US Tax: United States Tax Court Ruled Interchange Income is Properly Treated as Original Issue Discount (OID)
What is Interchange?
Interchange is an income collected by issuer of a credit card (whether Visa or MasterCard), when a purchase is made by the cardholder. Interchange is calculated on each and every credit card transaction as a percentage of the amount of the purchase price, and sometimes a flat fee is also added to the amount. Interchange rates vary between Visa and MasterCard and also vary between the type of the merchant.
When a cardholder goes to a merchant and uses a credit card for making the purchase, he/she pays the full amount of the purchase to the bank. The issuing bank (Capital One), however, allows Visa and MasterCard withdraw a less amount of money from their bank account, according to how Visa and MasterCard system functions. This discounted amount goes to merchant's bank. The difference between the original purchase price and the amount Visa or MasterCard withdrew from issuing bank's (Capital One) account is the interchange fee.
What the Story is About?
Capital One took 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) of the Internal Revenue Code. The IRS (INternal Revenue Service) claimed that interchange is not exactly equal to interest so interchange may not be treated as Original Issue Discount (OID) under sec. 1272(a)(6)(C)(iii) of the Internal Revenue Code. Capital one claimed that they acquired the credit card loans at a discounted price (interchange being the discount), accordingly, interchange was correctly evaluated as Original Issue Discount (OID).
Additionally, Capital One issued credit cards which are known as Milesone cards. Milesone cards are Visa and MasterCard credit cards which allowed owners to earn 1 mile for every dollar they spent. After reaching a certain amount, the cardholder then exchanges those miles with an airline ticket. Capital One bank deducted the estimated future cost of those miles according to section 1.451-4 of Income Tax Regulations. This section allows taxpayer deduct an estimate of the expenses related to redeem coupons (in Capital One's case, the cost of the airline miles) from their revenues.
Examinations of the Court
The court examined 3 issues:
1) The court examined whether interchange is properly recognized over the life of the pool of credit card loans to which the interchange relates under section 1272(a)(6)(C)(iii).
2) The court examined whether Capital One calculated the Original Issue Discount (OID) for interchange and overlimit fees properly.
3) The court examined whether Capital One can deduct the estimated cost of airline miles which can be redeemed by the cardholders as airline tickets, under section 1.451-4 of Income Tax Regulations.
The Court held that:
1) Interchange may be recognized over time as original issue discount (OID) under section 1272(a)(6)(C)(iii).
The court held that interchange is not a fee for a service, other than the lending of money. The issue price of a credit card loan is the price paid for that loan, which is the amount withdrawn from Capital One's account by Visa or MasterCard system, and deposited to the merchant's bank. The court held that interchange is properly treated as OID under sec. 1272(a)(6)(C)(iii) of the Internal Revenue Code.
2) The formula Capital One used to calculate Original Issue Discount (OID), with modifications required by the OID rules generally is reasonable.
Capital One used KPMG (the audit firm) for accounting purposes and KPMG used a model for calculating Original Issue Discount (OID). The court held that the KPMG model calculated the payment rate wrong by making additions to principal which took place after the first day of the accrual period and KPMG model calculated the payment rate wrong by implementing payments to finance charges which accrued during the period. Payments should be applied not the current month's finance charges, but to the previous month's finance charges first. In all other respects, the KPMG model was reasonable, the court explained.
3) Capital One may not deduct the cost of airline miles according to section 1.451-4 of Income Tax Regulations.
Airline miles issued by Capital One are not issued with sales, and Capital One did not have gross receipts with respect to sales within the meaning of sec. 1.451-4 of Income Tax Regulations. Therefore, Capital One may not deduct the estimated costs of redeeming the miles according to to section 1.451-4 of the Income Tax Regulations.
TAX NEWS - SEPTEMber 2009
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