The Tax Court rejected an attempt by credit card issuer Capital One to retroactively defer its recognition of income from fees for late payments of card balances. Capital One sought to do so by taking advantage of a law change allowing such payments to be characterized as changes to original issue discount (OID). OID, the excess of an obligation’s stated redemption price at maturity over its issue price, generally must be recognized as income or deducted by an issuer ratably over the life of the obligation. The government said the treatment might have been available to Capital One, but not without IRS consent to a change in accounting method, as required under section 446(e). The court agreed.
From 1995 through 1999, Capital One recognized late fees as income at the time they were charged to the cardholders. In 1997, the Taxpayer Relief Act (TRA) added IRC § 1272(a)(6)(C)(iii), which requires taxpayers to treat certain credit card receivables as creating or increasing OID on the pool of credit card loans related to the receivables.
One of the taxpayer’s subsidiaries attached Form 3115, Application for Change in Accounting Method, to its 1998 consolidated return, requesting a change in its method of accounting based on the provisions of section 1272(a)(6)(C)(iii). However, this form did not specify a change in accounting for late fees. The taxpayer continued to report late fees in current income in 1998 and 1999. In 2000, it began reporting late-fee income as an increase in OID.
The IRS issued notices of deficiency for 1997, 1998 and 1999. Capital One filed a petition with the Tax Court challenging the deficiencies. In an amended petition, it also sought to treat its late-fee income as an increase in OID in 1998 and 1999, which would reduce its taxable income by $425 million for the two years. The court found that the taxpayer’s application for a change in accounting method was not clearly indicative of the requested change.
The taxpayer relied on a provision of the TRA that provided that a change in accounting method to comply with the act could be “treated as made with the consent of the Secretary of the Treasury.” The court, however, observed that this provision was not codified. Even if it had been, the court said, the taxpayer would still have been required to follow applicable procedures to implement even such a required change in method. The consent requirement, the court noted, is intended to maintain consistency in the tax accounting method used, promote administrative simplicity for the IRS, and avoid volatility stemming from changes in revenue recognition.
The taxpayer also argued it was not dealing with a material item and thus not changing an accounting method. The court found, however, that the change did affect a material item, as defined by Treas. Reg. § 1.446-1(e)(2)(ii)(a).
Capital One Financial Corp. and Subsidiaries v. Commissioner, 130 TC no. 11
By Gerald P. Weinstein, CPA, Ph.D., professor and chair of accountancy, and Robert Bloom, Ph.D., professor and Wasmer Fellow in Accountancy, both of John Carroll University, University Heights, Ohio.