Fourth Circuit rejects retroactive accounting method change.

• Author: Fitzpatrick, Ellen A.

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 customers1 redeeming the miles before the customers actually redeemed the miles.

Of importance to the late fee issue, the Taxpayer Relief Act of 1997, RL. 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...