Fourth Circuit Rejects Retroactive Accounting Method Change

By Ellen Fitzpatrick, CPA, Washington, DC

Editor: Greg A. Fairbanks, J.D., LL.M.

Tax Accounting

In a recent case, Capital One Financial Corp., No. 10-1788 (4th Cir. 10/21/11), aff’g 130 T.C. 147 (2008) and 133 T.C. 136 (2009), the Fourth Circuit upheld a 2008 Tax Court decision that Capital One could not retroactively change its method of accounting for credit card late fees even though it was on an improper method. The Fourth Circuit also affirmed the Tax Court’s 2009 holding that the airline mile rewards that Capital One issued to customers did not qualify for coupon treatment under Regs. Sec. 1.451-4, which would have allowed the company to deduct costs of customers’ redeeming the miles before the customers actually redeemed the miles.

Of importance to the late fee issue, the Taxpayer Relief Act of 1997, P.L. 105-34 (TRA), extended original issue discount (OID) treatment for federal tax purposes to certain credit card revenues. As a result of the TRA, Capital One filed a Form 3115, Application for Change in Accounting Method, with its 1998 tax return to change its method of accounting for other types of credit card fees, but it did not specifically mention late fees in the Form 3115 or include late fees in its Sec. 481(a) adjustment, apparently because it was unclear in 1997 whether OID treatment in the TRA would apply to late fees.

On its tax returns for the years at issue, 1998 and 1999, Capital One recognized revenue from its credit card late fees as income in the year it charged the fees to customers, also called the current inclusion method. In 2000, Capital One changed its method (without filing a Form 3115 or recognizing a Sec. 481(a) adjustment) to treat the late fees as OID. In 2004, the IRS issued Rev. Proc. 2004-33 clarifying that credit card late fees could be treated as OID.

While the case was in Tax Court on the airline miles issue, Capital One sought to change its method of accounting retroactively to treat late fees as OID for the 1998 and 1999 tax years. This retroactive change would have resulted in approximately $400 million less of income for Capital One in those two years. The Tax Court held that Capital One could not retroactively change its method of accounting because it was required to secure the IRS’s consent to change its method, and it had not done so with respect to the late fees. The Fourth Circuit upheld this decision, stating that Sec. 446(e)’s prerequisite of prior consent prevents taxpayers from unilaterally amending tax returns because a different method is available and would provide a better tax result.

The Fourth Circuit cited Diebold Inc., 891 F.2d 1579 (Fed. Cir. 1989), to support its conclusion. Capital One claimed its case differed from Diebold because it was on an improper method in those years, and therefore it did not need the IRS’s consent for the change. The court pointed out that Rev. Proc. 98-60, which provides procedures for complying with the TRA, specifically forbids a retroactive change in method of accounting without consent. Further, this prohibition applies regardless of whether the change is from a permissible or an impermissible method.

The Fourth Circuit also rejected Capital One’s arguments that it did not need consent because the TRA obviated the general consent requirement of Sec. 446(e) and that the Form 3115 filed by Capital One in 1998 for other income streams also included the late fees. On the first argument, the court stated that a taxpayer is still required to file a Form 3115 where automatic consent applies because automatic consent does not exempt taxpayers from filing Form 3115 or take away the IRS’s oversight of accounting method changes. Responding to the argument that the Form 3115 filed by Capital One included the late fee revenue, the court found that the 3115 filing was insufficient to include the late fees in the change in accounting method. According to the court, Capital One did not describe the item in sufficient detail to include the late fees and did not include the late fees in the Sec. 481(a) adjustment.

The court also noted that Regs. Sec. 1.446-1(e)(2)(ii)(a) defines a change in method of accounting as “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.” Further, a material item is defined in the regulations as being “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.” Under this definition, the court found that the late fee revenue was a material item to Capital One. Since the late fees were not described in the Form 3115 specifically and Capital One did not actually change its method for those fees, the court held that the intent in filing the Form 3115 in 1998 did not include changing the method for the late fees.

The second issue addressed in the case was the Tax Court’s decision to disallow deductions for estimated future costs related to Capital One’s MilesOne program. Under the program, the cardholders earned miles for purchases made with their MilesOne credit cards and redeemed those miles for airline tickets purchased by Capital One. Under the all-events test, Capital One could deduct airline ticket redemption costs only when credit card holders redeemed their accumulated miles and Capital One was obligated to purchase the airline tickets for the customers. In its 1998 and 1999 returns, however, Capital One claimed a deduction for the estimated cost of airline miles redeemed under the theory that Regs. Sec. 1.451-4, relating to coupons issued concurrent with a sale, applied. This regulation provides an exception to the all-events test for taxpayers that issue trading stamps or coupons with sales when the coupons are redeemable for future merchandise or cash.

The Tax Court disallowed the treatment under Regs. Sec. 1.451-4 based on the fact that Capital One did not itself have a sale because the miles are earned when Capital One loans money to customers so that they can complete purchases with third parties. The Fourth Circuit upheld the Tax Court decision, emphasizing that a loan cannot be equated with a sale. The Fourth Circuit further found that Capital One did not issue the miles in conjunction with revenue it earned from its lending services. Therefore, Capital One could not deduct the estimated costs of the miles redemptions from the corresponding sales revenue, which is required by Regs. Sec. 1.451-4(a)(1) to qualify for the exception for coupons issued with sales.


Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

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