On September 27, 2010, the Internal Revenue Service (IRS) issued Chief Counsel Notice 2010-018, which formally announced that the IRS will no longer challenge the treatment of credit card interchange fees earned by credit card companies as original issue discount (or OID). Interchange fees are earned when credit card companies reimburse merchants for a good or service purchased using a credit card in an amount that is less than the amount charged. In a typical credit card transaction, the interchange fee ranges from 1 to 2 percent of the amount charged for a credit card purchase. As referenced in the notice, the IRS changed its litigating position after it lost the issue in a recent tax court decision, Capital One Financial Corporation and Subsidiaries v. Commissioner, 133 T.C. 136 (2009), in which McDermott Will & Emery lawyers represented Capital One.
Beginning in 1998 Capital One, one of the world’s largest credit card companies, reported interchange fees on its federal income tax returns as OID pursuant to Internal Revenue Code section 1272(a)(6)(C)(iii). This tax return reporting position permitted Capital One to recognize the interchange income over time as the credit card loans were repaid. The IRS challenged Capital One’s tax return position for interchange fees, arguing that the revenue should be recognized by Capital One immediately, when the credit card holder made a purchase and charged the credit card.
In a lengthy and well-reasoned opinion, the tax court rejected the IRS’s argument and held that interchange fees were properly treated by Capital One as OID. With the announcement of the change in litigating position in Chief Counsel Notice 2010-018, the IRS has effectively conceded the interchange issue.
The announcement that the IRS has conceded the interchange fee issue is a significant victory for all credit card companies. Annually, credit card companies earn more than $30 billion in interchange fees. This change in litigating position, however, may also be of interest to other taxpayers. The treatment of credit card interchange fees was an IRS Tier II issue (see April 22, 2008, memorandum from Walter Harris, LMSB-04-0208-002). Tiered issues are “coordinated” within the IRS and can be difficult to settle. Taxpayers challenging other tiered issues may take solace in the fact that the IRS does not always correctly evaluate its litigation hazards. Thus, those taxpayers with strong facts should consider litigating in some cases, including those in tax court.