Taxpayer Files Brief in Appeal of Tax Court Decision on Accounting Method Changes

The Tax Court also held that credit card lenders may not avail themselves of a long-standing regulation that is generally applicable to all service providers and that more accurately reflects the taxpayer's income. In reaching this conclusion, the Tax Court refused to allow into the record relevant, stipulated evidence.

Because these issues present novel legal questions and the subject matter is complex, Appellant Capital One Financial Corporation ("Capital One") believes that oral argument may be helpful to the Court.

On October 12, 2007, Capital One filed a motion for partial summary judgment relating to the Late Fees Issue. Doc. 57; App. 5. On October 15, 2007, Appellee filed a cross-motion for partial summary judgment. Doc. 59; App. 5. A hearing was held on January 24, 2008, before the Honorable Harry A. Haines on the motions. Doc. 82; App. 6.

On May 22 and May 23, 2008, the Tax Court issued an opinion and order, respectively, denying Capital One's motion and granting Appellee's cross-motion for partial summary judgment relating to the Late Fees Issue. Doc. 84, 85; App. 7, 59-97. The Tax Court ruled that Capital One was required to obtain consent from the IRS in order to treat Late Fees as OID in 1998 and 1999. App. 59-97. In addition, although Capital One sought and received automatic permission from the IRS to change its treatment of "interest and OID that are subject to the provisions of section 1004 of the Taxpayer Relief Act of 1997," the Tax Court ruled that Late Fees are a "separate and distinct item of income" for which Capital One did not request or receive consent. App. 83. The Tax Court concluded that attempting to treat Late Fees as OID in 1998 and 1999 constituted an impermissible "change in method of accounting" and not a mere correction of an error. App. 96-97.

On December 8, 2008, a non-jury trial was commenced to decide several issues in the case, including the Rewards Issue. Doc. 104; App. 8. On September 21, 2009, the Tax Court issued an opinion in which it ruled against Capital One with respect to the Rewards Issue. Doc. 138; App. 10. The Tax Court ruled that, in lending money to its cardholders, "Capital One provided a service, but that service does not transform a loan into a sale" within the meaning of Regulation 1.451-4. App. 188. According to the Tax Court, "[t]he regulation encompasses a sale of services, but it does not follow that every provision of services is a sale of services." App. 198 (emphasis in original). The Tax Court did find that Capital One earned revenues related to lending money to its cardholders, but held that these revenues were not "sales revenues" within the meaning of Regulation 1.451-4. App. 199-201.

Credit card issuers, like Capital One, earn various types of income from lending money including: (1) finance charges when cardholders carry a balance ("Stated Interest"); (2) fees charged to customers who are late in making payments ("Late Fees"); (3) overlimit fees when customers exceed their credit limit ("Overlimit Fees"); (4) cash advance fees when customers access cash using their credit cards ("Cash Advance Fees"); and (5) interchange income when the issuing bank reimburses the merchant (indirectly through an "acquiring bank") by paying the amount of the credit card purchase less a discount ("Interchange Fees"). During the years at issue, Capital One also charged cardholders an annual fee ("Annual Fee"). 1st Stip. ¶¶ 6, 7; 2nd Stip. ¶¶ 2, 3, 4, 5; App. 209, 220-21.

TRA § 1004(a), codified as Section 1272(a)(6)(C)(iii), required credit card lenders to begin reporting for federal income tax purposes most credit card revenues (other than Stated Interest) as original issue discount ("OID") for tax years beginning after August 5, 1997.⁵ 2nd Stip. ¶ 19; App. 225. TRA § 1004(b)(2) also provided:

On September 15, 1999, Capital One Bank filed a Form 3115 with the IRS by attaching it to Capital One's income tax return for 1998.⁶ 2nd Stip. ¶ 21; App. 225, 319-28. Because Section 1272(a)(6)(C)(iii) applies generally to "any pool of debt instruments the yield on which maybe affected by prepayments" and because at the time of its enactment there existed no guidance as to which of Capital One's credit card fees were OID, on its Form 3115 Capital One broadly explained:

On its tax returns for 1998 and 1999, Capital One reported income from Overlimit Fees, Cash Advance Fees, and Interchange Fees earned by Capital One Bank and Capital One F.S.B. as OID as required by Section 1272(a)(6). 2nd Stip. ¶ 24; App. 226. On its tax returns for 1998 and 1999, Capital One did not report income from Late Fees as OID, but instead incorrectly recognized those fees at the time the fees were charged to Capital One's credit card customers. 2nd Stip. ¶ 30; App. 228-29.

Beginning with its 2000 tax return, Capital One reported Late Fees for both Capital One Bank and Capital One F.S.B. correctly as OID pursuant to the accounting method required by Section 1272(a)(6). 2nd Stip. ¶ 32, 33; App. 229. Since 2000, Capital One has continually reported Late Fees as OID on its income tax returns. 2nd Stip. ¶ 32; App. 229. The IRS has neither disputed this treatment nor sought to adjust Capital One's treatment of Late Fees as OID for 2000-2002. 2nd Stip. ¶ 34; App. 229-30.

The IRS agrees that Overlimit Fees and Cash Advance Fees earned by Capital One Bank during 1998 and 1999 were correctly reported by Capital One as OID. 2nd Stip. ¶¶ 27, 28; App. 227-28. One of the issues that the parties tried below related to whether Interchange Fees were correctly considered OID. The IRS argued below that Interchange Fees were not OID because they were not paid as part of a lending transaction. The Tax Court ruled in Capital One's favor on this issue, holding that Interchange Fees are correctly considered OID.⁷ App. 98-202. Accordingly, the Late Fees Issue relates only to whether Capital One may correctly report Late Fees under Section 1272(a)(6) for 1998 and 1999.

It was not until 2004 that the IRS publicly informed taxpayers that Late Fees are OID under Section 1272(a)(6). See Rev. Proc. 2004-33, 2004-22 I.R.B. 989. See also I.R.S. Tech. Adv. Mem. 200533023 (Aug. 19, 2005); I.R.S. Tech. Adv. Mem. 200533022 (Aug. 19, 2005). 2nd Stip. ¶ 31; App. 229. The IRS stipulated below that if the court ultimately held that Capital One did not impermissibly change its accounting method for Late Fees for 1998 and 1999, then Capital One Bank's Late Fees may be treated as OID pursuant to Section 1272(a)(6). 2nd Stip. ¶ 35; App. 230.

If Capital One Bank prevails on the Late Fees Issue, Capital One would be entitled to reductions in income for 1998 and 1999 in the amounts $192,241,861 and $164,151,423,⁸ respectively, but there would be corresponding increases to Capital One's income in future years in amounts determined under Section 1272(a)(6)(C). 2nd Stip. ¶ l2; App. 222. Accordingly, if Capital One prevails, no Late Fee income will escape taxation; the taxation of the income merely will be postponed. 2nd Stip. ¶ 12; App. 222.

Under the terms of the MilesOne Program, once a cardholder accumulated the requisite number of miles, he could redeem those miles for an airline ticket that Capital One would purchase on his behalf. 1st Stip. ¶ 11; App. 210. In order to estimate its liability for future airline tickets and to enable it to deduct this estimate as contemplated by Regulation 1.451-4, Capital One estimated: (1) the rate at which cardholders redeemed their miles; and (2) the average cost of redeeming each mile. 1st Stip. ¶¶ 20, 21; App. 212-13.

For 1998, Capital One estimated future redemption costs related to its MilesOne Program to be $583,411 and deducted this amount on its tax return for 1998. 1st Stip. ¶¶ 26, 27; App. 214. However, due to the infancy of the MilesOne Program, Capital One's cash expenditures for actual MilesOne Program redemptions (e.g., airline ticket purchases) were extremely limited, totaling only $1,578 for 1998. 5th Stip. ¶ 19; App. 313-14.

For 1999, Capital One estimated future redemption costs related to the MilesOne Program of $34,010,086. Capital One reported taxable income on its 1999 tax return related to its lending activities under the MilesOne Program that exceeded these estimated future redemption costs. 1st Stip. ¶ 32; 5th Stip. ¶ 19; App. 215, 313-14. Capital One's cash expenditures for actual MilesOne Program redemptions were similarly limited in 1999, totaling only $315,513. 5th Stip. ¶ 19; App. 313-14.

The IRS agreed that Capital One reasonably and accurately estimated its estimated future redemption costs for the MilesOne Program for 1998 and 1999. 1st Stip. ¶ 42; Ex. 59-J ¶¶ 23, 25; App. 218, 672.

During trial, Capital One moved for admission of Exhibits 36-P through 50-P and Exhibit 60-P, which contained Capital One's financial data related to the MilesOne Program for 1998-2004, and which were filed as part of the parties' Fifth Stipulation of Facts. Tr. 159:5-11; 5th Stip. ¶¶ 19, 34; App. 313-14, 317, 454, 724-1925, 1942-62. The IRS objected on the grounds of relevance to any financial data relating to years after 1999. Tr. 159:13-20; App. 454. Capital One argued that the information was relevant to demonstrate how the application of Regulation 1.451-4 matches Capital One's MilesOne revenue with its estimated cost of redeeming the MilesOne miles. Tr. 159:22-160:18; App. 454-55. The Tax Court received Exhibit 60-P into evidence in its entirety. Tr. 172:23-173:3; App. 467-68, 1942-62. Exhibit 60-P included information relating to both the years at issue (1998 and 1999) as well as years not at issue (2000 through 2004). App. 1942-62. The Tax Court sustained the IRS's relevancy objection with respect to any post-1999 financial data contained in Exhibits 36-P through 50-P. Tr. 172:23-173:1, 176:15-18; App. 467-68, 471.

Almost seven years after the enactment of TRA § 1004 and the codification of Section 1272(a)(6)(C)(iii), the IRS finally informed taxpayers that Late Fees are reportable as OID. There is now no debate that Capital One could have and should have reported Late Fees as OID on its 1998 and 1999 returns for Capital One Bank and Capital One F.S.B. In this litigation, Capital One seeks to comply with the statute and report Late Fees correctly for 1998 and 1999. The IRS opposes this treatment, not because the method of accounting Capital One seeks to employ is incorrect, but rather solely because the IRS argues that Capital One failed to obtain its "consent" to change the way it reports Late Fees.

Capital One had no choice but to report Late Fees on its tax returns as OID beginning in 1998. Neither Capital One Bank nor Capital One F.S.B. needed IRS consent to report Late Fees as OID because Congress expressly obviated that requirement in the statutory enactment.

Moreover, because it timely filed a Form 3115, Capital One Bank is deemed to have "consent" to report all OID, including Late Fees, in accordance with Section 1272(a)(6). Capital One's failure to specifically and separately identify Late Fees as a category of income to which the change applied should not render it unable to comply with Congress' mandate.

In addition, even if Capital One did not have consent, Late Fees are merely one of Capital One's categories or components of OID and reporting those fees correctly now is simply correcting an inadvertent error, not a change in method of accounting.

Finally, because it was incorrect for Capital One not to treat Late Fees as OID on its tax return in 1998, and because 1998 is the first year in which Capital One was required to report credit card income as OID, Capital One should be permitted to make the correction.

The Tax Court erred, however, in arbitrarily distinguishing between the "provision" of services and the "sale" of services. There is no legal authority for drawing this distinction. The ruling unfairly discriminates against the banking industry compared to other taxpayers.

A taxpayer may elect to change, or be required to change, its method of accounting. "A change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan." Reg. 1.446-1(e)(2)(ii)(a). "A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction." Id. Not every modification to a tax position, however, constitutes a change in method of accounting. "Corrections" of certain "errors" are permissible. See Reg. 1.446-1(e)(2)(ii)(b). In addition, taxpayers generally must treat a single "item" of income or expense consistently. See Reg. 1.446-1(a)(2).

Generally, before a taxpayer may change its accounting method, it must obtain "consent" from the IRS. Section 446(e) provides:

A. Capital One Was Required To Report Late Fees As OID And Did Not Need Additional IRS Consent.

Beginning with its 1998 tax year, Capital One had no choice but to report Late Fees as OID. Section 1272(a)(6)(A) provides that:

Capital One does not need additional "consent" from the IRS to report Late Fees as OID. Notwithstanding the general "consent" requirement in Section 446(e) to change a method of accounting, Congress expressly exempted taxpayers that changed their accounting method for OID related to credit card loans. See TRA § 1004(b)(2); see also H.R. Rep. No. 105-220, at 522 (1997) (Conf. Rep.). Congress did not require taxpayers to obtain additional consent from the IRS to comply with the new law. Instead, any change was "treated as made with consent." Id.

The Tax Court held that, because TRA § 1004(b)(2) was not "codified" and made part of the Code, the statute may be ignored and the general consent requirement in Section 446(e) must be followed. App. 75-78. The Tax Court's ruling is thinly premised upon the language of Section 446(e), which begins "[e]xcept as otherwise expressly provided in this chapter. . . ." App. 75. The Tax Court reasoned: "Nothing in section 1272(a)(6)(C)(iii) expressly provides that a taxpayer is not required to receive consent to change its method of accounting." App. 75-76. The Tax Court acknowledged that there is an exemption from consent in the statutory enactment, but held that because it was not "codified," or "provided in this chapter," that portion of the statute does not "qualify as an exception to section 446(e)." App. 76.

In essence, the Tax Court has adopted the position that, solely because a statutory provision is not made part of the Code, it can be arbitrarily ignored. This is not correct. The U.S. Supreme Court has held that the fact that a statutory provision is not codified does not deprive it of force and effect:

The fact that the exemption in TRA § 1004(b)(2) was not "expressly provided" in Chapter One of the Code does not degrade the statute.¹⁰ Since Section 446(e) was enacted in 1954, Congress has enacted several statutes that were not codified but otherwise granted automatic consent to taxpayers seeking to change their accounting method.¹¹ The U.S. Supreme Court has ruled that a legislative entrenchment rule, like Section 446(e), does not require subsequent legislation to expressly state that it is superseding existing law to be effective. See Marcello v. Bonds, 349 U.S. 302, 310 (1955).

Even if the exemption from consent had been codified, the Tax Court nevertheless reasoned that "taxpayers would still be required to follow the applicable procedures in order to effect a change in accounting method." App. 76. To support its assertion, the Tax Court cited Section 448(d)(7), which contains language nearly identical to that in the enactment at issue. App. 76. The Tax Court pointed out that, despite this statutory language in Section 448(d)(7), Regulation 1.448-1(h)(2) specifically provides that a taxpayer forced to change its accounting method under Section 448 must still file a Form 3115. App. 77.

In contrast to the one example discovered by the Tax Court, in this case, Treasury has not promulgated regulations requiring taxpayers to obtain consent to change their accounting method or even file a Form 3115. To date Treasury has failed to issue any regulations relating to Section 1272(a)(6)(C)(iii). If anything, Treasury's failure to issue a regulation in this case similar to Regulation 1.448-1(h)(2) supports Capital One's position.

Congress knew that there existed a general consent requirement and is deemed to know the IRS rules and regulations. See Miles v. Apex Marine Corp., 498 U.S. 19, 32 (1990) (Congress is assumed to know the existing law at the time it passes legislation). Nonetheless, Congress obviated the requirements for taxpayers to seek IRS "consent" to change to the accounting method that Congress required in Section 1272(a)(6)(C)(iii), and there are no regulations altering that scheme.

B. Even If Capital One Needed IRS Consent To Report Late Fees Correctly, Capital One Bank Obtained "Automatic Consent" When It Included Form 3115 With Its Tax Return.

Even if Capital One was required to follow IRS procedures in order to obtain consent to report Late Fees properly, Capital One Bank did so and had "automatic consent" to report Late Fees as OID when it timely and properly filed a Form 3115 with its 1998 tax return. App. 319-28. On the Form 3115, Capital One Bank indicated that it was changing its accounting method in accordance with the "automatic consent" procedures promulgated in Revenue Procedure 98-60. Capital One Bank disclosed that it would begin to report "interest and original issue discount that are subject to the provisions of Section 1004 of the Taxpayer Relief Act of 1997" as OID. App. 327-28.

The Tax Court intimates that Capital One's Form 3115 was ambiguous since it did not single out Late Fees as the "item of income" that Capital One was changing. App. 83-85. This is incorrect. Capital One's Form 3115 was meant to apply broadly and disclose that Capital One intended to treat all applicable credit card income correctly under Congress' mandated accounting method.

Capital One's description of the item of income being changed is nearly identical to the language used by the taxpayer in I.R.S. Field Service Advice 200145013 (Aug. 3, 2001).¹² In that FSA, the taxpayer filed a Form 3115 and described the item of income being changed as "original issue discount ('OID') on any pool of debt instruments the yield on which may be affected by reason of prepayments." The IRS examination team asked the Chief Counsel whether this language was limited to so-called "grace period interest" or whether this language was broad enough to include credit card fees, like Late Fees. The Chief Counsel first provided advice as to when credit card fees, such as Late Fees, might constitute OID. The Chief Counsel also concluded that the taxpayer could include credit card fees in its Form 3115 in addition to grace period interest, in making the accounting method change in section 12.02 of the appendix to Revenue Procedure 98-60.

Capital One's Form 3115, similarly, does not single out Overlimit Fees or Interchange Fees as "items of income" that will be reported as OID. App. 327-28. Nowhere in Section 1272(a)(6)(C)(iii), the Conference Report to TRA § 1004, Revenue Procedure 98-60, or Form 3115 are Overlimit Fees or Interchange Fees even mentioned. Nevertheless, Capital One accounted for Overlimit Fees and Interchange Fees on its 1998 and 1999 tax returns as OID. 2nd Stip. ¶ 24; App. 226. The IRS accepts that Overlimit Fees earned by Capital One during 1998 and 1999 may be treated as OID, and has never contested that treatment. 2nd Stip. ¶ 27; App. 227-28.

The IRS did not accept that Interchange Fees are correctly treated as OID and the parties tried that issue before the Tax Court. The Tax Court ruled that Interchange Fees are OID. App. 98-202. Similarly, the IRS never challenged that Capital One did not have consent to report Interchange Fees as OID because they are not specifically listed on Form 3115. 2nd Stip. ¶¶ 24, 25; App. 226.

To make the IRS's position even more absurd, beginning with its 2000 return, Capital One began to correctly report Late Fees as OID. 2nd Stip. ¶¶ 32, 33; App. 229. The IRS did not adjust that reporting treatment or Capital One's correct reporting of Late Fees as OID on its 2000 through 2002 returns. 2nd Stip. ¶ 34; App. 229-30.

The position of convenience adopted by Appellee in this case should not be upheld. Late Fees are correctly accounted for as OID and Capital One should be permitted to follow Congress' mandate for 1998 and 1999.

Capital One's description of the "item" for which it was seeking to change its accounting method, "interest and OID" on all of its credit card loans, was sufficiently specific to permit Capital One to account for Late Fees correctly as OID. The reference to "item" throughout Regulation 1.446-1(e) refers to an "item of gross income or deduction." See Leonhart v. Comm'r, 27 T.C.M. (CCH) 443 (1968), aff'd, 414 F.2d 749 (4th Cir. 1969). This in turn invites the question, how does one define "item of income?" The Tax Court never fully answers this question.

Other courts, however, have answered this question. For example, when the U.S. Supreme Court was faced with a similar question of whether an amount was an "item of income" in Gitlitz v. Commissioner, 531 U.S. 206 (2001), it looked to Section 61, "Gross Income Defined," for guidance. In that case, the issue was whether "discharge of indebtedness income" was an "item of income" for purposes of the small corporation tax rules. The Court concluded that discharged debt "is indeed an 'item of income'" because it is specifically enumerated in Section 61 as being included in gross income. Gitlitz, 531 U.S. at 212-13. Although the Tax Court summarily dismissed Gitlitz, Courts have analyzed Section 61 for purposes of defining "item of income" in a variety of other contexts as well. See, e.g., Gardiner v. United States, 536 F.2d 903, 906 (10th Cir. 1976); Schwartz v. United States, 67 F.3d 838, 840 (9th Cir. 1995); In re Lilly, No. 89-20656, 1993 Bankr. LEXIS 906, at *3-4 (S.D. W. Va. 1993), aff'd, 76 F.3d 568 (4th Cir. 1996).

There is no dispute that Late Fees, Overlimit Fees, Interchange Fees, and Cash Advance Fees are OID. Together, these categories of credit card revenue constitute the "item of income" that Capital One disclosed on its Form 3115 to be reported as OID. In this case, however, the Tax Court ruled that "[a]n item under section 1.446-1(e) . . . may be narrower than the broad items of income listed in section 61." App. 82. The Tax Court fashioned a new test to determine whether a stream of income is an "item" for purposes of Section 446(e): "Whether particular income is an 'item' under section 1.446-1(e) . . . depends on all the facts and circumstances surrounding that income." App. 82. The Tax Court found that "Late fees are earned for reasons independent of the reasons other types of incomes are earned, such as finance charges, overlimit fees, interchange, and cash advance fees." App. 83.

The Tax Court's newly fashioned "you know it when you see it" test is untenable. Congress, the IRS, and the courts have never defined an item of income for purposes of determining whether consent was required based upon the facts and circumstances surrounding how the income was generated. Instead, as discussed above, courts have looked to the items of income enumerated in Section 61. This test is more administrable and provides a bright line that can easily be applied to treat all similarly situated taxpayers equally.

Instead, what truly bothered the Tax Court was the amount of the income at issue in this case. The Tax Court found that Capital One "earned more in late-fee income than any other type of fee." App. 82. Apparently to the Tax Court the amount of money earned by Capital One as Late Fees was too large to be anything other than "a separate and distinct item of income" worthy of special IRS consent. But this inquiry is incorrect and at odds with the regulations that define the term "material item" as "any item which involves the proper time for the inclusion of the item in income . . . ." Reg. 1.446-1(e)(2)(ii)(a). In this context, the amount of income involved truly does not matter.¹³

The Tax Court erroneously found that considering Late Fees as components of "interest and OID" and not separate items would "severely undermine the reasons for section 446(e)." App. 82. The Tax Court misses the point. This is not a situation where a taxpayer is trying to change the way it reports an item of income without ever having given the IRS notice. Here, Congress required Capital One to change the manner in which it reports Late Fees and Capital One timely filed the disclosure form for the first year of the change.

Capital One (and apparently even the IRS) did not know when it filed its Form 3115 that Late Fees were correctly considered OID. At the time Capital One filed its 1998 return, there was substantial uncertainty as to the correct treatment of a "late fee." Capital One's failure to report Late Fees as OID in 1998 and 1999 is understandable in the absence of guidance and in light of the IRS's litigating position and case law at the time ruling that late fees charged with respect to delinquent mortgage payments were not interest for tax purposes. See West v. Comm'r, 61 T.C.M. (CCH) 1694 (1991), aff'd, 967 F.2d 596 (9th Cir. 1992). It was not until almost seven years later that the IRS changed its view of Late Fees. See Rev. Proc. 2004-33, supra.

C. Capital One Did Not Need Consent Since Reporting Late Fees As OID Consistently With Reporting All Other Fees As OID Is Not A Change In Accounting Method.

Late Fees are simply one of the components that make up the "item of income" for which Capital One filed its Form 3115 and obtained automatic consent -- "interest and original issue discount that are subject to the provisions of Section 1004 of the Taxpayer Relief Act of 1997." App. 327-28. Correcting its error and reporting Late Fees as OID is not in itself an accounting method change for which Capital One needed to obtain separate and specific consent.

Not every modification to an original tax filing position constitutes a change in method of accounting. As the regulations explain:

The court in Gimbel Brothers, Inc. v. United States, 535 F.2d 14 (Ct. Cl. 1976), reached a similar result. In that case, a department store had originally elected the installment accounting method to report its installment sales income. For the years at issue, the taxpayer applied the installment method to all categories of installment sales except revolving charge accounts. The IRS had taken the legal position that sales on a revolving credit plan did not qualify for installment sale reporting and the taxpayer accounted for the sales income consistently with the IRS's guidance. A federal district court in an unrelated case, however, subsequently rejected the IRS's position, holding that sales on revolving credit were simply another category of installment sale.

The taxpayer in Gimbel Brothers sought to correct its erroneous reporting of sales on revolving charge accounts to be consistent with the treatment of its other categories of installment sales based upon the new decision. Like here, the IRS refused to permit the taxpayer to treat the sales properly, asserting that the correction was an accounting method change without requisite IRS consent. The court disagreed, holding that the taxpayer did not impermissibly change its accounting method. The court held that an installment sale on a revolving charge account was merely a component of the taxpayer's installment sales and that the taxpayer was simply reporting the sales consistently with its established accounting method. The court explained:

Similarly, in Korn Industries, Inc. v. United States, 532 F.2d 1352 (Ct. Cl. 1976), the taxpayer had adopted the accrual method of accounting. In valuing its finished goods inventory, however, the taxpayer improperly failed to include three material costs. These three elements, however, were not omitted from the raw materials, work-in-progress, or supplies inventory. In a subsequent year, the taxpayer discovered the error and, in computing its closing inventories, included the three previously omitted elements. The IRS contended that the omission of the three items in previous years and subsequent correction was an impermissible accounting method change.

The court disagreed and likened the mistake "to a mathematical or posting error," finding that the taxpayer had merely corrected an inventory error with respect to its established accounting method. Id. at 1356. Accord N. States Power Co. v. United States, 151 F.3d 876 (8th Cir. 1998) (taxpayer had established a proper accounting method for losses on "fuel," losses on "nuclear fuel" were a component of losses on fuel, and the taxpayer therefore had merely failed to account for losses on nuclear fuel consistently with its established accounting method); Potter v. Comm'r, 44 T.C. 159, 170-71 (1965) (holding that the IRS did not change the taxpayer's accounting method when it required him to correct inconsistent reporting of notes); Beacon Publ'g Co. v. Comm'r, 218 F.2d 697, 702 (10th Cir. 1955) (holding that the taxpayer may use a different accounting method when the change is necessary to correct errors and reflect income correctly); Wetherbee Elec. Co. v. Jones, 73 F. Supp. 765, 766 (W.D. Okla. 1947) (holding that a correction to deduction for overhead expenses was not an accounting method change but a correction of an error).

The Tax Court distinguished Capital One's position in this litigation with the rulings in cases like Standard Oil and Gimbel Brothers. First, the Tax Court reasoned that "unlike the taxpayers in those cases, neither COB or FSB adopted the OID method with respect to late-fee income. . . . [t]herefore, there was no deviation from or subsequent adherence to the OID method." App. 93. Second, the Tax Court stated that Standard Oil and Gimbel Brothers involve corrections "made to a component of the material item, not to the item itself." App. 93-94.

The Tax Court's reasoning, however, is circular. Under the Tax Court's ruling, the revolving charge sale income in Gimbel Brothers is a component of "installment sales" because "[a]ll of the installment sales income was earned the same way, from the sale of goods on an installment plan." App. 95. To the Tax Court, Late Fees are not a component of OID generated from credit card loans because they "are earned for a purpose independent of the other components of COB's and FSB's OID." App. 95.

The Tax Court's reasoning states a difference with little distinction. The parties agree that Late Fees are a type of OID, just like the revolving charge account sale in Gimbel Brothers is a type of installment sale. Although the revolving charge account sales are generated "in the same way" as other installment sales, the same can be said about Late Fees; they are generated from credit card loans.

D. If Capital One Did Not Obtain Automatic Consent To Treat Late Fees Properly As OID, Then The IRS's Refusal Constitutes An Abuse Of Discretion.

With the enactment of Section 1272(a)(6)(C)(iii), Capital One was required to change its accounting method for Late Fees. If, as the IRS contends, Capital One's Form 3115 did not act to grant it automatic consent to report Late Fees as OID, then the IRS abused its discretion in refusing to allow Capital One to report Late Fees in accordance with Section 1272(a)(6)(C)(iii).

The IRS is treating Capital One differently compared to other similarly situated taxpayers. The facts of I.R.S. Field Service Advice 200145013, supra, demonstrate that the IRS treated another taxpayer in a nearly identical situation differently than Capital One. Courts have considered this an important factor in considering whether the IRS has abused its discretion.

For example, in Farmers' and Merchants' Bank v. United States, 476 F.2d 406 (4th Cir. 1973), this Circuit considered a case with striking similarities to Capital One's case. The taxpayer in that case used a "uniform ratio method" to calculate its reserve for bad debts. "[U]nder a mistaken belief of their ineligibility," certain federally secured loans were "omitted" in computing the taxpayer's bad debt reserve for 1964. Id. at 407. In 1966, the taxpayer filed a claim for refund based on a recomputation of its bad debt reserve that included these loans. In 1968, the IRS issued a Revenue Ruling stating that it was in fact correct to exclude such loans. Nevertheless, the Revenue Ruling also indicated that the IRS would not make any adjustment for taxpayers that had previously included such loans in the computation of their bad debt reserves on tax returns filed prior to 1968. The IRS then denied the refund requested by Farmers' and Merchants' Bank on the basis of the position in its Revenue Ruling.

The Court held that the IRS had "abused his discretion," for "[t]he Commissioner cannot tax one and not tax another without some rational basis for the difference." Id. at 409 (internal citations omitted). Although the IRS argued that all banks would eventually be on the same footing because the benefit was just a difference in the timing of the deduction, the court rejected that position, stating that "the argument totally ignores [the taxpayer's] right to equal treatment for the specific tax year involved." Id. at 410. See also Int'l Bus. Machs. Corp. v. United States, 343 F.2d 914, 921 (Ct. Cl. 1965) (court held that the IRS abused its discretion in denying request for refund where taxpayer's principal competitor received a favorable private letter ruling on the same issue, which the IRS revoked only prospectively). Equal treatment is even more appropriate in this case where Capital One seeks merely to calculate OID correctly for 1998 and 1999, like other taxpayers did and as Capital One did in 2000.

Moreover, although Farmers' and Merchants' Bank did not involve a request for a change in an accounting method, other courts have specifically held that when a taxpayer requests an accounting method change from an improper to a proper method, the IRS's discretion is limited and denying a request to change from an incorrect to a correct accounting method constitutes an abuse of discretion. See, e.g., Sec. Benefit, 517 F. Supp. at 773 (court indicated that it was an abuse of discretion for the IRS to refuse a request for change from an improper to a proper method); SoRelle v. Comm'r, 22 T.C. 459, 469 (1954) (in the context of other questions, court made it clear that the IRS could not compel a taxpayer to remain on an improper accounting method). See also I.R.S. Field Svc. Adv. 200102004 (Aug. 14, 2000) ("Where the request for change is from an improper to a proper method, the Commissioner's discretion is limited.").

Although IRS consent may be required even where the taxpayer attempts to change from an improper method to a proper method, here, Capital One in fact disclosed the change when it filed Form 3115 with its 1998 tax return. App. 319-28. Accordingly, cases in which the IRS denied a request to change from one proper method to another are inapposite. See, e.g., FPL Grp., Inc. v. Comm'r, 115 T.C. 554, 576 (2000). Similarly, situations in which the taxpayer never filed a Form 3115, but merely requested a retroactive change in accounting method for the first time during litigation, are also not instructive.

Capital One either received automatic consent upon filing Form 3115, or Capital One should be deemed to have received consent because a denial would be an abuse of discretion. See also Kemper v. United States, 599 F. Supp. 392, 394 (W.D. Va. 1984) ("Since a change of accounting method is thus mandated, the consent of the Commissioner is not required.").

In summary, in this litigation the IRS refuses to allow Capital One to report Late Fees correctly despite the unequivocal language of the statute and the IRS's own guidance. Under the unique facts of this case, the IRS's position is outrageous -- the IRS acknowledges that Capital One disclosed that it was changing the way it reports "interest and OID" income on its credit card loans, but refuses to permit the change simply because the IRS does not like the way that Capital One filled out the form. The IRS's true motivation for not permitting Capital One to report Late Fees as OID is clear -- under these circumstances compliance with the tax law will temporarily reduce Capital One's income for 1998 and 1999. Capital One is required to report Late Fees as OID, and the IRS should not be permitted to abrogate Congress' mandate.

If Capital One satisfies the requirements of Regulation 1.451-4, then Capital One is permitted to deduct its reasonable estimated redemption cost of its MilesOne miles. That regulation provides in pertinent part:

There is no dispute that: (1) the purpose of Regulation 1.451-4 is to match revenues earned during the year with a reasonable estimate of the cost of redeeming the coupons that helped to generate those revenues; (2) Capital One earns revenues from lending money to its cardholders; (3) Capital One's MilesOne "miles" are "coupons" for purposes of the regulation; and (4) Capital One reasonably estimated the expense of redeeming those coupons. 1st Stip. ¶¶ 33, 42; Exhibit 59-J, ¶ 23, 25; Tr. 32:2-5, 40:5-20, 44:24-45:7; App. 215, 218, 389, 397, 401-02, 672. Where the parties disagree, and at the heart of the Tax Court's error, is whether Regulation 1.451-4 can apply to coupons issued incident to lending money.

The Tax Court opined that not all businesses that issue redeemable coupons can currently deduct the estimated redemption cost of those coupons. App. 198-99. The Tax Court ruled that the application of the regulation depends upon the type of activity that generated the revenue that is to be associated with the cost of redeeming the coupon. Id. Specifically, the Tax Court stated that while Capital One's lending transactions constituted lending services, they did not constitute a "sale" of lending services. App. 198. As a result, Capital One did not have "sales" and did not, therefore, issue its coupons "with sales" as required by the regulation. Thus, according to the Tax Court, because Capital One does not have sales revenues, it cannot deduct the estimated cost of issuing MilesOne miles. Id.

The Tax Court is incorrect. Regulation 1.451-4 is not limited to transactions that involve the sale of goods.

This issue was directly addressed by the IRS in I.R.S. General Counsel Memorandum 35524, 1973 GCM LEXIS 76 (Oct. 19, 1973),¹⁴ which involved a casino that was seeking to apply Regulation 1.451-4 to the estimated cost of redeeming coupons issued to gaming patrons. Specifically at issue was whether the taxpayer had "sales" for purposes of the regulation. In interpreting its own regulation, the IRS first examined the definition of "sale" in section 2-106(1) of the Uniform Commercial Code ("UCC"), which stated: "A 'sale' consists in the passing of title from the seller to the buyer for a price. . . ." After considering this definition, the IRS found it too restrictive to be applied to Regulation 1.451-4, stating that:

Thus, the IRS's own authorities indicate that the term "sale" in Regulation 1.451-4 was intended to be expansively construed to include a variety of income producing business activities -- including the provision of services. GCM 35524 declined to restrict the application of its own regulation to only those taxpayers engaged in "sale" transactions as doing so "would unfairly deny use of this method of accounting to service establishments." 1973 GCM LEXIS 76, at *3-4. This broad interpretation of the word "sale" is supported by similar definitions found elsewhere in the Code¹⁵ and is consistent with commonly accepted lay and legal definitions.¹⁶ A sale is not limited to transactions involving goods, but includes: "[t]he exchange of goods, property, or services for an agreed sum of money or credit." See Collins English Dictionary -- Complete & Unabridged (10th ed. 2010). See also In re Hastie, 2 F.3d 1042, 1045 (10th Cir. 1993) (defining "sale" for purposes of determining a security interest as a "revenue transaction where goods or services are delivered to a customer in return for cash or a contractual obligation to pay").

B. Capital One's MilesOne Program Meets The Terms And Spirit Of Regulation 1.451-4 -- Miles Were Only Issued If And When Capital One Made A Loan To The Cardholder.

The requirement that a taxpayer must issue a redeemable coupon "with sales" was not meant to impose a meaningless distinction between businesses that sell goods and businesses that provide services. There is no evidence of such word play in the regulation, and prior to the Tax Court's opinion in this case, neither the courts nor the IRS have ever expressed concern with what type of transaction generates the revenues in the first place -- whether it be a sale, a service, or a "sale of a service." Instead, the regulation was fashioned to associate the revenue generated from an actual business transaction with a reasonable estimate of the cost of redeeming the coupon issued in conjunction with that transaction. By so doing, the taxpayer can more accurately determine his taxable income.

Courts have held that redeemable coupons affixed to a product's packaging (so-called "on pack" coupons) and coupons inserted inside of a product's packaging (so-called "in pack" coupons) were issued "with sales." See Brown & Williamson Tobacco Corp. v. Comm'r, 16 T.C. 432, 434, 445 (1951) (coupons affixed to package of cigarettes and extra coupons placed in each carton); Creamette Co. v. Comm'r, 37 B.T.A. 216, 218 (1938) (coupon in each carton sent to retailer).

Texas Instruments v. Commissioner, 63 T.C.M. (CCH) 3070 (1992), is perhaps the seminal case interpreting Regulation 1.451-4. In that case, the court held that the taxpayer's rebate program satisfied the requirements of Regulation 1.451-4, despite the fact that the taxpayer distributed coupons through magazines and newspapers. The terms of that program required the customer to purchase a certain product and then submit the rebate coupon, a sales receipt, and some additional proof of purchase to the manufacturer. The customer, however, was not required to make a purchase to obtain the rebate coupons, as they were distributed gratuitously through the mail and in newspaper and magazine advertisements.

Importantly, in reviewing the rebate program, the IRS and the court focused not on the presence or lack of a "sale," but on whether the taxpayer had issued the coupons "with sales." The concern was a possible lack of a nexus between the issuance of the coupon and the income producing activity. The court found that the taxpayer designed the program to ensure that the customer actually purchased the product associated with the rebate program, in part by requiring the customer to submit a sales receipt and proof of purchase along with the rebate coupon. This, the court found, satisfied the requisite "match" between the revenue generated by the sale and the cost of redeeming the coupon. 63 T.C.M at *70, 84-85, 88-89.

Capital One's MilesOne program similarly creates the proper nexus between the issuance of the mile or coupon and the revenue generated from a particular loan. Capital One did not issue miles gratuitously to its cardholders; during the years at issue, MilesOne cardholders could only earn miles if and when they borrowed money from Capital One. 1st Stip. ¶ 4, 8; Tr. 52:12-20; App. 208-09, 409. Like the rebate program in Texas Instruments, Capital One designed the MilesOne Program to ensure that miles were only issued to cardholders when they borrowed money from Capital One. Tr. 52:17-20; App. 409. As a result, Capital One's MilesOne Program guarantees an even stronger temporal link than the rebate program in Texas Instruments. Because it was impossible for MilesOne cardholders to accumulate miles other than by borrowing money, the miles were issued "with sales" as required and contemplated by Regulation 1.451-4.

C. The Presence Of Irregular Or Uncertain Cash Flows Impacts Only The Amount Of The Accrual Under Regulation 1.451-4, And Not The Appropriateness Of The Accrual Itself.

To support its untenable position that lending transactions are not "sales of services," the Tax Court states that, at the time Capital One lends money it is not assured that there will be any revenue to match the incremental cost of issuing miles. App. 199-201. Although Capital One does not know precisely what the resulting revenue will be at the moment a cardholder borrows money, this sort of exactitude is not contemplated or required by Regulation 1.451-4. In promulgating that regulation, Treasury could have required such one-to-one pairing on a transaction-by-transaction basis, but it did not. Instead, Regulation 1.451-4 contemplates matching revenue and expense on an annual basis.

The concept of annual "matching" is a cornerstone of federal income tax law:

Furthermore, the Tax Court's reasoning rests on the naive notion that revenue generated from the sale of goods is necessarily fixed or certain. Many traditional merchant "sales" transactions have uncertain or contingent revenue streams -- such as lay away sales and installment sales. Revenues from the provision of gambling services are inherently uncertain, but the IRS held that such services could qualify as "sales" under Regulation 1.451-4. See GCM 35524, supra. Similarly, potential exchanges and returns with respect to merchant sales transactions belie the Tax Court's traditional view of such transactions as generating permanent and non-contingent streams of revenue. The Tax Court's opinion is not limited to sales transactions that generate non-contingent revenue streams. Instead, the Tax Court's opinion summarily excludes all lending transactions because the amount of the income ultimately realized is (allegedly) uncertain at the time of the loan.

Flexibility was intentionally built into Regulation 1.451-4. The regulation permits a taxpayer to deduct a reasonable estimate of the expenses against associated revenue; the regulation does not mandate what amount of revenue must be generated. If a taxpayer accurately estimates future redemption expenses, a deduction against related revenues will always be appropriate.

D. The Tax Court's Ruling Unfairly And Arbitrarily Impacts All Lenders.

The Tax Court's ruling effectively prohibits Capital One and all lenders from deducting their estimated redemption coupon costs. This blanket prohibition is made by the Tax Court without any published guidance or supporting authority. This position is incorrect.

By its terms, Regulation 1.451-4 applies to all accrual method taxpayers who issue redeemable coupons in association with their revenue generating activities. The predecessor to Regulation 1.451-4 makes it clear that the regulation was intended to apply to all corporations:

Prior to the Tax Court's ruling in this case, there were no decisions or rulings restricting the application of Regulation 1.451-4 to taxpayers based upon the way they generate revenue. In fact, the courts and the IRS have interpreted this regulation to enable all accrual method taxpayers, regardless of how they generated their revenue, to match and associate anticipated expenses with associated revenue generated when issuing redeemable coupons. For example, Regulation 1.451-4 has been applied based on a broad reading of the term "coupon." See Texas Instruments, supra. It has even been applied to taxpayers that were not specifically covered by the language of the regulation. See, e.g., Frontier Sav. Stamps, Inc. v. United States, 6 A.F.T.R. 2d 5092 (N.D. Tex. 1960) (regulation applied to trading stamp company prior to amendment of regulation allowing same); see also I.R.S. Tech. Mem. CC:LR-1446, 1970 TM LEXIS 131 (Jul. 14,1970) (discussing Frontier Sav. Stamps, supra).

The Tax Court does not make a meaningful distinction between lending and other factual scenarios in which courts have determined that there has been a "sale of a service." As a result, the Tax Court's ruling inexplicably treats Capital One differently from other similarly situated taxpayers that issue coupons in connection with their business operations. This Circuit has held that "[t]he Commissioner cannot tax one and not tax another without some rational basis for the difference." See Farmers' and Merchants' Bank, 476 F.2d at 409.

E. Capital One Applied Regulation 1.451-4 Beginning With The First Year Of The Program To Accurately Reflect Capital One's True Economic Position.

In the first year of the MilesOne Program, Capital One was required to select the method of accounting that would, in its judgment, best reflect the true economic position of the MilesOne Program over the life of the entire program. Once selected, Capital One was required to apply this same method of accounting for the remainder of the program. Capital One did not have the option of not applying the regulation in the early years of the program, only to apply it in later years. See Regulation 1.446-1(a)(2), -1(e).

As a result of these accounting rules, Capital One's executives were very focused on and thoroughly examined the economics of the MilesOne Program. Tr. 118:25-119:20, 127:18-128:4; App. 436-39. The types of revenues and expenses included in the average MilesOne account and the average non-MilesOne account were the same, with the exception of the additional expense of airline tickets for the MilesOne Program. Tr. 56:1-8, 60:8-61:6, 61:17-22, 143:16-25; Ex. 63-J at 8; App. 412, 416-17, 449, 712. This additional expense was real, material, and growing as cardholders continued to accumulate MilesOne miles. See Tr. 56:1-8; 63:3-13; App. 412, 419. From the inception of the program in 1998, Capital One executives monitored and tracked the rapidly accruing redemption expense and knew that this future expense was critical to understanding the profitability of the MilesOne Program. Tr. 118:25-119:20, 127:18-128:4; Ex. 62-J at 20; App. 436-39, 694. This airline ticket expense had to be included in the MilesOne profitability equation from the beginning of the program in 1998 or the program's profitability would continually and consistently be overstated. Tr. 61:17-62:2, 143:16-25; App. 417-18, 449.

In 1998 and 1999, Capital One earned millions of dollars by lending money to its MilesOne cardholders. The lending transactions that produced this revenue are the same transactions for which Capital One issued MilesOne miles. As cardholders accumulated MilesOne miles, Capital One accrued an expense for the future cost of redemption -- the purchase of airline tickets. The parties agreed that Capital One's estimated redemption costs were reasonable. Despite this, the Tax Court's decision holds that Capital One's MilesOne Program does not seem to "fit" within the framework of the regulation, because Capital One provides (rather than sells) lending services. As discussed above, there is no legal authority for drawing such a discriminatory distinction between businesses that sell goods and businesses that provide (in this case, lending) services. Prior to the Tax Court's opinion in this case, neither the courts nor the IRS have ever expressed concern with what type of transaction generates the revenues in the first place -- whether it be a sale, a service, or a "sale of a service." Instead, the regulation was fashioned to associate the revenue generated from a business transaction with all the associated costs, allowing taxpayers to more accurate reflect taxable income. All that Regulation 1.451-4 requires is that an accrual method taxpayer issues redeemable coupons in association with its revenue generating activities -- just as Capital One has done.

A. The Tax Court Erred In Refusing To Permit Capital One To Introduce Evidence That Shows That Regulation 1.451-4 Matches The Cost Of Issuing Miles With MilesOne Revenue.

In objecting to the admission of Capital One's post-1999 financial data, the IRS argued that this information was irrelevant "to a determination of what happened in '98 and '99." Tr. 162:7-10; App. 457. As Capital One argued below, post-1999 financial data demonstrates that the application of Regulation 1.451-4 to the MilesOne Program more accurately matches revenue and expenses associated with the costs of the miles issued over the life of the MilesOne Program. Tr. 159:22-160:18, 163:2-19, 164:8-16, 169:8-21, 170:21-171:12; App. 454-55, 458-59, 464-66.

Rule 401 of the Federal Rules of Evidence defines "relevant evidence" broadly as:

The underlying purpose of Regulation 1.451-4 is to match revenue and expenses to more accurately report a taxpayer's income. App. 194. This is precisely the purpose for which Capital One sought admission of the post-1999 financial data. Since the MilesOne Program began in 1998, viewing solely the 1998 and 1999 revenue data versus actual redemption costs and accrued costs is misleading. Only by viewing the MilesOne program over time could the Tax Court appreciate how the application of Regulation 1.451-4 more accurately reflects Capital One's income. The Tax Court was arbitrary in refusing to admit the post-1999 financial data and its admission could have affected the court's decision. See United States v. Simpson, 910 F.2d 154, 157-58 (4th Cir. 1990).

There is no dispute between the parties that these estimated costs were reasonable and reflect accurate estimates of Capital One's actual incurred liabilities in those years. See 1st Stip. ¶¶ 26, 27, 31, 32, 34, 42; Ex. 59-J at ¶¶ 23, 25, App. 214-18, 672. The fact that these estimated future liability amounts were high in relation to the start-up revenues does not change the fact that this expense deduction was necessary for Capital One to reflect its true economic status in 1998 and 1999 (and in later years). Tr. 61:17-62:2; 143:20-25; App. 417-18, 449.

Although revenues generated by the MilesOne Program were low in this first year, actual cash expenditures for airline tickets purchased by Capital One were even lower because, at that point in the MilesOne Program, most cardholders did not yet have sufficient miles to redeem for an airline ticket. Tr. 133:6-9. App. 443. Because the tax years at issue are also the first two years of the MilesOne Program's existence, the Tax Court's decision severely and unnecessarily handicaps Capital One. The Tax Court's decision limits Capital One's tax deduction in the start-up years (and in later years) to only the actual cash expenditures of the MilesOne Program -- $1,578 in 1998 and $315,513 in 1999. See 5th Stip. ¶ 18,19; Ex. 60-P, App. 312-14,1942-62.

In contrast, employing Regulation 1.451-4 to currently account for the airline ticket expenses associated with the MilesOne Program better reflects Capital One's actual income generated by the MilesOne Program and true economic position. If Capital One did not employ Regulation 1.451-4 to account for the MilesOne Program, the ever-increasing and present liability to fund the redemption of the miles would not be recognized until several years in the future, despite the fact that the accrued liability is directly related to the revenues that Capital One would be required to currently recognize. This would have the effect of distorting and overstating Capital One's income -- the nexus between the revenue generated and the costs associated with the MilesOne Program would be broken. Accordingly, the application of Regulation 1.451-4 more accurately reflects the true economic effect of the MilesOne Program and Capital One's income by matching revenue and related expenses within the same annual tax year.

The relevance of the post-1999 financial data that Capital One sought to admit is glaring as one looks at the results of the MilesOne Program in later years. Although the terms of the program essentially remained the same after 1999, the economics of the program changed dramatically. As the excluded post-1999 financial data shows, the MilesOne Program became wildly successful and revenues exploded, increasing from $40 million in 1999 to $188 million in 2000 to over $700 million in 2004 as stated below (which includes the excluded post-1999 financial data):

 MilesOne Tax Income

With this explosion of revenues, the mismatch that occurs from not applying Regulation 1.451-4 (and limiting Capital One's expense deduction to only cash expenditures) becomes staggering. Without the application of Regulation 1.451-4, Capital One would be limited to only deducting its actual cash expenditures, in the amounts and for the years stated below (which includes the excluded post-1999 financial data):

 MilesOne Cash Expenditures

 

 

The Tax Court based its decision, in part, on the uncertainty of Capital One's revenues. The Tax Court described the "variables" that may affect Capital One's revenues. And the Tax Court described these revenues as "contingent." The Tax Court referred to Interchange Fees as a "small percentage of the amount lent," and studiously ignored any discussion of the $19 or $29 Annual Fee amount that Capital One charged to each of its MilesOne cardholders. 1st Stip. ¶ 6. App. 199-201, 209.

Even though the IRS stipulated that Capital One's estimates were reasonable, the overall impression presented by the Tax Court is that Capital One would derive too large of a benefit in 1998 and 1999 by deducting an estimate of its future redemption costs. Because the Tax Court based its decision in part on the nature of the revenues received, Capital One should have been afforded the opportunity to present its best evidence (including data from years after 1999) to demonstrate that the MilesOne revenues and expenses are better matched by applying Regulation 1.451-4.

DATED: October 13, 2010

² "App." references are to the separately-bound record Joint Appendix. "Doc." references correspond to entries listed on the Tax Court docket sheet, reproduced at App. 1-10. "Ex." references are to the trial exhibits, reproduced at App. 545-2038.

³ Unless otherwise indicated, "Regulation" references are to the regulations promulgated by the U.S. Department of the Treasury ("Treasury"), embodied in Title 26 of the Code of Federal Regulations, and in effect for the tax years at issue.

⁴ "Stip." references are to the parties' Stipulations of Facts, reproduced at App. 207-318. "Tr." references are to the page(s) and line(s) of transcript excerpts of the trial proceedings, reproduced at App. 385-544.

⁵ OID is the difference between the "stated redemption price at maturity" and the "issue price" of a debt instrument. See Section 1273(a)(1). Holders of debt instruments with OID are generally required to include OID in taxable income over the life of the debt instrument. See Section 1272(a)(1).

⁶ On its Form 3115, Capital One listed the taxpayer as Capital One Bank, but did not mention Capital One F.S.B. 2nd Stip. ¶ 21; App. 225, 319.

⁷ On September 27, 2010, the IRS changed its litigating position on the treatment of Interchange Fees in light of the Capital One opinion. See I.R.S. Notice CC-2010-018 (Sept. 27, 2010).

⁸ These amounts differ from the adjustments to taxable income for Late Fees sought in Capital One's Amendment to Petition as a result of adjustments required by the Tax Court's opinion regarding the method of calculating OID for 1998 and 1999. App. 98-202.

⁹See also Rochelle v. Comm'r, 116 T.C. 356, 358 n.2 (2001), aff'd, 293 F.3d 740 (5th Cir. 2002); Smith v. Comm'r, 114 T.C. 489, 491 (2000), aff'd, 275 F.3d 912 (10th Cir. 2001).

¹⁰See Amandeep S. Grewal, Legislative Entrenchment Rules in the Tax Law, 62 Admin. L. Rev. (forthcoming 2010) ("The Tax Court [in the Capital One case] was wrong to treat uncodified automatic consent provisions as dead letter, and (ironically) the bizarre consequences of its opinion actually help show why legislative entrenchment rules are ineffective to the extent they purport to categorically control the interpretation of subsequent legislation . . . the uncodified consent provisions irreconcilably conflict with Section 446(e) . . . and the uncodified provisions should trump Section 446(e).").

¹¹See, e.g., Job Creation and Worker Assistance Act of 2002, Pub. L. No. 107-147, § 403(b)(2), 116 Stat. 21, 41 (2002); Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, § 7001(b)(2), 112 Stat. 685, 827 (1998); TRA § 1088(b)(2), 111 Stat. 788 (1997).

¹² A Field Service Advice or "FSA" is written advice provided by the IRS's Office of the Chief Counsel ("Chief Counsel") to questions proposed by IRS field examination agents. Tax Analysts v. IRS, 117 F.3d 607, 609 (D.C. Cir. 1997). A FSA may not be used or cited as precedent, but it may be some indication of the IRS's practice or position. See Sec. 6110(k)(3); Rowan Cos., Inc. v. United States, 452 U.S. 247, 261 n.17 (1981); Estate of Cristofani v. Comm'r, 97 T.C. 74, 84 n.5 (1991).

¹³ Because of growing controversy of what constituted a "material item," in 1968 Treasury proposed regulations that more clearly defined that term by focusing instead on timing. See Prop. Reg. 1.446-1(e)(2)(ii)(a), 33 Fed. Reg. 18,936 (Dec. 19, 1968).

¹⁴See supra note 12. A General Counsel Memorandum or "GCM" (like an FSA) provides some indication of the IRS's practice or position.

¹⁵ For example, the term "foreign base company sales income" in Section 954(d)(1) includes not only revenues earned through the sale of goods, but also income derived from commissions, fees, and other similar income producing activities. Likewise, in Regulation 7.999-1(b)(6), "sales made to a boycotting country" and "sales made to any country other than the United States" are defined to include gross receipts from the sale, exchange, other disposition, or use of tangible personal property, services performed, the end product of services, intangible property, securities, and real property.

¹⁶ For example, the legislative history of the Fair Labor Standards Act defines "sales" to include a variety of business activities including "making loans." See S. Rep. No. 1487, as reprinted in 1966, U.S.C.C.A.N. 3002, 3008-09.

¹⁷ In 1998, Capital One reported $2,327,837,063 on Line 1a of its tax return, which is denoted "Gross Receipts or Sales." Ex. 15-J at 1; App. 603. In 1999, Capital One reported $3,784,754,665 in this same category. Ex. 16-J at 1; App. 604.

¹⁸ This graphical representation of the admitted and excluded evidence demonstrates what the Tax Court could have relied upon in its examination of the MilesOne Program. 5th Stip. ¶ 19; App. 313-14.