t c no united_states tax_court capital one financial_corporation and subsidiaries commissioner of internal revenue respondent petitioners v docket nos filed date p’s subsidiaries cob and fsb issued visa and mastercard credit cards among the various revenues received from the credit card business cob and fsb earned interchange interchange is income earned by an issuer of visa and mastercard credit cards which accrues to the issuer each time a cardholder uses a credit card for a purchase it is almost always calculated as a percentage of the total purchase plus in some instances a small fixed amount when a cardholder used a credit card to purchase an item from a merchant the cardholder agreed to pay cob or fsb the full purchase_price of the item however because of the way the visa and mastercard systems operated cob and fsb authorized visa and mastercard to withdraw a lesser amount from capital one’s account which eventually was delivered to the merchant the difference between the purchase_price and the amount visa or mastercard withdrew from capital one’s account was the interchange on the transaction cob and fsb treated interchange as creating or increasing original_issue_discount oid on the pool of loans to which the interchange related under sec_1272 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 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 130_tc_147 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 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 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 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 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 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 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 i r c held further fsb did not follow the required procedures to change its method_of_accounting in accordance with sec_1272 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 i r c in that 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 the model incorrectly calculated the payment rate by including additions to principal which occurred after the first day of the accrual_period and 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 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 issue interchange contents c e f g h i j findings_of_fact a an introduction to interchange b the historical roots of the credit card industry and interchange interchange fees and the visa and mastercard systems the parties to a typical credit card purchase d transaction the issuing bank capital one the cardholder the acquiring bank the merchant the association visa or mastercard a typical credit card purchase transaction the clearing process net settlement cardholder payments merchant discount in detail interchange in detail factors influencing interchange rates capital one’s costs and interchange debit cards and interchange capital one’s accounting treatment of credit card purchases and associated interchange income opinion an overview of the issue and the law the srpm of a credit card loan the issue_price of a credit card loan whether interchange is a fee for a service and if so what service or economically equivalent to interest whether the cardholder the merchant or the acquiring bank pays interchange conclusion with respect to the interchange issue a b c d issue the calculation of oid under sec_1272 a b findings_of_fact accounting methods income and oid accruals of overlimit fees and interchange opinion accounting methods the standard of review sec_1272 the kpmg model a b c d the payment rate or prepayment assumption the weighted_average_maturity the yield_to_maturity oid accrual an adjustment for writeoffs the mid-month_convention the kpmg model table respondent’s arguments with respect to the kpmg model cob’s reasons for adopting the the monthly retirement and reissuance of the pooled_debt instrument a retired and reissued approach b retired and reissued approach the inclusion of new additions in the respondent’s alternative to the beginning issue_price payment rate issues the denominator a the numerator b c other published payment rates dr hakala’s default rate adjustment for overlimit fees dr hakala’s seasonality and trend adjustment conclusion with respect to the calculation of oid e f issue milesone rewards findings_of_fact the milesone reward program milesone program_costs and accounting opinion a b a b c d the history of accounting for the redemption of trading stamps and coupons the with sales requirement gross_receipts with respect to sales conclusion with respect to the milesone rewards issue haines judge respondent determined deficiencies in and penalties with respect to petitioners’ federal income taxes as follows year deficiency dollar_figure big_number big_number big_number big_number penalty sec_6662 n a n a dollar_figure big_number big_number capital one financial corp through its principal subsidiaries capital one bank cob and capital one f s b fsb collectively capital one is among the world’s largest issuers of visa and mastercard credit cards its headquarters is in virginia after concessions three issues remain for our decision all of which are issues of first impression and relate 1unless 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 2we refer to cob and fsb individually only when the difference is material to our analysis 3the parties were able to settle many issues including all issues with respect to petitioners’ and tax years 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 sec_1272 we hold that interchange may be recognized over time as original_issue_discount oid under sec_1272 the second issue is whether cob and fsb properly calculated the amount of oid for interchange and overlimit fees we hold that the formula cob used to calculate oid with modifications required by the oid rules generally and sec_1272 specifically as set forth infra is reasonable the third issue is whether capital one may deduct under sec_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 4subsumed 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 may not deduct those costs 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 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 interchange a an introduction to interchange findings_of_fact 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 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 days after a monthly statement was issued 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 5cards 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 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 dollar_figure annual fee and the merchants received percent of the cardholder’s total charge 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 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 6as we will see respondent argues that the merchant has paid percent of the charge to the bank and petitioners argue that the bank has received funds net of a 7-percent discount 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 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 bank of america converted its franchise system into an association national bankamericard inc national bankamericard inc became visa in and the interbank card association became mastercard in c interchange fees and the visa and mastercard systems a credit card transaction in the visa and mastercard the associations systems included five parties 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 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 7the association model is sometimes referred to as a four- party system because the association either visa or mastercard is not counted was lending money to its cardholders with whom it had a contractual relationship as spelled out in the cardholder agreement all issuing banks operated under the rules provided by the respective associations either visa’s by-laws and operating regulations visa rules or mastercard’s by-laws and rules and operating manuals mastercard rules the cardholder 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 amount owed capital one could not look for payment of the liability from the association the merchant or the acquiring bank 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 8acquiring banks are sometimes referred to as merchant’s banks 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 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 an authorization process to enable the merchant to obtain the issuing bank’s authorization for the cardholder’s purchase and 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 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 9in and capital one cardholders participated in big_number and big_number credit card transactions respectively 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 dollar_figure from a merchant using a visa or mastercard credit card issued by capital one the card is swiped through an electronic terminal at the merchant’s location the terminal is linked through the acquiring bank to the visa or mastercard network see step b the amount of the transaction and the cardholder information is routed from the merchant to the acquiring bank see step c the transaction information is routed from the acquiring bank through visanet or banknet to capital one see step sec_3 and 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 step sec_5 and 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 and by signing the transaction receipt the cardholder promises to pay capital one the total price shown thereon sometime in the future the cardholder may pay more than the total price shown on the transaction receipt for example the cardholder may incur finance_charges late fees or overlimit fees with respect to a credit card purchase transaction the amount capital one authorized to be charged the total purchase_price was equal to the amount it expected to be paid_by the cardholder however as discussed below capital one did not authorize visa or mastercard to withdraw the total purchase_price from its bank account as part of the net settlement process f 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 eg a grocery store or an airline the type of transaction eg 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 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 dollar_figure a hypothetical 2-percent interchange fee and a hypothetical merchant discount of percent the example assumes that no other transactions occurred for the cardholder the merchant the acquiring bank or the issuing bank in settlement of this hypothetical_transaction a the association withdraws dollar_figure from the issuing bank’s account representing the dollar_figure total price less the 2-percent interchange fee b the association deposits dollar_figure into the acquiring bank’s account also representing the dollar_figure total price less the percent interchange fee c the acquiring bank_deposits dollar_figure into the merchant’s bank account representing the dollar_figure total price less the percent merchant discount 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 otherwisedollar_figure 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 ie 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 10members 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 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 chargeback sec_11 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 11when 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 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 or percent of the cardholder’s outstanding balance with at least dollar_figure or dollar_figure 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 capital one provided its cardholders with a grace period that approximated days because capital one’s billing cycles approximated days and the grace period approximated days a cardholder could have up to 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 percent was attributable to transactors and 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 net merchant discount ie 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 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 the method of the purchase eg in person or on line the type of merchant the geographical area of the merchant eg domestic or international the type of cardholder eg individual personal or corporate business in some instances the size of the transaction eg a large ticket purchase over a certain threshold_amount and the type of purchase eg 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 consumer standard travel industries petroleum terminal supermarket corporate standard rates rates rate sec_2 dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure visa’s interchange rates included the following categories program name standard commercial other than certain travel-related charges cps retail1 commercial other than certain travel-related charges cps hotel and car rental supermarket incentive program non-commercial rate sec_2 dollar_figure rate sec_2 dollar_figure dollar_figure dollar_figure 1cps refers to custom payment service visa’s term for card transactions that are processed a certain way 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 year -29- issuing banks’ cost sec_1 dollar_figure percent dollar_figure per transaction dollar_figure percent dollar_figure per transaction dollar_figure percent dollar_figure per transaction 1edgar dunn broke the total cost down into components the issuing bank’s cost of lending money ie the financial carrying costs during the grace period were dollar_figure percent dollar_figure percent and dollar_figure percent of the total purchase_price during and respectively for and dollar_figure percent dollar_figure percent and dollar_figure percent of the total purchase_price represented the total risk costs edgar dunn calculated the issuing bank’s processing costs to be cents per transaction for visa estimated that the average processing cost per transaction was cents with the actual costs ranging between cents and cents for the average cost was cents per transaction with the actual costs ranging between cents and cents per transaction for and capital one’s cost of processing a credit card transaction was likely between cents and cents per transaction debit cards and interchange during the years at issue capital one did not issue signature debit cardsdollar_figure a signature debit card is linked to the 12capital 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 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 the interchange rate on signature debit card transactions was only slightly lower than the interchange rate on credit card transactions 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 ca sec_12 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 did not reflect any detail with respect to the amount of interchange received capital one maintained so called reports which were monthly summaries aggregating transaction data and financial accruals the 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 dollar_figure purchase transaction with a dollar_figure interchange fee capital one would enter the purchase amount as credit card outstanding an account receivable the dollar_figure interchange fee would be credited as interchange income for financial_accounting purposes capital one reported interchange income as noninterest income before 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 capital one recognized interchange income for both financial_accounting and federal_income_tax purposes at the time its cardholders’ transactions were net settled under the visa and mastercard rules for financial_accounting and regulatory reporting purposes 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 bankdollar_figure 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 and 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 sec_1272 13the regulatory reports were filed with the office of the comptroller of currency 14for federal_income_tax purposes capital one treated cash advance fees as creating or increasing oid before as well as after respondent has conceded this treatment is proper opinion a an overview of the issue and the law under sec_1272 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 130_tc_147 the issue is whether capital one’s interchange income is properly recognized over time under sec_1272 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 pincite we described in general terms the oid rules and sec_1272 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 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 the srpm includes all amounts payable at maturity sec_1273 in order to compute the amount of oid and the portion of oid allocable to a period the srpm and the time of maturity must be known this presents a problem for debts such as credit card loans and real_estate mortgages that may be satisfied over a very short or a very long period thus making the time of maturity an unknown at the inception of the debt for this reason special rules were created for determining the amount of oid allocated to a period for certain instruments that may be subject_to prepayment in the case of any regular_interest in a real_estate_mortgage_investment_conduit remic qualified mortgages held by a remic or 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 and ii sec_1272 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 sec_1272 was intended to apply to credit card loans and the related receivables see h conf rept pincite 1997_4_cb_1457 what was unclear at the time of enactment and is still not fully resolved is which credit card receivables increase oid under sec_1272 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 pincite 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 income_tax regs in the example of a dollar_figure purchase of goods or services from the merchant the srpm is equal to dollar_figure because the cardholder if she lived up to her agreement would have paid at least dollar_figure 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 ie qualified_stated_interest incurred c the issue_price of a credit card loan the parties dispute the calculation of the issue_price of a credit card loan sec_1273 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 income_tax regs if x bank lends dollar_figure to a an individual the issue_price of the loan would be dollar_figure however a credit card loan is part of a multiparty transaction where the funds lent are sent to the merchant via the 15qualified 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 sec_451 at least annually at a single fixed rate sec_1_1273-1 income_tax regs 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 instrumentdollar_figure sec_1273 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 ie dollar_figure for a dollar_figure purchase where capital one actually advanced dollar_figure 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 whether interchange is a fee for a service and if so what service or economically equivalent to interest 16if the issue_price was the amount_loaned see sec_1_1273-2 income_tax regs the parties would still dispute the amount_loaned to the cardholder using the dollar_figure purchase example the amount_loaned could be dollar_figure or dollar_figure 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 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_tc_979 affd 325_f2d_1022 9th cir 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 dollar_figure if the loan was dollar_figure or less and was the greater of dollar_figure or percent of the loan if the loan exceeded dollar_figure id it was not related to the duration of the loan and was not allocated to specific services id pincite the carrying_charge wa sec_1 percent per month of the principal sum of the loan if the loan was for dollar_figure or more id pincite 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 pincite see 108_f2d_206 1st cir 3-percent fee charged to all borrowers was interest because the only consideration the borrower received was the use of the money lent 45_bta_510 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 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 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 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 17mr jonas was responsible for among other things the development and implementation of mastercard’s interchange rate programs in the united_states 18mr sheedy had previously been employed as the executive vice president of interchange strategy for visa u s a inc respondent’s expert witness dr richard schmalensee 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’ 19dr 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 a text on the economics of payment_card systems 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 ’ 381_us_54 citations omitted under sec_1273 an amount payable 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 sec_1273 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 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 receivesdollar_figure 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 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 day or 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 20the 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 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 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 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 and the speed at which the cardholder loan is paid off can dramatically affect this rate returning seemingly exorbitant interest rates of over 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 and 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 pincitedr 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 most or daysdollar_figure 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 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 22capital one did not issue signature debit cards during the years at issue see paragraph j supra interests rate of interchange fees on a revolving account and determined that on average interchange raises the annual percentage rate by about 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 f 2d pincite 680_f2d_142 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 feedollar_figure 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 103_tc_345 modified on another issue 107_tc_187 crucial in establishing whether a particular payment constitutes interest is whether the payment 23the nominal fee portion of interchange transactions is usually between dollar_figure and dollar_figure in the average interchange fee for a visa credit card transaction was dollar_figure therefore the nominal fee accounted for between and percent of the total fee bears some relationship to the amount borrowed see also 75_tc_21 affd 689_f2d_87 6th cir 69_tc_421 respondent argues that interchange rates were not driven by movements in market interest rates for example between and the prime rate fell from percent to percent yet average interchange rates rose slightly from dollar_figure percent to dollar_figure 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 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 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 interestdollar_figure 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 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 ie the transaction receipt from the acquiring bank this would suggest that capital one acquired the debt_instrument at a discount returning to the dollar_figure purchase with 2-percent interchange example capital one authorized the cardholder to make a dollar_figure purchase but capital one did not authorize mastercard or visa to withdraw dollar_figure from its account it authorized only a dollar_figure withdrawal the purchase_price less interchange respondent 24petitioners 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 contends that capital one lends the cardholder dollar_figure for the cardholder’s promise to pay dollar_figure and that the acquiring bank paid capital one dollar_figure in this scenario dollar_figure 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 612_f2d_1139 9th cir the classic definition of ‘paid’ in the context of interest deductions under sec_163 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 sec_1_1273-2 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 of this section sec_1_1273-2 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 transactiondollar_figure 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 25at 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 cardholderdollar_figure therefore under sec_1_1273-2 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 sec_1_1273-2 example 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 dollar_figure in a transaction that is not a potentially_abusive_situation within the meaning of sec_1_1274-3 b makes a cash down payment of dollar_figure and borrows dollar_figure of the purchase_price from a lender l repayable in annual installments over a term of years calling for interest at a rate of percent compounded annually as part of the transaction a makes a payment of dollar_figure to l to facilitate the loan to b ii under the provisions of paragraphs g i and g of this section b is treated as having made an dollar_figure payment directly to l and a payment of only dollar_figure to a for the property the payment to l reduces the issue_price of b’s debt_instrument to dollar_figure resulting in dollar_figure of oid dollar_figure - dollar_figure 26respondent 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 a credit card loan is not a potentially_abusive_situation under sec_1_1274-3 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 sec_1_1273-2 and 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 issue the calculation of oid under sec_1272 findings_of_fact a accounting methods on date congress enacted the taxpayer_relief_act_of_1997 tra publaw_105_34 sec 111_stat_911 which added sec_1272 to the code on date cob submitted form_3115 application_for change in accounting_method by attaching it to petitioners’ consolidated federal_income_tax return for capital one fin corp v commissioner t c pincite cob stated on the form capital one bank cob a domestic_corporation requests permission under section dollar_figure of revproc_98_60 to change its method_of_accounting for interest and original_issue_discount that are subject_to the provisions of section of the tax relief act of fsb did not submit form_3115 to respondent requesting permission to change its accounting_method to conform to the requirements of sec_1272 and tra section nevertheless fsb as well as cob treated overlimit fees and interchange as creating or increasing oid under sec_1272 on petitioners’ consolidated and 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 sec_1272 and the principles behind calculating oid under that 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 taxable_year overlimit fee income for book purposes dollar_figure big_number big_number big_number big_number income recognized per kpmg model dollar_figure big_number big_number big_number big_number difference book v kpmg model dollar_figure big_number big_number big_number big_number unamortized oid bal at end of year dollar_figure big_number big_number big_number big_number 27we 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 interchange fees taxable_year interchange book income dollar_figure big_number big_number big_number big_number income recognized per kpmg model dollar_figure big_number big_number big_number big_number opinion difference book v kpmg model dollar_figure big_number big_number big_number big_number unamortized oid bal at end of year dollar_figure big_number big_number big_number big_number a accounting methods in congress added sec_1272 to allow taxpayers to change their method_of_accounting to accrue original_issue_discount on a pool of credit card receivables tra sec revproc_98_60 app sec_12 1998_2_cb_759 provided procedures by which taxpayers could receive automatic consent to change their method_of_accounting for pools of credit card receivables in accordance with sec_1272 under the revenue_procedure automatic consent was achieved by filing form_3115 with a taxpayer’s return id sec app sec_12 c b pincite 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 and late- fee income to the method called for by sec_1272 we held that cob which submitted form_3115 but did not change its method_of_accounting for late fees in or 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 sec_446 capital one fin corp v commissioner supra pincite- respondent argues that because fsb did not submit form_3115 in or 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 sec_1272 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 sec_1272 see revproc_98_60 1998_2_cb_759 failure to follow those procedures would negate automatic consent to the proposed change capital one fin corp v commissioner supra pincite 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 sec_1272 in or 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 sec_1_1272-1 and 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 sec_1_1272-1 income_tax regs provides that paragraph b does not apply to debt instruments subject_to sec_1272 however sec_1_671-5 income_tax regs provides that in calculating oid under sec_1272 the trustee of a widely_held_mortgage_trust in certain circumstances may use any reasonable prepayment assumption to calculate oid dollar_figure sec_1272 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 28the regulation provides trustees of widely held mortgage trusts a safe_harbor for reporting oid before the issuance of final regulations under sec_1272 no final regulations have been issued 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 sec_1272 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 439_us_522 360_us_446 see also sec_1_446-1 income_tax regs sec_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 104_tc_367 75_tc_410 affd 689_f2d_1 1st cir 56_tc_610 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 sec_1272 will generally clearly reflect income within the meaning of sec_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 sec_1272 in the case of any regular_interest in a real_estate_mortgage_investment_conduit remic qualified mortgages held by a remic or 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 sec_1272 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 sec_1272 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 sec_1272 provides guidance with respect to determining the present_value 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 pincite 1997_4_cb_1457 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 dollar_figure to be received in year is dollar_figure the present_value of dollar_figure to be received in years is dollar_figure 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 r n where n the number of periods until the payment is received r interest rate d the kpmg model 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 sec_1272 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 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 ratedollar_figure 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 dollar_figure debt with a 10-percent payment rate after month the outstanding debt will be dollar_figure after months it will be dollar_figure after months it will be dollar_figure and so forth in this way the payments continue forever with the debt becoming infinitesimally small assuming a 10-percent payment rate percent of the balance will be paid in months percent in months and percent in months from to the payment rate for cob’s pool of credit card receivables was calculated under the kpmg model to be an average of dollar_figure percent 29although 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 cob’s monthly and average payment rates dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure avg dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 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 percent is months divided by if the payment rate is percent the wam i sec_5 months divided by the calculation of the wam is a simplifying assumption in the present_value calculations in reality some cardholders make payments on their loan earlier and some later the wam is a mathematical assumption of a single point at which on average all cardholders will pay off their debt rather than calculating the present_value of each of a series of unequal periodic_payments of the pool every month the kpmg model simplifies the process by using the wam to limit the calculation to the present_value of one payment equal to the relevant balance of the entire pool at the wam specifically the wam is the number of periods or n in the present_value formula used in the kpmg model present_value future value or future value r n r wam from to the wam of cob’s pool of credit card receivables was calculated to be on average dollar_figure months and the average wam for and was dollar_figure months monthly and average wam dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure avg dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 function in excel which is expressed as follows rate nper pmt pv fv in this formula nper is the total number of payment periods for the loan and nper is equal to the wam 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 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 fv is the future value or a cash balance you wish to attain after the last payment is made and fv equal sec_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 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 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 an adjustment for writeoffs the kpmg model incorporates a sec_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 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 the kpmg model table the following chart shows the kpmg model’s calculations of oid for overlimit fees for the first months of dollar_figure 30figures are taken directly from exhibit 11-j and have not been adjusted for mathematical errors kpmg rolling balance oid calculator capital one financial_corporation cob - overlimit fees credit card fee pool for month oid created a unamortized oid at beginning of period overlimit big_number big_number big_number fees b total new additions of oid overlimit fees big_number big_number big_number c total oid before current month amortization big_number big_number big_number a b srpm d srpm at beginning of month big_number big_number big_number e monthly principal addition big_number big_number big_number f total srpm after new addition d e big_number big_number big_number g total srpm at end of month f-i big_number big_number big_number adjusted_issue_price h beginning issue_price incl new addition f-c big_number big_number big_number constant yield monthly i principal payment big_number big_number big_number j ending issue_price pv of future cash_flow big_number big_number big_number reversal of unamortized oid on write offs k ending issue_price srpm j g l basis_adjustment percentage i-k m gross write offs big_number big_number big_number n reversal of unamortized oid on write offs basis big_number big_number big_number adjustment oid amortization o oid amortization i j-h big_number big_number big_number p reversal of unamortized oid on write offs basis big_number big_number big_number adjustment q unamortized oid at ent of period c-o-p big_number big_number big_number oid amortization on calendar month basis r prior period oid recognized in current calendar big_number big_number big_number month s current period oid to be recognized in next calendar big_number big_number big_number month t adjusted oid amor for calendar month o r-s big_number big_number big_number u unamortized oid at end of calendar month q s big_number big_number big_number v tax adj inc recognized per calendar month t p big_number big_number big_number 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 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 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 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 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 sec_1_1272-1 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 income_tax regs sec_1_1275-2 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 income_tax regs similarly sec_1_1275-2 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 sec_1001 then solely for purposes of sec_1272 and sec_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 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 sec_1272 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 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 dollar_figure purchase and incurs a dollar_figure overlimit fee in month then makes principal payments and charges new purchases in the following months month balance purchases overlimit total with new charges payments payment rate amortized oid unamortized oid dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure respondent argues that because the cardholder paid a total of dollar_figure 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 percent translates into an actual liquidation of the debt in months essentially respondent contends that each payment should go toward the oldest debt first and any oid related to that debt respondent has no authority for this position other than his argument that a fifo method would clearly reflect cob’s income petitioners argue that using a constant payment rate of percent the cardholder will still have dollar_figure remaining on the original debt or percent of the original debt and percent of the oid will remain unamortized month balance purchases overlimit total with new charges payments payment rate amortized oid unamortized oid dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure petitioners argue that the kpmg model is thus proportional in that the cardholder recognizes oid at the same rate as the original debt is repaid the kpmg model accrues oid on the basis of the actual payment rates of cob’s cardholders if cob’s cardholders actually pay off their debts as quickly as the following hypothetical suggests cob would recognize oid more quickly month balance purchases overlimit total with new charges payments payment rate amortized oid unamortized oid dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure 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 pools rather dr hakala uses a fifo method 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 sec_1272 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 sec_1272 formula that may be true however congress provided the sec_1272 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 31petitioners 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 we need not address petitioners’ arguments on this point 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 sec_1272 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 sec_1272 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 additionsdollar_figure respondent argues that the use of a beginning issue_price that includes new additions results in an incorrect determination of oid accruals 32the 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 sec_1272 provides 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 sec_1272 however petitioners argue that new additions are included under sec_1272 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 sec_1272 not sec_1272 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 sec_1_1272-1 income_tax regs provides that the debt_instrument is treated as retired and reissued on the 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 date 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 date the regulations do not provide that at the end of the period for example january the taxpayer should look backward and recompute the january 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 ie the exercise of an option yet cob cannot recompute the various components of the sec_1272 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 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 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 days after the issuance of the statement although petitioners argue that new additions are included in the aipbeg figure under sec_1272 we cannot ignore sec_1272 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 ie the first day of the accrual_period it is inappropriate under either sec_1272 or b to include in the issue_price the additions that occurred on or after the first day of the accrual_period 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 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 dollar_figure lamp dollar_figure of gasoline and dollar_figure of coffee in november for a total of dollar_figure in december the cardholder charges a dollar_figure haircut incurs a dollar_figure overlimit fee and incurs dollar_figure in stated finance_charges resulting in a balance of dollar_figure in december the cardholder also makes a payment of dollar_figure under the kpmg model the december payment rate would be percent dollar_figure payment exclusive of finance_charges divided by a dollar_figure balance also excluding finance_charges in the example the cardholder pays dollar_figure after receiving a monthly statement from cob on december the statement would have shown that the cardholder owed dollar_figure 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 dollar_figure it is toward a dollar_figure balance resulting in a payment rate of percent it is unreasonable to conclude that the cardholder’s december payment rate is 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 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 charge may not have been due until january cob would 33cob issues statements to its cardholders throughout the month and given that the typical billing cycle i sec_30 days the average monthly statement date for all cardholders is the middle of the month 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 before thatdollar_figure 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 ie 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 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 34respondent 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 anticipates future defaults the legislative_history of sec_1272 suggests that defaults are not to be estimated when determining future cashflows h conf rept vol ii at ii-238 ndollar_figure 1986_3_cb_1 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 ratesdollar_figure 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 35the kpmg model deals with writeoffs in a separate adjustment which we conclude is reasonable however these other published payment rates are not based upon the formula set out in sec_1272 and its related regulations the published payment rate calculations include payments of finance_charges which are left out of the sec_1272 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 percent of principal per period for example a payment rate of percent including finance_charges would be approximately percent excluding finance chargesdollar_figure 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 sec_1272 and the related regulations not on published reports that use an analysis not based in the code dr hakala’s default rate adjustment for overlimit fees the kpmg model includes a sec_166 adjustment for book tax basis differences in receivables written off every month as reducing the end-of-month balance of unamortized oid 36in cob cardholders made payments totaling dollar_figure and accrued dollar_figure in finance_charges in other words approximately percent of all payments were attributable to finance_charges respondent proposes to modify this writeoff adjustment for default rates associated with late fees and overlimit fees because of our determination in 130_tc_147 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 reports dr hakala tracked the proportion of accounts that incurred late fees ultimately written off within 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 whereby the amount of oid recognized in connection with defaults is increased by a factor of again late fees are not at issue and we need not and do not reach a conclusion as to whether dr hakala’s late fee adjustment is appropriate dr hakala was not able to do a similar analysis with overlimit fees instead dr hakala took samples of capital one’s cardholder accounts and compared default rates of accounts with late fees versus default rates of accounts with overlimit fees using this sampling dr hakala determined that the default rate for accounts with overlimit fees was about half the default rate for late fees thus in his corrections to the accruals of overlimit fees he used a default factor of dollar_figure versus dollar_figure for late fees however dr hakala provides insufficient data to allow us to test his conclusions it seems that the dollar_figure figure is a ballpark estimate or an educated guess that is based on the theory that cardholders who incur overlimit fees like cardholders who incur late fees have a higher rate of default dr hakala also states that customer accounts that incur past due and overlimit fees may tend to be slightly slower in paying off principal than the average customer and this finding may moderate the adjustment dr hakala testified that he did moderate the adjustment and therefore his default rate adjustment was not a 100-percent adjustment but dr hakala does not explain how or to what extent he moderated the adjustment put simply there is insufficient support for dr hakala’s proposed default rate adjustment his ballpark estimate of the default rate factor may be correct or it may not without supporting data we cannot conclude that the kpmg model was unreasonable or failed to clearly reflect cob’s income as it relates to writeoffs further on the record before us we cannot conclude that dr hakala’s proposed default rate adjustment would more clearly reflect cob’s income than did the kpmg model 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 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 sec_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 sec_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 milesone rewards a the milesone reward program findings_of_fact 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 a milesone cardholder paid capital one an annual membership fee of either dollar_figure or dollar_figure in exchange for that fee a milesone cardholder earned mile for every dollar charged on the milesone card for purchases however a cardholder was limited to big_number miles per billing cycle additionally a cardholder could earn up to big_number 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 big_number miles in comparison a round-trip coach ticket from the united_states to europe required big_number miles and an around-the-world coach ticket required big_number miles business class and first class tickets were also available but required more miles than similar coach tickets capital one provided each milesone cardholder a quarterly statement reflecting the cardholder’s total accumulated points the number of points redeemed for airline tickets and the number of points due to expire within days points not redeemed within 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 ie 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 big_number miles for an in-zone domestic ticket could request a ticket costing up to dollar_figure a cardholder redeeming big_number miles for a united_states to europe ticket could request a ticket costing up to dollar_figure therefore capital one’s maximum potential cost per mile wa sec_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 the estimated rate of future redemptions and 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 date milesone cardholders had an outstanding accumulated balance of big_number milesdollar_figure capital 37in and capital one awarded big_number and big_number miles in connection with balance transfers and bonus continued one estimated that percent of the miles would ultimately be redeemed and that each mile would cost cents to redeem using these figures capital one estimated its future redemption_costs to be dollar_figure this amount was used as its contingent reserve for redemption_costs on its general ledger for financial_accounting purposes and was deducted under sec_1_451-4 income_tax regs on petitioners’ consolidated federal_income_tax returndollar_figure as of date milesone cardholders had an outstanding accumulated balance of big_number miles capital one estimated that percent of these miles would be redeemed and that each mile would cost dollar_figure cents to redeem accordingly capital one estimated its future redemption_costs to be dollar_figure the difference between that figure and the figure dollar_figure 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 38we note that the percent and 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 39capital one actually spent dollar_figure and dollar_figure to redeem milesone miles during and respectively 40again the percent and dollar_figure cents figures would result in a slightly higher cost of redemption dollar_figure on its general ledger for financial_accounting purposes through an error petitioners neglected to deduct that amount on their consolidated 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 sec_1_451-4 income_tax regs the actual redemption rates of points earned by cardholders in and through their 5-year expiration period were percent and percent respectively the actual cost of redemption was just over cents per mile for points earned in and dollar_figure cents per mile for those earned in dollar_figure 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 sec_162 is governed by the all_events_test 269_us_422 in anderson the supreme court held that a taxpayer was entitled to deduct from its income a tax on profits from munitions sales that took place in although the tax would not be assessed and therefore would not formally be due until all the events had occurred in to fix the amount of the tax and to 41petitioners did not explain why the cost of redemption was more than the ostensible maximum payout of cents per mile determine the taxpayer’s liability to pay it the all_events_test is now embodied in sec_1_461-1 income_tax regs which during the years at issue provided under an accrual_method of accounting a liability as defined in sec_1_446-1 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 providing that the all_events_test shall not be treated as met any earlier than when economic_performance occurs 481_us_239 in 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 provides an exception to the general_rule of sec_461 allowing a deduction for a reserve for estimated expenses if such a deduction is otherwise allowable under the code 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 art ninety years later the essential elements of the exception still remain and are embodied in sec_1_451-4 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 420_f2d_400 5th cir tex instruments inc v commissioner tcmemo_1992_306 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 sec_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 sec_1_451-4 income_tax regs and its predecessors in 37_bta_216 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 art a predecessor to sec_1_451-4 income_tax regs creamette co v commissioner supra pincite in 16_tc_432 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 deduct the reasonable estimate of its future cost of redemption id pincite 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 sec_1_451-4 income_tax regs we disagreed and held that for purposes of sec_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 sec_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 although most credit card transactions involve sales of goods or services ie 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 sec_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 sec_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 39_tc_999 affd in part and revd in part on other grounds 335_f2d_125 9th cir we faced the question of whether a lender’s mortgage loans made in the ordinary course of business were ordinary or capital assets under sec_1221dollar_figure we held that the loans were notes receivable acquired for services rendered and thus were ordinary rather than capital assets id pincite we explained that the business of a savings and loan company could properly be described as ‘rendering the service’ of making loans id pincite0 sec_1221 of the internal_revenue_code of 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 in fnma v commissioner 100_tc_541 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 operation of the taxpayer’s business further supports that it was providing a service in exchange for the mortgages id pincite petitioners argue that these cases indicate that the lending of money is the sale of a service and therefore when capital one extends credit to its cardholders it is selling lending services to the cardholder the argument is strained the cases cited by capital one and discussed above are inapplicable to the current case whether loans in the hands of a lender are a capital or ordinary asset has no bearing on whether capital one issued its miles with sales in lending its cardholders funds capital one provided a service but that service does not transform a loan into a sale within the meaning of sec_1_451-4 income_tax regs the regulation encompasses a sale of services but it does not follow that every provision of services is a sale of services a sale requires two parties a buyer and a seller see u c c sec 102_f2d_787 3d cir a sale requires parties standing to each other in the relation of buyer and seller assent of the minds to the same proposition and passing of consideration affg 37_bta_542 sec_1_451-4 income_tax regs allows a seller a current deduction for estimated future expenses in a lending transaction such as the extension of credit to a cardholder the cardholder has not bought lending services from the lender and the lender has not sold lending services to the cardholder in fact as argued by petitioners on the interchange issue with respect to a credit card purchase transaction the lender is the buyer having purchased a note receivable c gross_receipts with respect to sales sec_1_451-4 income_tax regs allows the deduction of contingent liabilities from gross_receipts with respect to sales with which trading stamps or coupons are issued sec_1_451-4 income_tax regs contemplates a scenario where the expenses are contingent but the gross_receipts are not the revenue from a sale is known at the time of sale and is the purchase_price with respect to credit card transactions capital one receives various types of revenue when it lends money to its cardholders the first income received is from interchange which is a small percentage of the amount lent interchange is known at the time of sale but interchange is not a fee for any service other than the lending of money and the lending of money is not a sale of a loan or lending services capital one receives much of its income from finance_charges on cardholder loans finance_charges are charged to the cardholder only if the cardholder does not pay the monthly balance in full within the grace period a cardholder may pay interest with respect to the loan for many months or even many years similarly a cardholder may incur late fees if a timely payment is not made a late fee may be incurred with respect to the first bill capital one sends the cardholder or with respect to a bill sent many months or years later if the cardholder has not repaid the loan in full many other variables may affect the revenues capital one receives with respect to its loan to the cardholder capital one may alter interest rates the cardholder may default on the loan exceed the credit limit and incur an overlimit fee or incur an insufficient funds fee if a check paid to capital one is not honored by the cardholder’s bank although these revenues are related to capital one’s lending to its cardholders they are not gross_receipts with respect to sales with which coupons are issued within the meaning of sec_1_451-4 income_tax regs capital one did not issue miles with respect to the revenues capital one earned with the arguable exception of interchangedollar_figure miles were issued only for the amount of the cardholder’s purchase and a cardholder earned no miles for finance_charges or any fees incurred in short interest interchange and the various fees a cardholder may incur are not sales revenues and the purpose of the regulation is to match sales revenues with the expenses associated with the sale specifically the cost of coupon redemption mooney aircraft inc v united_states f 2d pincite d conclusion with respect to the milesone rewards issue petitioners argue that deducting capital one’s estimated cost of redemption would most clearly reflect its income without undue distortion with respect to the milesone program for book purposes capital one estimated its future liability for airline tickets at dollar_figure and dollar_figure in and respectively respondent agrees that the estimates are reasonable however the reasonableness of the estimates and the economics of the milesone program are irrelevant because the miles were not issued with sales and therefore the requirements of sec_1_451-4 income_tax regs have not been met accordingly the all_events_test applies limiting capital one’s deduction for airline tickets with respect to the milesone 44the number of miles issued had no direct relationship to the amount of interchange capital one earned program to those amounts which are fixed and known and for which economic_performance has occurreddollar_figure in reaching our holdings on all three issues we have considered all arguments made and to the extent not mentioned we conclude that they are moot irrelevant or without merit to reflect the foregoing decisions will be entered under rule 45because we hold that the milesone coupons were not issued with sales as required by sec_1_451-4 income_tax regs we need not address respondent’s alternative arguments that capital one failed to attach the informational statement required by sec_1_451-4 income_tax regs explaining how the future redemption expenses were calculated the airline tickets were not other_property and the milesone program was impermissibly conditional in that capital one could terminate the program at any time