (the amount of the original loan plus the overlimit fee)
COB should recognize the entire fee. The effect is to suggest
that a payment rate of 15 percent translates into an actual
liquidation of the debt in 8 months. Essentially, respondent
contends that each payment should go toward the oldest debt first
and any OID related to that debt. Respondent has no authority
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for this position other than his argument that a FIFO method
would clearly reflect COB’s income.
Petitioners argue that using a constant payment rate of 15
percent, the cardholder will still have $241 remaining on the
original debt, or 32 percent of the original debt, and 32 percent
of the OID will remain unamortized.
Month 1 2 3 4 5 6 7 8
Balance 0 640 544 462 393 334 283 241
Purchases 600
Overlimit 40
Total With 640 640 544 462.40 393.04 334.08 283.97 241.38
New Charges
Payments 96 81.60 69.36 58.96 50.11 42.60 36.21
Payment 0% 15% 15% 15% 15% 15% 15%
Rate
Amortized 0 6 5.10 4.34 3.68 3.13 2.66 2.26
OID
Unamortized 40 34 28.90 24.57 20.88 17.75 15.09 12.82
OID
Petitioners argue that the KPMG model is thus proportional in
that the cardholder recognizes OID at the same rate as the
original debt is repaid.
The KPMG model accrues OID on the basis of the actual
payment rates of COB’s cardholders. If COB’s cardholders
actually pay off their debts as quickly as the following
hypothetical suggests, COB would recognize OID more quickly.
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Month 1 2 3 4 5 6 7 8
Balance 0 640 544 454 364 274 184 94
Purchases 600
Overlimit 40
Total With 640 640 544 454 364 274 184 94
New Charges
Payments 96 90 90 90 90 90 94
Payment 0% 15% 16.54% 19.82% 24.73% 32.85% 48.91% 100%
Rate
Amortized 0 6 5.63 5.63 5.63 5.63 5.63 5.85
OID
Unamortized 40 34 28.38 22.75 17.13 11.50 5.88 0
OID
COB’s cardholders, on a pooled basis, do not pay off their
debts at anywhere near the rates suggested by the hypothetical.
Further, COB’s cardholders do not pay off a fixed amount of
principal each month on their existing debt because they add new
purchases every month and some portion of the payments may apply to
the new debt.
This is a fundamental difference between the parties.
Respondent views COB’s pool of debt as made up of hundreds of
millions of loans made to millions of cardholders. Petitioners
view the pool as a single debt instrument. Dr. Hakala,
respondent’s expert, and respondent assume that cardholders pay off
a constant amount on their credit card debt in the same way that a
debtor pays off a fixed debt. Respondent and Dr. Hakala assert that
a group of fixed pools may be more appropriate and would clearly
reflect income. However, Dr. Hakala’s models do not use fixed
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pools. Rather, Dr. Hakala uses a FIFO method,31 and there are
significant problems with it.
The FIFO method amortizes OID in a straight line to the WAM so
that all OID is accrued by the WAM. This rapidly accelerates the
accrual of OID because an adjusted WAM is required. Dr. Hakala
reweighted the WAMs according to the relative duration of each
month’s balance of unamortized OID in the collective pool of
unamortized OID. Dr. Hakala’s adjustment is designed to match OID
accruals to the actual liquidation of the pertinent debt. However,
he ignores the fact that some cardholders actually make principal
payments after the WAM. Most importantly, Dr. Hakala’s FIFO
adjustment abandons the section 1272(a)(6) formula: OIDn = [Cash
flown + AIPn] - AIPn-1. Dr. Hakala calculates the OID simply by
multiplying the beginning issue price (including new additions) by
the YTM.
Respondent argues that Dr. Hakala’s formula for computing OID
is a close approximation of the section 1272(a)(6) formula. That
may be true; however, Congress provided the section 1272(a)(6)
formula, and we cannot require COB to use some other formula no
matter how similar to the formula provided in the Code.
Furthermore, we cannot find a taxpayer’s method of accounting which
31
Petitioners argue that Dr. Hakala’s method is not actually
a FIFO method. As we find Dr. Hakala’s method unreasonable and
at odds with sec. 1272(a)(6), we need not address petitioners’
arguments on this point.
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follows a formula provided by Congress to be unreasonable because a
different formula may more clearly reflect the taxpayer’s income.
We conclude that COB’s use of a retired and reissued debt
instrument, as provided for in the regulations under similar
circumstances, is a reasonable method of implementing the formula
provided in section 1272(a)(6) given the inherent difficulties in
applying fixed-pool accounting to a dynamic pool of loans.
Furthermore, respondent’s adjustments to this aspect of the KPMG
model are unreasonable and at odds with section 1272(a)(6).
2. The Inclusion of New Additions in the Beginning Issue
Price
The KPMG model uses a beginning issue price which includes
new cardholder purchases and other charges (additions in the
parlance of the KPMG model). The name given to this figure by
KPMG is descriptive: “Beginning issue price (including new
additions)”. This figure is derived by subtracting the sum of the
carryover balance of unamortized OID and the current month’s fee
to be treated as OID from “Total SRPM After New Additions”, which
is the SRPM at the beginning of the accrual period plus new
additions.32 Respondent argues that the use of a beginning issue
price that includes new additions results in an incorrect
determination of OID accruals.
32
The difference between the AIPbeg figure respondent
contends must be used and the AIPbeg figure used by the KPMG
model is the present value of the current month’s aggregate new
cardholder purchases and charges.
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Section 1272(a)(4) provides:
(4) Adjusted issue price.--For purposes of this
subsection, the adjusted issue price of any debt
instrument at the beginning of any accrual period is
the sum of--
(A) the issue price of such debt instrument,
plus
(B) the adjustments under this subsection to
such issue price for all periods before the first
day of such accrual period.
The parties agree that the additions that occur after the start of
the accrual period cannot be included in the AIPbeg figure under
section 1272(a)(4)(B). However, petitioners argue that new
additions are included under section 1272(a)(4)(A):
Respondent, however, fails to take into account the
“retired and reissued” approach described above.
Applying the concept of a monthly pool that is deemed
to be retired and reissued at its adjusted issue price,
the result is a monthly rolling pool with the issue
price of the new pool each month equal to the adjusted
issue price of the prior month-end, increased for the
issue price of new loans to cardholders in the pool
prior to the assumed reissue date. In essence, the
clock is “reset” to the beginning of the period every
month. Therefore, the issue price of the newly
reissued debt under section 1272(a)(4)(A) (not section
1272(a)(4)(B)) must include the Additions. Similarly,
the SRPM is equal to the SRPM at the prior month-end,
increased by net new additions to cardholder accounts
in the pool.
The regulations petitioners cite as authority for the use of
a retired and reissued instrument suggest that new additions
should not be included retroactively in the AIPbeg figure. For
example, section 1.1272-1(c)(6), Income Tax Regs., provides that
the debt instrument is treated as retired and reissued on the
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date of the change in circumstances. In the case of a pool of
credit card loans, the KPMG model retires and reissues the debt
instrument on the first day of every month. So on January 1,
1999, the pool of debt instruments is retired, and the debt
instrument is reissued for the issue price on that date.
Unamortized OID is rolled over to the next period (January), and
the debt instrument is then retired and reissued on February 1,
1999. The regulations do not provide that at the end of the
period, for example January 31, the taxpayer should look backward
and recompute the January 1 issue price on the basis of events
that occurred during January.
However, we must acknowledge the differences between a pool
of debt instruments and the types of debt instruments assumed for
purposes of the regulations. COB’s pool of credit card debt is
constantly changing. The regulations posit a single change in
circumstances; i.e., the exercise of an option. Yet COB cannot
recompute the various components of the section 1272(a)(6)
formula constantly. It must pick a period and calculate the OID
accrual for that period. COB chose to do so monthly, which is
reasonable given the nature of the credit card business.
In support of their positions on this issue, the parties
again demonstrate a fundamental difference in the way they view a
credit card loan. Petitioners argue that it is appropriate to
include new additions in the AIPbeg figure because each credit
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card purchase transaction that occurred in a given month was an
outstanding loan at the end of month. In petitioners’ view the
loan becomes part of the SRPM at the time the loan is made (or at
least at the time it is settled under the associations’ systems,
usually 1 day later). Therefore, it is appropriate to include
new additions in the issue price for the purpose of calculating
the accrual of OID.
Respondent argues that it is inappropriate to include new
additions because they have not been billed, that is, a statement
has not been sent to the cardholder requesting payment until
later in the current month or in the following month, and
payments are not due until 30 days after the issuance of the
statement.
Although petitioners argue that new additions are included
in the AIPbeg figure under section 1272(a)(4)(A), we cannot
ignore section 1272(a)(4)(B). Subparagraph (B) makes clear that
the beginning issue price includes only the adjustments to the
issue price included before the first day of the accrual period.
The reissuance of the pool of debt instruments occurs on the
first day of every month; i.e., the first day of the accrual
period. It is inappropriate under either section 1272(a)(4)(A)
or (B) to include in the issue price the additions that occurred
on or after the first day of the accrual period.
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3. Payment Rate Issues
Under the KPMG model, the payment rate is a fraction where
the numerator is cash collections net of finance charges and the
denominator is the beginning credit card receivable balance plus
that month’s new additions (net of finance charges):
Payments - Stated finance charges
Outstanding Balance + New additions
Respondent raises several issues with respect to the calculation
of the payment rate.
a. The Denominator
Respondent argues that the inclusion of current month
cardholder charges and fees in the calculations used to derive
the payment rate is inappropriate because those new charges would
not have been billed until later in the current month or in the
next month, and would not have been due until 30 days after the
charges were billed. We agree with respondent on this point.
A simple example helps illustrate the calculation of the
payment rate in the KPMG model. Assume a cardholder purchases a
$100 lamp, $40 of gasoline, and $10 of coffee in November, for a
total of $150. In December the cardholder charges a $25 haircut,
incurs a $25 overlimit fee, and incurs $10 in stated finance
charges, resulting in a balance of $210. In December the
cardholder also makes a payment of $30. Under the KPMG model,
the December payment rate would be 10 percent ($20 payment
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(exclusive of finance charges) divided by a $200 balance (also
excluding finance charges)).
In the example, the cardholder pays $30 after receiving a
monthly statement from COB on December 1. The statement would
have shown that the cardholder owed $150. No finance charges
would have been billed to the cardholder because it was possible
he would pay his entire balance and incur no finance charges.
Therefore, when the cardholder pays $30, it is toward a $150
balance, resulting in a payment rate of 20 percent. It is
unreasonable to conclude that the cardholder’s December payment
rate is 10 percent simply because she incurs new charges when
those charges are not yet billed to her.
However, respondent goes even further, arguing that the
additions made after the average statement date33 of the prior
month should also not have been included because those charges
would not have been billed until the current month. For example,
when calculating the December payment rate, respondent argues
that a charge made on November 25 should not have been included
in the total outstanding balance portion of the denominator. We
disagree with respondent on this point. Although payment of the
November 25 charge may not have been due until January, COB would
33
COB issues statements to its cardholders throughout the
month, and given that the typical billing cycle is 30 days, the
average monthly statement date for all cardholders is the middle
of the month.
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have requested payment of the debt during December, and it is
appropriate to include it in the denominator when calculating the
payment rate.
Therefore, the denominator of the payment rate formula
should be the total cardholder outstanding balance as of the end
of the previous month.
b. The Numerator
The numerator of the payment rate calculation begins with
the current month’s payments and then subtracts the current
month’s accrued finance charges. Respondent agrees that finance
charges must be subtracted from the payments, but disagrees as to
which finance charges should be subtracted. The KPMG model
subtracts finance charges accrued during the current month.
Essentially, the KPMG model applies current month payments
against the current month’s accrued, but unbilled, finance
charges. Respondent argues this is unreasonable for the same
reasons new additions should not be included in the denominator,
and we agree. It is inappropriate to apply payments to charges
which have not been billed.
Respondent argues that the finance charges which should have
been subtracted are two-thirds of the prior month’s finance
charges and one-third of the finance charges from the month
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before that.34 In determining the beginning issue price of the
debt instrument and the denominator of the payment rate
calculation, it is appropriate to include all the prior month’s
additions to principal whether billed or unbilled as of the first
day of the current month because COB will request payment of
those debts during the current month. We think it logical,
therefore, that current month payments should first be applied to
finance charges which relate to all the debts included in the
beginning issue price; i.e., the total outstanding balance of the
pool as of the beginning of the accrual period. In other words,
current month payments should first be applied to prior month
finance charges, but not current month finance charges or finance
charges from 2 months previous, before reducing the principal
amount.
In his calculations Dr. Hakala includes writeoffs in the
numerator. Writeoffs are those debts COB determines are not
collectible. Respondent argues that “a write-off, practically
speaking, is no different from a payment of principal in that
both reduce outstanding principal balances”. A writeoff,
however, is an amount that is uncollectible, and it is not
equivalent to a payment. The payment rate is used to calculate
future payments. Including writeoffs in the calculation
34
Respondent also argues that one-half of the prior month
finance charges should be deducted and one-half of the finance
charges from the month before that.
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anticipates future defaults. The legislative history of section
1272(a)(6) suggests that defaults are not to be estimated when
determining future cashflows. H. Conf. Rept. 99-841 (Vol II), at
II-238 n.22 (1986), 1986-3 C.B. (Vol.4) 1, 238 (“In computing the
accrual of OID (or market discount) on qualified mortgages held
by the REMIC, only assumptions about the rate of prepayments on
such mortgages would be taken into account.” (Emphasis added.)).
We conclude that writeoffs should not be included in the
numerator when calculating payment rates.35
Therefore, the numerator of the payment rate formula should
be the total cardholder payments for the current month less the
finance charges accrued during the prior month.
c. Other Published Payment Rates
Moody’s Investors Services publishes historical credit card
payment rates showing the average performance of various pools of
credit card loans related to credit-card-backed securities. In
addition, Capital One files reports with the Securities and
Exchange Commission and issues prospectuses related to its sale
of credit-card-backed securities. Each of these reports includes
information about the payment rates of the loans that backed the
securities.
35
The KPMG model deals with writeoffs in a separate
adjustment, which we conclude is reasonable.
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However, these other published payment rates are not based
upon the formula set out in section 1272(a)(6) and its related
regulations. The published payment rate calculations include
payments of finance charges which are left out of the section
1272(a)(6) formula because they are considered to be stated
interest. Taking finance charges out of the equation, at least
in the case of the numbers reported by Capital One, decreases the
payment rates by approximately 1 percent of principal per period.
For example, a payment rate of 10 percent including finance
charges would be approximately 9 percent excluding finance
charges.36 Other adjustments were made in some calculations.
For example, some of the calculations use an average outstanding
principal amount for the month, rather than the outstanding
amount at the beginning or end of the month.
Our determinations on these issues are based on section
1272(a)(6) and the related regulations, not on published reports
that use an analysis not based in the Code.
4. Dr. Hakala’s Default Rate Adjustment for Overlimit Fees
The KPMG model includes a section 166 adjustment for
book/tax basis differences in receivables written off every month
as reducing the end-of-month balance of unamortized OID.
36
In 1999 COB cardholders made payments totaling
$23,984,854,095, and accrued $2,088,871,186 in finance charges.
In other words, approximately 9 percent of all payments were
attributable to finance charges.
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Respondent proposes to modify this writeoff adjustment for
default rates associated with late fees and overlimit fees.
Because of our determination in Capital One Fin. Corp. v.
Commissioner, 130 T.C. 147 (2008), late fees are not at issue.
Although they are not at issue, respondent argues that Dr.
Hakala’s analysis of the default characteristics of cardholders
who incurred overlimit fees depends on his analysis of defaults
associated with late fees.
Using data from Capital One’s 310 reports, Dr. Hakala
tracked the proportion of accounts that incurred late fees
ultimately written off within 180 days of being in “non-payment”
status. Dr. Hakala determined how much of a late fee is
ultimately paid and how much is written off. On the basis of
this analysis, respondent argues that a greater percentage of the
outstanding principal in accounts that have incurred late fees is
written off than in cardholder accounts generally. Dr. Hakala
devised a default adjustment for late fees, expressed as a factor
of 3.56, whereby the amount of OID recognized in connection with
defaults is increased by a factor of 3.56. Again, late fees are
not at issue, and we need not and do not reach a conclusion as to
whether Dr. Hakala’s late fee adjustment is appropriate.
Dr. Hakala was not able to do a similar analysis with
overlimit fees. Instead, Dr. Hakala took samples of Capital
One’s cardholder accounts and compared default rates of accounts
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with late fees versus default rates of accounts with overlimit
fees. Using this sampling, Dr. Hakala determined that the
default rate for accounts with overlimit fees was about half the
default rate for late fees. Thus, in his corrections to the
accruals of overlimit fees, he used a default factor of 1.78
versus 3.56 for late fees. However, Dr. Hakala provides
insufficient data to allow us to test his conclusions. It seems
that the 1.78 figure is a ballpark estimate or an educated guess
that is based on the theory that cardholders who incur overlimit
fees, like cardholders who incur late fees, have a higher rate of
default.
Dr. Hakala also states that “customer accounts that incur
past due and overlimit fees may tend to be slightly slower in
paying off principal than the average customer, and this finding
may moderate the adjustment.” Dr. Hakala testified that he did
moderate the adjustment, and therefore his default rate
adjustment was not a 100-percent adjustment. But Dr. Hakala does
not explain how or to what extent he moderated the adjustment.
Put simply, there is insufficient support for Dr. Hakala’s
proposed default rate adjustment. His ballpark estimate of the
default rate factor may be correct or it may not. Without
supporting data, we cannot conclude that the KPMG model was
unreasonable or failed to clearly reflect COB’s income as it
relates to writeoffs. Further, on the record before us we cannot
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conclude that Dr. Hakala’s proposed default rate adjustment would
more clearly reflect COB’s income than did the KPMG model.
5. Dr. Hakala’s Seasonality and Trend Adjustment
As part of his adjustments to the KPMG model, Dr. Hakala
included a seasonality adjustment to “smooth out seasonal
fluctuations and to capture the trend in aggregate payment rates
for forecasting purposes.” For example, the adjustment addresses
the spike in credit card use and dip in payment rates associated
with holiday shopping. Dr. Hakala testified that adjustments for
seasonality and trends are standard practice for purposes of
prepayment assumptions in REMICs. Mr. Nelson, on the other hand,
testified that seasonality adjustments are not standard practice
for REMICs.
Respondent contends that a seasonality adjustment is
necessary because the payment rates in some months were
artificially high and in others artificially low. We disagree.
The KPMG model calls for calculating payment rates each month.
Therefore, the process takes into account seasonality effects by
calculating a new payment rate every month. Payment rates may
have been higher in April and lower in December, but the KPMG
model takes that into account by changing the present value of
the debt instrument as the payment rates change. We conclude
that, in this respect, the KPMG model is reasonable and clearly
reflected COB’s income.
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F. Conclusion With Respect to the Calculation of OID
Although COB may enjoy some latitude in its method of
calculating the accrual of OID, it may not run afoul of section
1272 and the OID regulations. We conclude that COB may not
include new additions, as defined in the KPMG model, in the
beginning issue price of the monthly pool of debt instruments.
Further, COB’s calculations of the payment rate run afoul of
section 1272 by applying payments first to accrued, but unbilled,
finance charges. Lastly, the denominator of the payment rate
calculation may not include new additions because those additions
were not billed to the cardholders and should not have been
included in the beginning issue price. We conclude that, in all
other respects, the KPMG model is reasonable.
Issue 3: Milesone Rewards
FINDINGS OF FACT
A. The Milesone Reward Program
In an effort to attract new cardholders and to encourage
cardholders to use their cards more often, Capital One issued
Milesone credit cards, Signature Milesone credit cards, and Small
Business Milesone credit cards (collectively Milesone cards).
The Milesone cards were typical Visa and MasterCard credit cards
(as described above) except that they allowed a cardholder to
earn “miles” which could be redeemed for airline tickets.
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A Milesone cardholder paid Capital One an annual membership
fee of either $19 or $29. In exchange for that fee, a Milesone
cardholder earned 1 mile for every dollar charged on the Milesone
card for purchases. However, a cardholder was limited to 10,000
miles per billing cycle. Additionally, a cardholder could earn
up to 3,000 miles by transferring an existing balance from a non-
Capital One credit card account to a Milesone account. A
Milesone cardholder earned no miles for cash advances, checks, or
fees of any kind, including finance charges.
Capital One provided Milesone cardholders with a rewards
schedule detailing the number of miles needed to qualify for the
various airline tickets offered. Once enough miles were
accumulated, the cardholder could redeem the miles for a round-
trip airline ticket purchased by Capital One. The least
expensive ticket was a round-trip coach ticket within the
cardholder’s zone (either the eastern, middle, or western United
States) and required 18,000 miles. In comparison, a round-trip
coach ticket from the United States to Europe required 50,000
miles, and an around-the-world coach ticket required 150,000
miles. Business class and first class tickets were also available
but required more miles than similar coach tickets.
Capital One provided each Milesone cardholder a quarterly
statement reflecting the cardholder’s total accumulated points,
the number of points redeemed for airline tickets, and the number
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of points due to expire within 90 days. Points not redeemed
within 5 years of the end of the quarter in which they were
earned expired at that time. Points were redeemed on a first-in,
first-out basis; i.e., the oldest points were redeemed first.
Capital One purchased the airline tickets from a vendor.
Each class of ticket was assigned a value. For example, a
cardholder redeeming 18,000 miles for an in-zone domestic ticket
could request a ticket costing up to $360. A cardholder
redeeming 50,000 miles for a United States to Europe ticket could
request a ticket costing up to $1,000. Therefore, Capital One’s
maximum potential cost per mile was 2 cents.
B. Milesone Program Costs and Accounting
Capital One estimated its cost of redeeming its cardholders’
miles. The estimates depended primarily on two variables: (1)
The estimated rate of future redemptions and (2) the estimated
average cost of redemption. These variables were used to
calculate an accrual rate used to estimate Capital One’s future
airline ticket redemption costs for financial accounting
purposes. The accrual rate was a percentage of outstanding
accumulated Milesone miles at the end of the year.
As of December 31, 1998, Milesone cardholders had an
outstanding accumulated balance of 58,370,500 miles.37 Capital
37
In 1998 and 1999 Capital One awarded 29,254,871 and
323,169,272 miles in connection with balance transfers and bonus
(continued...)
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One estimated that 70 percent of the miles would ultimately be
redeemed and that each mile would cost 1.4 cents to redeem.
Using these figures, Capital One estimated its future redemption
costs to be $583,411.38 This amount was used as its contingent
reserve for redemption costs on its general ledger for financial
accounting purposes and was deducted under section 1.451-4,
Income Tax Regs., on petitioners’ consolidated 1998 Federal
income tax return.39
As of December 31, 1999, Milesone cardholders had an
outstanding accumulated balance of 2,661,038,279 miles. Capital
One estimated that 80 percent of these miles would be redeemed
and that each mile would cost 1.65 cents to redeem. Accordingly,
Capital One estimated its future redemption costs to be
$34,593,497.40 The difference between that figure and the 1998
figure, $583,411, was the change in the contingent reserve for
future redemption costs. Capital One deducted the difference,
37
(...continued)
miles. The record is not clear about what constituted bonus
miles.
38
We note that the 70 percent and 1.4 cents figures would
result in a slightly higher cost of redemption. We assume the
parties rounded the figures for our benefit. In any event, the
discrepancy does not appear to bother the parties, and therefore
it does not bother us.
39
Capital One actually spent $1,578 and $313,513 to redeem
Milesone miles during 1998 and 1999, respectively.
40
Again, the 80 percent and 1.65 cents figures would result
in a slightly higher cost of redemption.
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$34,010,086, on its general ledger for financial accounting
purposes. Through an error petitioners neglected to deduct that
amount on their consolidated 1999 Federal income tax return.
During the IRS’ examination and in its petition to this Court,
Capital One asserted that it was entitled to the deduction under
section 1.451-4, Income Tax Regs.
The actual redemption rates of points earned by cardholders
in 1998 and 1999 through their 5-year expiration period were 68
percent and 81 percent, respectively. The actual cost of
redemption was just over 2 cents per mile for points earned in
1998 and 1.59 cents per mile for those earned in 1999.41
OPINION
A. The History of Accounting for the Redemption of Trading
Stamps and Coupons
Whether a business expense has been incurred so as to
entitle an accrual basis taxpayer to deduct it under section
162(a) is governed by the all events test. United
States v. Anderson, 269 U.S. 422, 441 (1926). In Anderson, the
Supreme Court held that a taxpayer was entitled to deduct from
its 1916 income a tax on profits from munitions sales that took
place in 1916. Although the tax would not be assessed and
therefore would not formally be due until 1917, all the events
had occurred in 1916 to fix the amount of the tax and to
41
Petitioners did not explain why the cost of redemption was
more than the ostensible maximum payout of 2 cents per mile.
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determine the taxpayer’s liability to pay it. The all events
test is now embodied in section 1.461-1(a)(2), Income Tax Regs.,
which during the years at issue provided:
Under an accrual method of accounting, a liability (as
defined in § 1.446-1(c)(1)(ii)(B)) is incurred, and
generally is taken into account for Federal income tax
purposes, in the taxable 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.
* * *
See also sec. 461(h) (providing that the all events test shall
not be treated as met any earlier than when economic performance
occurs);42 United States v. Gen. Dynamics Corp., 481 U.S. 239,
242-243 (1987).
In 1919 the Commissioner carved out an exception to the all
events test, allowing a taxpayer to deduct from its sales
revenues an estimate of the contingent liabilities incurred with
respect to the redemption of coupons or trading stamps issued
with those sales.
Where a taxpayer, for purposes of promoting his
business, issues with sales trading stamps or premium
coupons redeemable in merchandise or cash, he should in
computing the income from such sales subtract only the
amount received or receivable which will be required
for the redemption of such part of the total issue of
trading stamps or premium coupons issued during the
taxable year as will eventually be presented for
42
Sec. 461(h)(5) provides an exception to the general rule
of sec. 461(h), allowing a deduction for a reserve for estimated
expenses if such a deduction is otherwise allowable under the
Code.
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redemption. This amount will be determined in the
light of the experience of the taxpayer in his
particular business and of other users engaged in
similar business. * * *
Regs. 45, art. 88 (1919). Ninety years later, the essential
elements of the exception still remain and are embodied in
section 1.451-4(a)(1), Income Tax Regs., which for the years at
issue provided:
If an accrual method taxpayer issues trading stamps or
premium coupons with sales, or an accrual method
taxpayer is engaged in the business of selling trading
stamps or premium coupons, and such stamps or coupons
are redeemable by such taxpayer in merchandise, cash,
or other property, the taxpayer should, in computing
the income from such sales, subtract from gross
receipts with respect to sales of such stamps or
coupons (or from gross receipts with respect to sales
with which trading stamps or coupons are issued) an
amount equal to--
(i) The cost to the taxpayer of merchandise,
cash, and other property used for redemption in
the taxable year,
(ii) Plus the net addition to the provision
for future redemptions during the taxable year (or less
the net subtraction from the provision for future
redemptions during the taxable year).
The regulation’s purpose is to match sales revenues with the
expenses incurred in generating those revenues, and taxpayers are
entitled to a present deduction for only that portion of the
stamps or coupons that they expect to eventually be redeemed.
See Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 411
(5th Cir. 1969); Tex. Instruments, Inc. v. Commissioner, T.C.
Memo. 1992-306.
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Petitioners contend that the miles Capital One issued to its
cardholders are coupons issued with sales, that those coupons are
redeemable by the cardholders in property, and that therefore it
may subtract from its gross receipts the estimated cost of
redeeming those miles. Respondent agrees that the miles are
coupons within the meaning of section 1.451-4, Income Tax Regs.,
but disagrees that the miles are issued with sales and that
Capital One had gross receipts with respect to sales.
B. The “With Sales” Requirement
Over the years we have been asked to interpret and apply
section 1.451-4, Income Tax Regs., and its predecessors. In
Creamette Co. v. Commissioner, 37 B.T.A. 216 (1938), the taxpayer
created a program to increase sales of its macaroni product. It
issued with each carton of its product sold one coupon which was
redeemable for certain selected articles of merchandise. The
Board of Tax Appeals, predecessor to this Court, allowed the
taxpayer to deduct a reasonable estimate of its future cost of
redemption under Regs. 77, art. 335, a predecessor to section
1.451-4, Income Tax Regs. Creamette Co. v. Commissioner, supra
at 218. In Brown & Williamson Tobacco Corp. v. Commissioner, 16
T.C. 432 (1951), to spur sales of its cigarettes, the taxpayer
issued coupons with each pack of its cigarettes sold which could
be redeemed for merchandise or cash. We allowed the taxpayer to
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deduct the reasonable estimate of its future cost of redemption.
Id. at 445-446.
In Tex. Instruments, Inc. v. Commissioner, supra, the
taxpayer did not include coupons on the product sold in the same
way as the taxpayers in Creamette and Brown & Williamson but
rather placed coupons in stores and in newspaper and magazine
advertisements. To redeem the coupon, the consumer was required
to submit to the taxpayer an original sales receipt and some
additional type of proof of purchase, such as a part of the
product box. The Commissioner contended that the taxpayer’s
coupons were merely advertisements inducing customers to purchase
its products and were not issued with sales within the meaning of
section 1.451-4, Income Tax Regs. We disagreed and held that,
for purposes of section 1.451-4, Income Tax Regs., the proofs of
purchase, such as part of the product’s box, functioned as
coupons issued with sales of the product.
In Tex. Instruments, there was no dispute that sales took
place. The issue was whether coupons were issued with those
sales. If the coupon, for purposes of section 1.451-4, Income
Tax Regs., was the advertisement, it would not have been issued
with the sale. The issue in this case is different. Although
respondent argues that the miles were not issued with sales, the
focus of his argument is that there were no sales with which
coupons could be issued.
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Although most credit card transactions involve sales of
goods or services, i.e., a consumer purchases a product from a
merchant, petitioners do not argue that the merchant’s sale of
goods to the cardholder is relevant for purposes of section
1.451-4, Income Tax Regs. Rather, petitioners argue that when a
cardholder uses a Milesone card, Capital One has sold its lending
services to the cardholder and issued miles with that sale.
Respondent concedes that “sales” as used in section 1.451-4,
Income Tax Regs., is broad enough to include the sale of services
as well as the sale of goods.
Petitioners argue that we have interpreted the term
“service” to include the lending of money. In Burbank
Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), affd. in
part and revd. in part on other grounds 335 F.2d 125 (9th Cir.
1964), we faced the question of whether a lender’s mortgage loans
made in the ordinary course of business were ordinary or capital
assets under section 1221(4).43 We held that the loans were
“notes receivable acquired for * * * services rendered” and thus
were ordinary, rather than capital assets. Id. at 1009. We
explained that “the business of a savings and loan company could
properly be described as ‘rendering the service’ of making
loans.” Id. at 1009-1010.
43
Sec. 1221(4) of the Internal Revenue Code of 1954 excluded
from capital assets: “accounts or notes receivable acquired in
the ordinary course of trade or business for services rendered or
from the sale of property”.
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In FNMA v. Commissioner, 100 T.C. 541, 576-578 (1993), we
faced a similar question with respect to the character of home
mortgage loans. However, the lender had not originated the loans
but had purchased them on the secondary market. Nevertheless, we
held that “the actual operation of * * * [the taxpayer’s
business] further supports that it was providing a service in
exchange for the mortgages.” Id. at 578.
Petitioners argue that these cases indicate that the lending
of money is the sale of a service and therefore when Capital One
extends credit to its cardholders, it is selling lending services
to the cardholder. The argument is strained. The cases cited by
Capital One and discussed above are inapplicable to the current
case. Whether loans in the hands of a lender are a capital or
ordinary asset has no bearing on whether Capital One issued its
miles with sales. In lending its cardholders funds, Capital One
provided a service, but that service does not transform a loan
into a sale within the meaning of section 1.451-4, Income Tax
Regs. The regulation encompasses a sale of services, but it does
not follow that every provision of services is a sale of
services.
A sale requires two parties, a buyer and a seller. See
U.C.C. sec. 2-106(1) (2008); Commissioner v. Freihofer, 102 F.2d
787, 789-790 (3d Cir. 1939) (a “sale” requires parties standing
to each other in the relation of buyer and seller, assent of the
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minds to the same proposition, and passing of consideration),
affg. Greisler v. Commissioner, 37 B.T.A. 542 (1938). Section
1.451-4, Income Tax Regs., allows a seller a current deduction
for estimated future expenses. In a lending transaction, such as
the extension of credit to a cardholder, the cardholder has not
bought lending services from the lender and the lender has not
sold lending services to the cardholder. In fact, as argued by
petitioners on the interchange issue, with respect to a credit
card purchase transaction the lender is the buyer, having
purchased a note receivable.
C. Gross Receipts With Respect to Sales
Section 1.451-4(a)(1), Income Tax Regs., allows the
deduction of contingent liabilities from “gross receipts with
respect to sales with which trading stamps or coupons are
issued”. Section 1.451-4, Income Tax Regs., contemplates a
scenario where the expenses are contingent, but the gross
receipts are not. The revenue from a sale is known at the time
of sale and is the purchase price.
With respect to credit card transactions, Capital One
receives various types of revenue when it lends money to its
cardholders. The first income received is from interchange,
which is a small percentage of the amount lent. Interchange is
known at the time of sale, but interchange is not a fee for any
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service other than the lending of money, and the lending of money
is not a sale of a loan or lending services.
Capital One receives much of its income from finance charges
on cardholder loans. Finance charges are charged to the
cardholder only if the cardholder does not pay the monthly
balance in full within the grace period. A cardholder may pay
interest with respect to the loan for many months or even many
years. Similarly, a cardholder may incur late fees if a timely
payment is not made. A late fee may be incurred with respect to
the first bill Capital One sends the cardholder or with respect
to a bill sent many months or years later if the cardholder has
not repaid the loan in full.
Many other variables may affect the revenues Capital One
receives with respect to its loan to the cardholder. Capital One
may alter interest rates. The cardholder may default on the
loan, exceed the credit limit and incur an overlimit fee, or
incur an insufficient funds fee if a check paid to Capital One is
not honored by the cardholder’s bank. Although these revenues
are related to Capital One’s lending to its cardholders, they are
not “gross receipts with respect to sales with which * * *
coupons are issued” within the meaning of section 1.451-4(a)(1),
Income Tax Regs. Capital One did not issue miles with respect to
the revenues Capital One earned, with the arguable exception of
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interchange.44 Miles were issued only for the amount of the
cardholder’s purchase, and a cardholder earned no miles for
finance charges or any fees incurred. In short, interest,
interchange, and the various fees a cardholder may incur are not
sales revenues, and the purpose of the regulation is to match
sales revenues with the expenses associated with the sale,
specifically the cost of coupon redemption. Mooney Aircraft,
Inc. v. United States, 420 F.2d at 411.
D. Conclusion With Respect to the Milesone Rewards Issue
Petitioners argue that deducting Capital One’s estimated
cost of redemption would most clearly reflect its income without
undue distortion. With respect to the Milesone program, for book
purposes Capital One estimated its future liability for airline
tickets at $583,411 and $34,010,086 in 1998 and 1999,
respectively. Respondent agrees that the estimates are
reasonable. However, the reasonableness of the estimates and the
economics of the Milesone program are irrelevant because the
miles were not issued with sales and therefore, the requirements
of section 1.451-4, Income Tax Regs., have not been met.
Accordingly, the all events test applies, limiting Capital One’s
deduction for airline tickets with respect to the Milesone
44
The number of miles issued had no direct relationship to
the amount of interchange Capital One earned.
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program to those amounts which are fixed and known and for which
economic performance has occurred.45
In reaching our holdings on all three issues, we have
considered all arguments made, and to the extent not mentioned,
we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
45
Because we hold that the Milesone coupons were not issued
“with sales” as required by sec. 1.451-4, Income Tax Regs., we
need not address respondent’s alternative arguments that:
Capital One failed to attach the informational statement required
by sec. 1.451-4(e), Income Tax Regs., explaining how the future
redemption expenses were calculated; the airline tickets were not
“other property”; and the Milesone Program was impermissibly
conditional in that Capital One could terminate the program at
any time.