Capital One Fin. Corp. v. Comm'r of Internal Revenue, s. 19519–05

Citation133 T.C. No. 8,133 T.C. 136
Decision Date21 September 2009
Docket Number24260–05.,Nos. 19519–05,s. 19519–05
PartiesCAPITAL ONE FINANCIAL CORPORATION and Subsidiaries, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
CourtUnited States Tax Court

133 T.C. 136
133 T.C. No. 8

CAPITAL ONE FINANCIAL CORPORATION and Subsidiaries, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 19519–05

24260–05.

United States Tax Court.

Sept. 21, 2009.


[133 T.C. 136]

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 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., 130 T.C. 147, 2008 WL 2152132 (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

[133 T.C. 137]

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 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.

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.

HAINES, Judge.
+-----------------------------------------------------------------------------+
                ¦CONTENTS ¦
                +-----------------------------------------------------------------------------¦
                ¦Issue¦ ¦Interchange ¦8 ¦
                ¦1: ¦ ¦ ¦ ¦
                +-------------------------------------------------------------------------+---¦
                ¦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 ¦30 ¦
                ¦ ¦ ¦ ¦and Associated Interchange Income ¦ ¦
                +-------------------------------------------------------------------------+---¦
                ¦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 ¦36 ¦
                ¦ ¦ ¦ ¦Service) or Economically Equivalent to Interest ¦ ¦
                +-----+--+--+-------------------------------------------------------------+---¦
                ¦ ¦ ¦2.¦Whether the Cardholder, the Merchant, or the Acquiring Banks ¦48 ¦
                ¦ ¦ ¦ ¦Pays Interchange ¦ ¦
                +-----+--+----------------------------------------------------------------+---¦
                ¦ ¦D.¦Conclusion With Respect to the Interchange Issue ¦52 ¦
                +-----+--+----------------------------------------------------------------+---¦
                ¦Issue¦ ¦The Calculation of OID Under Section 1272(a)(6)(C) ¦53 ¦
                ¦2: ¦ ¦ ¦ ¦
                +-----+-------------------------------------------------------------------+---¦
                ¦ ¦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
...

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