Capital One Financial Corp.. v. Comm'r of Internal Revenue

Citation659 F.3d 316,108 A.F.T.R.2d 2011,2011 USTC P 50687
Decision Date21 October 2011
Docket NumberNo. 10–1788.,10–1788.
PartiesCAPITAL ONE FINANCIAL CORPORATION, AND SUBSIDIARIES, Petitioner–Appellant,v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.The Clearing House Association L.L.C., Amicus Supporting Appellant.
CourtUnited States Courts of Appeals. United States Court of Appeals (4th Circuit)

659 F.3d 316
108 A.F.T.R.2d 2011-6875
2011-2 USTC P 50,687

CAPITAL ONE FINANCIAL CORPORATION, AND SUBSIDIARIES, Petitioner–Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.The Clearing House Association L.L.C., Amicus Supporting Appellant.

No. 10–1788.

United States Court of Appeals, Fourth Circuit.

Argued: Sept. 20, 2011.Decided: Oct. 21, 2011.


[659 F.3d 318]

ARGUED: Jean A. Pawlow, McDermott, Will & Emery, LLP, Washington, D.C., for Appellant. Deborah K. Snyder, United States Department of Justice, Washington, D.C., for Appellee. ON BRIEF: Elizabeth Erickson, Kevin Spencer, McDermott, Will & Emery, LLP, Washington, D.C., for Appellant. John A. DiCicco, Acting Assistant Attorney General, Teresa E. McLaughlin, United States Department of Justice, Washington, D.C., for Appellee. Bruce E. Clark, H. Rodgin Cohen, Diana L. Wollman, David A. Castleman, Sullivan & Cromwell LLP, New

[659 F.3d 319]

York, New York, for Amicus Supporting Appellant.Before WILKINSON, NIEMEYER, and FLOYD, Circuit Judges.Affirmed by published opinion. Judge WILKINSON wrote the opinion, in which Judge NIEMEYER and Judge FLOYD joined.
OPINION
WILKINSON, Circuit Judge:

This case presents two questions, each born of the efforts of Capital One, a credit card issuer, to defer significant tax liability. The first question is whether Capital One can retroactively change the method of accounting used to report credit-card late fees on its 1998 and 1999 tax returns in such a fashion as would reduce its taxable income for those years by roughly $400,000,000. The second is whether Capital One can deduct the estimated costs of coupon redemption related to its MilesOne credit card program before credit card customers actually redeem those coupons. We cannot accept Capital One's views on either of the questions herein. For the reasons that follow, we shall affirm the judgment of the Tax Court.

I.
A.

Capital One is a publicly held financial and bank holding company. Its principal subsidiaries, Capital One Bank (“COB”) and Capital One, F.S.B. (“FSB”), provide consumer-lending products and issue Visa and MasterCard credit cards. Capital One earns part of its income from a variety of fees associated with its lending services, including late fees charged to customers who do not make their payments on time, overlimit fees charged to customers who exceed their credit limits, interchange fees on purchase transactions, and cash advance fees. In 1998 and 1999, late fees comprised a larger percentage of Capital One's annual income than any other single type of fee.

In its 1998 tax return, Capital One changed its tax treatment of income from certain fees in response to the Taxpayer Relief Act of 1997 (“the TRA”). Pub.L. No. 105–34, § 1004, 111 Stat. 788, 911 (1997) (partially codified at I.R.C. § 1272(a)(6)). The TRA extended original issue discount treatment for federal income tax purposes to certain credit card revenues, or “any pool of debt instruments the yield on which may be affected by reason of prepayments.” I.R.C. § 1272(a)(6)(C)(iii). Original issue discount (“OID”) is defined in the Code as “the excess (if any) of [a debt instrument's] stated redemption price at maturity, over ... the issue price.” I.R.C. § 1273(a)(1). Under the Code, the gain from OID is included in gross income as interest over the obligation's duration, rather than entirely at the time the debt instrument is issued or is redeemed. See I.R.C. § 1272(a)(1). With respect to certain credit card fees that Capital One historically included as income when charged to the customer, changing to an OID accounting method would spread the fee income over the period between when the fee was first charged and when it was reasonably expected to be collected from the credit card holder. See I.R.C. § 1272(a)(3)-(6).

To change accounting methods, a taxpayer must first obtain the consent of the Secretary. See I.R.C. § 446(e) (a taxpayer who intends to change his method of accounting “shall, before computing his taxable income under the new method, secure the consent of the Secretary”). To request the Secretary's consent, a taxpayer typically files a Form 3115, “Application for

[659 F.3d 320]

Change in Accounting Method.” See Treas. Reg. § 1.446–1(e)(3)(i). With respect to the TRA, Revenue Procedure 98–60 clarifies that a taxpayer can secure “automatic consent” to change accounting methods due to the enactment of § 1272(a)(6)(C)(iii) as long as the taxpayer timely files and correctly fills out Form 3115. Rev. Proc. 98–60, § 6.01–02, app. § 12, 1998–2 C.B. 761.

COB, but not FSB, did file a Form 3115 with its 1998 income tax return. In its form, COB stated: “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 Taxpayer Relief Act of 1997.” In the Form 3115, the taxpayer is required to “provide a detailed description of the pool(s) of debt instruments and the proposed [accounting] method” to be adopted. Rev. Proc. 98–60, app. § 12.02. COB specified that the “pool of debt instruments consists of all credit card receivables held by the taxpayer” and “[t]he proposed method is to account for interest and OID as required by Section 1272(a)(6).” Adopting this proposed change in accounting method, Capital One reported income from overlimit fees, cash advance fees, and interchange fees as OID in its 1998 and 1999 returns.

Capital One did not, however, report late-fee income as OID in those returns. Rather it continued to recognize this income under the current-inclusion method, meaning at the time those fees were charged to cardholders. Had Capital One treated late fee revenue as OID it would have deferred millions of dollars of tax liability by distributing the revenue over the period between when the fee was charged and when the customer was expected to actually pay the fee.

B.

At the same time, Capital One in 1998 began its “MilesOne program.” In exchange for an annual membership fee, participants were issued Visa and MasterCard “MilesOne” credit cards and earned “miles” for every dollar charged on a Miles–One credit card account. Participants could earn up to an additional 3,000 miles for balances transferred to their MilesOne account and were limited to a maximum of 10,000 miles earned per billing cycle. Once sufficiently accumulated, these miles were redeemable for airline tickets purchased by Capital One.

In 1998 and 1999, Capital One estimated future redemption costs related to its MilesOne program and deducted this amount on its tax returns for those years. An accrual-method taxpayer such as Capital One is generally prohibited from deducting estimated future costs, see I.R.C. § 461(h), with an exception when a “taxpayer issues trading stamps or premium coupons with sales ... and such stamps or coupons are redeemable by such taxpayer in merchandise, cash, or other property,” Treas. Reg. § 1.451–4(a)(1). Where the exception applies, the reasonable estimated redemption costs are deducted from “gross receipts with respect to sales with which trading stamps or coupons are issued.” Id. Capital One relied on this exception when it claimed current deductions for estimated liability for future airline tickets in the amount of $583,411 for 1998 and $34,010,086 for 1999. Upon audit, the Commissioner disallowed the deductions on the basis that the rewards program reserve estimates did not qualify for the § 1.451–4 exception.

C.

Capital One brought suit in the Tax Court contesting, inter alia, the Commissioner's

[659 F.3d 321]

disallowance of deductions claimed for estimated miles redemption costs. In an amended petition, Capital One also sought to change its accounting method for late fees for 1998 and 1999. Seven years after filing its 1998 and 1999 tax forms Capital One sought to retroactively report late fees as OID and so reduce its taxable income by $209,143,757 for 1998 and by $216,698,486 for 1999. The Commissioner and Capital One filed cross-motions for partial summary judgment with respect to the late fees issue (taxpayers' motion was limited to COB) and the Tax Court granted the Commissioner's motion.

The Tax Court held that Capital One could not retroactively change its treatment of COB's and FSB's late-fee income for 1998 and 1999 because it would be an “impermissible change in method of accounting” under I.R.C. § 446(e). Capital One Fin. Corp. v. Comm'r, 130 T.C. 147, 170 (2008). According to the court, Capital One was required to secure the Commissioner's consent to change its accounting method and it failed to do so with respect to its treatment of late-fee income on its 1998 and 1999 returns. The court emphasized that the consent requirement serves an important purpose, “to assure consistency in the method of accounting used for tax purposes and thus prevent distortions of income which usually accompany a change of accounting method and which could have an adverse effect upon the revenue.” Id. at 154.

After a bench trial, the Tax Court also disallowed Capital One's deduction of estimated costs associated with the rewards program. The court held that the taxpayers' MilesOne program did not constitute “sales” as required by Treasury Regulation § 1.451–4. Rather, Capital One's lending “provide[s] a service, but that service does not transform a loan into a sale” for purposes of § 1.451–4. Capital One Fin. Corp. v. Comm'r, 133 T.C. 136, 200 (2009). Interpreting § 1.451–4, the Tax Court explained that “[t]he regulation encompasses a sale of services, but it does not follow that every provision of services is a sale of services.” Id. In addition, the court held that Capital One did not have “gross receipts” under the regulation from which to deduct the estimated costs because “Capital One did not issue miles with respect to the revenues Capital One earned.” Id. at 201.

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