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
In our previous Opinion in this case,
COB 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
133 T.C. 136">*139 HAINES,
Penalty | ||
Year | Deficiency | |
1995 | $ 1,459,146 | N/A |
1996 | 7,162,060 | N/A |
1997 | 37,656,474 | $ 5,487,734 |
1998 | 72,995,902 | 5,220,381 |
1999 | 175,286,436 | 13,194,525 |
Capital One Financial Corp., through its principal subsidiaries Capital One Bank (COB) and Capital One, F.S.B. (FSB) (collectively Capital One), 22009 U.S. Tax Ct. LEXIS 28">*33 is among the world's largest 133 T.C. 136">*140 issuers of Visa and MasterCard credit cards. Its headquarters is in Virginia. After concessions, 3 three issues remain for our decision, all of which are issues of first impression and relate to the proper tax treatment of Capital One's income and expenses from its credit card business.
The first issue is whether certain credit card income, known as interchange, is properly recognized at the time the interchange accrues under the all events test (when the cardholder's credit card purchase is settled through either the Visa or MasterCard system) or whether it is properly recognized over the anticipated life of the pool of credit card loans to which the interchange relates under
The second issue is whether COB and FSB properly calculated the amount of OID for interchange and overlimit fees. 42009 U.S. Tax Ct. LEXIS 28">*34 We hold that the formula COB used to calculate OID, with modifications required by the OID rules generally and
The third issue is whether Capital One may deduct under
The parties have stipulated many of the facts and they are so found. The stipulations of facts and the exhibits attached thereto are incorporated herein. For the most part the three issues are discrete, and for convenience we have set forth below separately our Findings of Fact and Opinion for each issue.
FINDINGS OF FACT
A.
Interchange is income earned by an issuer of MasterCard or Visa credit cards which accrues to the issuer every time a cardholder uses a card for a purchase. Interchange is typically calculated as a percentage of the total amount of the purchase plus, 2009 U.S. Tax Ct. LEXIS 28">*35 in most but not all instances, a small fixed fee.
To better understand interchange, respondent suggests we review how and why interchange developed and the contractual relationships between the multiple parties in a credit card transaction, as well as the interchange systems in other payment card systems such as signature debit cards and personal identification number (PIN) debit cards. Petitioners, on the other hand, would have us focus on the economics of the credit card transaction, specifically the cashflows. In making our determination, we do not limit our analysis to one aspect or one viewpoint of the interchange system.
B.
Payment card systems, like those of Visa and MasterCard, facilitate transactions between merchants and cardholders. They allow consumers a convenient way to purchase goods without having to carry cash or use a check. Merchants also benefit from payment card systems because they open themselves up to more potential consumers and they receive some assurance of payment and protection from fraud.
Hotels, gas companies, and department stores began issuing payment cards to some of their customers in the 2009 U.S. Tax Ct. LEXIS 28">*36 early 20th century. Such a card was usually accepted only by the merchant who issued the card. Some of the payment cards offered their cardholders a line of credit, while others required the cardholder to pay the balance in full by a fixed date, for example 30 days after a monthly statement was issued. 5
133 T.C. 136">*142 In the 1950s a new type of payment card system was created, Diner's Club, and shortly thereafter American Express created a similar system. Unlike previous cards issued by a single merchant, Diner's Club and American Express cards were accepted by many different merchants if the merchant had joined the respective system. Diner's Club adopted the following price structure, known by some in the payment card industry as a "merchant's pay" structure: cardholders paid a $ 3 annual fee and the merchants received 93 percent of the cardholder's total charge. 6 The difference between the amount of the cardholder's charge and the amount the merchant received was retained by the issuer and was known as merchant discount. American Express set a slightly 2009 U.S. Tax Ct. LEXIS 28">*37 higher annual fee and smaller merchant discount than Diner's Club.
The Diner's Club and American Express systems involved three parties: the cardholder, the merchant, and the card issuer. In these systems the card issuers not only issued cards to cardholders; they also recruited merchants to join the system and processed the card transactions. Of the various payment card systems, this three-party system is known as the "go it alone" system because the card issuer performed the various functions necessary to operate the system.
In 1958 Bank of America also chose to go it alone and began issuing its own payment cards, called BankAmericards, which were credit cards in that cardholders could carry a balance from month to month. Later on, in an effort to compete with Diner's Club and American Express, Bank of America franchised its cards to selected banks across the country. Each franchisee operated the program independently using the BankAmericard name, and participating merchants accepted all cards carrying 2009 U.S. Tax Ct. LEXIS 28">*38 the name whether they were issued by Bank of America or one of the franchisees. Franchisees paid Bank of America .5 percent of purchase volume plus a franchise entry fee. This was known as the franchise model.
A third model developed in the 1960s, the bank association. The idea was that banks would cooperate at the card system level by setting operational standards and fees. Each bank would compete for cardholders as well as merchants. 133 T.C. 136">*143 The association members agreed that a cardholder carrying a card issued by any member bank could use the card at a merchant signed up by any member bank. The banks also cooperated in promoting the card brand name which involved making the association's name more prominent on the card than the individual bank's name. Several associations developed in the 1960s, the most enduring of which was the Interbank Association, which issued Master Charge cards. By the late 1960s banks were rushing to become either BankAmericard franchisees or Interbank Association members. Ultimately, most banks preferred being members of an association rather than franchisees. Bowing to this pressure, in 1970 Bank of America converted its franchise system into an association, National 2009 U.S. Tax Ct. LEXIS 28">*39 BankAmericard, Inc. National BankAmericard, Inc., became Visa in 1976 and the Interbank Card Association became MasterCard in 1979.
A credit card transaction in the Visa and MasterCard (the associations) systems included five parties. 7 In the three-party go it alone model, the card issuer, for example American Express, would set a merchant discount rate acceptable to both parties, maximizing the bank's profits. In the five-party association model the bank that issued the card was usually not the bank that recruited the merchant, and each sought to maximize profits, often at the other's expense. The interchange system was created to solve that problem.
D.
To explain how interchange works, we begin with a description of the five parties to a typical credit card purchase transaction under either the Visa or MasterCard system.
During the years at issue Capital One was an issuing bank, in that it issued cards to 2009 U.S. Tax Ct. LEXIS 28">*40 cardholders, but it did not recruit merchants to join the system. The issuing bank's primary 133 T.C. 136">*144 service was lending money to its cardholders with whom it had a contractual relationship as spelled out in the cardholder agreement. All issuing banks operated under the rules provided by the respective associations, either Visa's By-Laws and Operating Regulations (Visa rules) or MasterCard's By-Laws and Rules and Operating Manuals (MasterCard rules).
The cardholder received a card from the issuing bank. The credit card evidenced a line of credit that had been established by the issuing bank upon which the cardholder could draw to purchase goods or services and in some cases transfer a balance or obtain a cash advance. The amount of the line of credit and the terms and conditions for use of the line of credit were provided in the cardholder agreement. The relationship between the cardholder and Capital One was also described in solicitation materials sent to the cardholder and the application filled out by the cardholder when applying for a Capital One credit card.
Under the terms and conditions of Capital One's cardholder agreements, Capital One promised to extend credit on 2009 U.S. Tax Ct. LEXIS 28">*41 a revolving basis to the cardholder in exchange for the cardholder's promise to pay Capital One the total price of the goods and services purchased by the cardholder using the Capital One card, along with any finance charges and fees as provided under the terms of the cardholder agreement. If a cardholder failed to pay an amount owed, Capital One could not look for payment of the liability from the association, the merchant, or the acquiring bank.
An acquiring bank recruited, screened, and accepted merchants into the associations' credit card systems. An acquiring bank entered into agreements with merchants regarding the merchants' acceptance of credit cards (merchant agreement). The acquiring bank's contractual relationship with the merchant was separate and distinct from the acquiring bank's relationship with the association. Neither Capital 133 T.C. 136">*145 One, the cardholder, nor the association was a party to the agreement between the acquiring bank and the merchant.
An acquiring bank processed credit card transactions on behalf of its merchants and carried out the settlement process for them within the respective 2009 U.S. Tax Ct. LEXIS 28">*42 credit card systems. An acquiring bank also typically provided services to the merchant including deployment of credit card terminals at the point of sale, back-end customer service, risk management, and marketing activities.
The merchant sold goods or services to the cardholder. With respect to a credit card purchase transaction, the merchant had no contract with the issuing bank.
Visa and MasterCard provided the infrastructure which enabled credit card transactions to take place. They processed transactions between acquiring and issuing banks, allowing purchases to be authorized. Further, the associations provided the infrastructure which allowed the parties to clear and settle millions of credit card transactions. These processes are described below.
E.
Credit card purchase transactions typically included (1) an authorization process to enable the merchant to obtain the issuing bank's authorization for the cardholder's purchase and (2) a clearance process to transmit information regarding credit card transactions among the merchant, the acquiring bank, and the issuing bank as required under 2009 U.S. Tax Ct. LEXIS 28">*43 the association's operating rules. 9 Credit card purchase transactions also included a separate flow of funds for settling accounts between issuing banks, acquiring banks, and merchants. Visa and MasterCard each operated electronic network systems to process their respective card transactions, including approval, consolidation, and settlement. These systems are referred to as interchange systems. MasterCard's interchange 133 T.C. 136">*146 system is known as BankNet, and Visa's is known as VisaNet.
A typical credit card purchase transaction is initiated by a cardholder who wants to make a purchase from a merchant. The cardholder presents the card to the merchant in payment for goods or services. The merchant swipes the cardholder's card in a credit card terminal, and data (including the purchase amount, cardholder identifying information, and merchant identity) flows from the merchant to the acquiring bank and then from the acquiring bank through the association to the issuing bank. Approval or denial of the transaction then flows from the issuing bank back through the association 2009 U.S. Tax Ct. LEXIS 28">*44 to the acquiring bank and then to the merchant. This flow of information typically takes place in a matter of seconds.
The process by which Visa and MasterCard credit card purchases were generally authorized is depicted in the chart below. In this hypothetical transaction:
(a) A cardholder purchases a lamp for a total price of $ 100 from a merchant using a Visa or MasterCard credit card issued by Capital One. The card is swiped through an electronic terminal at the merchant's location. The terminal is linked through the acquiring bank to the Visa or MasterCard network. See step 1.
(b) The amount of the transaction and the cardholder information is routed from the merchant to the acquiring bank. See step 2.
(c) The transaction information is routed from the acquiring bank through VisaNet or BankNet to Capital One. See steps 3 and 4.
(d) Capital One either authorizes or declines the transaction, and a message is routed electronically through VisaNet or BankNet to the acquiring bank, and then to the merchant. See steps 5, 6, and 7. (The example assumes Capital One authorizes the purchase.)
(e) Once the merchant receives approval of the transaction, the cardholder provides the merchant with 2009 U.S. Tax Ct. LEXIS 28">*45 a signed transaction receipt, the merchant issues a receipt to the cardholder (sales receipt), and the cardholder departs with the lamp. See steps 8, 9, and 10.
133 T.C. 136">*147 Credit Card Purchase Transaction Authorization Process
[Image Omitted]
By signing the transaction receipt, the cardholder promises to pay Capital One the total price shown thereon sometime in the future. The cardholder may pay more than the total price shown on the transaction receipt. For example, the cardholder may incur finance charges, late fees, or overlimit fees.
With respect to a credit card purchase transaction, the amount Capital One authorized to be charged (the total purchase price) was equal to the amount it expected to be paid by the cardholder. However, as discussed below, Capital One did not authorize Visa or MasterCard to withdraw the total purchase price from its bank account as part of the net settlement process.
F. T
For each credit card purchase transaction, the merchant furnished (either electronically or on paper) a detailed record to its acquiring bank that contained specific information about the transaction including the total price, the date of the purchase, the cardholder's account number, 2009 U.S. Tax Ct. LEXIS 28">*46 the brand and type of credit card used, the merchant's identifying information, the type of merchant (e.g., a grocery store or an airline), the type of transaction (e.g., a face-to-face purchase 133 T.C. 136">*148 or an Internet transaction), and the issuing bank's authorization code, if obtained. The merchant had to transmit this information to its acquiring bank to receive payment for the purchase. In turn, the acquiring bank was required to accept and pay all properly presented transaction receipts from its merchant.
The acquiring bank consolidated and compiled information from all its merchants, calculated the applicable merchant discount (see section I,
G.
Capital One maintained a bank account with the Federal Reserve Bank of Richmond. In accordance with their respective rules, the associations were authorized to withdraw/debit and/or deposit/credit funds into Capital One's bank account to settle Capital One's credit card transactions each day. For credit card purchase transactions, the associations withdrew funds from Capital One's account and deposited funds in the corresponding acquiring bank's account. Both MasterCard and Visa were authorized to withdraw only the total price less the applicable interchange fee from Capital One's Federal Reserve Bank account.
The process through which credit card purchase transactions were settled during the years at issue is shown in the illustration below. This is an example of a single credit card purchase transaction, using a total price of $ 100, a hypothetical 2-percent interchange fee, and a hypothetical merchant discount of 2.5 percent. The example assumes that no other transactions occurred for the cardholder, the merchant, 133 T.C. 136">*149 the acquiring bank, or 2009 U.S. Tax Ct. LEXIS 28">*48 the issuing bank. In settlement of this hypothetical transaction:
a. The association withdraws $ 98 from the issuing bank's account, representing the $ 100 total price less the 2-percent interchange fee.
b. The association deposits $ 98 into the acquiring bank's account, also representing the $ 100 total price less the 2percent interchange fee.
c. The acquiring bank deposits $ 97.50 into the merchant's bank account, representing the $ 100 total price less the 2.5percent merchant discount.
Settlement of $ 100 Credit Card Purchase Transaction
[Image Omitted]
Although the chart above illustrates the settlement of a single discrete cardholder credit card purchase transaction, transactions were not typically settled individually. Rather, credit card transactions were aggregated and processed in large batches. The associations' settlement systems consolidated all batched transactions for a given period, usually daily, and settled accounts among the various members through a process known as direct net settlement. Direct net settlement resulted in the netting of all cash due to, from, and between the associations' respective members. Association 133 T.C. 136">*150 members were required to net settle their transactions 2009 U.S. Tax Ct. LEXIS 28">*49 unless two members agreed otherwise. 10
The association calculated the aggregate settlement position for each of its members. The association then withdrew funds from a member with a negative aggregate settlement position; i.e., a member who owed funds. With respect to credit card purchase transactions, the association withdrew funds from the issuing bank and deposited the net amount owed in the account of the acquiring bank. The amount deposited by the association with the acquiring bank in these circumstances would equal the total credit card purchases made at all of that acquiring bank's merchants by all the issuing bank's cardholders less the total amount of interchange fees determined by the association with respect to those transactions. Typically, the net settlement position determined by the association included any chargebacks 11 (reversed or canceled purchases initiated by issuing banks) processed that day, credits (initiated by merchants), and any other fees owed between issuing 2009 U.S. Tax Ct. LEXIS 28">*50 banks and acquiring banks.
To complete the process, the acquiring bank determined the amount of funds, net of the applicable merchant discount, due each of its merchants with respect to that merchant's aggregate settled credit card transactions. However, this was not part of the associations' net settlement processes.
H.
When a Capital One cardholder signed a transaction receipt, the cardholder promised to pay Capital One the full purchase price in accordance with the terms of the cardholder agreement. Capital One sent its cardholders monthly statements containing detailed purchase transaction entries reflecting the amounts owed by the cardholders. The monthly statements also listed fees Capital One charged the cardholders, such as overlimit fees or late fees. The monthly statements did not list the amount of interchange applicable to the transactions.
133 T.C. 136">*151 Under the terms of the cardholder agreement, a cardholder was obligated to pay Capital One 2009 U.S. Tax Ct. LEXIS 28">*51 at least a certain amount (minimum payment) by the due date specified in the statement. The minimum payment was typically 2 or 3 percent of the cardholder's outstanding balance with at least $ 10 or $ 15 due. The cardholder agreement did not specify a date by which the charge would have to be paid in full.
The cardholder agreement provided for a grace period with respect to purchase transactions in which finance charges on new purchases could be avoided if the total outstanding balance was paid in full before the due date specified on the statement. The cardholder agreement explained: You may avoid finance charge[s] on new purchases and on other new charges by paying the total new balance in full prior to the date payment is due (this is the grace period on new purchases). If you do not pay the entire new balance from the previous statement, finance charges will accrue on the entire previous new balance from the first date of the new billing period. Finance charges, when applicable, will be assessed as follows: o Transactions made during the current billing period from transaction date. o Undated transactions and transactions made with convenience checks: from the date the transaction 2009 U.S. Tax Ct. LEXIS 28">*52 is processed to your account. o Transactions made prior to the current billing period: from the first calendar day of the current billing period.
Cardholders who routinely pay their balance in full every month are known in the credit card industry as transactors. Cardholders who routinely carry a balance on their card are known as revolvers. Of Capital One's total credit card purchase volume (in dollars), approximately 50 percent was attributable to transactors and 50 percent to revolvers.
The difference between the total price of the goods or services sold to cardholders and the amount remitted to the merchant 133 T.C. 136">*152 by the acquiring bank is known as the merchant discount or gross merchant discount. The merchant discount was typically a fixed percentage of the total price of the goods or services sold and compensated acquiring banks for the services they provided the 2009 U.S. Tax Ct. LEXIS 28">*53 merchant. Unlike interchange, the merchant discount was not determined by the association. Rather, merchant discounts were negotiated between acquiring banks and their respective merchants. The difference between the amount the acquiring bank receives from the issuing bank and the amount the acquiring bank sends to the merchant is generally known as the net merchant discount; i.e., the difference between the gross merchant discount and the interchange fee.
J.
MasterCard and Visa set the interchange rates on their respective systems but did not publish them during the years at issue. At some point later, they began publishing their interchange rates. Both MasterCard and Visa used the interchange system to maximize system participation through increased issuance of cards and increased acceptance by merchants. If interchange rates were set too high, acquiring banks would raise the merchant discount, and merchants would be less likely to accept MasterCard or Visa cards. If interchange rates were set too low, issuing banks were less likely to issue MasterCard or Visa cards because they might not have been able to cover their costs and make a sufficient profit.
To balance the interests of the various parties to a credit card purchase transaction and to maximize system participation, both Visa and MasterCard have implemented a variety of interchange rates. The rates were based on a number of factors including: (1) The method of the purchase (e.g., in person or on line); (2) the type of merchant; (3) the geographical area of the merchant (e.g., domestic or international); (4) the type of cardholder (e.g., individual/personal or corporate/business); (5) in some instances the size of the transaction (e.g., a "large ticket" purchase over a certain 133 T.C. 136">*153 threshold amount); and (6) the type of purchase (e.g., corporate travel and entertainment expense).
The associations also set lower interchange rates to better compete with other payment systems or methods. For example, supermarkets typically operated on low gross profit margins and were reluctant to accept Visa and MasterCard cards because of the merchant discount. Both Visa and MasterCard implemented lower interchange rates for supermarkets, resulting in lower merchant discounts, thereby incentivizing card acceptance. The associations also implemented lower interchange rates 2009 U.S. Tax Ct. LEXIS 28">*55 to better penetrate other markets including automated fuel dispensers.
MasterCard's interchange rates included the following categories:
Program Name | 1997-1998 Rates | 1998-1999 Rates | 1999-2000 Rates |
Consumer | 2.15% + $ 0.10 | 2.35% + $ 0.10 | 2.65% + $ 0.10 |
Standard | |||
Travel | 1.35% + $ 0.10 | 1.43% + $ 0.10 | 1.58% + $ 0.10 |
Industries | |||
Petroleum | 1.35% + $ 0.05 | 1.40% + $ 0.05 | 1.50% + $ 0.05 |
Terminal | |||
Supermarket | 1.10% | 1.15% | 1.15% |
Corporate | 2.25% | 2.52% + 0.10 | 2.65% + 0.10 |
Standard |
Visa's interchange rates included the following categories:
Program Name | 9/27/97-3/27/98 | 3/28/98-4/9/99 |
Rates | Rates | |
Standard Commercial | 2.00% + $ 0.11 | 2.09% + $ 0.10 |
(Other than Certain | ||
Travel-Related Charges) | ||
CPS/Retail n.1Commercial | 1.25% | 1.31% |
(Other than Certain | ||
Travel-Related Charges | ||
CPS/Hotel and Car | 1.93% + $ 0.06 | 2.02% + $ 0.10 |
Rental | ||
Supermarket Incentive | 1.10% | 1.15% |
Program, Non-Commercial | ||
*3*n.1 CPS refers to "custom payment service", Visa's term | ||
*3*for card transactions that are processed a certain way. |
The costs of issuing banks, such as Capital One, were one factor associations considered when they set interchange rates. Both Visa and MasterCard studied issuing banks' costs. MasterCard hired Edgar, Dunn & Co. (Edgar Dunn), 2009 U.S. Tax Ct. LEXIS 28">*56 a consulting firm, to study issuing banks' costs as part of MasterCard's process for setting interchange rates. The costs 133 T.C. 136">*154 studied included the grace period cost of funds for transactors, risk costs for credit card transactions generally (credit and fraud risks), and processing costs for credit card transactions. These studies did not address the cost of funds for revolvers; that is, cardholders who carry a balance on their card and therefore pay monthly finance charges. Edgar Dunn's composite issuing bank cost figures were as follows:
Year | Issuing Banks' Costs n.1 |
1997 | 2.52 percent + $ 0.10 per transaction |
1998 | 2.92 percent + $ 0.10 per transaction |
1999 | 2.97 percent + $ 0.10 per transaction |
*2*n.1 Edgar Dunn broke the total cost down into | |
*2*components. The issuing bank's cost of lending | |
*2*money, i.e., the financial carrying costs during | |
*2*the grace period, were .20 percent, .22 percent, | |
*2*and .20 percent of the total purchase price | |
*2*during 1997, 1998, and 1999, respectively. For | |
*2*1997, 1998, and 1999, 2.32 percent, 2.70 percent, | |
*2*and 2.77percent of the total purchase | |
*2*price represented the total risk costs.Edgar Dunn | |
*2*calculated the issuing bank's processing | |
*2* costs to be 10 cents per transaction. |
For 2009 U.S. Tax Ct. LEXIS 28">*57 1997 Visa estimated that the average processing cost per transaction was 8.4 cents, with the actual costs ranging between 4.8 cents and 11.4 cents. For 2000 the average cost was 6.6 cents per transaction, with the actual costs ranging between 3.8 cents and 9.7 cents per transaction. For 1998 and 1999 Capital One's cost of processing a credit card transaction was likely between 4.6 cents and 8.2 cents per transaction.
3.
During the years at issue Capital One did not issue signature debit cards. 12 A signature debit card is linked to the cardholder's deposit account, from which the purchase price of the goods or services purchased is withdrawn, as opposed to a credit card which evidences a line of credit. However, other issuing banks which were members of the associations did offer debit cards. Both Visa and MasterCard set interchange 133 T.C. 136">*155 rates for their debit cards. MasterCard's interchange rates for credit card transactions were identical to those for debit card transactions for each of MasterCard's consumer interchange programs. In a number of instances, Visa's debit card interchange rates were equal to the interchange rates for its credit card transactions. 2009 U.S. Tax Ct. LEXIS 28">*58 Data published by the Federal Reserve System in a report to Congress shows that until 2002, the interchange rate on signature debit card transactions was only slightly lower than the interchange rate on credit card transactions.
Capital One kept track of all its cardholders' charges in what is known as its cardholder account system (CAS). The CAS reflected the amount of each purchase made with a Capital One card which was the same as the total purchase 2009 U.S. Tax Ct. LEXIS 28">*59 price of whatever the cardholder purchased in that particular transaction. The CAS did not reflect any detail with respect to the amount of interchange received. Capital One maintained so called "310 reports", which were monthly summaries aggregating transaction data and financial accruals. The 310 reports did not include any information about interchange either on an individual cardholder basis or on an aggregate basis.
For financial accounting purposes, Capital One accounted for credit card purchase amounts and interchange fees through separate systems. Capital One used daily summary reports from Visa and MasterCard for purposes of booking interchange income. Using the example of a $ 100 purchase transaction with a $ 2 interchange fee, Capital One would enter the purchase amount as "credit card outstanding" (an account receivable). The $ 2 interchange fee would be credited as "interchange income". For financial accounting purposes, Capital One reported interchange income as "noninterest income".
Before 1998 Capital One recognized income from late fees and overlimit fees for both financial accounting purposes and 133 T.C. 136">*156 Federal income tax purposes at the time the fees were charged to the cardholder. 2009 U.S. Tax Ct. LEXIS 28">*60 Before 1998 Capital One recognized interchange income for both financial accounting and Federal income tax purposes at the time its cardholders' transactions were net settled under the Visa and MasterCard rules. For financial accounting and regulatory reporting purposes, 13 Capital One differentiated between interest and noninterest income according to whether the particular income was attributable to an activity of the cardholder. For example, Capital One treated cash advance fees as noninterest income because a cardholder would have withdrawn cash at an ATM or a bank. 14 Similarly Capital One treated interchange as noninterest income for financial accounting and regulatory reporting purposes because it is triggered by the cardholder's purchase.
On their Federal income tax returns for 1998 and 1999, petitioners recognized Capital One's income from overlimit fees, cash advance fees, and interchange fees as creating or 2009 U.S. Tax Ct. LEXIS 28">*61 increasing the amount of OID on Capital One's pool of credit card loans, thereby deferring the recognition of income and reducing their Federal income tax liabilities. Respondent challenges petitioners' treatment of Capital One's interchange income as creating or increasing OID under
OPINION
A.
Under 133 T.C. 136">*157 The holder of a debt instrument with OID generally accrues and includes in gross income, 2009 U.S. Tax Ct. LEXIS 28">*62 as interest, the OID over the life of the obligation, even though the interest may not be received until the maturity of the instrument. 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, 2009 U.S. Tax Ct. LEXIS 28">*63 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. [Fn. Ref. omitted]
Respondent has conceded that as a general proposition cash advance fees, overlimit fees, and late fees may be treated as creating or increasing OID on the pool of loans to which such income relates. See
B.
The parties agree that the SRPM of a credit card loan is the sum of all payments provided by the debt instrument other than finance charges. See
The parties dispute the calculation of the issue price of a credit card loan. if an issue consists of a single debt instrument that is issued for money, the issue price of the debt instrument is the amount 2009 U.S. Tax Ct. LEXIS 28">*65 paid for the debt instrument. For example, in the case of a debt instrument evidencing a loan to a natural person, the issue price of the instrument is the amount loaned. * * *
However, a credit card loan is part of a multiparty transaction where the funds lent are sent to the merchant via the acquiring bank. The cardholder never receives the funds, and the funds received by the merchant are always less than the amount the cardholder must repay. The issue price of a credit card loan is the price paid for the debt instrument. 162009 U.S. Tax Ct. LEXIS 28">*66
Petitioners argue that Capital One acquired the loan at a discount from the price at which the cardholder purchased goods or services from the merchant, with the discount being the amount of interchange, i.e., $ 2 for a $ 100 purchase, where Capital One actually advanced $ 98 to the acquiring bank. Respondent argues that Capital One cannot have acquired the loan at a discount because the acquiring bank, and not the cardholder, paid interchange to Capital One during the net settlement process. Further, respondent argues that interchange was a fee for services rendered by the 133 T.C. 136">*159 issuing bank, not economically equivalent to interest, and therefore not OID.
1.
Respondent argues that interchange is a fee for a service, and that Capital One acquired a credit card loan for an amount equal to the full price at which the cardholder purchased goods or services from the merchant, but that Capital One simultaneously received a payment from the acquiring bank equal to the interchange amount. Thus in respondent's view the issue price paid by Capital One to acquire 2009 U.S. Tax Ct. LEXIS 28">*67 the loan would be the total purchase price of the goods or services which would in turn equal the SRPM resulting in no OID.
In determining whether interchange is a service fee or economically equivalent to interest, we draw on other areas of the tax law where distinctions between fees and interest have been made. Courts, including this Court, have held that fees earned by a lender relating to the lending of money are properly treated as interest unless the fee is for a specific service. Although courts look to all the facts and circumstances to determine whether an item of income is a service fee or interest, the primary inquiry is whether the charge compensates the lender for specifically stated services it provided to and for the benefit of the borrower beyond the lending of money. In We do not think the mere fact that the contract designates certain uses to which the funds will be put makes the charge any less a fee paid by 133 T.C. 136">*160 the borrower for use of the lender's money, unless it is shown that the charge was actually used for such purposes and the charge is justifiably a charge to the borrower separate from interest. Unless such can be shown, we believe the service charges made by small loan companies must be considered interest because basically the nature of the small loan company business is to make a profit in the form of interest on money loaned and the borrower is interested only in obtaining the loan and pays whatever is required of him to get the use of the lender's money. * * *
On direct examination by respondent, MasterCard's Steven Jonas, the senior business leader for financial analysis with MasterCard Worldwide, 17 was asked whether interchange compensated an issuing bank for a specific service. He testified: I don't think directly. I think the issuers are providing a service to the cardholders, enabling them to go out and transact. Not directly -- I mean, to some extent, the issuer does provide value to a merchant because they now have enabled the cardholder to go out and make purchases, and the acquirer makes money by processing transactions. And the merchant makes money by selling goods and services. But I think I view the transaction, the service 2009 U.S. Tax Ct. LEXIS 28">*70 being provided is to the cardholder who is borrowing money and, therefore, going out and making purchases.
Similarly, when asked about his statement that "Interchange rates are not a fee for any specific service provided by issuing banks", William Sheedy, the President of Visa, Inc., 18 explained: We're not looking at any particular service. We're considering the product in general, the premium credit product. We want the issuers to invest in that product, to choose to do business with Visa, as compared to our 133 T.C. 136">*161 competitors. And we also want the product and rate structure to be configured in a way that the issuers will prioritize that within their business and market it and promote it and put resources against it, because our experience is when that happens, it grows our business.
Respondent's expert witness, Dr. Richard Schmalensee, 19 testified that the service provided "is putting customers on the streets with cards eager 2009 U.S. Tax Ct. LEXIS 28">*71 to use them to buy from merchants." Credit cards evidence a line of credit on which cardholders can draw, and providing credit cards that can be used to make purchases is the lending of money. Certainly the lending of money benefits cardholders, merchants, and acquiring banks, but the receipt of a benefit does not mean that those parties have been provided a service other than the lending of money to the cardholder.
In arguing that interchange is a fee for a service, respondent focuses on the purpose of interchange, which is to balance the two sides of the credit card business to encourage the overall growth of the respective systems. If interchange rates are set too high, acquiring bank and merchant participation are disincentivized. If interchange is set too low, card issuing is disincentivized. Respondent makes much of MasterCard's 2009 U.S. Tax Ct. LEXIS 28">*72 and Visa's desire to use optimal interchange rates to increase their business. However, using interchange to balance the two sides of the credit card business is entirely consistent with petitioners' position that interchange compensates issuing banks for the cost of lending money.
We agree that setting interchange rates is a balancing act, but we ask: what are the associations balancing? MasterCard and Visa balance the issuing banks' and the acquiring banks' needs to profit on credit card transactions. Profit is the excess of revenues over costs. When lending money to its cardholders, Capital One incurs the cost of processing transactions, financial carrying costs, and the risk costs associated with credit card transactions, for example, the risk that fraud was committed (fraud risk) and the risk that the cardholder will be unable to repay the loan (credit risk). In short, 133 T.C. 136">*162 interchange compensates banks for the costs of lending money.
Respondent argues that interchange has little to do with the costs of lending money, specifically the time value of Capital One's money lent to the cardholders. In respondent's view if interchange is not akin to interest, it must be a fee for a service. 2009 U.S. Tax Ct. LEXIS 28">*73 Respondent's argument presupposes that for interchange to be treated as creating or increasing OID, it must be economically equivalent to interest.
OID "serves the same function as stated interest * * *; it is simply 'compensation for the use or forbearance of money.'" the amount fixed by the last modification of the purchase agreement and includes interest
For many transactors 2009 U.S. Tax Ct. LEXIS 28">*74 interchange would be the only revenue Capital One receives. 20 The length of Capital One's loan to a transactor may be as little as a day or two (if the cardholder pays Capital One immediately upon making a charge) or as long as 60 days (if the cardholder makes a charge on the first day of the billing cycle and pays the statement balance on the last day of the grace period). Whether for 1 day or 60, Capital One has forgone the use of those funds, and payments for such use resemble interest. If interchange is not payment for the use of the funds Capital One has lent, then Capital One would not have received compensation for the use of approximately half the funds lent to its cardholders. 133 T.C. 136">*163 With respect to transactors, interchange compensates Capital One for the expenses and costs associated with lending money to cardholders, including financial carrying costs and credit and fraud risks.
MasterCard's rules explain the relationship between interchange fees and issuing banks' costs of lending: Purpose of Fees. The interchange 2009 U.S. Tax Ct. LEXIS 28">*75 fee * * * [is] designed to compensate a member for particular expenses that it incurs as the result of interchange transactions. For sale transactions, various elements of expense make up the interchange fee, including costs of processing, costs of money, and increased risk due to the use of MasterCard cards in interchange transactions.
Respondent's expert witness, Dr. Schmalensee, testified that "[interchange is] a revenue stream that serves to compensate banks for all the costs involved in credit card and other payment card programs."
In determining interchange rates, Visa and MasterCard studied and considered issuing banks' costs of lending. The Edgar Dunn studies break down an issuing bank's costs into three of the largest categories: Risk costs, financial carrying costs, and processing costs. Risk costs include credit and fraud risks. The financial carrying costs are the "imputed interest cost to the issuing member of carrying the interchange transactions from the time of account posting to the receipt of funds or accruing of cardholder interest by the issuing member."
Petitioners' expert witness, Dr. Peter Tufano, 21 explained that when interchange is viewed as an "economic" interest 2009 U.S. Tax Ct. LEXIS 28">*76 rate, the average annualized rate is "similar to those of interest rates for unsecured consumer loans during 1998 and 1999." The speed at which the cardholder loan is paid off can dramatically affect this rate, returning seemingly exorbitant interest rates of over 100 percent in situations where the cardholder pays the loan off within a few days. However, very high interest rates are not uncommon in numerous forms of unsecured consumer lending, such as so-called payday loans where the effective interest rate can be between 390 and 500 percent depending on when the loan is repaid. 133 T.C. 136">*164 That the effective interest rate varies depending on when the cardholder pays off the loan does not affect the function of interchange, which is to compensate issuing banks for the cost of lending money.
Respondent also invites our attention to signature debit cards, which involve little or no lending, just a "float" of at most 1 2009 U.S. Tax Ct. LEXIS 28">*77 or 2 days. 22 Visa's and MasterCard's interchange rates for signature debit cards were often identical to the interchange rates for credit cards during the years at issue. Until 2002 interchange rates on debit card transactions were only slightly lower than the rates on credit card transactions. Respondent concludes that interchange is not equivalent to interest because similar interchange rates were used for debit cards, which involve little to no lending. Just as the associations considered several factors in setting credit card interchange rates, we assume they considered similar factors in setting debit card interchange rates. The similarity between the rates during the years at issue does not negate our conclusion that interchange compensates Capital One for its costs of lending money.
Revolvers, as opposed to transactors, pay finance charges which are stated separately on the cardholder's monthly statements. Stated finance charges compensate Capital One for the use of the money lent, and revolvers do not have the benefit of a grace period during which they receive the use of 2009 U.S. Tax Ct. LEXIS 28">*78 funds interest free. Dr. Tufano testified that, with respect to revolvers, interchange is viewed as additional compensation for the use of the money lent. Dr. Tufano analyzed the effective interests rate of interchange fees on a revolving account and determined that, on average, interchange raises the annual percentage rate by about 1.7 percent, which was still comparable with other types of consumer loans.
Credit and fraud risks are also costs associated with lending money. Interest, including OID, compensates lenders for the time value of their money, the risk that the borrower may not repay principal, and the expenses of pursuing delinquent debtors.
Interchange resembles interest in other ways as well. In almost all instances, it is expressed as a percentage of the amount lent, usually with an additional nominal fee. 23 Thus, as the amount of the loan increases, the amount of interchange increases, just as the amount of interest increases as the amount of the loan increases. As we said in 2009 U.S. Tax Ct. LEXIS 28">*79
Respondent argues that interchange rates were not driven by movements in market interest rates. For example, between 1999 and 2004 the prime rate fell from 8 percent to 4 percent, yet average interchange rates rose slightly, from 1.62 percent to 1.71 percent. Petitioners' expert witness, David Boucher, counters that certain interest rates are "sticky" in that they do not often change, and that sticky interest rates are not uncommon in consumer lending. For example, the interest rate for payday loans has not changed in at least 10 years. Furthermore, 2009 U.S. Tax Ct. LEXIS 28">*80 interchange rates take into account various other factors such as credit and fraud risk, processing costs, and Visa's and MasterCard's efforts to maximize their business by competing with other payment systems and balancing the competing sides of the credit card business.
That interchange did not cover all of Capital One's costs of lending does not make it less "interestlike". Interchange rates were not set by Capital One but were set by VISA and MasterCard to increase their business, compete with other payment card systems, and penetrate new markets. To continue issuing Visa and MasterCard credit cards Capital One was required to accept those rates. Whether interchange covered all of Capital One's costs, or covered just a small fraction of them for certain types of credit card transactions is 133 T.C. 136">*166 not dispositive of our determination of whether interchange is a fee for a service or economically equivalent to interest. 242009 U.S. Tax Ct. LEXIS 28">*81
We conclude that interchange is not a fee for any service other than lending money to cardholders, income from which is generally treated as interest. Petitioners have shown that interchange fees are a form of interest compensating Capital One for the costs of lending money.
2.
The parties present two competing views of a credit card purchase transaction. Petitioners argue that Capital One acquired the credit card receivable, i.e., the transaction receipt, from the acquiring bank. This would suggest that Capital One acquired the debt instrument at a discount. Returning to the $ 100 purchase with 2-percent interchange example, Capital One authorized the cardholder to make a $ 100 purchase, but Capital One did not authorize MasterCard or Visa to withdraw $ 100 from its account. It authorized only a $ 98 withdrawal, the purchase price less interchange. Respondent contends that Capital One lends the cardholder $ 100 for the cardholder's promise to pay $ 100, and that the acquiring bank paid Capital One $ 2. In this scenario, $ 2 would be a fee for services and not OID.
Neither 2009 U.S. Tax Ct. LEXIS 28">*82 the Code nor the regulations define the term "paid", but courts have generally defined it as the paying out of cash or its equivalent. See
But the debate about who really bears the cost of interchange is largely academic, and we need not, and do not, base our decision on its outcome. Whether merchants, acquiring banks, or cardholders ultimately pay interchange is not 133 T.C. 136">*167 determinative of the tax treatment of interchange. If we accept respondent's argument that acquiring banks pay interchange to issuing banks, we would still conclude that interchange is properly treated as creating or increasing OID on the pool of loans to which it relates.
If, as part of a lending transaction, a party other than 2009 U.S. Tax Ct. LEXIS 28">*83 the borrower (the third party) makes a payment to the lender, the payment is treated in appropriate circumstances as made from the third party to the borrower followed by a payment in the same amount from the borrower to the lender and governed by the provisions of paragraph (g)(2) of this section. * * * a payment from the borrower to the lender (other than a payment for property or for services provided by the lender, such as commitment fees or loan processing costs) reduces the issue price of the debt instrument evidencing the loan. * * *
Respondent argues that interchange is not a part of a lending transaction because the purpose of interchange is to balance the competing interests of the issuing and acquiring banks. As discussed earlier interchange compensates issuing banks for the costs of lending money, and but for the lending of money, Capital One would not earn any interchange. In short, interchange is part of a lending transaction. 252009 U.S. Tax Ct. LEXIS 28">*84
Under respondent's theory, a third party, the acquiring bank, pays interchange to the lender, Capital One. As discussed above, that payment is not for property or services provided by the lender other than the service of lending of money to the cardholder. 26 Therefore, under
The regulations provide an example of 2009 U.S. Tax Ct. LEXIS 28">*85 a situation in which a payment from a third party to a lender results in OID. (i) Facts. A sells real property to B for $ 500,000 in a transaction that is not a potentially abusive situation (within the meaning of (ii) * * * Under the provisions of paragraphs (g)(2)(i) and (g)(4) of this section, B is treated as having made an $ 8,000 payment directly to L and a payment of only $ 492,000 to A for the property. * * * The payment to L reduces the issue price of B's debt instrument to $ 392,000, resulting in $ 8,000 of OID ($ 400,000 - $ 392,000). * * *
A credit card loan is not a "potentially abusive situation" under
Under these circumstances, we conclude that even if respondent is correct that the acquiring bank pays interchange to the issuing bank, that amount is considered a payment between a third party and a lender which reduces the issue price of the debt instrument under
D.
The SRPM of a credit card loan is the purchase price of the goods and services financed by the loan. The issue price of a credit card loan is the amount the issuing bank pays for the loan. Because Capital One authorized MasterCard and Visa to withdraw the purchase price less the applicable interchange amount for every credit card purchase transaction, Capital One paid an amount less than the SRPM for the credit card loan. The difference between the SRPM and the issue 133 T.C. 136">*169 price, the interchange on the transaction, is therefore properly treated as OID.
FINDINGS OF FACT
On August 5, 1997, Congress enacted the Taxpayer Relief Act of 1997 (TRA), Pub. L. 105-34, sec. 1004, 111 Stat. 911, which added Capital One Bank (COB), a domestic corporation, requests permission under Section 12.02 of
Nevertheless, FSB as well as COB treated overlimit fees and interchange as creating or increasing OID under
B.
The following chart shows the fees COB 27 earned for book purposes (when the fee was charged to the cardholder in the case of overlimit fees and when the cardholder's purchase 133 T.C. 136">*170 was settled by the associations in the case of fees for interchange), the amount of COB's related OID included on petitioners' consolidated income tax return, the difference between them, and the amount of accrued but unrecognized OID carrying over to the following year.
Overlimit Fees
Overlimit | Income | |||
Fee Income | Recognized | Difference: | Unamortized | |
Taxable | for book | per KPMG | Book v. | OID Bal. at |
Year | purposes | Model | KPMG Model | End of Year |
1995 | $ 62,492,312 | $ 21,823,631 | $ 40,668,680 | $ 40,668,681 |
1996 | 147,929,903 | 71,177,420 | 76,752,482 | 117,421,163 |
1997 | 288,906,382 | 192,694,592 | 96,211,790 | 213,632,953 |
1998 | 436,215,910 | 323,714,900 | 112,501,010 | 326,133,963 |
1999 | 539,618,976 | 488,702,655 | 50,916,321 | 377,050,283 |
Interchange 2009 U.S. Tax Ct. LEXIS 28">*89 Fees
Income | ||||
Recognized | Difference: | Unamortized | ||
Taxable | Interchange | per KPMG | Book v. | Bal. OID at |
Year | Book Income | Model | KPMG Model | End of Year |
1995 | $ 76,425,718 | $ 26,786,819 | $ 49,638,899 | $ 49,638,899 |
1996 | 97,892,344 | 68,308,342 | 29,584,002 | 79,222,901 |
1997 | 109,487,559 | 94,175,860 | 15,311,699 | 94,534,599 |
1998 | 168,336,313 | 126,972,006 | 41,364,307 | 135,898,906 |
1999 | 298,347,199 | 223,016,501 | 75,330,698 | 211,229,604 |
OPINION
A.
In 1997 Congress added
Our previous Opinion addressed the parties' cross-motions for partial summary judgment on the issue of whether COB and FSB were permitted to change their treatment of 1998 and 1999 late-fee income to the method 2009 U.S. Tax Ct. LEXIS 28">*90 called for by
Respondent argues that because FSB did not submit Form 3115 in 1998 or 1999, requesting to change its method of accounting for interchange or overlimit fees, it may not now treat those fees as creating or increasing OID under In the light of the purposes for requiring notification to the Commissioner of a taxpayer's change in method of accounting, the Court holds that petitioners were required to follow all applicable procedures put in place by respondent in order to receive consent to change their method of accounting to comply with
B.
No specific precedent articulates the standard to apply in determining whether a taxpayer's assumptions used to calculate the proper amount of OID included in gross income in a given year are proper. Although
Respondent also notes his authority to require a certain method of tax accounting when the taxpayer's method of accounting fails to reflect the taxpayer's income clearly. SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING. (a) General 2009 U.S. Tax Ct. LEXIS 28">*93 Rule. -- Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books. (b) Exceptions. -- If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income.
Where a taxpayer is required to use assumptions and estimates to compute the accrual of OID, a reasonableness standard is appropriate. Further, a reasonable method of calculating the accrual of OID under
As described below, we find that in some respects the KPMG model does not comply with the OID rules and regulations. The methods used for calculating the accrual of OID must comply with those rules and regulations.
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 portion of the OID on such debt instruments is determined by taking into account an assumption regarding the prepayment of such instruments. (A) In general. -- In the case of any debt instrument to which this paragraph applies, the daily portion of the original issue discount shall be determined by allocating to each day in any accrual period its ratable portion of the excess (if any) of -- (i) the sum of (I) the present value determined under subparagraph (B) of all remaining payments under the debt instrument as of the close of such period, 2009 U.S. Tax Ct. LEXIS 28">*95 and (II) the payments during the accrual period of amounts included in the stated redemption price of the debt instrument, over (ii) the adjusted issue price of such debt instrument at the beginning of such period.
133 T.C. 136">*174 Where: OIDn = OID for the period.
Cashflown = amounts included in the SRPM received in the current accrual period.
AIPn = Present value of all remaining payments as of the end of the period or adjusted issue price at the end of the period.
AIPn-1 = Adjusted issue price at the beginning of the period.
(B) Determination of present value. -- For purposes of subparagraph (A), the present value shall be determined on the basis of -- (i) the original yield to maturity (determined on the basis of compounding at the close of each accrual period and properly adjusted for the length of the accrual period), (ii) events which have 2009 U.S. Tax Ct. LEXIS 28">*96 occurred before the close of the accrual period, and (iii) a prepayment assumption determined in the manner prescribed by regulations. if a taxpayer holds a pool of credit card receivables that require interest to be paid if the borrowers do not pay their accounts by a specified date, the taxpayer would be required to accrue interest or OID on such a pool based on a reasonable assumption regarding the timing of the payments of the accounts in the pool. * * *
The "timing of the payments of the accounts in the pool" is critical because the present value of a future payment decreases as the payment date becomes more distant, hence the adage "a dollar today is worth more than a dollar in the future." For example, assuming a 10-percent interest rate, the present value of $ 100 to be received in 1 year is $ 90.91. The present value of $ 100 to be received in 2009 U.S. Tax Ct. LEXIS 28">*97 2 years is $ 82.65, 133 T.C. 136">*175 and so forth. The present value of a payment to be received in the future is represented by the following formula:
Present Value = Future Value
____________
(1 + R)n
Where: n = the number of periods until the payment is received
R = interest rate
D.
With respect to credit card loans, there is no fixed date by which a loan needs to be paid off. Therefore, a prepayment assumption under
Under the KPMG model, the payment rate is a fraction where the numerator is cash collections net of finance charges and the denominator is the beginning credit card receivable balance plus that month's new additions (excluding finance charges). For purposes of computing OID, COB treats stated finance charges as "stated interest" and 2009 U.S. Tax Ct. LEXIS 28">*98 recognizes such interest as income currently as it is billed to the cardholder. Therefore stated finance charges are not included in either the numerator or the denominator of the payment rate. 29 The payment rate is calculated using the following formula:
Payments - Stated Finance Charges
_________________________________
Outstanding Balance + Net Additions
The KPMG model uses a constant monthly payment rate. For example, on a $ 100 debt with a 10-percent payment rate, after 1 month the outstanding debt will be $ 90, after 2 months it will be $ 81, after 3 months it will be $ 72.90, and 133 T.C. 136">*176 so forth. In this way the payments continue forever with the debt becoming infinitesimally small. Assuming a 10-percent payment rate, 72 percent of the balance will be paid in 12 months, 92 percent in 24 months, and 98 percent in 36 months.
From 1995 to 1999 the payment rate for COB's pool of credit card receivables was calculated under the KPMG model to be an average of 8.91 percent.
COB'S MONTHLY AND AVERAGE PAYMENT RATES
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | AVG | |
1995 | 9.07 | 9.05 | 9.73 | 8.03 | 8.67 | 8.35 | 8.46 | 8.02 | 7.21 | 8.90 | 8.47 | 7.66 | 8.47 |
1996 | 9.43 | 9.51 | 9.36 | 9.26 | 8.34 | 7.75 | 8.65 | 7.58 | 7.66 | 7.96 | 7.34 | 7.62 | 8.37 |
1997 | 8.16 | 8.23 | 8.82 | 8.01 | 8.77 | 8.92 | 8.59 | 8.00 | 8.20 | 8.58 | 8.22 | 8.53 | 8.42 |
1998 | 8.97 | 8.64 | 10.02 | 9.13 | 8.85 | 8.92 | 8.7 | 9.00 | 8.35 | 9.55 | 8.80 | 8.30 | 8.94 |
1999 | 8.85 | 9.39 | 11.01 | 9.94 | 10.72 | 9.87 | 10.70 | 10.54 | 10.77 | 10.98 | 10.68 | 10.70 | 10.35 |
The 2009 U.S. Tax Ct. LEXIS 28">*99 payment rate is critical to the calculation of OID because it is used to calculate the weighted average maturity (WAM) and the yield to maturity (YTM), both of which enter into the calculation of the present value of future expected payments.
In the KPMG model the WAM is the inverse of the payment rate and is expressed in months. For example, the WAM of a pool of debt instruments with an expected payment rate of 10 percent is 10 months (1 divided by .1 = 10). If the payment rate is 20 percent, the WAM is 5 months (1 divided by .2 = 5).
The calculation of the WAM is a simplifying assumption in the present value calculations. In reality some cardholders make payments on their loan earlier and some later. The WAM is a mathematical assumption of a single point at which on average all cardholders will pay off their debt.
Rather than calculating the present value of each of a series of unequal periodic payments of the pool every month, the KPMG model simplifies the process by using the WAM to limit the calculation to the present value of one payment (equal to the relevant balance of the entire pool) at the WAM. Specifically, the WAM is the number of periods, 2009 U.S. Tax Ct. LEXIS 28">*100 or "n" in the present value formula used in the KPMG model.
133 T.C. 136">*177 Present Value = Future Value or Future Value
_____________ _____________
(1 + R)n (1 + R)WAM
From 1995 to 1999 the WAM of COB's pool of credit card receivables was calculated to be on average 11.35 months and the average WAM for 1998 and 1999 was 10.46 months.
Monthly and Average WAM
1 | 2 | 3 | 4 | 5 | 6 | 7 | |
1995 | 9.07 | 9.05 | 9.73 | 8.03 | 8.67 | 8.35 | 8.46 |
1996 | 9.43 | 9.51 | 9.36 | 9.26 | 8.34 | 7.75 | 8.65 |
1997 | 8.16 | 8.23 | 8.82 | 8.01 | 8.77 | 8.92 | 8.59 |
1998 | 8.97 | 8.64 | 10.02 | 9.13 | 8.85 | 8.92 | 8.71 |
1999 | 8.85 | 9.39 | 11.01 | 9.94 | 10.72 | 9.87 | 10.70 |
8 | 9 | 10 | 11 | 12 | AVG | |
1995 | 8.02 | 7.21 | 8.90 | 8.47 | 7.66 | 8.47 |
1996 | 7.58 | 7.66 | 7.96 | 7.34 | 7.62 | 8.37 |
1997 | 8.00 | 8.20 | 8.58 | 8.22 | 8.53 | 8.42 |
1998 | 9.00 | 8.35 | 9.55 | 8.80 | 8.30 | 8.94 |
1999 | 10.54 | 10.77 | 10.98 | 10.68 | 10.70 | 10.35 |
In the KPMG model, the YTM is calculated using a formula in a Microsoft Excel worksheet to derive the interest rate at which the sum of the net present values of all of the future payments is equal to the issue price of the debt pool. The issue price is the amount of cash advanced by COB as the issuing bank to acquire the debt. Specifically, the YTM is calculated using the RATE function in Excel, which is expressed as follows: RATE = (Nper, Pmt, PV, FV).
In this formula: (1) Nper is the total number of payment 2009 U.S. Tax Ct. LEXIS 28">*101 periods for the loan and Nper is equal to the WAM; (2) Pmt is the payment made each period and Pmt equals zero for purposes of this calculation (there are no monthly payments assumed but rather the entire SRPM (FV)) is considered collected at the WAM; (3) PV is the present value, the total amount that a series of future payments is worth at that point and PV equals Beginning Issue Price (including new additions)/SRPM (including new additions); and (4) FV is the future value, or a cash balance you wish to attain after the last payment is made and FV equals 1.
Calculating the YTM assuming payment of the SRPM at the WAM is the mathematical equivalent of any combination of prepayment assumptions that pays off the SRPM over various other periods with the same WAM.
With a YTM and a WAM, the KPMG model then calculates the present value of the future payment stream.
Having determined a payment rate, a WAM, and a YTM, the KPMG model then uses a beginning issue price, an ending issue price, and principal payments for every month, which are derived from COB's financial accounting reports. The beginning issue price is the issue price of the pool at the beginning of the month (the SRPM 2009 U.S. Tax Ct. LEXIS 28">*102 less OID accrued for prior periods) plus new additions during the month (new principal). The ending issue price is the present value of the future cashflow. The principal payments are the actual principal payments received during the month. The KPMG model then determines the unadjusted OID accrual for a given month using the formula: OIDn = [Cash flown + AIPn] - AIPn-1.
The KPMG model incorporates a
The KPMG model assumes that all charges or lending transactions creating the monthly pool occur on the 15th of the month. The model therefore allocates fourteen-thirtieths of the OID for each monthly period to the calendar month of the calculation and sixteen-thirtieths to the following calendar month.
7.
The following chart shows the KPMG model's calculations of OID for overlimit fees for the first 3 months of 1999. 302009 U.S. Tax Ct. LEXIS 28">*103 133 T.C. 136">*179
KPMG/Rolling Balance OID Calculator | ||
Capital One Financial Corporation (COB) | ||
1999-Overlimit Fees | ||
Credit Card Fee Pool for Month | 1 | 2 |
OID Created: | ||
(A) Unamortized OID At Beginning of Period | 311,048,903 | 325,983,582 |
(overlimit fees) | ||
(B) Total New Additions of OID (overlimit fees) | 48,238,609 | 41,029,513 |
(C) Total OID Before Current Month Amortization | 359,287,512 | 367,013,095 |
(A+B) | ||
SRPM | ||
(D) SRPM At Beginning of Month | 15,572,919,690 | 15,602,686,253 |
(E) MonthlyPrincipal Addition | 1,545,483,606 | 1,220,461,154 |
(F) Total SRPM After New Addition (D+E) | 17,118,403,196 | 16,823,147,407 |
(G) Total SRPM at End of Month (F-I) | 15,602,686,253 | 15,243,211,562 |
Adjusted Issue Price$ | ||
(H) Beginning Issue Price (Incl. New Addition | 16,759,115,684 | 16,456,134,312 |
(F-C)) Constant Yield (Monthly) | 0.1879921% | 0.2073659% |
(I) Principal Payment | 1,515,716,943 | 1,579,935,845 |
(J) Ending IssuePrice (PV of Future Cash Flow) | 15,275,211,181 | 14,910,666,283 |
Reversal of Unamortized OID On Write Offs | ||
(K) Ending Issue Price/SRPM (J/G) | 97.90% | 97.82% |
(L) Basis Adjustment Percentage (I-K) | 2.10% | 2.18% |
(M) Gross Write Offs | 71,062,684 | 68,338,064 |
(N) Reversal of Unamortized OID on Write Offs | 1,491,490 | 1,490,860 |
Basis Adjustment) | ||
OID Amortization | ||
(O) OID Amortization (I+J-H) | 31,812,440 | 34,467,816 |
(P)Reversal of Unamortized OID on Write Offs | 1,491,490 | 1,490,860 |
(Basis Adjustment) | ||
(Q) Unamortized OID at Ent of Period (C-O-P) | 325,983,582 | 331,054,419 |
OID Amortization on Calendar Month Basis | ||
(R) Prior Period OIDRecognized in Current | 15,085,059 | 16,966,634 |
Calendar Month | ||
(S) Current Period OID to be Recognized in | 16,966,634 | 18,382,835 |
Next Calendar Month | ||
(T) Adjusted OID Amor. for Calendar Month | 29,930,865 | 33,051,615 |
(O+R-S) | ||
(U) Unamortized OID at End of Calendar | 342,950,217 | 349,437,254 |
Month (Q+S) | ||
(V) Tax Adj. Inc. Recognized Per Calendar | 31,422,355 | 34,542,475 |
Month (T+P) |
KPMG/Rolling Balance OID Calculator | |
Capital One Financial Corporation (COB) | |
1999-Overlimit Fees | |
Credit Card Fee Pool for Month | 3 |
OID Created: | |
(A) Unamortized OID At Beginning of Period | 331,054,419 |
(overlimit fees) | |
(B) Total New Additions of OID (overlimit fees) | 43,915,549 |
(C) Total OID Before Current Month Amortization | 374,969,968 |
(A+B) | |
SRPM | |
(D) SRPM At Beginning of Month | 15,243,211,562 |
(E) MonthlyPrincipal Addition | 1,844,061,105 |
(F) Total SRPM After New Addition (D+E) | 17,087,272,667 |
(G) Total SRPM at End of Month (F-I) | 15,205,183,121 |
Adjusted Issue Price$ | |
(H) Beginning Issue Price (Incl. New Addition (F-C)) | 16,712,302,699 |
Constant Yield (Monthly) | 0.2073659% |
(I) Principal Payment | 1,882,089,546 |
(J) Ending Issue Price (PV of Future Cash Flow) | 14,871,514,481 |
Reversal of Unamortized OID On Write Offs | |
(K) Ending Issue Price/SRPM (J/G) | 97.81% |
(L) Basis Adjustment Percentage (I-K) | 2.19% |
(M) Gross Write Offs | 76,530,491 |
(N) Reversal of Unamortized OID on Write Offs (Basis | 1,679,416 |
Adjustment) | |
OID Amortization | |
(O) OID Amortization (I+J-H) | 41,301,328 |
(P)Reversal of Unamortized OID on Write Offs | 1,679,416 |
(Basis Adjustment) | |
(Q) Unamortized OID at Ent of Period (C-O-P) | 331,989,224 |
OID Amortization on Calendar Month Basis | |
(R) Prior Period OIDRecognized in Current Calendar | 18,382,835 |
Month | |
(S) Current Period OID to be Recognized in Next | 22,027,375 |
Calendar Month | |
(T) Adjusted OID Amor. for Calendar Month (O+R-S) | 37,656,788 |
(U) Unamortized OID at End of Calendar Month (Q+S) | 354,016,599 |
(V) Tax Adj. Inc. Recognized Per Calendar Month (T+P) | 39,336,204 |
133 T.C. 136">*180 E.
Respondent argues that the results produced by the KPMG model are unreasonable and do not clearly reflect COB's income. Respondent raises a number of specific issues with respect to the KPMG model and proposes corrections and adjustments which respondent argues are necessary for COB's income to be clearly reflected.
Respondent argues that the formulas and concepts originally used for accruing OID on REMICs should apply in some reasonable fashion to accruals of OID on a pool of revolving credit card debt. A REMIC is a fixed pool of mortgages that pays down as the underlying mortgages are themselves paid down. OID accruals with respect to a REMIC are typically computed according to the speed at which the REMIC's entire pool of mortgages pays down over time. See
Respondent concedes that COB's revolving pool of credit card loans does not fit comfortably into the fixed-pool REMIC model. Respondent also concedes that the KPMG model seeks to apply fixed-pool accounting to a dynamic pool of credit card loans by using a 1-month instrument that is retired and reissued, referred to as the "rolling balance" method. However, respondent argues that "this notion of a 'retired' and 'reissued' debt is the antithesis of a fixed pool of self-amortizing debt like that of a REMIC." Petitioners find themselves in a difficult situation. Under respondent's theory, COB should use the fixed-pool accounting rules applicable to REMICs. However, COB's pool of loans is not fixed. To try to apply fixed-pool accounting to the dynamic pool of credit card loans, COB uses a 1-month fixed pool that is retired and reissued at the end of each month. Respondent argues that this method is unreasonable.
We ask two questions. First, what authority did COB rely upon when adopting the retired and reissued approach? Second, what alternative does respondent suggest?
133 T.C. 136">*181 a.
To solve the problem of how to apply fixed-pool 2009 U.S. Tax Ct. LEXIS 28">*105 accounting to a dynamic pool of loans, Dennis Nelson, the KPMG partner responsible for developing the KPMG model, looked to the OID regulations to determine how OID is calculated when a debt instrument is modified or there is a change in circumstance. If the terms of a debt instrument are modified to defer one or more payments, and the modification does not cause an exchange under the instrument's adjusted issue price on that date. * * *
None of the above-quoted regulations apply directly to a pool of credit card loans. In fact, none of the OID regulations apply directly to the issue at hand. However, petitioners argue that these regulations provide an apt analogy, and we agree.
A pool of credit card loans, the debt instrument, is constantly modified as cardholders make principal payments, charge additional purchases, transfer balances, and incur various types of fees, many of which are contingent and cannot be anticipated at the time the loan is made. The retirement of a debt instrument under the regulations generally 133 T.C. 136">*182 results in no gain or loss but requires the rolling of unamortized OID into a newly issued debt instrument to be taken into account over the new debt instrument's anticipated life.
b.
There are significant practical difficulties in developing a model without the retired and reissued approach, in other words a model with static pools. Mr. Nelson testified: in the end, it was an absolute nightmare. They couldn't reconcile the results. They didn't know how to allocate the payments. Because in the end, it all came down to what payments should we assign to these static pools that we created. And they didn't have a good way of being able to assign that. Their results were totally dependent on how to assume the payments were spread among these static pools. So they created mountains of work for the client and ourselves.
Respondent maintains that the most accurate way to calculate OID would be cardholder by cardholder, but concedes that the sheer number of cardholders would make such calculations burdensome. More importantly,
Under the KPMG model an accrual of a single item of OID can extend beyond the underlying indebtedness to which the OID relates because 2009 U.S. Tax Ct. LEXIS 28">*108 the KPMG model applies payments proportionally across all outstanding debt. Respondent argues that COB must track or trace its cardholder accounts on a first-in, first-out (FIFO) basis so as to match the OID earned with the particular loan transaction that gives rise to the OID. Respondent describes the difference between the parties' positions: Petitioners contend that the credit card fees attributable to specific cardholder accounts and accrual periods should be treated, instead, as OID arising in the aggregate on the constantly changing balance of that pool. Petitioners are not troubled by the prospect that, under the KPMG model, a cardholder could close his account and transfer his balance to another lender, yet leave unamortized OID on petitioners' books. Nor are petitioners troubled by the fact that, under the KPMG model, cardholders can transfer balances to petitioner from other lenders as to which no OID 133 T.C. 136">*183 exists, even though such transactions, when commingled with petitioners' cardholder loans on which there is OID, will dramatically slow the rate at which OID is accrued on those older accounts and balances that do not have OID.
Respondent demonstrates the problem by providing 2009 U.S. Tax Ct. LEXIS 28">*109 an illustration of a single cardholder who makes a $ 600 purchase and incurs a $ 40 overlimit fee in month 1, then makes principal payments and charges new purchases in the following months.
Month | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
Balance | 0 | 640 | 600 | 600 | 600 | 600 | 600 | 600 |
Purchases | 600 | 56 | 90 | 90 | 90 | 90 | 90 | 90 |
Overlimit | 40 | |||||||
Total with | 640 | 696 | 690 | 690 | 690 | 690 | 690 | 690 |
New Charges | ||||||||
Payments | 96 | 90 | 90 | 90 | 90 | 90 | 94 | |
Payment | 0% | 15% | 15% | 15% | 15% | 15% | 15% | 15.67% |
Rate | ||||||||
Amortized | 0 | 6 | 5.10 | 4.34 | 3.68 | 3.13 | 2.66 | 2.36 |
OID | ||||||||
Unamortized | 40 | 34 | 28.90 | 24.57 | 20.88 | 17.75 | 15.09 | 12.72 |
OID |
Respondent argues that because the cardholder paid a total of $ 640 (the amount of the original loan plus the overlimit fee) COB should recognize the entire fee. The effect is to suggest that a payment rate of 15 percent translates into an actual liquidation of the debt in 8 months. Essentially, respondent contends that each payment should go toward the oldest debt first and any OID related to that debt. Respondent has no authority for this position other than his argument that a FIFO method would clearly reflect COB's income.
Petitioners argue that using a constant payment rate of 15 percent, the cardholder will still have $ 241 remaining on the original debt, or 32 percent of the original debt, and 32 percent of the OID will remain 2009 U.S. Tax Ct. LEXIS 28">*110 unamortized.
Month | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
Balance | 0 | 640 | 544 | 462 | 393 | 334 | 283 | 241 |
Purchases | 600 | |||||||
Overlimit | 40 | |||||||
Total With | 640 | 640 | 544 | 462.40 | 393.04 | 334.08 | 283.97 | 241.38 |
New Charges | ||||||||
Payments | 96 | 81.60 | 69.36 | 58.96 | 50.11 | 42.60 | 36.21 | |
Payment | 0% | 15% | 15% | 15% | 15% | 15% | 15% | |
Rate | ||||||||
Amortized | 0 | 6 | 5.10 | 4.34 | 3.68 | 3.13 | 2.66 | 2.26 |
OID | ||||||||
Unamortized | 40 | 34 | 28.90 | 24.57 | 20.88 | 17.75 | 15.09 | 12.82 |
OID |
133 T.C. 136">*184 Petitioners argue that the KPMG model is thus proportional in that the cardholder recognizes OID at the same rate as the original debt is repaid.
The KPMG model accrues OID on the basis of the actual payment rates of COB's cardholders. If COB's cardholders actually pay off their debts as quickly as the following hypothetical suggests, COB would recognize OID more quickly.
Month | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 |
Balance | 0 | 640 | 544 | 454 | 364 | 274 | 184 | 94 |
Purchases | 600 | |||||||
Overlimit | 40 | |||||||
Total With | 640 | 640 | 544 | 454 | 364 | 274 | 184 | 94 |
New Charges | ||||||||
Payments | 96 | 90 | 90 | 90 | 90 | 90 | 94 | |
Payment | 0% | 15% | 16.54% | 19.82% | 24.73% | 32.85% | 48.91% | 100% |
Rate | ||||||||
Amortized | 0 | 6 | 5.63 | 5.63 | 5.63 | 5.63 | 5.63 | 5.85 |
OID | ||||||||
Unamortized | 40 | 34 | 28.38 | 22.75 | 17.13 | 11.50 | 5.88 | 0 |
OID |
COB's cardholders, on a pooled basis, do not pay off their debts at anywhere near the rates suggested by the hypothetical. Further, COB's cardholders do not pay off a fixed amount of principal each month on their existing debt because they add new purchases every 2009 U.S. Tax Ct. LEXIS 28">*111 month and some portion of the payments may apply to the new debt.
This is a fundamental difference between the parties. Respondent views COB's pool of debt as made up of hundreds of millions of loans made to millions of cardholders. Petitioners view the pool as a single debt instrument. Dr. Hakala, respondent's expert, and respondent assume that cardholders pay off a constant amount on their credit card debt in the same way that a debtor pays off a fixed debt. Respondent and Dr. Hakala assert that a group of fixed pools may be more appropriate and would clearly reflect income. However, Dr. Hakala's models do not use fixed pools. Rather, Dr. Hakala uses a FIFO method, 31 and there are significant problems with it.
The FIFO method amortizes OID in a straight line to the WAM so that all OID is accrued by the WAM. This rapidly accelerates the accrual of OID because an adjusted WAM is required. Dr. Hakala reweighted the WAMs according to the relative duration of each month's balance 2009 U.S. Tax Ct. LEXIS 28">*112 of unamortized OID in the collective pool of unamortized OID. Dr. Hakala's adjustment 133 T.C. 136">*185 is designed to match OID accruals to the actual liquidation of the pertinent debt. However, he ignores the fact that some cardholders actually make principal payments after the WAM. Most importantly, Dr. Hakala's FIFO adjustment abandons the
Respondent argues that Dr. Hakala's formula for computing OID is a close approximation of the
We conclude that COB's use of a retired and reissued debt instrument, as provided for in the regulations under similar circumstances, is a reasonable method of implementing the formula 2009 U.S. Tax Ct. LEXIS 28">*113 provided in
The KPMG model uses a beginning issue price which includes new cardholder purchases and other charges (additions in the parlance of the KPMG model). The name given to this figure by KPMG is descriptive: "Beginning issue price (including new additions)". This figure is derived by subtracting the sum of the carryover balance of unamortized OID and the current month's fee to be treated as OID from "Total SRPM After New Additions", which is the SRPM at the beginning of the accrual period plus new additions. 32 Respondent argues that the use of a beginning issue price that includes new 133 T.C. 136">*186 additions results in an incorrect determination of OID accruals.
(4) Adjusted issue price. -- For purposes of this subsection, the adjusted issue price of any debt instrument at the beginning of any accrual period is the sum of -- (A) the issue price of such debt instrument, plus (B) the adjustments under this subsection to such issue price for all periods before the first day of such accrual period. Respondent, however, fails to take into account the "retired and reissued" approach described above. Applying the concept of a monthly pool that is deemed to be retired and reissued at its adjusted issue price, the result is a monthly rolling pool with the issue price of the new pool each month equal to the adjusted issue price of the prior month-end, increased for the issue price of new loans to cardholders in the pool
The regulations petitioners cite as authority for the use of a retired and reissued instrument suggest that new additions should not be included retroactively in the AIPbeg figure. For example,
133 T.C. 136">*187 However, we must acknowledge the differences between 2009 U.S. Tax Ct. LEXIS 28">*116 a pool of debt instruments and the types of debt instruments assumed for purposes of the regulations. COB's pool of credit card debt is constantly changing. The regulations posit a single change in circumstances; i.e., the exercise of an option. Yet COB cannot recompute the various components of the
In support of their positions on this issue, the parties again demonstrate a fundamental difference in the way they view a credit card loan. Petitioners argue that it is appropriate to include new additions in the AIPbeg figure because each credit card purchase transaction that occurred in a given month was an outstanding loan at the end of month. In petitioners' view the loan becomes part of the SRPM at the time the loan is made (or at least at the time it is settled under the associations' systems, usually 1 day later). Therefore, it is appropriate to include new additions in the issue price for the purpose of calculating the accrual of OID.
Respondent argues that it is inappropriate to include 2009 U.S. Tax Ct. LEXIS 28">*117 new additions because they have not been billed, that is a statement has not been sent to the cardholder requesting payment until later in the current month or in the following month, and payments are not due until 30 days after the issuance of the statement.
Although petitioners argue that new additions are included in the AIPbeg figure under section
Under the KPMG model, the payment rate is a fraction where the numerator is cash collections net of finance 133 T.C. 136">*188 charges and the denominator is the beginning credit card receivable balance plus that month's new additions (net of finance charges):
Payments - Stated finance charges
_________________________________
Outstanding 2009 U.S. Tax Ct. LEXIS 28">*118 Balance + New additions
Respondent raises several issues with respect to the calculation of the payment rate.
a.
Respondent argues that the inclusion of current month cardholder charges and fees in the calculations used to derive the payment rate is inappropriate because those new charges would not have been billed until later in the current month or in the next month, and would not have been due until 30 days after the charges were billed. We agree with respondent on this point.
A simple example helps illustrate the calculation of the payment rate in the KPMG model. Assume a cardholder purchases a $ 100 lamp, $ 40 of gasoline, and $ 10 of coffee in November, for a total of $ 150. In December the cardholder charges a $ 25 haircut, incurs a $ 25 overlimit fee, and incurs $ 10 in stated finance charges, resulting in a balance of $ 210. In December the cardholder also makes a payment of $ 30. Under the KPMG model, the December payment rate would be 10 percent ($ 20 payment (exclusive of finance charges) divided by a $ 200 balance (also excluding finance charges)).
In the example, the cardholder pays $ 30 after receiving a monthly statement from COB on December 1. The statement 2009 U.S. Tax Ct. LEXIS 28">*119 would have shown that the cardholder owed $ 150. No finance charges would have been billed to the cardholder because it was possible he would pay his entire balance and incur no finance charges. Therefore, when the cardholder pays $ 30, it is toward a $ 150 balance, resulting in a payment rate of 20 percent. It is unreasonable to conclude that the cardholder's December payment rate is 10 percent simply because she incurs new charges when those charges are not yet billed to her.
However, respondent goes even further, arguing that the additions made after the average statement date 332009 U.S. Tax Ct. LEXIS 28">*120 of the 133 T.C. 136">*189 prior month should also not have been included because those charges would not have been billed until the current month. For example, when calculating the December payment rate, respondent argues that a charge made on November 25 should not have been included in the total outstanding balance portion of the denominator. We disagree with respondent on this point. Although payment of the November 25 charge may not have been due until January, COB would have requested payment of the debt during December, and it is appropriate to include it in the denominator when calculating the payment rate.
Therefore, the denominator of the payment rate formula should be the total cardholder outstanding balance as of the end of the previous month.
b.
The numerator of the payment rate calculation begins with the current month's payments and then subtracts the current month's accrued finance charges. Respondent agrees that finance charges must be subtracted from the payments, but disagrees as to which finance charges should be subtracted. The KPMG model subtracts finance charges accrued during the current month. Essentially, the KPMG model applies current month payments against the current month's accrued, but unbilled, finance charges. Respondent argues this is unreasonable for the same reasons new additions should not be included in the denominator, and we agree. It is inappropriate to apply payments to charges which have not been billed.
Respondent argues that the finance charges which should have been subtracted are two-thirds of the prior month's finance charges and one-third of the finance 2009 U.S. Tax Ct. LEXIS 28">*121 charges from the month before that. 34 In determining the beginning issue price of the debt instrument and the denominator of the payment rate calculation, it is appropriate to include all the prior month's additions to principal whether billed or unbilled as of the first day of the current month because COB will request payment of those debts during the current 133 T.C. 136">*190 month. We think it logical, therefore, that current month payments should first be applied to finance charges which relate to all the debts included in the beginning issue price; i.e., the total outstanding balance of the pool as of the beginning of the accrual period. In other words, current month payments should first be applied to prior month finance charges, but not current month finance charges or finance charges from 2 months previous, before reducing the principal amount.
In his calculations Dr. Hakala includes writeoffs in the numerator. Writeoffs are those debts COB determines are not collectible. Respondent argues that "a write-off, practically speaking, is no different 2009 U.S. Tax Ct. LEXIS 28">*122 from a payment of principal in that both reduce outstanding principal balances". A writeoff, however, is an amount that is uncollectible, and it is not equivalent to a payment. The payment rate is used to calculate future payments. Including writeoffs in the calculation anticipates future defaults. The legislative history of
Therefore, the numerator of the payment rate formula should be the total cardholder payments for the current month less the finance charges accrued during the prior month.
c.
Moody's Investors Services publishes historical credit card payment rates showing 2009 U.S. Tax Ct. LEXIS 28">*123 the average performance of various pools of credit card loans related to credit-card-backed securities. In addition, Capital One files reports with the Securities and Exchange Commission (SEC) and issues prospectuses related to its sale of credit-card-backed securities. Each of these reports 133 T.C. 136">*191 includes information about the payment rates of the loans that backed the securities.
However, these other published payment rates are not based upon the formula set out in
Our determinations on these issues are based on
The KPMG model includes a
Using data from Capital One's 310 reports, Dr. Hakala tracked the proportion of accounts that incurred late fees ultimately 2009 U.S. Tax Ct. LEXIS 28">*125 written off within 180 days of being in "non-payment" status. Dr. Hakala determined how much of a late fee is ultimately paid and how much is written off. On the basis of this analysis, respondent argues that a greater percentage 133 T.C. 136">*192 of the outstanding principal in accounts that have incurred late fees is written off than in cardholder accounts generally. Dr. Hakala devised a default adjustment for late fees, expressed as a factor of 3.56, whereby the amount of OID recognized in connection with defaults is increased by a factor of 3.56. Again, late fees are not at issue, and we need not and do not reach a conclusion as to whether Dr. Hakala's late fee adjustment is appropriate.
Dr. Hakala was not able to do a similar analysis with overlimit fees. Instead, Dr. Hakala took samples of Capital One's cardholder accounts and compared default rates of accounts with late fees versus default rates of accounts with overlimit fees. Using this sampling, Dr. Hakala determined that the default rate for accounts with overlimit fees was about half the default rate for late fees. Thus, in his corrections to the accruals of overlimit fees, he used a default factor of 1.78 versus 3.56 for late fees. However, 2009 U.S. Tax Ct. LEXIS 28">*126 Dr. Hakala provides insufficient data to allow us to test his conclusions. It seems that the 1.78 figure is a ballpark estimate or an educated guess that is based on the theory that cardholders who incur overlimit fees, like cardholders who incur late fees, have a higher rate of default.
Dr. Hakala also states that "customer accounts that incur past due and overlimit fees may tend to be slightly slower in paying off principal than the average customer, and this finding may moderate the adjustment." Dr. Hakala testified that he did moderate the adjustment, and therefore his default rate adjustment was not a 100-percent adjustment. But Dr. Hakala does not explain how or to what extent he moderated the adjustment.
Put simply, there is insufficient support for Dr. Hakala's proposed default rate adjustment. His ballpark estimate of the default rate factor may be correct or it may not. Without supporting data, we cannot conclude that the KPMG model was unreasonable or failed to clearly reflect COB's income as it relates to writeoffs. Further, on the record before us we cannot conclude that Dr. Hakala's proposed default rate adjustment would more clearly reflect COB's income than did the KPMG2009 U.S. Tax Ct. LEXIS 28">*127 model.
As part of his adjustments to the KPMG model, Dr. Hakala included a seasonality adjustment to "smooth out seasonal fluctuations and to capture the trend in aggregate payment rates for forecasting purposes." For example, the adjustment addresses the spike in credit card use and dip in payment rates associated with holiday shopping. Dr. Hakala testified that adjustments for seasonality and trends are standard practice for purposes of prepayment assumptions in REMICs. Mr. Nelson, on the other hand, testified that seasonality adjustments are not standard practice for REMICs.
Respondent contends that a seasonality adjustment is necessary because the payment rates in some months were artificially high and in others artificially low. We disagree. The KPMG model calls for calculating payment rates each month. Therefore, the process takes into account seasonality effects by calculating a new payment rate every month. Payment rates may have been higher in April and lower in December, but the KPMG model takes that into account by changing the present value of the debt instrument as the payment rates change. We conclude that, in this respect, 2009 U.S. Tax Ct. LEXIS 28">*128 the KPMG model is reasonable and clearly reflected COB's income.
Although COB may enjoy some latitude in its method of calculating the accrual of OID, it may not run afoul of
FINDINGS OF FACT
A.
In an effort to attract new cardholders and to encourage cardholders to use their cards more often, Capital One issued Milesone credit cards, Signature Milesone credit cards, and Small Business Milesone credit cards (collectively Milesone cards). The Milesone cards were typical Visa and MasterCard 2009 U.S. Tax Ct. LEXIS 28">*129 credit cards (as described above) except that they allowed a cardholder to earn "miles" which could be redeemed for airline tickets.
A Milesone cardholder paid Capital One an annual membership fee of either $ 19 or $ 29. In exchange for that fee, a Milesone cardholder earned 1 mile for every dollar charged on the Milesone card for purchases. However, a cardholder was limited to 10,000 miles per billing cycle. Additionally, a cardholder could earn up to 3,000 miles by transferring an existing balance from a non-Capital One credit card account to a Milesone account. A Milesone cardholder earned no miles for cash advances, checks, or fees of any kind, including finance charges.
Capital One provided Milesone cardholders with a rewards schedule detailing the number of miles needed to qualify for the various airline tickets offered. Once enough miles were accumulated, the cardholder could redeem the miles for a round-trip airline ticket purchased by Capital One. The least expensive ticket was a round-trip coach ticket within the cardholder's zone (either the eastern, middle, or western United States) and required 18,000 miles. In comparison, a round-trip coach ticket from the United States2009 U.S. Tax Ct. LEXIS 28">*130 to Europe required 50,000 miles, and an around-the-world coach ticket required 150,000 miles. Business class and first class tickets were also available but required more miles than similar coach tickets.
Capital One provided each Milesone cardholder a quarterly statement reflecting the cardholder's total accumulated points, the number of points redeemed for airline tickets, and the number of points due to expire within 90 days. Points not redeemed within 5 years of the end of the quarter in which they were earned expired at that time. Points were redeemed 133 T.C. 136">*195 on a first-in, first-out basis; i.e., the oldest points were redeemed first.
Capital One purchased the airline tickets from a vendor. Each class of ticket was assigned a value. For example, a cardholder redeeming 18,000 miles for an in-zone domestic ticket could request a ticket costing up to $ 360. A cardholder redeeming 50,000 miles for a United States to Europe ticket could request a ticket costing up to $ 1,000. Therefore, Capital One's maximum potential cost per mile was 2 cents.
B.
Capital One estimated its cost of redeeming its cardholders' miles. The estimates depended primarily on two variables: 2009 U.S. Tax Ct. LEXIS 28">*131 (1) The estimated rate of future redemptions and (2) the estimated average cost of redemption. These variables were used to calculate an accrual rate used to estimate Capital One's future airline ticket redemption costs for financial accounting purposes. The accrual rate was a percentage of outstanding accumulated Milesone miles at the end of the year.
As of December 31, 1998, Milesone cardholders had an outstanding accumulated balance of 58,370,500 miles. 37Capital One estimated that 70 percent of the miles would ultimately be redeemed and that each mile would cost 1.4 cents to redeem. Using these figures, Capital One estimated its future redemption costs to be $ 583,411. 382009 U.S. Tax Ct. LEXIS 28">*132 This amount was used as its contingent reserve for redemption costs on its general ledger for financial accounting purposes and was deducted under
As of December 31, 1999, Milesone cardholders had an outstanding accumulated balance of 2,661,038,279 miles. Capital One estimated that 80 percent of these miles would be redeemed and that each mile would cost 1.65 cents to redeem. Accordingly, Capital One estimated its future 133 T.C. 136">*196 redemption costs to be $ 34,593,497. 402009 U.S. Tax Ct. LEXIS 28">*133 The difference between that figure and the 1998 figure, $ 583,411, was the change in the contingent reserve for future redemption costs. Capital One deducted the difference, $ 34,010,086, on its general ledger for financial accounting purposes. Through an error petitioners neglected to deduct that amount on their consolidated 1999 Federal income tax return. During the IRS' examination and in its petition to this Court, Capital One asserted that it was entitled to the deduction under
The actual redemption rate of points earned by cardholders in 1998 and 1999 through their 5-year expiration period was 68 percent and 81 percent, respectively. The actual cost of redemption was just over 2 cents per mile for points earned in 1998 and 1.59 cents per mile for those earned in 1999. 41
OPINION
A.
Whether a business expense has been incurred so as to entitle an accrual basis taxpayer to deduct it under Under an accrual method of accounting, a liability (as defined in
In 1919 the Commissioner carved out an exception to the all events test, allowing a taxpayer to deduct from its sales revenues an estimate of the contingent liabilities incurred with respect to the redemption of coupons or trading stamps issued with those sales. Where a taxpayer, for purposes of promoting his business, issues with sales trading stamps 2009 U.S. Tax Ct. LEXIS 28">*135 or premium coupons redeemable in merchandise or cash, he should in computing the income from such sales subtract only the amount received or receivable which will be required for the redemption of such part of the total issue of trading stamps or premium coupons issued during the taxable year as will eventually be presented for redemption. This amount will be determined in the light of the experience of the taxpayer in his particular business and of other users engaged in similar business. * * *
Regs. 45, art. 88 (1919). Ninety years later, the essential elements of the exception still remain and are embodied in If an accrual method taxpayer issues trading stamps or premium coupons with sales, or an accrual method taxpayer is engaged in the business of selling trading stamps or premium coupons, and such stamps or coupons are redeemable by such taxpayer in merchandise, cash, or other property, the taxpayer should, in computing the income from such sales, subtract from gross receipts with respect to sales of such stamps or coupons (or from gross receipts with respect to sales with which trading stamps or coupons 2009 U.S. Tax Ct. LEXIS 28">*136 are issued) an amount equal to -- (i) The cost to the taxpayer of merchandise, cash, and other property used for redemption in the taxable year, (ii) Plus the net addition to the provision for future redemptions during the taxable year (or less the net subtraction from the provision for future redemptions during the taxable year).
The regulation's purpose is to match sales revenues with the expenses incurred in generating those revenues, and taxpayers are entitled to a present deduction for only that portion of the stamps or coupons that they expect to eventually be redeemed. See
Petitioners contend that the miles Capital One issued to its cardholders are coupons issued with sales, that those coupons are redeemable by the cardholders in property, and that therefore it may subtract from its gross receipts the estimated cost of redeeming those miles. Respondent agrees that the miles are coupons within the meaning of
B.
Over the years we have been asked to interpret and apply
In
In
Although most credit card transactions involve sales of goods or services, i.e., a consumer purchases a product 2009 U.S. Tax Ct. LEXIS 28">*139 from a merchant, petitioners do not argue that the merchant's sale of goods to the cardholder is relevant for purposes of
Petitioners argue that we have interpreted the term "service" to include the lending of money. In
In
Petitioners argue that these cases indicate that the lending of money is the sale of a service and therefore when Capital One extends credit to its cardholders, it is selling lending services to the cardholder. The argument is strained. The cases cited by Capital One and discussed above are inapplicable to the current case. Whether loans in the hands of a lender are a capital or ordinary asset has no bearing on whether Capital One issued its miles with sales. In lending its cardholders funds, Capital One provided a service, but that service does not transform a loan into a sale within the meaning of
A sale requires two parties, a buyer and a seller. See
133 T.C. 136">*201 With respect to credit card transactions, Capital One receives various types of revenue when it lends money to its cardholders. The first income received is from interchange, which is a small percentage of the amount lent. Interchange is known at the time of sale, but interchange is not a fee for any service other than the lending of money, and the lending of money is not a sale of a loan or lending services.
Capital One receives much of its income from finance charges on cardholder loans. Finance charges are charged to the cardholder only if the cardholder does not pay the monthly balance in full within the grace period. A cardholder may pay interest with respect to the loan for many months or even many years. Similarly, a cardholder may incur late fees if a timely payment is not made. A late fee may be incurred with respect to the first bill Capital One sends the cardholder or with respect to a bill sent many months or years later if the cardholder has not repaid the loan in full.
Many other variables may affect the 2009 U.S. Tax Ct. LEXIS 28">*143 revenues Capital One receives with respect to its loan to the cardholder. Capital One may alter interest rates. The cardholder may default on the loan, exceed the credit limit and incur an overlimit fee, or incur an insufficient funds fee if a check paid to Capital One is not honored by the cardholder's bank. Although these revenues are related to Capital One's lending to its cardholders, they are not "gross receipts with respect to sales with which * * * coupons are issued" within the meaning of
133 T.C. 136">*202 D.
Petitioners argue that deducting Capital One's estimated cost of redemption would most clearly reflect its income without undue distortion. With respect to the Milesone program, for book purposes Capital One estimated its future liability for airline tickets at $ 583,411 and $ 34,010,086 in 1998 and 1999, respectively. Respondent agrees that the estimates are reasonable. However, the reasonableness of the estimates and the economics of the Milesone program are irrelevant because the miles were not issued with sales and therefore, the requirements of
In reaching our holdings on all three issues, we have considered all arguments made, and to the extent not mentioned, we conclude that they are moot, irrelevant, or without merit.
To reflect the foregoing,
1. Unless otherwise indicated, section references are to the Internal Revenue Code (Code), as amended. Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. We refer to COB and FSB individually only when the difference is material to our analysis.
3. The parties were able to settle many issues, including all issues with respect to petitioners' 1995 and 1996 tax years.↩
4. Subsumed in this issue is whether FSB is precluded from treating interchange and overlimit fees as creating or increasing OID on the pool of loans to which it relates because it did not request to change its method of accounting. We hold that FSB did not request to change its method of accounting and may not treat interchange or overlimit fees as OID.
5. Cards that require full payment and do not allow cardholders to carry a balance from month to month are known in the banking industry as charge cards.↩
6. As we will see, respondent argues that the merchant has paid 7 percent of the charge to the bank, and petitioners argue that the bank has received funds net of a 7-percent discount.↩
7. The association model is sometimes referred to as a four-party system because the association, either Visa or MasterCard, is not counted.↩
8. Acquiring banks are sometimes referred to as merchant's banks.↩
9. In 1998 and 1999 Capital One cardholders participated in 211,152,400 and 335,188,370 credit card transactions, respectively.↩
10. Members could, but rarely did, negotiate agreements among themselves to settle the transactions, in what were known as bilateral agreements. Capital One did not enter into any bilateral agreements.↩
11. When a chargeback was processed through MasterCard's interchange system, the interchange rate applied to the reversal of the transaction was not necessarily the same rate that applied when the original transaction was settled.↩
12. Capital One also did not issue PIN debit cards which are linked to a cardholder's checking account issued by the cardholder's bank. Unlike signature debit cards, the systems are not operated by Visa or MasterCard; these systems are operated by a number of other systems, including Plus and Cirrus. Rather than signing her name, the cardholder enters her PIN. A PIN debit transaction is processed through an electronic funds transfer network and effects an immediate withdrawal from the cardholder's account to satisfy the purchase amount. There can be interchange and a merchant discount in these transactions as well, either a percentage or a flat fee.↩
13. The regulatory reports were filed with the Office of the Comptroller of Currency.↩
14. For Federal income tax purposes Capital One treated cash advance fees as creating or increasing OID before 1998 as well as after 1998. Respondent has conceded this treatment is proper.↩
15. Qualified stated interest is defined as the "stated interest that is unconditionally payable in cash or in property (other than debt instruments of the issuer), or that will be constructively received under
16. If the issue price was the "amount loaned", see
17. Mr. Jonas was responsible for, among other things, the development and implementation of MasterCard's interchange rate programs in the United States.↩
18. Mr. Sheedy had previously been employed as the executive vice president of interchange strategy for Visa, U.S.A., Inc.↩
19. Dr. Schmalensee is the Howard W. Johnson Professor of Management and Economics at the Massachusetts Institute of Technology and the John C. Head III Dean Emeritus of the Massachusetts Institute of Technology Sloan School of Management. He is the coauthor of two editions of Paying with Plastic (1999 & 2005), a text on the economics of payment card systems.↩
20. The exception would be a cardholder who paid an annual fee for the privilege of having a Capital One card or a cardholder who incurred another fee such as an overlimit fee.↩
21. Dr. Tufano is the Sylvan C. Coleman Professor of Financial Management and Senior Associate Dean at Harvard Business School. He has taught courses in finance, capital markets, financial engineering, and consumer finance in the MBA and Executive Programs at Harvard Business School.↩
22. Capital One did not issue signature debit cards during the years at issue. See paragraph J.3.,
23. The nominal fee portion of interchange transactions is usually between $ .05 and $ .10. In 1999 the average interchange fee for a Visa credit card transaction was $ 1.62. Therefore, the nominal fee accounted for between 3 and 6 percent of the total fee.↩
24. Petitioners argue that a credit card purchase transaction is like a factoring transaction. However, the record is devoid of any evidence that Capital One engaged in factoring; that is to say, Capital One did not purchase debts owed to another, stepping into the lender's shoes, but is itself the lender ab initio.
25. At trial, Dr. Schmalensee, respondent's expert, was asked: "you would agree with me, wouldn't you, Dr. Schmalensee, that interchange in a Visa or MasterCard credit card transaction is part of a lending transaction, isn't that correct?" Dr. Schmalensee replied: "It's part of a lending transaction."
26. Respondent argues that in exchange for paying interchange merchants receive substantial services from Capital One including protection from fraud and credit risk, the reduced costs of handling cash, reduced employee costs, increased sales, and access to new markets. Merchants certainly receive benefits from consumers' use of credit cards, but Capital One does not provide merchants a service simply because merchants receive a benefit. As discussed above, the service provided is the lending of money, which benefits all the parties in a credit card purchase transaction.↩
27. We include data with respect to COB only because of our holding,
28. The regulation provides trustees of widely held mortgage trusts a safe harbor for reporting OID before the issuance of final regulations under
29. Although they dispute the manner in which it should be done, the parties agree that stated finance charges are stated interest and should be excluded from the payment rate calculation.↩
30. Figures are taken directly from Exhibit 11-J and have not been adjusted for mathematical errors.
31. Petitioners argue that Dr. Hakala's method is not actually a FIFO method. As we find Dr. Hakala's method unreasonable and at odds with
32. The difference between the AIPbeg figure respondent contends must be used and the AIPbeg figure used by the KPMG model is the present value of the current month's aggregate new cardholder purchases and charges.↩
33. COB issues statements to its cardholders throughout the month, and given that the typical billing cycle is 30 days, the average monthly statement date for all cardholders is the middle of the month.
34. Respondent also argues that one-half of the prior month finance charges should be deducted and one-half of the finance charges from the month before that.↩
35. The KPMG model deals with writeoffs in a separate adjustment, which we conclude is reasonable.↩
36. In 1999 COB cardholders made payments totaling $ 23,984,854,095, and accrued $ 2,088,871,186 in finance charges. In other words, approximately 9 percent of all payments were attributable to finance charges.↩
37. In 1998 and 1999 Capital One awarded 29,254,871 and 323,169,272 miles in connection with balance transfers and bonus miles. The record is not clear about what constituted bonus miles.↩
38. We note that the 70 percent and 1.4 cents figures would result in a slightly higher cost of redemption. We assume the parties rounded the figures for our benefit. In any event, the discrepancy does not appear to bother the parties, and therefore it does not bother us.
39. Capital One actually spent $ 1,578 and $ 313,513 to redeem Milesone miles during 1998 and 1999, respectively.↩
40. Again, the 80 percent and 1.65 cents figures would result in a slightly higher cost of redemption.
41. Petitioners did not explain why the cost of redemption was more than the ostensible maximum payout of 2 cents per mile.↩
42.
43.
44. The number of miles issued had no direct relationship to the amount of interchange Capital One earned.
45. Because we hold that the Milesone coupons were not issued "with sales" as required by