Credit Card Fees Are OID

The Tax Court held that credit card “interchange” fees received by subsidiaries of credit card issuer Capital One resembled interest that increased or created original issue discount (OID) related to the company’s pool of credit card receivables. As OID, a daily amount was properly included in income over the life of the credit card obligation, the court said. The court also found that the accounting method used by the taxpayer to calculate the daily inclusion of OID related to over-limit fees and interchange fees was generally reasonable; however, it revised three components of the calculation, saying they did not comply with IRC § 1272.

Taxpayers holding debt instruments with OID, defined as the excess of an instrument’s stated redemption price at maturity over its issue price, must accrue and include in gross income OID daily over the life of the instrument. For a pool of credit card receivables, the IRS has held that annual fees do not create or increase OID but has conceded that late fees, cash advance fees and over-limit fees do. If a debt instrument’s principal payments may be accelerated due to prepayments, as in credit card loans, the life of the instrument is unknown, making it difficult to compute the daily OID. For such instruments, section 1272(a)(6) provides guidance in computing daily OID, and section 1272(a)(6)(B)(iii) requires the use of “a prepayment assumption determined in the manner prescribed by regulations.” However, those regulations have not yet been issued.

Capital One Financial Corp., through its subsidiaries, Capital One Bank (COB) and Capital One FSB (FSB), issued credit cards to consumers. Under the credit card agreements, the cardholders promised to pay the companies the amount charged by using the cards plus any applicable finance charges, late fees or other such charges. When consumers used their Capital One cards, card systems Visa or MasterCard, as part of their agreements with Capital One, would withdraw from Capital One’s account an amount equal to the consumer’s purchase price less an amount called an interchange fee. Visa or MasterCard would remit the remainder to an intermediary bank, which, after deducting a smaller amount, would pay the merchant. COB and FSB treated this interchange as creating or adding to the OID of its pool of credit card receivables and recognized the interchange amount over time, using a method developed by accounting firm KPMG.

Upon examination of Capital One’s tax returns for 1995–1999, the IRS assessed additional tax and penalties of approximately $295 million and $24 million, respectively. The IRS contended that (1) interchange fees were not OID; (2) FSB could not retroactively prorate interchange fees and over-limit fees for 1998 and 1999, since it had previously used the current-inclusion method and had not filed Form 3115, Application for Change in Accounting Method; and (3) the KPMG model was an unreasonable method that did not clearly reflect income. Capital One petitioned the Tax Court for relief.

The IRS argued that the interchange was a fee for service, since its amount was intended to encourage banks to issue credit cards and merchants to accept them. The Service also argued that Capital One did not acquire a discounted loan from the cardholder, since an intermediary bank paid the interchange to Capital One, not the cardholder.

The court, however, held that the interchange resembled interest, as it compensated Capital One for the costs of giving up the use of its funds from the time cardholders made a purchase until the end of their grace period. Another way the interchange resembled interest was that its amount increased as the amount of a cardholder’s purchase (the loan) increased. The court also stated that it didn’t matter if an intermediary bank paid the interchange to Capital One, since under Treas. Reg. § 1.1273-2(g), such third-party payments reduce the issue price, therefore creating or increasing OID.

The Tax Court agreed with the IRS that FSB could not change its accounting method and begin to prorate OID from over-limit fees and interchange fees for tax years 1998 and 1999. The court relied on its previous decision in Capital One Financial Corp. and Subsidiaries v. Commissioner, 130 TC 147, in which it denied the company’s attempt to retroactively prorate the OID resulting from late fees over time, since the company had failed to obtain the consent of the IRS. (For prior coverage, see “Tax Matters: What’s in Their Wallet?” JofA, Sept. 08, page 89.)

The IRS argued that COB should compute the daily OID inclusion amount by using the same approach as used for a fixed pool of mortgages. However, that argument was rejected by the court, since the company’s credit card pool was a dynamic pool of loans with constantly fluctuating account balances. Overall, the court found the KPMG method for recognizing interchange as OID to be reasonable except that it had incorrectly included new customer purchases when determining the method’s payment rate (necessary to compute the yield to maturity) and the beginning issue price of the debt instrument. Also, when computing the payment rate, the method incorrectly applied payments first to accrued but unbilled finance charges, the court said.

In an issue unrelated to OID, the court also held that the company could not take a deduction in 1999 of more than $34 million for its increase in the estimated future cost of reward points (redeemable for airline tickets) earned by cardholders in that year. The court rejected the company’s argument that the points were coupons issued with sales and redeemable in property that Treas. Reg. § 1.451-4 allows as a current deduction, saying the redemption expense could be recognized only under the all-events test.

  Capital One Financial Corp. and Subsidiaries v. Commissioner, 133 TC no. 8

By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.