Opinion

Capital One Financial Corporation and Subsidiaries v. Commissioner

133 T.C. No. 8

Court: United States Tax Court
Filed: Sep 21, 2009
Cited by: 0 cases
Authority: More cited than 6.2%

a “sale” requires parties standing to each other in the relation of buyer and seller, assent of the -102- minds to the same proposition, and passing of consideration

How later courts described this case

a “sale” requires parties standing to each other in the relation of buyer and seller, assent of the -102- minds to the same proposition, and passing of consideration
“The classic definition of ‘paid’ * * * [in the context of interest deductions under section 163(a)] is ‘a payment (of) cash or its equivalent’.”
“interest typically covers credit risk, credit administration, and cost of funds.”
3-percent fee charged to all borrowers was interest because the only consideration the borrower received was the use of the money lent

Written by the judges who cited it.

The opinion

133 T.C. No. 8

UNITED STATES TAX COURT

CAPITAL ONE FINANCIAL CORPORATION AND SUBSIDIARIES,

Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 19519-05, 24260-05. Filed September 21, 2009.

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

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and the amount Visa or MasterCard withdrew from Capital

One’s account was the interchange on the transaction.

COB and FSB treated interchange as creating or

increasing original issue discount (OID) on the pool of

loans to which the interchange related under sec.

1272(a)(6)(C)(iii), I.R.C. R argues that interchange

is a fee for a service paid by the merchant or the

merchant’s bank, and not by the borrower. Furthermore,

R argues that interchange is not economically

equivalent to interest and therefore may not be treated

as OID under sec. 1272(a)(6)(C)(iii), I.R.C. Ps argue

that COB and FSB acquired the credit card loans at a

discount, the discount being the amount of interchange,

and therefore interchange was properly treated as OID.

In our previous Opinion in this case, Capital One

Fin. Corp. v. Commissioner, 130 T.C. 147 (2008), we

held that a taxpayer was required to follow all

procedures put in place by the Commissioner to change

its method of accounting in accordance with sec.

1272(a)(6)(C)(iii), I.R.C. FSB did not request to

change its method of accounting by filing Form 3115,

Application for Change in Accounting Method, with its

return.

Sec. 1272(a)(6)(C)(iii), I.R.C., provides a

specific formula by which OID accruals should be

calculated on a debt instrument subject to prepayment

such as a pool of credit card loans. Sec.

1272(a)(6)(C)(iii), I.R.C. requires the use of a

prepayment assumption. COB used a formula developed by

the accounting firm KPMG (KPMG model). R raises

several issues with respect to the KPMG model, arguing

that it did not comply with sec. 1272(a)(6)(C)(iii),

I.R.C., and that the results produced by the model were

unreasonable.

COB and FSB issued certain Visa and MasterCard

credit cards known as Milesone cards which allowed

cardholders to earn 1 mile for every dollar used for a

purchase transaction, with certain limitations. A

cardholder earned no miles for fees or finance charges

incurred. When a cardholder reached a certain number

of miles, they could be redeemed for airline tickets.

COB and FSB deducted the estimated future cost of

redeeming the miles under sec. 1.451-4, Income Tax

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Regs., which allows a taxpayer to deduct from sales

revenues an estimate of the expenses associated with

redeeming coupons that were issued with sales.

Held: Interchange is not a fee for any service

other than the lending of money. The issue price of a

credit card loan is the price paid for the loan, which

is the amount withdrawn from COB’s and FSB’s account

and deposited with the merchant’s bank. Therefore,

interchange is properly treated as OID under sec.

1272(a)(6)(C)(iii), I.R.C.

Held, further: FSB did not follow the required

procedures to change its method of accounting in

accordance with sec. 1272(a)(6)(C)(iii), I.R.C.

Therefore, FSB may not treat interchange and overlimit

fees as OID.

Held, further: The KPMG model did not comply with

sec. 1272(a)(6), I.R.C., in that: (1) The model

included in the beginning issue price of the debt

instrument additions to principal which occurred after

the first day of the accrual period; (2) the model

incorrectly calculated the payment rate by including

additions to principal which occurred after the first

day of the accrual period; and (3) the model

incorrectly calculated the payment rate by applying

payments to finance charges which accrued during the

period. Payments should first be applied to the prior

month’s accrued finance charges, and not the current

month’s finance charges. In all other respects, the

KPMG model was reasonable.

Held, further: The miles issued by COB and FSB

were not issued with sales, and COB and FSB did not

have gross receipts with respect to sales within the

meaning of sec. 1.451-4, Income Tax Regs. Therefore,

they may not deduct the estimated costs of redeeming

the miles pursuant to sec. 1.451-4, Income Tax Regs.,

but must do so under the all events test as to those

amounts that are fixed and known and for which economic

performance has occurred.

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Jean Ann Pawlow, Elizabeth A. Erickson, Holly K. Hemphill,

Kevin Spencer, and Robin L. Greenhouse, for petitioners.

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

respondent.

CONTENTS

Issue 1: Interchange . . . . . . . . . . . . . . . . . . . 8

FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 8

A. An Introduction to Interchange . . . . . . . . . . 8

B. The Historical Roots of the Credit Card

Industry and Interchange . . . . . . . . . . . 9

C. Interchange Fees and the Visa and

MasterCard Systems . . . . . . . . . . . . . . 12

D. The Parties to a Typical Credit Card Purchase

Transaction . . . . . . . . . . . . . . . . . . 12

1. The Issuing Bank (Capital One) . . . . . . . 12

2. The Cardholder . . . . . . . . . . . . . . . 13

3. The Acquiring Bank. . . . . . . . . . . . . . 14

4. The Merchant . . . . . . . . . . . . . . . . 15

5. The Association (Visa or MasterCard) . . . . 15

E. A Typical Credit Card Purchase Transaction . . . . 15

F. The Clearing Process . . . . . . . . . . . . . . . 19

G. Net Settlement . . . . . . . . . . . . . . . . . . 20

H. Cardholder Payments . . . . . . . . . . . . . . . 23

I. Merchant Discount in Detail . . . . . . . . . . . 25

J. Interchange in Detail . . . . . . . . . . . . . . 26

1. Factors Influencing Interchange Rates . . . . 26

2. Capital One’s Costs and Interchange . . . . . 28

3. Debit Cards and Interchange . . . . . . . . . 29

4. Capital One’s Accounting Treatment of

Credit Card Purchases and Associated

Interchange Income . . . . . . . . . . . . 30

OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . 33

A. An Overview of the Issue and the Law . . . . . . . 33

B. The SRPM of a Credit Card Loan . . . . . . . . . . 34

C. The Issue Price of a Credit Card Loan . . . . . . 35

1. Whether Interchange Is a Fee for a Service

(and If So, What Service) or Economically

Equivalent to Interest . . . . . . . . . . 36

2. Whether the Cardholder, the Merchant, or

the Acquiring Bank Pays Interchange . . . 48

D. Conclusion With Respect to the Interchange Issue . 52

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Issue 2: The Calculation of OID Under Section

1272(a)(6)(C) . . . . . . . . . . . . . . . . . 53

FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . 53

A. Accounting Methods . . . . . . . . . . . . . 53

B. Income and OID Accruals of Overlimit Fees

and Interchange . . . . . . . . . . . . . 54

OPINION . . . . . . . . . . . . . . . . . . . . . . . . 55

A. Accounting Methods . . . . . . . . . . . . . 55

B. The Standard of Review . . . . . . . . . . . 57

C. Section 1272(a)(6)(C) . . . . . . . . . . . . 59

D. The KPMG Model . . . . . . . . . . . . . . . 62

1. The Payment Rate or Prepayment

Assumption . . . . . . . . . . . . . 62

2. The Weighted Average Maturity . . . . . 64

3. The Yield to Maturity . . . . . . . . . 65

4. OID Accrual . . . . . . . . . . . . . . 66

5. An Adjustment for Writeoffs . . . . . . . 67

6. The Mid-Month Convention . . . . . . . . 67

7. The KPMG Model Table . . . . . . . . . . 67

E. Respondent’s Arguments With Respect to the

KPMG Model . . . . . . . . . . . . . . . . 69

1. The Monthly Retirement and Reissuance

of the Pooled Debt Instrument . . . . 69

a. COB’s Reasons for Adopting the

“Retired and Reissued” Approach. 71

b. Respondent’s Alternative to the

“Retired and Reissued” Approach. 72

2. The Inclusion of New Additions in the

Beginning Issue Price . . . . . . . . 78

3. Payment Rate Issues . . . . . . . . . . 82

a. The Denominator . . . . . . . . . . 82

b. The Numerator . . . . . . . . . . . 84

c. Other Published Payment Rates . . . 86

4. Dr. Hakala’s Default Rate Adjustment

for Overlimit Fees . . . . . . . . . 87

5. Dr. Hakala’s Seasonality and

Trend Adjustment . . . . . . . . . . 90

F. Conclusion With Respect to the

Calculation of OID . . . . . . . . . . . . 91

Issue 3: Milesone Rewards . . . . . . . . . . . . . . . . . 91

FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . 91

A. The Milesone Reward Program . . . . . . . . . 91

B. Milesone Program Costs and Accounting . . . . 93

OPINION . . . . . . . . . . . . . . . . . . . . . . . . 95

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A. The History of Accounting for the

Redemption of Trading Stamps and

Coupons . . . . . . . . . . . . . . . . . 95

B. The “With Sales” Requirement . . . . . . . . 98

C. Gross Receipts With Respect to Sales . . . . 102

D. Conclusion With Respect to the Milesone

Rewards Issue . . . . . . . . . . . . . . 104

HAINES, Judge: Respondent determined deficiencies in, and

penalties with respect to, petitioners’ Federal income taxes as

follows:1

Penalty

Year Deficiency Sec. 6662(a)

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),2 is among the world’s largest 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

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.

We refer to COB and FSB individually only when the

difference is material to our analysis.

The parties were able to settle many issues, including all

issues with respect to petitioners’ 1995 and 1996 tax years.

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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 section 1272(a)(6)(C)(iii).

We hold that interchange may be recognized over time as original

issue discount (OID) under section 1272(a)(6)(C)(iii).

The second issue is whether COB and FSB properly calculated

the amount of OID for interchange and overlimit fees.4 We hold

that the formula COB used to calculate OID, with modifications

required by the OID rules generally and section 1272(a)(6)

specifically, as set forth infra, is reasonable.

The third issue is whether Capital One may deduct under

section 1.451-4, Income Tax Regs., the estimated cost of future

redemptions of “miles” it issued to certain cardholders which

could be redeemed for airline tickets. We hold that Capital One

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.

-8-

may not deduct those costs pursuant to section 1.451-4, Income

Tax Regs., but must do so under the all events test as to those

amounts that are fixed and known and for which economic

performance has occurred.

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.

Issue 1: Interchange

FINDINGS OF FACT

A. An Introduction to Interchange

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, 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

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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. The Historical Roots of the Credit Card Industry and

Interchange

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 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

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

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.

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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 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

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.

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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 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. 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

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of America converted its franchise system into an association,

National BankAmericard, Inc. National BankAmericard, Inc.,

became Visa in 1976 and the Interbank Card Association became

MasterCard in 1979.

C. Interchange Fees and the Visa and MasterCard Systems

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. The Parties to a Typical Credit Card Purchase Transaction

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.

1. The Issuing Bank (Capital One)

During the years at issue Capital One was an issuing bank,

in that it issued cards to cardholders, but it did not recruit

merchants to join the system. The issuing bank’s primary service

The association model is sometimes referred to as a four-

party system because the association, either Visa or MasterCard,

is not counted.

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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).

2. The Cardholder

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 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

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amount owed, Capital One could not look for payment of the

liability from the association, the merchant, or the acquiring

bank.

3. The Acquiring Bank8

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 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 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.

Acquiring banks are sometimes referred to as merchant’s

banks.

-15-

4. The Merchant

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.

5. The Association (Visa or MasterCard)

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. A Typical Credit Card Purchase Transaction

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 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

In 1998 and 1999 Capital One cardholders participated in

211,152,400 and 335,188,370 credit card transactions,

respectively.

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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 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 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

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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.

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 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.

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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

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authorize Visa or MasterCard to withdraw the total purchase price

from its bank account as part of the net settlement process.

F. The Clearing Process

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, 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 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, infra) for those merchants’ transactions

on the basis of the applicable merchant codes and other factors,

and then transmitted that information to the applicable

association for settlement. The association then sorted and

provided the relevant cardholder transaction information from all

the acquiring banks, along with the association’s interchange fee

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computation, to each of its issuing banks for the respective

issuing bank’s cardholder transactions via a transaction record.

MasterCard and Visa computed the interchange fees on a

transaction-by-transaction basis for every credit card

transaction submitted. The transaction records were compiled and

reported daily to the issuing bank.

G. Net Settlement

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, the acquiring bank, or

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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 2-

percent interchange fee.

c. The acquiring bank deposits $97.50 into the merchant’s

bank account, representing the $100 total price less the 2.5-

percent merchant discount.

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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 members were

required to net settle their transactions 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

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.

-23-

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 chargebacks11

(reversed or canceled purchases initiated by issuing banks)

processed that day, credits (initiated by merchants), and any

other fees owed between issuing 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. Cardholder Payments

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

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.

-24-

late fees. The monthly statements did not list the amount of

interchange applicable to the transactions.

Under the terms of the cardholder agreement, a cardholder

was obligated to pay Capital One 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:

• Transactions made during the current billing

period from transaction date.

• Undated transactions and transactions made

with convenience checks: from the date the

transaction is processed to your account.

• Transactions made prior to the current

billing period: from the first calendar day

of the current billing period.

-25-

Capital One provided its cardholders with a grace period that

approximated 30 days. Because Capital One’s billing cycles

approximated 30 days and the grace period approximated 30 days, a

cardholder could have up to 60 days between the date a credit

card purchase was made and the date payment was due.

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.

I. Merchant Discount in Detail

The difference between the total price of the goods or

services sold to cardholders and the amount remitted to the

merchant 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 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

-26-

net merchant discount; i.e., the difference between the gross

merchant discount and the interchange fee.

J. Interchange in Detail

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.

1. Factors Influencing Interchange Rates

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)

-27-

in some instances the size of the transaction (e.g., a “large

ticket” purchase over a certain 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 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

-28-

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/Retail1 Commercial 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

CPS refers to “custom payment service”, Visa’s term for

card transactions that are processed a certain way.

2. Capital One’s Costs and Interchange

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), a consulting

firm, to study issuing banks’ costs as part of MasterCard’s

process for setting interchange rates. The costs 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:

-29-

Year Issuing Banks’ Costs1

1997 2.52 percent + $0.10 per transaction

1998 2.92 percent + $0.10 per transaction

1999 2.97 percent + $0.10 per transaction

Edgar Dunn broke the total cost down into components. The

issuing bank’s cost of lending money, i.e., the financial

carrying costs during the grace period, were .20 percent, .22

percent, and .20 percent of the total purchase price during 1997,

1998, and 1999, respectively. For 1997, 1998, and 1999, 2.32

percent, 2.70 percent, and 2.77 percent of the total purchase

price represented the total risk costs. Edgar Dunn calculated

the issuing bank’s processing costs to be 10 cents per

transaction.

For 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. Debit Cards and Interchange

During the years at issue Capital One did not issue

signature debit cards.12 A signature debit card is linked to the

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

(continued...)

-30-

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 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. 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.

4. Capital One’s Accounting Treatment of Credit Card

Purchases and Associated Interchange Income

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 price of whatever

the cardholder purchased in that particular transaction. The CAS

(...continued)

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.

-31-

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 Federal

income tax purposes at the time the fees were charged to the

cardholder. 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

-32-

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 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 section 1272(a)(6)(C)(iii).

The regulatory reports were filed with the Office of the

Comptroller of Currency.

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.

-33-

OPINION

A. An Overview of the Issue and the Law

Under section 1272(a)(6)(C)(iii) taxpayers that issue credit

cards and lend money to their cardholders are required to treat

certain credit card receivables as creating or increasing OID on

the pool of credit card loans to which the receivables relate.

See Capital One Fin. Corp. v. Commissioner, 130 T.C. 147, 150

(2008). The issue is whether Capital One’s interchange income is

properly recognized over time under section 1272(a)(6)(C)(iii),

or whether interchange income is properly recognized at the time

the cardholders’ charge is settled under the respective

associations’ systems. In our prior Opinion, Capital One Fin.

Corp. v. Commissioner, supra at 150-151, we described in general

terms the OID rules and section 1272(a)(6)(C)(iii):

The holder of a debt instrument with OID generally

accrues and includes in gross income, as interest, the

OID over the life of the obligation, even though the

interest may not be received until the maturity of the

instrument. Sec. 1272(a)(1). The amount of OID with

respect to a debt instrument is the excess of the

stated redemption price at maturity (SRPM) over the

issue price of the debt instrument. Sec. 1273(a)(1).

The SRPM includes all amounts payable at maturity.

Sec. 1273(a)(2). In order to compute the amount of OID

and the portion of OID allocable to a period, the SRPM

and the time of maturity must be known. This presents

a problem for debts such as credit card loans and real

estate mortgages that may be satisfied over a very

short or a very long period, thus making the time of

maturity an unknown at the inception of the debt.

-34-

For this reason, special rules were created for

determining the amount of OID allocated to a period for

certain instruments that may be subject to prepayment.

In the case of (1) any regular interest in a real

estate mortgage investment conduit (REMIC), (2)

qualified mortgages held by a REMIC, or (3) any other

debt instrument if payments under the instrument may be

accelerated by reason of prepayments of other

obligations securing the instrument, the daily portions

of the OID on such debt instruments are determined by

taking into account an assumption regarding the

prepayment of principal for such instruments. Sec.

1272(a)(6)(C)(i) and (ii).

Section 1272(a)(6)(C)(iii) applies this special

OID rule to any pool of debt instruments the payments

on which may be accelerated by reason of prepayments.

It is clear that section 1272(a)(6)(C)(iii) was

intended to apply to credit card loans and the related

receivables. See H. Conf. Rept. 105-220, at 522

(1997), 1997-4 C.B. (Vol. 2) 1457, 1992. What was

unclear at the time of enactment and is still not fully

resolved is which credit card receivables increase OID

under section 1272(a)(6)(C) and which do not.

[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 id. at 153-154.

B. The SRPM of a Credit Card Loan

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 sec. 1.1273-1(b), Income Tax Regs. In the

example of a $100 purchase of goods or services from the

merchant, the SRPM is equal to $100 because the cardholder, if

-35-

she lived up to her agreement, would have paid at least $100 to

Capital One. The starting point for the SRPM is the total price

of the goods or services the cardholder purchases. The SRPM may

increase if the cardholder incurs a late fee or an overlimit fee,

but the SRPM is not increased by any finance charges, i.e.,

qualified stated interest,15 incurred.

C. The Issue Price of a Credit Card Loan

The parties dispute the calculation of the issue price of a

credit card loan. Section 1273(b)(2) defines the issue price of

an instrument issued for money and not publicly offered as “the

price paid by the first buyer of such debt instrument.” The

regulations expand on this definition:

if an issue consists of a single debt instrument that

is issued for money, the issue price of the debt

instrument is the amount 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. * * *

Sec. 1.1273-2(a)(1), Income Tax Regs. If X Bank lends $1,000 to

A, an individual, the issue price of the loan would be $1,000.

However, a credit card loan is part of a multiparty

transaction where the funds lent are sent to the merchant via the

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 section 451, at least annually at a

single fixed rate”. Sec. 1.1273-1(c)(1)(i), Income Tax Regs.

-36-

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.16 Sec. 1273(b)(2).

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 issuing bank, not economically

equivalent to interest, and therefore not OID.

1. Whether Interchange Is a Fee for a Service (and If So,

What Service) or Economically Equivalent to Interest

If the issue price was the “amount loaned”, see sec.

1.1273-2(a)(1), Income Tax Regs., the parties would still dispute

the amount loaned to the cardholder. Using the $100 purchase

example, the amount loaned could be $98 or $100, depending on

whether interchange is viewed as a fee for a service as

respondent contends or as a discount as petitioners contend. In

this way, determining the issue price by determining the “amount

loaned” would require the same analysis as determining the “price

paid” for the credit card loan, and our conclusion would be the

same.

-37-

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 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 W.

Credit Co. v. Commissioner, 38 T.C. 979, 980 (1962), affd. 325

F.2d 1022 (9th Cir. 1963), a lender in the business of making

small loans to individuals levied a “contract charge” and a

“carrying charge” on each loan. The contract charge was $10 if

-38-

the loan was $100 or less, and was the greater of $15 or 3

percent of the loan if the loan exceeded $100. Id. It was not

related to the duration of the loan and was not allocated to

specific services. Id. at 987. The carrying charge was 1

percent per month of the principal sum of the loan if the loan

was for $100 or more. Id. at 980. The lender also charged fees

for filing and recording chattel mortgages and life insurance

premiums on the borrower’s life. Id. The issue we faced was

whether the contract charge constituted interest. We held:

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 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. * * *

Id. at 987-988; see Noteman v. Welch, 108 F.2d 206, 213 (1st Cir.

1939) (3-percent fee charged to all borrowers was interest

because the only consideration the borrower received was the use

of the money lent); Seaboard Loan & Sav. Association v.

Commissioner, 45 B.T.A. 510, 516 (1941) (service fees charged by

a loan company ostensibly for investigating, closing, and

servicing loans were interest because “all the services charged

for were for the benefit of the lender and not for the benefit of

-39-

the borrower, and the only consideration received for the amounts

paid by the borrower was the money loaned”).

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 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 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.

Mr. Jonas was responsible for, among other things, the

development and implementation of MasterCard’s interchange rate

programs in the United States.

Mr. Sheedy had previously been employed as the executive

vice president of interchange strategy for Visa, U.S.A., Inc.

-40-

Respondent’s expert witness, Dr. Richard Schmalensee,19

testified that the service provided “is putting customers on the

streets with cards eager 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 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’

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.

-41-

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, 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. 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.’”

United States v. Midland-Ross Corp., 381 U.S. 54, 57 (1965)

(citations omitted). Under section 1273(a)(2) an amount payable

-42-

at the maturity of a debt instrument need not bear all the

characteristics of interest to be included in the SRPM, and thus

increase the amount of OID on the instrument. Section 1273(a)(2)

defines the SRPM as:

the amount fixed by the last modification of the

purchase agreement and includes interest and other

amounts payable at that time (other than any interest

based on a fixed rate, and payable unconditionally at

fixed periodic intervals of 1 year or less during the

entire term of the debt instrument). [Emphasis added.]

If Capital One acquired the loan for less than the SRPM, there

was OID on the transaction regardless of whether amounts included

in the SRPM and not included in the issue price were equivalent

to interest. Nevertheless, interchange resembles interest in

many ways.

For many transactors 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 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.

-43-

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. 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 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

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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 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. 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

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.

-45-

most 1 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 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

Capital One did not issue signature debit cards during the

years at issue. See paragraph J.3., supra.

-46-

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.

Noteman v. Welch, 108 F.2d at 212-213; Bank of Am. v. United

States, 230 Ct. Cl. 679, 680 F.2d 142, 148 (1982) (“interest

typically covers credit risk, credit administration, and cost of

funds.”).

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 Fort Howard Corp. & Subs.

v. Commissioner, 103 T.C. 345, 374 (1994), modified on another

issue 107 T.C. 187 (1996): “Crucial in establishing whether a

particular payment constitutes interest is whether the payment

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.

-47-

bears some relationship to the amount borrowed”. See also Sharp

v. Commissioner, 75 T.C. 21, 32 (1980), affd. 689 F.2d 87 (6th

Cir. 1982); Lay v. Commissioner, 69 T.C. 421, 438 (1977).

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,

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,

-48-

or covered just a small fraction of them for certain types of

credit card transactions is not dispositive of our determination

of whether interchange is a fee for a service or economically

equivalent to interest.24

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. Whether the Cardholder, the Merchant, or the Acquiring

Bank Pays Interchange

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

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.

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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 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 United States v. Clardy, 612 F.2d 1139, 1151

(9th Cir. 1980) (“The classic definition of ‘paid’ * * * [in the

context of interest deductions under section 163(a)] is ‘a

payment (of) cash or its equivalent’.”). In a credit card

transaction cash flows as an initial matter from the issuing

bank, not to the issuing bank; therefore petitioners argue that

the cashflow from the issuing bank to the acquiring bank was the

amount paid for the debt instrument.

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

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.

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Section 1.1273-2(g)(4), Income Tax Regs., provides:

If, as part of a lending transaction, a party other

than 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. * * *

Section 1.1273-2(g)(2)(i), Income Tax Regs., provides:

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.25

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

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.”

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cardholder.26 Therefore, under section 1.1273-2(g)(4), Income Tax

Regs., that payment may, in appropriate circumstances, be treated

as a payment from the cardholder to the lender. The question is:

what are appropriate circumstances?

The regulations provide an example of a situation in which a

payment from a third party to a lender results in OID. Section

1.1273-2(g)(5), Example (3), Income Tax Regs., describes a

situation where a real property seller pays the buyer’s “points”

to facilitate the buyer’s loan to purchase property:

(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 §1.1274-3). B

makes a cash down payment of $100,000 and borrows

$400,000 of the purchase price from a lender, L,

repayable in annual installments over a term of 15

years calling for interest at a rate of 9 percent,

compounded annually. As part of the transaction, A

makes a payment of $8,000 to L to facilitate the loan

to B.

(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). * * *

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.

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A credit card loan is not a “potentially abusive situation”

under section 1.1274-3(a), Income Tax Regs. In this example the

seller pays the purchaser’s points in order to facilitate the

loan. Mr. Sheedy, Mr. Jonas, Dr. Schmalensee, and Dr. Tufano all

testified that interchange encourages issuing banks to lend money

to cardholders so that the cardholders can make purchases.

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 section 1.1273-2(g)(2)(i) and (4), Income

Tax Regs.

D. Conclusion With Respect to the Interchange Issue

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 price, the interchange

on the transaction, is therefore properly treated as OID.

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Issue 2: The Calculation of OID Under Section 1272(a)(6)(C)

FINDINGS OF FACT

A. Accounting Methods

On August 5, 1997, Congress enacted the Taxpayer Relief Act

of 1997 (TRA), Pub. L. 105-34, sec. 1004, 111 Stat. 911, which

added section 1272(a)(6)(C)(iii) to the Code. On September 15,

1999, COB submitted Form 3115, Application for Change in

Accounting Method, by attaching it to petitioners’ consolidated

Federal income tax return for 1998. Capital One Fin. Corp. v.

Commissioner, 130 T.C. at 149. COB stated on the Form 3115:

Capital One Bank (COB), a domestic corporation,

requests permission under Section 12.02 of Rev. Proc.

98-60 to change its method of accounting for interest

and original issue discount that are subject to the

provisions of Section 1004 of the Tax Relief Act of

1997.

FSB did not submit Form 3115 to respondent requesting permission

to change its accounting method to conform to the requirements of

section 1272(a)(6)(C)(iii) and TRA section 1004.

Nevertheless, FSB as well as COB treated overlimit fees and

interchange as creating or increasing OID under section

1272(a)(6)(C)(iii) on petitioners’ consolidated 1998 and 1999

returns. To calculate the proper amount of OID includable on

their returns, COB and FSB used a complex formula developed by

the accounting firm KPMG (KPMG model). After discussing section

1272(a)(6) and the principles behind calculating OID under that

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section for a pool of loans, we will discuss the KPMG model in

detail.

B. Income and OID Accruals of Overlimit Fees and Interchange

The following chart shows the fees COB27 earned for book

purposes (when the fee was charged to the cardholder in the case

of overlimit fees and when the cardholder’s purchase 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

We include data with respect to COB only because of our

holding, infra par. A, that FSB did not request permission to

change its method of accounting for overlimit fee and interchange

income and therefore may not treat such income as increasing or

creating OID.

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Interchange Fees

Income

Recognized Difference: Unamortized

Taxable Interchange per KPMG Book v. OID Bal. 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. Accounting Methods

In 1997 Congress added section 1272(a)(6)(C)(iii) to allow

taxpayers to change their method of accounting to accrue original

issue discount on a pool of credit card receivables. TRA sec.

1004. Rev. Proc. 98-60, app. sec. 12, 1998-2 C.B. 759, 786,

provided procedures by which taxpayers could receive “automatic

consent” to change their method of accounting for pools of credit

card receivables in accordance with section 1272(a)(6)(C). Under

the revenue procedure, automatic consent was achieved by filing

Form 3115 with a taxpayer’s return. Id. sec. 6.02, app. sec. 12,

1998-2 C.B. at 765, 786.

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 called for by section

-56-

1272(a)(6)(C)(iii). We held that COB, which submitted Form 3115

but did not change its method of accounting for late fees in 1998

or 1999, and FSB, which did not submit Form 3115 or change its

method of accounting for late fees, could not retroactively

change their methods of accounting for late fees under section

446(e). Capital One Fin. Corp. v. Commissioner, supra at 156-

170.

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 section

1272(a)(6)(C)(iii). As we stated in our prior Opinion:

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 section 1272(a)(6)(C)(iii). See Rev.

Proc. 98-60, 1998-2 C.B. 759. Failure to follow those

procedures would negate automatic consent to the

proposed change.

Capital One Fin. Corp. v. Commissioner, supra at 158. FSB did

not follow the applicable procedures to receive consent to change

its method of accounting. Therefore, it may not treat its

relevant credit card receivables as creating or increasing OID

under section 1272(a)(6)(C)(iii) in 1998 or 1999.

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B. The Standard of Review

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 section 1.1272-1(b)(1)(ii) and (4)(iii),

Income Tax Regs., provides reasonableness standards for computing

the length of accrual periods and the amount of OID allocable to

the initial accrual periods, section 1.1272-1(b)(2)(i), Income

Tax Regs., provides that paragraph (b)(1) does not apply to debt

instruments subject to section 1272(a)(6). However, section

1.671-5(g)(1)(iv)(A)(2), Income Tax Regs., provides that in

calculating OID under section 1272(a)(6)(C), the trustee of a

widely held mortgage trust in certain circumstances “may use any

reasonable prepayment assumption to calculate OID”.28

Section 1272(a)(6)(B)(iii) requires taxpayers to use a

prepayment assumption as prescribed by regulations. No such

regulations have been issued. The models developed by KPMG and

by respondent’s expert call for the use of estimates. Under

these circumstances, COB’s assumptions and calculations used to

determine the amount of OID included in its gross income will be

respected so long as the assumptions and calculations are

The regulation provides trustees of widely held mortgage

trusts a safe harbor for reporting OID before the issuance of

final regulations under sec. 1272(a)(6)(C)(iii). No final

regulations have been issued.

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reasonable. Petitioners and respondent, in their briefs, agree

that a reasonableness standard is appropriate. However, the KPMG

model may not run afoul of the statutory scheme for calculating

the accrual of OID in general nor run afoul of section 1272(a)(6)

in particular.

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. Thor Power Tool

Co. v. Commissioner, 439 U.S. 522, 532 (1979); Commissioner v.

Hansen, 360 U.S. 446, 467 (1959); see also sec. 1.446-1(a)(2),

Income Tax Regs. Section 446 provides in part:

SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.

(a) General 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.

We generally give deference to the Commissioner’s determination

that a taxpayer’s method of accounting does not clearly reflect

income. However, if a taxpayer uses a method of accounting which

clearly reflects income, the Commissioner is not authorized to

adjust a taxpayer’s method of accounting to a method that may

more clearly reflect income.

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Ansley-Sheppard-Burgess Co. v. Commissioner, 104 T.C. 367, 371

(1995); Bay States Gas Co. v. Commissioner, 75 T.C. 410, 422

(1980), affd. 689 F.2d 1 (1st Cir. 1982); Garth v. Commissioner,

56 T.C. 610, 623 (1971).

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 section 1272(a)(6)(C)(iii)

will generally clearly reflect income within the meaning of

section 446.

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.

C. Section 1272(a)(6)(C)

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. Sec. 1272(a)(6).

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Section 1272(a)(6)(A) provides:

(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, 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.

The computation is represented by the following mathematical

equation: OIDn = [Cashflown + AIPn] - AIPn-1.

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.

Section 1272(a)(6)(A) requires COB to compute the present

value of all payments remaining to be made on its pool of credit

card receivables at the end of the accrual period. Section

1272(a)(6)(B) provides guidance with respect to determining the

present value:

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(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 occurred before the

close of the accrual period, and

(iii) a prepayment assumption determined in

the manner prescribed by regulations.

No regulations have been promulgated with respect to the

prepayment assumption that must be made in valuing credit card

receivables. The legislative history of the TRA provides some

guidance as to how taxpayers are to calculate OID on a pool of

credit card receivables:

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. * * *

H. Conf. Rept. 105-220, at 522 (1997), 1997-4 C.B. (Vol.2)

1457, 1992.

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

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$100 to be received in 2 years is $82.65, 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. The KPMG Model

1. The Payment Rate or Prepayment Assumption

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 section 1272(a)(6)(B)(iii) is simply a payment

rate. There is a direct correlation between the payment rate and

the amount of OID to be recognized. The higher the payment rate,

the more quickly COB recognizes OID; the lower the payment rate,

the more slowly COB recognizes OID. The KPMG model assumes that

the actual cash collected during each period is the best evidence

of the expected future payment rate.

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 recognizes such interest as income

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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 + New 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 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.

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.

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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 8.71 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

8.91

The 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.

2. The Weighted Average Maturity

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

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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, or “n” in the present value

formula used in the KPMG model.

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 8 9 10 11 12 AVG

1995 11.02 11.05 10.28 12.45 11.54 11.98 11.82 12.47 13.87 11.24 11.81 13.06 11.88

1996 10.61 10.51 10.68 10.80 11.99 12.90 11.56 13.20 13.05 12.56 13.63 13.12 12.05

1997 12.25 12.14 11.34 12.48 11.40 11.21 11.64 12.50 12.20 11.65 12.17 11.72 11.89

1998 11.15 11.58 9.98 10.96 11.29 11.21 11.48 11.12 11.98 10.48 11.36 12.05 11.22

1999 11.29 10.65 9.08 10.06 9.33 10.13 9.34 9.49 9.29 9.11 9.36 9.34 9.71

11.35

3. The Yield to Maturity

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

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function in Excel, which is expressed as follows: RATE = (Nper,

Pmt, PV, FV).

In this formula: (1) Nper is the total number of payment

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.

4. OID Accrual

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

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SRPM 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.

5. An Adjustment for Writeoffs

The KPMG model incorporates a section 166 Schedule M-1

adjustment for book/tax basis differences in receivables written

off by recognizing an additional and proportional amount of

income to offset the portion of the writeoff expense that had not

been previously accrued in income.

6. The Mid-Month Convention

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 KPMG Model Table

The following chart shows the KPMG model’s calculations of

OID for overlimit fees for the first 3 months of 1999.30

Figures are taken directly from Exhibit 11-J and have not

been adjusted for mathematical errors.

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KPMG/Rolling Balance OID Calculator

Capital One Financial Corporation (COB)

1999 - Overlimit Fees

Credit Card Fee Pool for Month 1 2 3

OID Created:

(A) Unamortized OID At Beginning of Period (overlimit 311,048,903 325,983,582 331,054,419

fees)

(B) Total New Additions of OID (overlimit fees) 48,238,609 41,029,513 43,915,549

(A+B)

SRPM

(D) SRPM At Beginning of Month 15,572,919,690 15,602,686,253 15,243,211,562

(E) Monthly Principal Addition 1,545,483,606 1,220,461,154 1,844,061,105

(F) Total SRPM After New Addition (D+E) 17,118,403,196 16,823,147,407 17,087,272,667

(G) Total SRPM at End of Month (F-I) 15,602,686,253 15,243,211,562 15,205,183,121

Adjusted Issue Price

(H) Beginning Issue Price (Incl. New Addition (F-C)) 16,759,115,684 16,456,134,312 16,712,302,699

Constant Yield (Monthly) 0.1879921% 0.2073659% 0.2446986%

(I) Principal Payment 1,515,716,943 1,579,935,845 1,882,089,546

(J) Ending Issue Price (PV of Future Cash Flow) 15,275,211,181 14,910,666,283 14,871,514,481

Reversal of Unamortized OID On Write Offs

(K) Ending Issue Price /SRPM (J/G) 97.90% 97.82% 97.81%

(L) Basis Adjustment Percentage (I-K) 2.10% 2.18% 2.19%

(M) Gross Write Offs 71,062,684 68,338,064 76,530,491

(N) Reversal of Unamortized OID on Write Offs (Basis 1,491,490 1,490,860 1,679,416

Adjustment)

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1 2 3

OID Amortization

(O) OID Amortization (I+J-H) 31,812,440 34,467,816 41,301,328

(P) Reversal of Unamortized OID on Write Offs (Basis 1,491,490 1,490,860 1,679,416

Adjustment)

(Q) Unamortized OID at Ent of Period (C-O-P) 325,983,582 331,054,419 331,989,224

OID Amortization on Calendar Month Basis

(R) Prior Period OID Recognized in Current Calendar 15,085,059 16,966,634 18,382,835

Month

(S) Current Period OID to be Recognized in Next Calendar 16,966,634 18,382,835 22,027,375

Month

(T) Adjusted OID Amor. for Calendar Month (O+R-S) 29,930,865 33,051,615 37,656,788

(U) Unamortized OID at End of Calendar Month (Q+S) 342,950,217 349,437,254 354,016,599

(V) Tax Adj. Inc. Recognized Per Calendar Month (T+P) 31,422,355 34,542,475 39,336,204

E. Respondent’s Arguments With Respect to the KPMG Model

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.

1. The Monthly Retirement and Reissuance of the Pooled

Debt Instrument

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

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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 sec. 1272(a)(6)(A) and (B). Unlike a REMIC, COB’s

credit card loan pool is dynamic, with cardholders making

payments and incurring new principal additions each month, and

with some cardholder accounts terminating as others enter the

pool.

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.

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We ask two questions. First, what authority did COB rely

upon when adopting the retired and reissued approach? Second,

what alternative does respondent suggest?

a. COB’s Reasons for Adopting the “Retired and

Reissued” Approach

To solve the problem of how to apply fixed-pool 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.

Section 1.1272-1(c), Income Tax Regs., provides rules to

determine the yield and maturity of certain debt instruments that

provide for an alternative payment schedule applicable upon the

occurrence of a contingency. “If a contingency * * * actually

occurs or does not occur, contrary to the assumption made * * *

[by the taxpayer] then * * * the debt instrument is treated as

retired and then reissued on the date of the change in

circumstances for an amount equal to its adjusted issue price on

that date.” Sec. 1.1272-1(c)(6), Income Tax Regs. Section

1.1275-2(h), Income Tax Regs., provides rules for debt

instruments subject to remote and incidental contingencies. If a

change in circumstance occurs, “the debt instrument is treated as

retired and then reissued on the date of the change in

circumstances for an amount equal to the instrument’s adjusted

issue price on that date.” Sec. 1.1275-2(h)(6)(ii), Income Tax

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Regs. Similarly, section 1.1275-2(j), Income Tax Regs., provides

that

If the terms of a debt instrument are modified to defer

one or more payments, and the modification does not

cause an exchange under section 1001, then, solely for

purposes of sections 1272 and 1273, the debt instrument

is treated as retired and then reissued on the date of

the modification for an amount equal to 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 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. Respondent’s Alternative to the “Retired and

Reissued” Approach

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:

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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, section 1272(a)(6)(C)(iii) applies

the OID rules to a pool of loans, and there is no authority

suggesting that COB was required to calculate OID individually

for each of its millions of cardholders.

Under the KPMG model an accrual of a single item of OID can

extend beyond the underlying indebtedness to which the OID

relates because 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

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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 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 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

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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 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

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.

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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 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

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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 of unamortized OID in the collective pool of

unamortized OID. Dr. Hakala’s adjustment 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 section 1272(a)(6) formula: OIDn = [Cash

flown + AIPn] - AIPn-1. Dr. Hakala calculates the OID simply by

multiplying the beginning issue price (including new additions) by

the YTM.

Respondent argues that Dr. Hakala’s formula for computing OID

is a close approximation of the section 1272(a)(6) formula. That

may be true; however, Congress provided the section 1272(a)(6)

formula, and we cannot require COB to use some other formula no

matter how similar to the formula provided in the Code.

Furthermore, we cannot find a taxpayer’s method of accounting which

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 sec. 1272(a)(6), we need not address petitioners’

arguments on this point.

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follows a formula provided by Congress to be unreasonable because a

different formula may more clearly reflect the taxpayer’s income.

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

provided in section 1272(a)(6) given the inherent difficulties in

applying fixed-pool accounting to a dynamic pool of loans.

Furthermore, respondent’s adjustments to this aspect of the KPMG

model are unreasonable and at odds with section 1272(a)(6).

2. The Inclusion of New Additions in the Beginning Issue

Price

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 additions results in an incorrect

determination of OID accruals.

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.

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Section 1272(a)(4) provides:

(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.

The parties agree that the additions that occur after the start of

the accrual period cannot be included in the AIPbeg figure under

section 1272(a)(4)(B). However, petitioners argue that new

additions are included under section 1272(a)(4)(A):

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

prior to the assumed reissue date. In essence, the

clock is “reset” to the beginning of the period every

month. Therefore, the issue price of the newly

reissued debt under section 1272(a)(4)(A) (not section

1272(a)(4)(B)) must include the Additions. Similarly,

the SRPM is equal to the SRPM at the prior month-end,

increased by net new additions to cardholder accounts

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, section 1.1272-1(c)(6), Income Tax Regs., provides that

the debt instrument is treated as retired and reissued on the

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date of the change in circumstances. In the case of a pool of

credit card loans, the KPMG model retires and reissues the debt

instrument on the first day of every month. So on January 1,

1999, the pool of debt instruments is retired, and the debt

instrument is reissued for the issue price on that date.

Unamortized OID is rolled over to the next period (January), and

the debt instrument is then retired and reissued on February 1,

1999. The regulations do not provide that at the end of the

period, for example January 31, the taxpayer should look backward

and recompute the January 1 issue price on the basis of events

that occurred during January.

However, we must acknowledge the differences between 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 section 1272(a)(6)

formula constantly. It must pick a period and calculate the OID

accrual for that period. COB chose to do so monthly, which is

reasonable given the nature of the credit card business.

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

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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 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 1272(a)(4)(A), we cannot

ignore section 1272(a)(4)(B). Subparagraph (B) makes clear that

the beginning issue price includes only the adjustments to the

issue price included before the first day of the accrual period.

The reissuance of the pool of debt instruments occurs on the

first day of every month; i.e., the first day of the accrual

period. It is inappropriate under either section 1272(a)(4)(A)

or (B) to include in the issue price the additions that occurred

on or after the first day of the accrual period.

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3. Payment Rate Issues

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 (net of finance charges):

Payments - Stated finance charges

Outstanding Balance + New additions

Respondent raises several issues with respect to the calculation

of the payment rate.

a. The Denominator

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

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(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 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 date33 of the 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

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.

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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

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 charges from the month

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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 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 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

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.

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anticipates future defaults. The legislative history of section

1272(a)(6) suggests that defaults are not to be estimated when

determining future cashflows. H. Conf. Rept. 99-841 (Vol II), at

II-238 n.22 (1986), 1986-3 C.B. (Vol.4) 1, 238 (“In computing the

accrual of OID (or market discount) on qualified mortgages held

by the REMIC, only assumptions about the rate of prepayments on

such mortgages would be taken into account.” (Emphasis added.)).

We conclude that writeoffs should not be included in the

numerator when calculating payment rates.35

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. Other Published Payment Rates

Moody’s Investors Services publishes historical credit card

payment rates showing 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 and issues prospectuses related to its sale

of credit-card-backed securities. Each of these reports includes

information about the payment rates of the loans that backed the

securities.

The KPMG model deals with writeoffs in a separate

adjustment, which we conclude is reasonable.

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However, these other published payment rates are not based

upon the formula set out in section 1272(a)(6) and its related

regulations. The published payment rate calculations include

payments of finance charges which are left out of the section

1272(a)(6) formula because they are considered to be stated

interest. Taking finance charges out of the equation, at least

in the case of the numbers reported by Capital One, decreases the

payment rates by approximately 1 percent of principal per period.

For example, a payment rate of 10 percent including finance

charges would be approximately 9 percent excluding finance

charges.36 Other adjustments were made in some calculations.

For example, some of the calculations use an average outstanding

principal amount for the month, rather than the outstanding

amount at the beginning or end of the month.

Our determinations on these issues are based on section

1272(a)(6) and the related regulations, not on published reports

that use an analysis not based in the Code.

4. Dr. Hakala’s Default Rate Adjustment for Overlimit Fees

The KPMG model includes a section 166 adjustment for

book/tax basis differences in receivables written off every month

as reducing the end-of-month balance of unamortized OID.

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.

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Respondent proposes to modify this writeoff adjustment for

default rates associated with late fees and overlimit fees.

Because of our determination in Capital One Fin. Corp. v.

Commissioner, 130 T.C. 147 (2008), late fees are not at issue.

Although they are not at issue, respondent argues that Dr.

Hakala’s analysis of the default characteristics of cardholders

who incurred overlimit fees depends on his analysis of defaults

associated with late fees.

Using data from Capital One’s 310 reports, Dr. Hakala

tracked the proportion of accounts that incurred late fees

ultimately 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 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

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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, 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

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conclude that Dr. Hakala’s proposed default rate adjustment would

more clearly reflect COB’s income than did the KPMG model.

5. Dr. Hakala’s Seasonality and Trend Adjustment

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, the KPMG model is reasonable and clearly

reflected COB’s income.

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F. Conclusion With Respect to the Calculation of OID

Although COB may enjoy some latitude in its method of

calculating the accrual of OID, it may not run afoul of section

1272 and the OID regulations. We conclude that COB may not

include new additions, as defined in the KPMG model, in the

beginning issue price of the monthly pool of debt instruments.

Further, COB’s calculations of the payment rate run afoul of

section 1272 by applying payments first to accrued, but unbilled,

finance charges. Lastly, the denominator of the payment rate

calculation may not include new additions because those additions

were not billed to the cardholders and should not have been

included in the beginning issue price. We conclude that, in all

other respects, the KPMG model is reasonable.

Issue 3: Milesone Rewards

FINDINGS OF FACT

A. The Milesone Reward Program

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 credit cards

(as described above) except that they allowed a cardholder to

earn “miles” which could be redeemed for airline tickets.

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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 States 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

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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 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. Milesone Program Costs and Accounting

Capital One estimated its cost of redeeming its cardholders’

miles. The estimates depended primarily on two variables: (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.37 Capital

In 1998 and 1999 Capital One awarded 29,254,871 and

323,169,272 miles in connection with balance transfers and bonus

(continued...)

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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 $583,411.38 This amount was used as its contingent

reserve for redemption costs on its general ledger for financial

accounting purposes and was deducted under section 1.451-4,

Income Tax Regs., on petitioners’ consolidated 1998 Federal

income tax return.39

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 redemption costs to be

$34,593,497.40 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,

(...continued)

miles. The record is not clear about what constituted bonus

miles.

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.

Capital One actually spent $1,578 and $313,513 to redeem

Milesone miles during 1998 and 1999, respectively.

Again, the 80 percent and 1.65 cents figures would result

in a slightly higher cost of redemption.

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$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

section 1.451-4, Income Tax Regs.

The actual redemption rates of points earned by cardholders

in 1998 and 1999 through their 5-year expiration period were 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. The History of Accounting for the Redemption of Trading

Stamps and Coupons

Whether a business expense has been incurred so as to

entitle an accrual basis taxpayer to deduct it under section

162(a) is governed by the all events test. United

States v. Anderson, 269 U.S. 422, 441 (1926). In Anderson, the

Supreme Court held that a taxpayer was entitled to deduct from

its 1916 income a tax on profits from munitions sales that took

place in 1916. Although the tax would not be assessed and

therefore would not formally be due until 1917, all the events

had occurred in 1916 to fix the amount of the tax and to

Petitioners did not explain why the cost of redemption was

more than the ostensible maximum payout of 2 cents per mile.

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determine the taxpayer’s liability to pay it. The all events

test is now embodied in section 1.461-1(a)(2), Income Tax Regs.,

which during the years at issue provided:

Under an accrual method of accounting, a liability (as

defined in § 1.446-1(c)(1)(ii)(B)) is incurred, and

generally is taken into account for Federal income tax

purposes, in the taxable year in which all the

events have occurred that establish the fact of the

liability, the amount of the liability can be

determined with reasonable accuracy, and economic

performance has occurred with respect to the liability.

* * *

See also sec. 461(h) (providing that the all events test shall

not be treated as met any earlier than when economic performance

occurs);42 United States v. Gen. Dynamics Corp., 481 U.S. 239,

242-243 (1987).

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 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

Sec. 461(h)(5) provides an exception to the general rule

of sec. 461(h), allowing a deduction for a reserve for estimated

expenses if such a deduction is otherwise allowable under the

Code.

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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

section 1.451-4(a)(1), Income Tax Regs., which for the years at

issue provided:

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 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 Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 411

(5th Cir. 1969); Tex. Instruments, Inc. v. Commissioner, T.C.

Memo. 1992-306.

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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 section 1.451-4, Income Tax Regs.,

but disagrees that the miles are issued with sales and that

Capital One had gross receipts with respect to sales.

B. The “With Sales” Requirement

Over the years we have been asked to interpret and apply

section 1.451-4, Income Tax Regs., and its predecessors. In

Creamette Co. v. Commissioner, 37 B.T.A. 216 (1938), the taxpayer

created a program to increase sales of its macaroni product. It

issued with each carton of its product sold one coupon which was

redeemable for certain selected articles of merchandise. The

Board of Tax Appeals, predecessor to this Court, allowed the

taxpayer to deduct a reasonable estimate of its future cost of

redemption under Regs. 77, art. 335, a predecessor to section

1.451-4, Income Tax Regs. Creamette Co. v. Commissioner, supra

at 218. In Brown & Williamson Tobacco Corp. v. Commissioner, 16

T.C. 432 (1951), to spur sales of its cigarettes, the taxpayer

issued coupons with each pack of its cigarettes sold which could

be redeemed for merchandise or cash. We allowed the taxpayer to

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deduct the reasonable estimate of its future cost of redemption.

Id. at 445-446.

In Tex. Instruments, Inc. v. Commissioner, supra, the

taxpayer did not include coupons on the product sold in the same

way as the taxpayers in Creamette and Brown & Williamson but

rather placed coupons in stores and in newspaper and magazine

advertisements. To redeem the coupon, the consumer was required

to submit to the taxpayer an original sales receipt and some

additional type of proof of purchase, such as a part of the

product box. The Commissioner contended that the taxpayer’s

coupons were merely advertisements inducing customers to purchase

its products and were not issued with sales within the meaning of

section 1.451-4, Income Tax Regs. We disagreed and held that,

for purposes of section 1.451-4, Income Tax Regs., the proofs of

purchase, such as part of the product’s box, functioned as

coupons issued with sales of the product.

In Tex. Instruments, there was no dispute that sales took

place. The issue was whether coupons were issued with those

sales. If the coupon, for purposes of section 1.451-4, Income

Tax Regs., was the advertisement, it would not have been issued

with the sale. The issue in this case is different. Although

respondent argues that the miles were not issued with sales, the

focus of his argument is that there were no sales with which

coupons could be issued.

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Although most credit card transactions involve sales of

goods or services, i.e., a consumer purchases a product from a

merchant, petitioners do not argue that the merchant’s sale of

goods to the cardholder is relevant for purposes of section

1.451-4, Income Tax Regs. Rather, petitioners argue that when a

cardholder uses a Milesone card, Capital One has sold its lending

services to the cardholder and issued miles with that sale.

Respondent concedes that “sales” as used in section 1.451-4,

Income Tax Regs., is broad enough to include the sale of services

as well as the sale of goods.

Petitioners argue that we have interpreted the term

“service” to include the lending of money. In Burbank

Liquidating Corp. v. Commissioner, 39 T.C. 999 (1963), affd. in

part and revd. in part on other grounds 335 F.2d 125 (9th Cir.

1964), we faced the question of whether a lender’s mortgage loans

made in the ordinary course of business were ordinary or capital

assets under section 1221(4).43 We held that the loans were

“notes receivable acquired for * * * services rendered” and thus

were ordinary, rather than capital assets. Id. at 1009. We

explained that “the business of a savings and loan company could

properly be described as ‘rendering the service’ of making

loans.” Id. at 1009-1010.

Sec. 1221(4) of the Internal Revenue Code of 1954 excluded

from capital assets: “accounts or notes receivable acquired in

the ordinary course of trade or business for services rendered or

from the sale of property”.

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In FNMA v. Commissioner, 100 T.C. 541, 576-578 (1993), we

faced a similar question with respect to the character of home

mortgage loans. However, the lender had not originated the loans

but had purchased them on the secondary market. Nevertheless, we

held that “the actual

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