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

• Decision Date: 22 May 2008
• Docket Number: Nos. 19519–05,24260–05.,s. 19519–05
• Citation: 130 T.C. No. 11,130 T.C. 147
• Parties: CAPITAL ONE FINANCIAL CORPORATION AND SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

130 T.C. 147

130 T.C. No. 11

CAPITAL ONE FINANCIAL CORPORATION AND SUBSIDIARIES, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 19519–05

24260–05.

United States Tax Court.

May 22, 2008.

Ps' subsidiaries, Capital One Bank (COB) and Capital One, F.S.B. (FSB), issuers of Visa and MasterCard credit cards, earn income from late fees charged to cardholders who do not timely pay at least their minimum monthly payment due. From 1995 to 1997 COB and FSB included the late fees in income when the fees were charged to cardholders; i.e., when they accrued under the all events test.

On Aug. 5, 1997, Congress enacted the Taxpayer Relief Act of 1997, Pub.L. 105–34, sec. 1004, 111 Stat. 911, which codified sec. 1272(a)(6)(C)(iii), I.R.C. This provision allows taxpayers who maintain a pool of debt instruments, such as credit card loans, to treat certain receivables related to that pool of debt instruments as creating or increasing original issue discount (OID).

In 1998 R provided that a taxpayer could receive “automatic consent” to change its method of accounting in accordance with sec. 1272(a)(6)(C)(iii), I.R.C., by filing Form 3115, Application for Change in Accounting Method, with the taxpayer's return. COB submitted Form 3115 with Ps' 1998 return. Ps treated certain credit card receivables as creating or increasing OID on their 1998 and 1999 returns, but they continued to recognize COB's and FSB's late-fee income at the time the fee was charged to the cardholder.

Through this proceeding Ps seek to retroactively treat COB's and FSB's 1998 and 1999 late-fee income under sec. 1272(a)(6)(C)(iii), I .R.C., thereby reducing their taxable income substantially.

Held: COB and FSB were required to obtain consent to change their treatment of credit card receivables to comply with sec. 1272(a)(6)(C)(iii), I.R.C.

Held, further: Neither COB nor FSB received consent to change its treatment of late-fee income on Ps' 1998 or 1999 return.

Held, further: Ps may not retroactively change their treatment of COB's and FSB's 1998 and 1999 late-fee income because the requested change is a change in the treatment of a material item and is therefore an impermissible change in method of accounting under sec. 446(e), I.R.C., and sec. 1.446–1(e)(2)(ii)(a), Income Tax Regs.

Held, further: Ps' motion for partial summary judgment on the late fees issue will be denied, and R's motion for partial summary judgment will be granted.

Jean Ann Pawlow, Elizabeth A. Erickson, Holly K. Hemphill, Kevin Spencer, and Robin L. Greenhouse, for petitioners.

Gary D. Kallevang, James Hill, and Alan R. Peregoy, for respondent.

OPINION

HAINES, Judge:

This case is before the Court on the parties' cross-motions for partial summary judgment filed pursuant to Rule 121.¹ The issue for decision is whether section 446(e) prohibits Capital One Bank (COB) and Capital One, F.S.B. (FSB), from changing their treatment of late-fee income from the current-inclusion method (when it accrued under the all events test) to a method which allows late-fee income to create or increase original issue discount (OID).²

Background

The parties have stipulated the facts applicable to the issue considered in this Opinion. Capital One Financial Corp. is a publicly held financial and bank holding company based in McLean, Virginia. Its principal subsidiaries, COB and FSB, are among the world's largest issuers of Visa and MasterCard credit cards.

During the years at issue COB and FSB earned various types of income from their credit card business, including finance charges when cardholders carried a balance on their cards, annual fees, overlimit fees when cardholders exceeded their credit limit, cash advance fees when cardholders accessed cash with their cards, and interchange.³ Pertinent to these motions for partial summary judgment, COB and FSB also earned income from late fees charged when the cardholder was delinquent in making at least the minimum payment due. For the years 1995 through 1999, COB and FSB recognized late-fee income at the time the fee was charged to the cardholder for financial accounting purposes as well as tax purposes. Late-fee income was recognized in the following amounts.

On September 15, 1999, COB submitted Form 3115, Application for Change in Accounting Method, to respondent by attaching it to petitioners' consolidated Federal income tax return for 1998. 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.

Petitioners did not treat late-fee income as OID under the Taxpayer Relief Act of 1997(TRA), Pub.L. 105–34, sec. 1004, 111 Stat. 911 (section 1272(a)(6)(C)(iii)) in 1998 or 1999. They continued to use the current-inclusion method for late-fee income. Petitioners did not attempt to amend their 1998 or 1999 return to treat late-fee income as increasing OID. Petitioners began to treat COB's and FSB's late-fee income as increasing OID on their 2000 return. Respondent has not conceded that petitioners had consent under section 446(e) to make that change.

In response to respondent's notice of deficiency with respect to 1997, 1998, and 1999, petitioners timely filed a petition with this Court. Petitioners subsequently filed their amended petition, claiming they are required to treat late-fee income as increasing OID on their pool of credit card loans, thus reducing their taxable income for 1998 and 1999 by $209,143,757 and $216,698,486, respectively.⁴ On October 12, 2007, the parties filed cross-motions for summary adjudication on the late fees issue. On December 7, 2007, the parties filed objections to each other's motions. A hearing was held on the motions in Washington, D.C., on January 24, 2008.

Discussion

I. Change in the Law

On August 5, 1997, Congress enacted TRA sec. 1004, which added section 1272(a)(6)(C)(iii) to the Code. Section 1272(a)(6)(C)(iii) has the effect, as explained below, of requiring taxpayers to treat credit card receivables as creating or increasing OID on the pool of credit card loans to which the receivables relate. Petitioners seek to change their treatment of COB's and FSB's 1998 and 1999 late-fee income from the current-inclusion method to a method based on section 1272(a)(6)(C)(iii).

The parties have stipulated that if the Court finds that a change in the treatment of late-fee income is permissible, then such income may be treated as creating or increasing OID under section 1272(a)(6)(C)(iii). An understanding of that section and its application to credit card receivables is helpful to an understanding of the issues in this case.

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.

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. ⁵

Rev. Proc. 98–60, app. sec. 12, 1998–2 C.B. 759, 786, provides procedures by which taxpayers may 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 is achieved by filing Form 3115 with a taxpayer's return. Id. sec. 6.02, app. sec. 12, 1998–2 C .B. at 765, 786.

When section 1272(a)(6)(C)(iii) was added to the Code, credit card companies could be certain that grace period interest fell under the new rule. See Rev. Proc. 98–60, app. sec. 12; Staff of Joint Comm. on Taxation, Description and Analysis of Certain Revenue–Raising Provisions Contained in the President's Fiscal Year 1998 Budget Proposal 31–34 (JCS–10–97) (J. Comm. Print 1997). Grace period interest is the interest that accrues from the date of a credit card charge if the balance of a cardholder's account is not paid by the end of the grace period, usually 30 days after the close of a monthly billing cycle.⁶ If the cardholder pays the balance within those 30 days, no interest is charged.

The operation of section 1272(a)(6)(C)(iii) with respect to grace period interest is best explained by...