Capital One Financial Corporation and Subsidiaries v. Commissioner ( 2008 )

130 T.C. No. 11UNITED STATES TAX COURT
CAPITAL ONE FINANCIAL CORPORATION AND SUBSIDIARIES,
Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 19519-05, 24260-05. Filed May 22, 2008.
Ps’ subsidiaries, Capital One Bank (COB) and
Capital One, F.S.B. (FSB), issuers of Visa and
MasterCard credit cards, earn income from late fees
charged to cardholders who do not timely pay at least
their minimum monthly payment due. From 1995 to 1997
COB and FSB included the late fees in income when the
fees were charged to cardholders; i.e., when they
accrued under the all events test.
On Aug. 5, 1997, Congress enacted the Taxpayer
Relief Act of 1997, Pub. L. 105-34, sec. 1004, 111
Stat. 911, which codified sec. 1272(a)(6)(C)(iii),
I.R.C. This provision allows taxpayers who maintain a
pool of debt instruments, such as credit card loans, to
treat certain receivables related to that pool of debt
instruments as creating or increasing original issue
discount (OID).
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In 1998 R provided that a taxpayer could receive
“automatic consent” to change its method of accounting
in accordance with sec. 1272(a)(6)(C)(iii), I.R.C., by
filing Form 3115, Application for Change in Accounting
Method, with the taxpayer’s return. COB submitted Form
3115 with Ps’ 1998 return. Ps treated certain credit
card receivables as creating or increasing OID on their
1998 and 1999 returns, but they continued to recognize
COB’s and FSB’s late-fee income at the time the fee was
charged to the cardholder.
Through this proceeding Ps seek to retroactively
treat COB’s and FSB’s 1998 and 1999 late-fee income
under sec. 1272(a)(6)(C)(iii), I.R.C., thereby reducing
their taxable income substantially.
Held: COB and FSB were required to obtain consent
to change their treatment of credit card receivables to
comply with sec. 1272(a)(6)(C)(iii), I.R.C.
Held, further: Neither COB nor FSB received
consent to change its treatment of late-fee income on
Ps’ 1998 or 1999 return.
Held, further: Ps may not retroactively change
their treatment of COB’s and FSB’s 1998 and 1999 late-
fee income because the requested change is a change in
the treatment of a material item and is therefore an
impermissible change in method of accounting under sec.
446(e), I.R.C., and sec. 1.446-1(e)(2)(ii)(a), Income
Tax Regs.
Held, further: Ps’ motion for partial summary
judgment on the late fees issue will be denied, and R’s
motion for partial summary judgment will be granted.
Jean Ann Pawlow, Elizabeth A. Erickson, Holly K. Hemphill,
Kevin Spencer, and Robin L. Greenhouse, for petitioners.
Gary D. Kallevang, James Hill, and Alan R. Peregoy, for
respondent.
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OPINION
HAINES, Judge: This case is before the Court on the
parties’ cross-motions for partial summary judgment filed
pursuant to Rule 121.1 The issue for decision is whether section
446(e) prohibits Capital One Bank (COB) and Capital One, F.S.B.
(FSB), from changing their treatment of late-fee income from the
current-inclusion method (when it accrued under the all events
test) to a method which allows late-fee income to create or
increase original issue discount (OID).2
Background
The parties have stipulated the facts applicable to the
issue considered in this Opinion. Capital One Financial Corp. is
a publicly held financial and bank holding company based in
McLean, Virginia. Its principal subsidiaries, COB and FSB, are
among the world’s largest issuers of Visa and MasterCard credit
cards.
During the years at issue COB and FSB earned various types
of income from their credit card business, including finance
1
Unless 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. Amounts are
rounded to the nearest dollar.
2
Petitioners’ motion applies only to COB because FSB, unlike
COB, did not file a Form 3115, Application for Change in
Accounting Method, with petitioners’ consolidated 1998 return.
Respondent’s motion applies to COB and FSB.
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charges when cardholders carried a balance on their cards, annual
fees, overlimit fees when cardholders exceeded their credit
limit, cash advance fees when cardholders accessed cash with
their cards, and interchange.3 Pertinent to these motions for
partial summary judgment, COB and FSB also earned income from
late fees charged when the cardholder was delinquent in making at
least the minimum payment due. For the years 1995 through 1999,
COB and FSB recognized late-fee income at the time the fee was
charged to the cardholder for financial accounting purposes as
well as tax purposes. Late-fee income was recognized in the
following amounts.
COB FSB
Year Late-Fee Income Year Late-Fee Income
1995 $86,620,377 1995 -0-
1996 143,520,881 1996 $9,737,796
1997 287,400,477 1997 20,598,116
1998 510,017,513 1998 11,926,000
1999 722,277,703 1999 29,732,338
Total 1,749,836,951 Total 71,994,250
3
In addition to the motions for partial summary judgment
addressed in this Opinion, petitioners filed a motion for partial
summary judgment as to the proper tax treatment of interchange.
Interchange is a fee (usually a percentage of the amount charged)
that is paid on every credit card transaction to the bank which
has issued the card. Petitioners contend that interchange
increases OID under sec. 1272(a)(6)(C)(iii) because the
cardholder bears the economic burden of paying interchange.
Respondent disagrees and contends that the merchant’s bank, not
the cardholder, is contractually responsible for paying
interchange to the bank which issued the card.
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On September 15, 1999, COB submitted Form 3115, Application
for Change in Accounting Method, to respondent by attaching it to
petitioners’ consolidated Federal income tax return for 1998.
COB stated on the Form 3115:
Capital One Bank (COB), a domestic corporation,
requests permission under Section 12.02 of Rev. Proc.
98-60 to change its method of accounting for interest
and original issue discount that are subject to the
provisions of Section 1004 of the Tax Relief Act of
1997.
Petitioners did not treat late-fee income as OID under the
Taxpayer Relief Act of 1997 (TRA), Pub. L. 105-34, sec. 1004, 111
Stat. 911 (section 1272(a)(6)(C)(iii)) in 1998 or 1999. They
continued to use the current-inclusion method for late-fee
income. Petitioners did not attempt to amend their 1998 or 1999
return to treat late-fee income as increasing OID. Petitioners
began to treat COB’s and FSB’s late-fee income as increasing OID
on their 2000 return. Respondent has not conceded that
petitioners had consent under section 446(e) to make that change.
In response to respondent’s notice of deficiency with
respect to 1997, 1998, and 1999, petitioners timely filed a
petition with this Court. Petitioners subsequently filed their
amended petition, claiming they are required to treat late-fee
income as increasing OID on their pool of credit card loans, thus
reducing their taxable income for 1998 and 1999 by $209,143,757
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and $216,698,486, respectively.4 On October 12, 2007, the
parties filed cross-motions for summary adjudication on the late
fees issue. On December 7, 2007, the parties filed objections to
each other’s motions. A hearing was held on the motions in
Washington, D.C., on January 24, 2008.
Discussion
I. Change in the Law
On August 5, 1997, Congress enacted TRA sec. 1004, which
added section 1272(a)(6)(C)(iii) to the Code. Section
1272(a)(6)(C)(iii) has the effect, as explained below, of
requiring taxpayers to treat credit card receivables as creating
or increasing OID on the pool of credit card loans to which the
receivables relate. Petitioners seek to change their treatment
of COB’s and FSB’s 1998 and 1999 late-fee income from the
current-inclusion method to a method based on section
1272(a)(6)(C)(iii).
The parties have stipulated that if the Court finds that a
change in the treatment of late-fee income is permissible, then
such income may be treated as creating or increasing OID under
section 1272(a)(6)(C)(iii). An understanding of that section and
4
Treating late-fee income as OID decreases petitioners’
taxable income because under the current-inclusion method
petitioners recognized late-fee income when a cardholder’s
liability for the fee accrued, whereas treating late-fee income
as OID allows recognition to be deferred; i.e., included in
increments over time on the basis of reasonable assumptions
regarding how long it will take a cardholder to pay off the debt.
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its application to credit card receivables is helpful to an
understanding of the issues in this case.
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(a)(1). 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(a)(1). The SRPM
includes all amounts payable at maturity. Sec. 1273(a)(2). 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 (1) any
regular interest in a real estate mortgage investment conduit
(REMIC), (2) qualified mortgages held by a REMIC, or (3) 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
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debt instruments are determined by taking into account an
assumption regarding the prepayment of principal for such
instruments. Sec. 1272(a)(6)(C)(i) and (ii).
Section 1272(a)(6)(C)(iii) 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 section
1272(a)(6)(C)(iii) was intended to apply to credit card loans and
the related receivables. See H. Conf. Rept. 105-220, at 522
(1997), 1997-4 C.B. (Vol. 2) 1457, 1992. What was unclear at the
time of enactment and is still not fully resolved is which credit
card receivables increase OID under section 1272(a)(6)(C) and
which do not.5
Rev. Proc. 98-60, app. sec. 12, 1998-2 C.B. 759, 786,
provides procedures by which taxpayers may receive “automatic
consent” to change their method of accounting for pools of credit
card receivables in accordance with section 1272(a)(6)(C). Under
the revenue procedure, automatic consent is achieved by filing
Form 3115 with a taxpayer’s return. Id. sec. 6.02, app. sec. 12,
1998-2 C.B. at 765, 786.
When section 1272(a)(6)(C)(iii) was added to the Code,
credit card companies could be certain that grace period interest
5
Although the Commissioner has clarified the scope of sec.
1272(a)(6)(C)(iii) by revenue procedures and other published
guidance, issues still remain, such as whether interchange income
is properly treated as OID.
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fell under the new rule. See Rev. Proc. 98-60, app. sec. 12;
Staff of Joint Comm. on Taxation, Description and Analysis of
Certain Revenue-Raising Provisions Contained in the President’s
Fiscal Year 1998 Budget Proposal 31-34 (JCS-10-97) (J. Comm.
Print 1997). Grace period interest is the interest that accrues
from the date of a credit card charge if the balance of a
cardholder’s account is not paid by the end of the grace period,
usually 30 days after the close of a monthly billing cycle.6 If
the cardholder pays the balance within those 30 days, no interest
is charged.
The operation of section 1272(a)(6)(C)(iii) with respect to
grace period interest is best explained by the following example.
Assume the cardholders of a credit card company (a calendar year
taxpayer) incur $10 million of charges in December of year 1.
Grace period interest will be charged to the cardholders who do
not pay their balances in full by January 30 of year 2, the end
of their grace period. Before enactment of section
1272(a)(6)(C)(iii), the taxpayer was not required to include any
6
Grace period interest is the equivalent of a finance
charge, and is distinct from a late fee. Assume a cardholder
with a zero balance at the beginning of a billing cycle charges
$1,000 during that cycle and the credit card company calculates a
minimum payment due of $100. If the cardholder timely pays $100,
he will be liable for grace period interest because the entire
balance was not paid in full. If the cardholder timely pays
$1,000, no grace period interest will be charged. If the
cardholder does not make a timely payment of at least the minimum
due, he will be liable for grace period interest and a late fee.
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interest income in year 1 with respect to the December charges
because it was possible that all the cardholders would pay off
their balances by January 30, year 2. Of course, not all
cardholders paid their balances within the grace period; thus the
taxpayer was permitted to defer grace period interest allocable
to December year 1, until year 2.
Under section 1272(a)(6)(C)(iii), the taxpayer is required
to make a reasonable assumption as to what portion of the
December balances will not be paid off within the grace period
and is required to accrue interest income through the end of year
1 with respect to that portion. The taxpayer then adjusts the
accrual in the following year to reflect the extent to which the
prepayment assumption reflected the actual payments received
before expiration of the grace period.7
The application of section 1272(a)(6)(C)(iii) to grace
period interest causes a taxpayer to recognize income in a
taxable year which it previously had deferred to the following
year, thus increasing the tax due. The application of section
1272(a)(6)(C)(iii) to other credit card receivables, such as
late-fee income, generally has the effect of deferring income to
later years which otherwise would be recognized in the year the
fee was charged to the cardholder. See supra note 4. Which
7
Petitioners treated COB’s and FSB’s 1998 and 1999 grace
period interest under sec. 1272(a)(6)(C)(iii).
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receivables are eligible for this treatment has been the subject
of contention.
Respondent has conceded that cash advance fees generally
increase OID under section 1272(a)(6)(C)(iii).8 See Rev. Proc.
2005-47, 2005-2 C.B. 269. When a cardholder repays the loan (the
amount of cash advanced), the cardholder will also pay the cash
advance fee. Thus, the SRPM is the amount of the loan plus the
fee. As the SRPM is greater than the issue price (the amount of
the loan), there is OID on the transaction. Before 1998
petitioners treated COB’s and FSB’s cash advance fee income as
increasing OID. For 1998 and 1999 petitioners continued to treat
cash advance fee income as increasing OID under section
1272(a)(6)(C)(iii). Respondent concedes this treatment is
proper.
Respondent has taken the position that overlimit fees paid
by a cardholder to a credit card company increase OID. Tech.
Adv. Mem. 2005-33023 (Aug. 19, 2005). Before 1998 petitioners
treated overlimit fees under the current-inclusion method.
Petitioners treated COB’s and FSB’s 1998 and 1999 overlimit fee
8
To treat cash advance fees as increasing OID, the taxpayer
must be able to demonstrate that the amount of the fee is
separately stated on the cardholder’s account and that the fee is
not charged for property or specific services performed by the
taxpayer for the benefit of the cardholder. Rev. Proc. 2005-47,
sec. 5, 2005-2 C.B. 269, 270.
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income as increasing OID under section 1272(a)(6)(C)(iii).
Respondent concedes this treatment is proper.9
In contrast to overlimit fees and cash advance fees, the
parties agree that annual fees may not be treated as increasing
OID under section 1272(a)(6)(C)(iii). Annual fees are charged to
the cardholder for all of the benefits and services available
under the credit card agreement, and not for any specific
service. Rev. Rul. 2004-52, 2004-1 C.B. 973. Therefore, annual
fees are compensation for services and not for the use or
forbearance of money. Thus, they are not interest and do not
increase OID.
Whether interchange increases OID under section
1272(a)(6)(C)(iii) is the subject of petitioners’ separate motion
for partial summary judgment which is still before the Court.
Petitioners treated COB’s and FSB’s 1998 and 1999 interchange
income as increasing OID under section 1272(a)(6)(C)(iii).
Respondent has taken the position that interchange income does
not increase OID. See Tech. Adv. Mem. 2005-33023 (Aug. 19,
2005).
Respondent has conceded that as a general proposition credit
card late-fee income may be treated as increasing OID on the pool
9
Although respondent has conceded petitioners’ treatment of
cash advance fees and overlimit fees is proper, respondent has
not conceded that petitioners correctly calculated the amount
includable.
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of credit card loans to which the income relates.10 Rev. Proc.
2004-33, 2004-1 C.B 989. From 1995 through 1999 petitioners
treated COB’s and FSB’s late-fee income under the current-
inclusion method. The issue in these motions is whether section
446(e) prohibits a retroactive change in the treatment of the
1998 and 1999 late-fee income from the current-inclusion method
to a method based on section 1272(a)(6)(C)(iii).
II. Section 446(e)
Section 446(e), at issue in this case, provides:
SEC. 446(e). Requirement Respecting Change of
Accounting Method.--Except as otherwise expressly
provided in this chapter, a taxpayer who changes the
method of accounting on the basis of which he regularly
computes his income in keeping his books shall, before
computing his taxable income under the new method,
secure the consent of the Secretary.
The purpose of the section 446(e) consent requirement is to
assure consistency in the method of accounting used for tax
purposes and thus prevent distortions of income which usually
accompany a change of accounting method and which could have an
adverse effect upon the revenue. See Commissioner v. O.
Liquidating Corp., 292 F.2d 225, 231 (3d Cir. 1961), revg. T.C.
10
To treat late fees as increasing OID, the taxpayer must be
able to demonstrate that the amount of the late fee is separately
stated on the cardholder’s account and that the late fee is not
charged for property or specific services performed by the
taxpayer for the benefit of the cardholder. Rev. Proc. 2004-33,
sec. 5, 2004-1 C.B. 989, 990.
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Memo. 1960-29; Casey v. Commissioner, 38 T.C. 357, 386-387
(1962); Wright Contracting Co. v. Commissioner, 36 T.C.
620, 634 (1961), affd. 316 F.2d 249 (5th Cir. 1963); Advertisers
Exch., Inc. v. Commissioner, 25 T.C. 1086, 1092-1093 (1956),
affd. per curiam 240 F.2d 958 (2d Cir. 1957). In part, the
consent requirement is also intended to lessen the Commissioner’s
burden of administering the Code. See Lord v. United States, 296
F.2d 333, 335 (9th Cir. 1961); Casey v. Commissioner, supra at
386. This Court identified the following as the policy reasons
served by section 446(e): “‘(1) To protect against the loss of
revenues; (2) to prevent administrative burdens and inconvenience
in administering the tax laws; and (3) to promote consistent
accounting practice thereby securing uniformity in collection of
the revenue.’” FPL Group, Inc. & Subs. v. Commissioner, 115 T.C.
554, 574 (2000) (quoting Barber v. Commissioner, 64 T.C. 314,
319-320 (1975)).
By requiring the taxpayer to obtain the Commissioner’s
consent before changing its method of accounting, section 446(e)
gives the Commissioner authority to approve or disapprove such
changes prospectively. This Court has stated that the
Commissioner also has discretion to accept or reject a request
for a retroactive change in a taxpayer’s choice between two
permissible methods of computing taxable income. See Barber v.
Commissioner, supra at 318.
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If the Commissioner, acting within his discretion, does not
consent to the taxpayer’s request to make a change in the
taxpayer’s method of computing taxable income, the taxpayer is
required to continue computing taxable income under the
taxpayer’s old method of accounting. See, e.g., United States v.
Ekberg, 291 F.2d 913, 925 (8th Cir. 1961); Schram v. United
States, 118 F.2d 541, 543-544 (6th Cir. 1941); Drazen v.
Commissioner, 34 T.C. 1070, 1075-1076 (1960) (and the cases cited
thereat); Advertisers Exch., Inc. v. Commissioner, supra at 1092-
1093. If the taxpayer changes the method of accounting used in
computing taxable income without first obtaining consent, the
Commissioner can assert section 446(e) and require the taxpayer
to abandon the new method of accounting and to report taxable
income using the old method of accounting. See, e.g.,
Commissioner v. O. Liquidating Corp., supra; Drazen v.
Commissioner, supra at 1076; Advertisers Exch., Inc. v.
Commissioner, supra at 1093.
In deciding whether to consent to a change of accounting
method, the Commissioner is invested with wide discretion. See,
e.g., Commissioner v. O. Liquidating Corp., supra at 231; Capitol
Fed. Sav. & Loan Association & Sub. v. Commissioner, 96 T.C. 204,
213 (1991); Drazen v. Commissioner, supra at 1076. In a case in
which the taxpayer has requested the Commissioner’s consent to
change methods of accounting, the Commissioner’s action in
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refusing to give consent is reviewed under an abuse of discretion
standard. See Schram v. United States, supra at 544; Capitol
Fed. Sav. & Loan Association & Sub. v. Commissioner, supra at
213; S. Pac. Transp. Co. v. Commissioner, 75 T.C. 497, 681
(1980).
In a case in which the taxpayer does not first obtain the
Commissioner’s consent, such as where the taxpayer attempts in a
court proceeding to retroactively alter the manner in which the
taxpayer accounted for an item on its tax return, the question is
whether the change constitutes a change of accounting method that
is subject to section 446(e). See S. Pac. Transp. Co. v.
Commissioner, supra at 682; Wright Contracting Co. v.
Commissioner, supra at 635-636; cf. Poorbaugh v. United States,
423 F.2d 157, 163 (3d Cir. 1970); Hackensack Water Co. v. United
States, 173 Ct. Cl. 606, 352 F.2d 807 (1965); FPL Group, Inc. &
Subs. v. Commissioner, supra at 573-575. If the change
constitutes a change of accounting method that is subject to
section 446(e), then the taxpayer is foreclosed from making the
change by section 446(e) and the regulations promulgated
thereunder without regard to whether the new method would be
proper. See S. Pac. Transp. Co. v. Commissioner, supra at 682;
Wright Contracting Co. v. Commissioner, supra at 635-636.
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III. Whether Consent Is Required Under Section 1272(a)(6)(C)(iii)
As a preliminary matter, the Court must address whether
taxpayers are required to obtain consent in order to change their
method of accounting to comply with section 1272(a)(6)(C)(iii).
Petitioners argue that Congress provided that a taxpayer did not
need consent to change its method of accounting to comply with
section 1272(a)(6)(C)(iii). TRA sec. 1004(b)(2) provides:
(2)Change in method of accounting.--In the case of
any taxpayer required by this section to change its
method of accounting for its first taxable year
beginning after the date of the enactment of this Act--
(A) such change shall be treated as initiated by
the taxpayer,
(B) such change shall be treated as made with the
consent of the Secretary of the Treasury, * * *
The Court must read this provision, which was not codified, with
section 446(e) and the regulations promulgated thereunder, which
require a taxpayer to secure consent before adopting a new method
of accounting by filing Form 3115 and setting forth the classes
of items that will be treated differently.11 Sec. 1.446-
1(e)(3)(i), Income Tax Regs.
Section 446(e) begins with the qualification: “Except as
otherwise expressly provided in this chapter”. Nothing in
section 1272(a)(6)(C)(iii) expressly provides that a taxpayer is
not required to receive consent to change its method of
11
Petitioners have not challenged the validity of the sec.
446 regulations.
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accounting. TRA sec. 1004(b)(2) was not codified and therefore
does not qualify as an exception to section 446(e).
Nevertheless, if that provision had been codified, taxpayers
would still be required to follow the applicable procedures in
order to effect a change in accounting method. Language similar
to that of TRA sec. 1004(b)(2) has been used in other provisions
of the Code. The manner in which taxpayers change their method
of accounting under those provisions informs the Court’s
interpretation of TRA.
Section 448(a) bars C corporations and partnerships if one
or more partners is a C corporation from using the cash method of
accounting. Exceptions apply to this prohibition. See sec.
448(b). For example, entities with annual gross receipts of $5
million or less may use the cash method. Sec. 448(b)(3), (c).
If section 448 forces a taxpayer off the cash method, such as a C
corporation that no longer meets the gross receipts test, the
mandatory adoption of another method (presumably the accrual
method) is a change in method of accounting generally requiring
consent. Section 448(d)(7) provides:
(7) Coordination with section 481.-- In the case
of any taxpayer required by this section to change its
method of accounting for any taxable year--
(A) such change shall be treated as initiated
by the taxpayer,
(B) such change shall be treated as made with
the consent of the Secretary, * * *
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Nevertheless, a taxpayer forced to change its method of
accounting under section 448 must still file a Form 3115 with its
return for the year of change. Sec. 1.448-1(h)(2), Income Tax
Regs. If the Form 3115 is not filed timely, a taxpayer forced
off the cash method must comply with the requirements of section
1.446-1(e)(3), Income Tax Regs., in order to secure the consent
of the Commissioner. Sec. 1.448-1(h)(4), Income Tax Regs.
Pursuant to section 1.446-1(e)(3), Income Tax Regs., a taxpayer
requesting to change its method of accounting is required to file
a Form 3115 during the year in which it intends to make the
change. In effect, the filing of a Form 3115 is a request for a
ruling from the Commissioner. Sunoco, Inc. & Subs. v.
Commissioner, T.C. Memo. 2004-29; see Capitol Fed. Sav. & Loan
Association & Sub. v. Commissioner, 96 T.C. at 211; sec.
601.204(c), Statement of Procedural Rules. The issuance of such
a ruling is a matter within the Commissioner’s discretion.
Capitol Fed. Sav. & Loan Association & Sub. v. Commissioner,
supra at 212.
Timely notification of an accounting method change prevents
the loss of tax revenue because the Commissioner may then ensure
that appropriate adjustments are made to the taxpayer’s taxable
income in accordance with section 481. Without notification, the
Commissioner would be unaware that such adjustments are
necessary. Furthermore, timely notification prevents
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administrative burdens and inconvenience in administering the tax
laws and promotes consistent accounting practice, thereby
securing uniformity in collection of the revenue. See FPL Group,
Inc. & Subs. v. Commissioner, 115 T.C. at 574.
Section 448 and the regulations promulgated thereunder
illustrate that when the law provides that a change is treated as
made with consent, the taxpayer must still comply with the
applicable procedures in order to effect the change. If the
taxpayer does not file a timely Form 3115, automatic consent will
not be granted. Sec. 1.448-1(h)(4), Income Tax Regs. It follows
that if the taxpayer files an incomplete or otherwise deficient
Form 3115, automatic consent will not be granted. This would be
especially true when the change in accounting method is more
complex than the change envisioned by section 448 (a change from
the overall cash method to the overall accrual method).
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 section 1272(a)(6)(C)(iii). See Rev. Proc. 98-60, 1998-2
C.B. 759. Failure to follow those procedures would negate
automatic consent to the proposed change.
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IV. The Meaning of “Item”
The parties dispute the meaning of “item” as it is used in
section 1.446-1(e), Income Tax Regs. Section 1.446-
1(e)(2)(ii)(a), Income Tax Regs., provides:
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. Although a method of
accounting may exist under this definition without the
necessity of a pattern of consistent treatment of an
item, in most instances a method of accounting is not
established for an item without such consistent
treatment. 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. * * *
The dispute arises because COB requested permission to
change its method of accounting for “interest and OID that are
subject to the provisions of section 1004 of the Taxpayer Relief
Act of 1997.” Petitioners contend that the relevant item is
interest, including OID, and by using that description COB
obtained consent to change its treatment of late-fee income, a
“component” of interest, including OID. Respondent contends that
the relevant item is late-fee income. Respondent further argues
that the description used by COB is ambiguous at best and that
because COB did not apply the OID rules to late-fee income on its
return for 1998 or 1999, COB did not obtain consent to change the
treatment of late-fee income. See infra V.
The meaning of “item” is also important to our discussion,
infra VI, regarding whether a change in the treatment of late-fee
-22-
income is a change in the treatment of a material item. See sec.
1.446-1(e)(2)(ii)(a), Income Tax Regs. Whether an item is
material is a question of timing, but before determining
materiality we must know which item to address, interest or late-
fee income.
Petitioners contend that the references to “item” throughout
section 1.446-1(e), Income Tax Regs., mean an “item of income or
deduction”. “Items of income” are listed in section 61. Under
petitioners’ theory, because item means item of income, under
Gitlitz v. Commissioner, 531 U.S. 206 (2001), the Court must look
to section 61 to determine what an item is. Petitioners give the
Supreme Court’s holding in Gitlitz far too much weight. Gitlitz
involved the effect of discharge of indebtedness income on the
basis of S corporation stock, not the ability of an entity to
change its method of accounting. The Court addressed the
Commissioner’s argument that the discharge of indebtedness of an
insolvent S corporation was not an “item of income”. Id. at 212.
To resolve the issue, the Court looked to section 61, which
provides that discharge of indebtedness is generally included in
gross income. Id. at 213. The Court did not address how narrow
an item of income may be or whether a specific type of discharge
of indebtedness is also an item under section 1.446-1(e), Income
Tax Regs.
-23-
The regulations promulgated under section 446(e) make
frequent reference to the broad term “item” and the narrower term
“material item”. “Material items” are necessarily a subset of
the broader group “items”. Courts have identified a variety of
“material items”, all of which are narrower than the broad items
of income listed in section 61. For example, courts have found
the following to be material items: (1) Commissions from a
particular insurance company, Leonhart v. Commissioner, T.C.
Memo. 1968-98, affd. 414 F.2d 749 (4th Cir. 1969); (2) the
treatment of automated teller machine replacement modules,
Diebold, Inc. v. United States, 891 F.2d 1579, 1583 (Fed. Cir.
1989); (3) gain from sales of automotive inventory, Huffman v.
Commissioner, 126 T.C. 322, 343 (2006), affd. 578 F.3d 357 (6th
Cir. 2008); (4) the treatment of natural gas as “working gas”
(inventory) or “cushion gas” (capital asset), Pac. Enters. v.
Commissioner, 101 T.C. 1, 23 (1993); (5) the treatment of costs
as a repair expense or as depreciable, FPL Group, Inc. & Subs. v.
Commissioner, 115 T.C. 554 (2000); (6) a change in depreciation
method resulting from a change from section 1250 property to
section 1245 property, Standard Oil Co. (Indiana) v.
Commissioner, 77 T.C. 349, 410 (1981); and (7) overburden removal
costs under section 616(a), Sunoco, Inc. & Subs. v. Commissioner,
T.C. Memo. 2004-29. See also sec. 1.446-1(e)(2)(iii), Example
(2), Income Tax Regs. (real estate taxes are a material item);
-24-
sec. 1.446-1(3)(2)(iii), Example (6), Income Tax Regs.
(allocation of overhead to value of inventory is a material
item). The preceding examples fall within the narrow group
“material items” and therefore must also be “items”.
An item under section 1.446-1(e), Income Tax Regs., may be
narrower than the broad items of income listed in section 61.
Whether particular income is an “item” under section 1.446-1(e),
Income Tax Regs., depends on all the facts and circumstances
surrounding that income. COB and FSB earned most of their income
from interest and items deemed to be interest for Federal tax
purposes.
A taxpayer is required to obtain the Commissioner’s consent
before making changes to the treatment of a material item used in
its overall plan of accounting. Sec. 1.446-1(e)(2), Income Tax
Regs. Under petitioners’ theory, because late-fee income, and
presumably other credit card receivables, are not “items”
themselves, but are merely components of the “item” of interest,
they would also not be “material items.” Consequently,
petitioners could make changes to these “components” of interest
without first receiving respondent’s consent.
Defining item in this way would severely undermine the
reasons for section 446(e). In 1998 and 1999 COB and FSB earned
late-fee income of $521,943,513 and $752,010,041. They earned
more in late-fee income than any other type of fee. In 1998
-25-
COB’s and FSB’s late-fee income accounted for approximately 22
percent of the gross receipts and 15 percent of the total income
reported on petitioners’ consolidated return. Late fees are
earned for reasons independent of the reasons other types of
income are earned, such as finance charges, overlimit fees,
interchange, and cash advance fees. Late fees are a separate and
distinct item of income. In this context, the Court holds that
the relevant item for purposes of section 1.446-1(e), Income Tax
Regs., is late-fee income.
V. Whether COB Received Consent To Change Its Treatment of
Late-Fee Income
Having found that the relevant item is late-fee income, we
must determine whether COB received consent to change its
treatment of late-fee income by requesting permission to change
its treatment of “interest and OID that are subject to the
provisions of section 1004 of the Taxpayer Relief Act of 1997.”
Petitioners argue the description is sufficient to obtain consent
to change COB’s treatment of late-fee income. Petitioners
further argue that since COB received consent, they may now fix
their error in failing to implement the change. Respondent
argues COB’s description of the item to be changed was ambiguous
at best and that because COB did not apply the OID rules to late-
fee income on its 1998 or 1999 return, it did not obtain consent
to change its treatment of late-fee income.
-26-
In response to the enactment of section 1272(a)(6)(C)(iii),
the Commissioner set forth the procedures by which consent would
be given to a taxpayer to change its method of accounting. Rev.
Proc. 98-60, 1998-2 C.B. 759. Specifically, a taxpayer was
required to file Form 3115 with its return. Id. COB filed a
Form 3115 which stated:
Capital One Bank (COB), a domestic corporation,
requests permission under Section 12.02 of Rev. Proc.
98-60 to change its method of accounting for interest
and original issue discount that are subject to the
provisions of Section 1004 of the Tax Relief Act of
1997.
Question 9 on Form 3115 states:
If the applicant is not changing its overall
method of accounting, attach a description of each of
the following:
a. The item being changed.
b. The applicant’s present method for the
item being changed. * * *
In response COB stated:
Question 9a
The taxpayer proposes to change its method of
accounting for interest and original issue discount
that are subject to the provisions of Section 1004 of
the Taxpayer Relief Act of 1997 (Pub. L. 105-34).
Question 9b
Credit card obligations are not currently
accounted for as required by section 1272(a)(6) of the
Internal Revenue Code. The taxpayer’s present method
of account[ing] for credit card obligations is to take
into account the differences between issue price and
stated principal amount upon origination in certain
-27-
cases. Cash advance fees are taken into account as
original issue discount.
In accordance with Rev. Proc. 98-60, app. sec. 12.02(a), COB
also stated:
Additional Requirements
Pursuant to Section 12.02 of Rev. Proc. 98-60, the
taxpayer makes the following representations. The pool
of debt instruments consists of all credit card
receivables held by the taxpayer. The proposed method
is to account for interest and OID as required by
Section 1272(a)(6). The prepayment assumption on the
pool is the actual rate at which payments occur on the
whole pool in the succeeding months. The amount of
grace period interest included is determined using the
same assumption used for book purposes. Cash advance
fees continue to be accounted for as original issue
discount.
The Form 3115 did not mention late fees. On petitioners’
consolidated 1998 return filed with the Form 3115, they treated
COB’s income from overlimit fees, cash advance fees, and
interchange as increasing OID on its pool of credit card loans
under section 1272(a)(6)(C). On their returns for 1998 and 1999
petitioners did not treat COB’s late-fee income as increasing OID
but instead continued to recognize late-fee income at the time it
was charged to the cardholder.
As discussed previously, the relevant item in this context
is late-fee income. Neither Rev. Proc. 98-60, supra, nor COB’s
Form 3115, nor petitioners’ 1998 or 1999 return gave any
indication that late-fee income would be treated as OID. The
language used in COB’s application to change its method of
-28-
accounting was ambiguous and vague. The ambiguities in COB’s
description of the item to be changed were clarified by the
treatment of the respective fees on petitioners’ consolidated
returns. The Court therefore finds that COB did not receive
consent to change its treatment of late-fee income for 1998 or
1999. In fact, by failing to mention late fees or to account for
late fees as OID on the returns for those years, COB did not seek
consent for the change.12 Even though petitioners began to treat
late-fee income as increasing OID with their 2000 return, they
made no effort to change their treatment of late-fee income for
1998 and 1999 until they filed a motion to amend their petition
in May 2006.13
12
Petitioners contend that if respondent did not consent to
COB’s 1999 request to change its method of accounting for late-
fee income, then that refusal constituted an abuse of discretion.
Because COB did not make clear to respondent that it was
requesting permission to change its method of accounting for
late-fee income, petitioners’ contention is unpersuasive.
13
Even if COB had been given consent to change its
accounting method for late-fee income with its 1999 return, the
Court doubts that COB would be entitled to correct its error in
implementation. By failing to implement the change and
continuing to treat late-fee income under the current-inclusion
method for 1998 and 1999, COB did not adopt the OID method for
late-fee income. The “error” petitioners would be attempting to
correct would be a total failure to implement the accounting
method, not a mere correction of an adopted method. It is
doubtful that such a correction would be permissible under sec.
446. See Standard Oil Co. (Indiana) v. Commissioner, 77 T.C.
349, 383-384 (1981) (although sec. 446 is inapplicable where
certain intangible drilling costs are treated improperly, sec.
446 may be applicable where all intangible drilling costs are
treated improperly). A correction of that nature would likely be
(continued...)
-29-
VI. Whether Recharacterization of Late-Fee Income as OID Is a
Prohibited Change in Petitioners’ Method of Accounting
Petitioners argue that if COB did not receive consent, it is
still entitled to change its treatment of late-fee income because
it is not changing its treatment of a material item and is
therefore not changing its method of accounting.14 See sec.
1.446-1(e)(2)(ii)(a), Income Tax Regs. We have determined that
the relevant item is late-fee income; now we must determine
whether a change in the treatment of late-fee income would be
material as that term is used in section 1.446-1(e)(2)(ii)(a),
Income Tax Regs. If the recharacterization of late-fee income is
material, petitioners will be foreclosed from making the change
by section 446(e) and the regulations promulgated thereunder
without regard to whether the new method would be proper. See S.
Pac. Transp. Co. v. Commissioner, 75 T.C. at 682; Wright
Contracting Co. v. Commissioner, 36 T.C. at 635-636.
A. The Regulations
Before a taxpayer changes its method of accounting, it must
secure the consent of the Commissioner. Sec. 446(e); sec. 1.446-
1(e)(2)(i), Income Tax Regs. The Code does not define the phrase
13
(...continued)
a prohibited change in method of accounting under sec. 1.446-
1(e), Income Tax Regs.
14
Petitioners’ motion applies only to COB, but their
argument on this subissue is equally applicable to FSB.
Respondent’s motion applies to both COB and FSB.
-30-
“method of accounting”. The Court has held that the phrase
includes “the consistent treatment of any recurring, material
item, whether that treatment be correct or incorrect.” See Bank
One Corp. v. Commissioner, 120 T.C. 174, 282 (2003), affd. in
part and vacated in part sub nom. J.P. Morgan Chase & Co. v.
Commissioner, 458 F.3d 564 (7th Cir. 2006); H.F. Campbell Co. v.
Commissioner, 53 T.C. 439, 447 (1969), affd. 443 F.2d 965 (6th
Cir. 1971). The regulations promulgated under section 446 state:
“The term ‘method of accounting’ includes not only the over-all
method of accounting of the taxpayer but also the accounting
treatment of any item.” Sec. 1.446-1(a)(1), Income Tax Regs.
Section 1.446-1(e)(2)(ii)(a), Income Tax Regs., provides the
following discussion of changes of accounting method:
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. Although a method of
accounting may exist under this definition without the
necessity of a pattern of consistent treatment of an
item, in most instances a method of accounting is not
established for an item without such consistent
treatment. 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. * * *
To determine whether late-fee income is an item “which involves
the proper time for the inclusion of the item in income” and,
hence, is material under the regulation, we must determine
whether a change in the treatment of late-fee income will change
the taxpayer’s lifetime income or will merely postpone or
-31-
accelerate the reporting of income. See Wayne Bolt & Nut Co. v.
Commissioner, 93 T.C. 500, 510 (1989) (“When an accounting
practice merely postpones the reporting of income, rather than
permanently avoiding the reporting of income over the taxpayer’s
lifetime, it involves the proper time for reporting income.”).
Petitioners seek to change COB’s and FSB’s treatment of
late-fee income from the current-inclusion method to a method
where late-fee income creates or increases OID on the pool of
credit card loans to which it relates. Treatment as OID would
reduce petitioners’ 1998 and 1999 late-fee income considerably.15
The reductions would result in corresponding increases in later
years. Petitioners would include all of the late-fee income
under either method; the only difference being whether the income
is recognized entirely in the year the fee is charged to the
cardholder or whether the recognition of income is spread to
subsequent years. The difference is a matter of timing.
Therefore, the proposed method constitutes a change in a material
item in petitioners’ overall plan of accounting and is a change
in method of accounting.
The regulations detail certain situations that are not
considered changes in method of accounting. Section 1.446-
1(e)(2)(ii)(b), Income Tax Regs., provides:
15
Petitioners claim the reduction would be $209,143,757 and
$219,698,496 in 1998 and 1999, respectively.
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A change in method of accounting does not include
correction of mathematical or posting errors, or errors
in the computation of tax liability (such as errors in
computation of the foreign tax credit, net operating
loss, percentage depletion or investment credit).
Also, a change in method of accounting does not include
adjustment of any item of income or deduction which
does not involve the proper time for the inclusion of
the item of income or the taking of a deduction. For
example, corrections of items that are deducted as
interest or salary, but which are in fact payments of
dividends, and of items that are deducted as business
expenses, but which are in fact personal expenses, are
not changes in method of accounting. * * * A change in
the method of accounting also does not include a change
in treatment resulting from a change in underlying
facts. On the other hand, for example, a correction to
require depreciation in lieu of a deduction for the
cost of a class of depreciable assets which had been
consistently treated as an expense in the year of
purchase involves the question of the proper timing of
an item, and is to be treated as a change in method of
accounting.
The term “mathematical error” includes errors in arithmetic;
i.e., “‘an error in addition, subtraction, multiplication, or
division’”. Huffman v. Commissioner, 126 T.C. at 344 (quoting
section 6213(g)); see also Repetti v. Jamison, 131 F. Supp. 626,
628 (N.D. Cal. 1955). Whatever “error” petitioners made in
treating late-fee income under the current-inclusion method in
1998 and 1999, it was not a mathematical error.16
16
Petitioners argue that they made a mistake of law by
failing to treat late-fee income under sec. 1272(a)(6)(C)(iii),
and that a mistake of law which affects the computation of a
deduction under an established method of accounting, is
“‘tantamount to a mathematical error.’” Standard Oil Co.
(Indiana) v. Commissioner, 77 T.C. at 383 (quoting North Carolina
Granite Corp. v. Commissioner, 43 T.C. 149 (1964)). COB did not
establish the OID method of accounting for late-fee income.
(continued...)
-33-
The term “posting error” means an error in “‘the act of
transferring an original entry to a ledger.’” Wayne Bolt & Nut
Co. v. Commissioner, supra at 510-511 (quoting Black’s Law
Dictionary 1050 (5th ed. 1979)). In support of their position
that section 1.446-1(e)(2)(ii)(b), Income Tax Regs., should be
broadly construed, petitioners cite N. States Power Co. v. United
States, 151 F.3d 876 (8th Cir. 1998). In that case, the court
held that the taxpayer’s failure to account for losses on nuclear
fuel contracts in the same way it accounted for coal and oil
losses was nothing more than a type of posting error. Id. at
884. The taxpayer, an energy company, was required by the
Federal Energy Regulatory Commission (FERC) to use a prescribed
method of accounting for book purposes. Id. The taxpayer’s tax
department was unaware that nuclear fuel losses were accounted
for as a portion of work order capital accounts under the method
prescribed by FERC. Id. Had the taxpayer’s tax department known
of the error, it would have been corrected; and nuclear fuel
losses would have been treated in the same way as losses from
other types of fuel. Id.
16
(...continued)
Therefore, there were no mistakes made under that method.
Furthermore, the Court in Standard Oil did not hold that the
taxpayer’s mistake was tantamount to a mathematical error. The
Court did so in North Carolina Granite Corp., a case which
analyzed the regulations prior to the 1970 revisions, which gave
consistency and timing considerations an important role. See
Huffman v. Commissioner, 126 T.C. 322, 342-345 (2006), affd. 518
F.3d 357 (6th Cir. 2008).
-34-
Petitioners’ error was not made in transferring late-fee
income from their financial accounting books to their tax books.
Petitioners were fully aware of the nature of late-fee income and
how it was accounted for under financial accounting principles.
Petitioners may not have been aware that late-fee income could be
treated as increasing OID under the new statutory provision, but
that is not akin to a posting error.
Because petitioners made neither a mathematical nor a
posting error and because a change in the treatment of late-fee
income is a change in the treatment of a material item, this
issue appears to be resolved in respondent’s favor. However, our
discussion cannot end here.
B. The Caselaw
This Court has previously noted that there appears to be an
incongruity between section 1.446-1(e)(2)(ii)(b), Income Tax
Regs., and “the proposition * * * evidenced by a body of caselaw
(including cases of this Court), that a taxpayer does not change
its method of accounting when it does no more than conform to a
prior accounting election or some specific requirement of law.”
Huffman v. Commissioner, supra at 352.
Petitioners use that body of caselaw to argue that a change
in the treatment of late-fee income is not a prohibited change in
method of accounting. Petitioners cite numerous cases that were
decided before the 1970 revisions to section 1.446-1(e), Income
-35-
Tax Regs. E.g., Beacon Publg. Co. v. Commissioner, 218 F.2d 697(10th Cir. 1955), revg. 21 T.C. 610 (1954); Potter v.
Commissioner, 44 T.C. 159 (1965); Wetherbee Elec. Co. v.
Commissioner, 73 F. Supp. 765 (W.D. Okla. 1947). These cases do
not address the consistency and timing considerations emphasized
in section 1.446-1(e)(2)(ii), Income Tax Regs. Therefore, their
weight is uncertain. See Huffman v. Commissioner, supra at 347.
The cases decided after 1970 on which petitioners rely are
Standard Oil Co. (Indiana) v. Commissioner, 77 T.C. 349 (1981),
and Gimbel Bros., Inc. v. United States, 210 Ct. Cl. 17, 535 F.2d
14 (1976).17 Petitioners equate the requirement of section
1272(a)(6)(C)(iii) with the elections made in those two cases, so
that deviation from the chosen method and subsequent adherence to
that method do not amount to changes in accounting method.
Petitioners’ argument fails for a number of reasons. First,
unlike the taxpayers in those cases, neither COB nor FSB adopted
the OID method with respect to late-fee income. Therefore, there
was no deviation from or subsequent adherence to the OID method.
Second, these cases raise the issue of what “item” is being
corrected. In Standard Oil and Gimbel Bros. the correction was
17
The Court notes that Gimbel Bros., Inc. v. United States,
210 Ct. Cl. 17, 535 F.2d 14 (1976), was decided by the Court of
Claims and is therefore not binding on this Court. Further, the
case analyzes and applies prior regulations in effect before
1970. The case is included because it was decided after issuance
of the regulations in effect in the instant case.
-36-
made to a component of the material item, not to the item itself.
In Standard Oil, the relevant item was intangible drilling costs
(IDC). The taxpayer, in error, failed to deduct certain
components of IDC, and this Court held that the retroactive
correction of that error was permissible. Id. The Court stated
the taxpayer’s “position constitutes an attempt to remedy its
failure to report similar items consistently under a fixed method
of accounting.” Id. at 383.
In Gimbel Bros., the taxpayer was a department store which
validly elected the installment method of accounting to report
its installment sales income. The taxpayer applied the election
to all installment sales except revolving or rotating charge
accounts. Id. The taxpayer subsequently attempted to change its
treatment of revolving charge accounts. Id. The Court held that
revolving charge accounts were a component of installment sales
and that therefore the taxpayer was correcting its error rather
than changing an accounting method. Id.
Petitioners analogize the components of IDC and the
components of installment sales income with the components of OID
(late fees, cash advance fees, overlimit fees, and grace period
interest).18 Petitioners’ analogy falls short of the mark. As
discussed above, late-fee income, not interest (including OID) is
18
Petitioners would also include interchange income as a
component of OID. Whether interchange income is properly treated
under sec. 1272(a)(6)(C)(iii) is still an issue before the Court.
-37-
the relevant item. Late fees are earned for a purpose
independent of the other components of COB’s and FSB’s OID. The
same cannot be said about the “other costs” the taxpayer in
Standard Oil failed to deduct. Those costs were expenses
incurred during the first phase of the construction of offshore
drilling platforms. Id. at 361. Costs for the other three
phases of construction and installation of the platforms were
deducted as IDC. Id. The four phases of construction and
installation were interdependent in a way that late-fee income
and the other types of credit card receivables are not. The same
can be said about the installment sales income the taxpayer in
Gimbel Bros. failed to treat consistently with the rest of its
installment sales income. All of the installment sales income
was earned in the same way, from the sale of goods on an
installment plan.
Finally, more recent cases of this Court hold that a
taxpayer does change its method of accounting when it changes its
treatment of an item in order to adhere to a method adopted
pursuant to a prior accounting election. These cases cast doubt
on Standard Oil Co. (Indiana) v. Commissioner, supra, and Gimbel
Bros. Inc. v. Commissioner, supra. See Huffman v. Commissioner,
126 T.C. at 353 (“We question whether there is vitality to the
notion that a taxpayer conforming to a required but theretofore
-38-
ignored method of accounting does not change its method of
accounting by so conforming.”).
In Sunoco, Inc. & Subs. v. Commissioner, T.C. Memo. 2004-29,
this Court held that a retroactive attempt to change treatment of
certain mining expenses would be a change in method of
accounting, and not a correction of an error, where the taxpayer
had knowingly and consistently, albeit improperly, capitalized
and amortized expenses that should have been included in the
taxpayer’s cost of goods sold. In First Natl. Bank of
Gainesville v. Commissioner, 88 T.C. 1069 (1987), a transferee
liability case, the transferee argued that the transferor’s
alteration of a LIFO inventory valuation procedure constituted
the correction of an accounting error and not a change in method
of accounting. The Court held that, although the alteration in
question may have constituted the correction of an error, it also
constituted a change in method of accounting pursuant to section
472(e). Id. at 1085. The Court added: “Where the correction of
an error results in a change in accounting method, the
requirements of section 446(e) are applicable.” Id.
VII. Conclusion
Neither COB nor FSB received consent to change its method of
accounting for late-fee income under section 446(e) in 1999.
They continued to treat late-fee income under the current-
inclusion method and did not deviate from that treatment until
-39-
the submission of their 2000 return. A retroactive change in the
treatment of 1998 and 1999 late-fee income is a change in the
treatment of a material item and is therefore a prohibited change
in method of accounting. The “error” petitioners attempt to
correct is neither a posting error nor a mathematical error, and
petitioners are not entitled to correct that “error” with
retroactive effect for 1998 and 1999 because to do so would be a
prohibited change in method of accounting. Accordingly, the
Court holds that petitioners’ requested recharacterization of
late-fee income is an impermissible change in method of
accounting under section 446(e).
To reflect the foregoing,
An order will be issued
denying petitioners’ motion for
partial summary judgment on the
late fees issue and granting
respondent’s motion for partial
summary judgment.