Tier II Issue – Interchange and Merchant Discount Fees
LMSB Control No: LMSB-04-0208-002
Impacted IRM 4.51.5
April 22, 2008
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR OF REPORTING COMPLIANCE, SBSE
FROM: Walter L. Harris /s/ Walter L. Harris
SUBJECT: Tier II Issue – Interchange and Merchant Discount Fees
This memorandum is an alert to the field on the Tier II Issue, Interchange and Merchant Discount Fees.
Background / Strategic Importance
The deferral of Interchange and Merchant Discount fee income has been designated a Tier II issue by LMSB. The Issue Owner Executive (IOE) is Stanley Locke, Director, Field Operations (East), Financial Services. IRM 18.104.22.168 requires issue coordination under direction of the IOE.
In recognition of the strategic importance of this Tier II issue, Financial Services created an Issue Management Team (IMT) to improve Service-wide coordination of the Interchange and Merchant Discount Fee issues. The IMT was formed to help identify, develop, and resolve cases with these issues. A primary purpose of the IMT is to ensure that when these issues are identified for audit, they are examined fairly and consistently for all taxpayers. The IMT also plays a key role in providing guidance and technical support to the field on issue development and resolution.
This issue has been identified on the tax returns of Issuing Banks and Merchant Banks processing VISA/MasterCard type transactions on behalf of customers/cardholders and merchants, respectively. It has also been identified on tax returns of retailers, who issue their own credit cards through captive financing arms. This issue is present with debit and charge cards, as well as credit cards.
Many Issuing Banks and Merchant Banks take the position that Interchange and Merchant Discount fees are interest and Original Issue Discount (OID) and rely on IRC Sec. 1272(a)(6) to defer the recognition of these fees. LMSB's position is that these fees are more in the nature of service fees, and therefore are not interest and OID.
Example of Interchange & Merchant Discount Fees
Interchange and Merchant Discount fees can best be illustrated by a typical 4-party transaction involving the purchase of an item using a typical VISA/MasterCard type general purpose credit card issued by a bank. When a Customer purchases a $100 item from a Merchant using a typical VISA/MasterCard type credit card, the Merchant passes on the $100 charge to its Merchant Bank in exchange for $98.00, pursuant to the Merchant’s contract with the Merchant Bank. The Merchant Bank submits the $100 charge into the VISA/MasterCard system and receives $98.50 from the customer’s credit card Issuing Bank (less a small processing VISA/MasterCard fee). The Issuing Bank eventually receives $100 from the Customer/Cardholder when the credit card charge is paid. Under this scenario, the Merchant Bank kept a $.50 “Merchant Discount” fee ($98.50 - $98.00), while the Issuing Bank has received a $1.50 “Interchange" fee ($100 - $98.50).
Please note that there can be many variations of the above illustration, such as when the same bank acts as both the Issuing Bank and Merchant Bank on a purchase, either within or outside the VISA/MasterCard system. Also, the same types of fees exist for debit and charge cards. Finally, the labels used by taxpayers to describe these fees are not controlling.
Audit Evaluation and Issue Development
As a Tier II issue, the Interchange and Merchant Discount fee issue should be raised and fully developed by examiners, subject to a documented risk and materiality analysis. On those cases where the issue is examined, the issue must be consistently developed. It is imperative that the risk assessment be performed early in the planning process to determine if the issue exists, and to allow sufficient time to examine the issue.
The examiner should request all the necessary documentation early in the examination process to allow time to properly develop the issue. The request should include relevant agreements and contracts as well as the calculation of the OID deferral. Since any deferral calculation under IRC Sec. 1272(a)(6) must be reasonable, it is necessary to examine the taxpayer’s deferral calculation. The IMT is currently developing pro forma IDRs and other materials, which will be issued once they are available.
As part of the initial risk analysis process, the examination team should engage the appropriate Technical Advisors. For assistance with audit evaluation, issue identification and development, examiners should contact the appropriate Technical Advisors: Jody Botsford and Jeff Kammerman, Banking; Dave Moser, Retail; or Phil Whitworth, Change in Accounting Method. Chief Counsel employees should contact Banking Industry Counsel, Vince Guiliano.
The position of LMSB is that Interchange and Merchant Discount fees are not interest and cannot constitute OID subject to deferral. LMSB encourages taxpayers to work with the examination team to resolve Interchange and Merchant Discount fee issues at the examination level. If agreement cannot be reached at the examination level, the IMT desires to insure consistency in issue development, and presentation of a consistent position for Appeals consideration. A secondary position should be developed based upon a review of the taxpayer’s deferral calculation.
For those taxpayers that are presently deferring taxable income from Interchange or Merchant Discount fees by treating that income as creating or increasing original issue discount (OID), LMSB encourages voluntary compliance with the existing statute and regulations. Rev. Proc. 97-27 offers incentives to encourage taxpayers to comply with proper tax accounting principles on a voluntary basis. Accordingly, taxpayers that are treating Interchange and Merchant Discount as creating or increasing OID are encouraged to consult Rev. Proc. 97-27 to determine their eligibility to make a voluntary change to a proper method of accounting for this income under section 451 using the more favorable terms and conditions applicable to voluntary accounting method changes.
LMSB has initiated a Compliance Initiative Project to identify taxpayers that are not in compliance with LMSB's position on Interchange and Merchant Discount fee income. Examiners will make adjustments to place such taxpayers on a proper method of accounting under section 451 for these items using the terms and conditions applicable to involuntary accounting method changes under Rev. Proc. 2002-18.
The issue has been designated as an Appeals Coordinated Issue (ACI). For unagreed cases examination teams should include the following statement on Form 3198 in the “other” section:
Case involves an Appeals Coordinated Issue. The Appeals Officer must contact Douglas Wilke, Appeals Technical Guidance Coordinator, at 1222 Spruce, St. Louis, MO 63103-2818.
Any questions regarding this directive may be directed to the Technical Advisors: Jody Botsford and Jeff Kammerman, Banking; Dave Moser, Retail; or Phil Whitworth, Change in Accounting Method; or to Banking Industry Counsel, Vince Guiliano.
This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
Attachment 1 - Information Document Request for Interchange and Merchant Discount Fees - Banks - 09-23-2008
Attachment 2 - Information Document Request for Interchange and Merchant Discount Fees - Retailers - 09-23-2008
Attachment 3 - Information Document Request for Interchange and Merchant Discount Fees - Calculator - 09-23-2008
cc: Commissioner, LMSB
Deputy Commissioner, Operations
Division Counsel, LMSB
Director, Pre-filing & Technical Guidance
Directors, Field Operations
Director, Performance, Quality, Analysis and Support