subsidiary bank corporations (issuing banks) issued Visa cards 2 to customers who qualified for the cards.

To apply for a card, a customer would complete a credit card application at the branch office of an issuing bank. The issuing bank's credit department would review the application and decide whether to issue a card to the applicant and, if so, the amount of the credit limit for that account. Once the card was issued, the cardholder could use the card to charge the cost of goods and services provided by merchants who accept payment by Visa card (merchants). Cardholders agreed to surrender their cards upon demand, and petitioner could cancel their cards at any time for almost any reason.

Cardholders received new cards annually. If a card was lost or stolen, petitioner would replace it at no additional charge. If the card was stolen, petitioner would issue a new card, and the cardholder's liability for any charges resulting from the theft of the old card, if any, was limited to $50. If the cardholder had a problem with the quality of a product or service purchased with the card, under certain conditions, the cardholder may have had the right not to pay the remaining amount due on that product or service. The cardholder could deduct disputed amounts from the balance, pending resolution of the dispute, when calculating the minimum monthly payment due to petitioner.

A convenience user is a cardholder who uses the card to purchase goods and services, but pays off the entire balance each month, thereby avoiding any finance charges (interest). During 1980 and 1981, approximately 35 percent of petitioner's cardholders were convenience users. During the taxable years 1980 and 1981, the issuing banks charged those cardholders who did not pay off their entire balance each month interest at the annual rate of 18 percent on their outstanding (revolving) balances. This was the maximum rate allowed under Florida law.

Each merchant would submit its Visa sales receipts (sales drafts) either to the issuing subsidiary bank or to another bank with which the merchant had a Visa merchant account relationship (merchant bank); the merchant received pay

2 During 1980 and 1981, a small number of MasterCard credit cards were outstanding. For purposes of convenience we refer to Visa cards or just cards; however, all references to Visa or cards apply to both Visa and MasterCard credit cards. The proposed adjustment relates to annual fees charged to both MasterCard and Visa cardholders.

ment from the bank in the amount of the sales drafts less the applicable merchant discount.3 The merchant discount was equal to a set percentage of the total charges. Petitioner determined the merchant's discount percentage based on the merchant's projected annual sales and the estimated costs of the merchant's participation in the Visa program. If the merchant bank was not the cardholder's issuing bank, the merchant bank would sell the sales draft to the issuing bank through the Visa interchange; the amount paid by the issuing bank to the merchant bank was the amount of the sales draft less an interchange fee. The issuing bank charged the cardholder the full amount of the sales draft.

In 1980 and 1981, Barnett Credit Services, Inc. (BCS), a nonbank subsidiary of Barnett Banks of Florida, Inc., performed various services for the subsidiary banks, and hence for the cardholders and merchants, with respect to Visa cards: Card issuance, credit authorization, accounting, data processing, billing services, investigation of problem charges resulting from lost or stolen cards, and planning and marketing support functions. None of these functions was performed by the subsidiary banks themselves.4 BCS offered customer assistance 24 hours a day. BCS was a nonprofit center with respect to the subsidiary banks, passing on the costs incurred. The subsidiary banks paid BCS on a monthly basis according to a fixed schedule based on the type and number of functions provided.5 BCS also provided many of these serv

3 The sales receipts or sales drafts were treated like deposits of cash into the merchant's bank account, less of course the merchant discount.

4 BCS, in turn, contracted with National Data Corp. (NDC) to provide the credit authorization services to the banks' merchant clients. BCS charged the banks for this service at NDC's rates. 5 BCS charges the following fees to the banks (charges are per item (transaction) unless otherwise noted):

ices to banks other than petitioner's subsidiaries, but charged higher fees to the other banks. See supra note 5. BCS did not track costs by individual cardholder.

Beginning on October 1, 1980, petitioner started to charge each cardholder an annual membership fee (sometimes referred to simply as annual fee) of $15, irrespective of the cardholder's credit line, usage, or account balance, if any, carried over from month to month. At that time, petitioner's major competitors were charging between $15 and $18 for such annual fees. Normally, a customer could not become, or remain, a cardholder after October 1, 1980, without payment of the annual fee, although bank managers had discretionary authority to waive the annual fee for certain customers. Those cardholders who chose to discontinue use of their cards on or before October 1, 1980, were not charged the annual fee and could pay off their existing balances in accordance with their previous agreements; no replacement cards were issued to such discontinuing cardholders.

For the years involved in this case and for some further period of time after the fee was instituted, the annual fee was refundable to the cardholder if the card was canceled for any reason. The refund was a prorated amount of the annual fee, based on the number of months remaining in the 12-month period for which the annual fee was charged.

Also beginning in October of 1980, some new services for cardholders were added, which petitioner offered through the use of third-party providers. Petitioner provided loss-protection service whereby cardholders who lost their wallets or purses could notify the designated third-party provider, with whom they had listed all of their credit card accounts, and

this company would contact all the card issuers. Petitioner made available life insurance in conjunction with the use of the card to purchase an airline ticket. Similarly, rental car insurance was provided when the cardholder charged the rental to the card.

The amount of the annual fee to be charged was limited by competitive factors in the industry. The annual fee did not cover the entire cost of serving the cardholders. During 1980 and 1981, petitioner's revenue with respect to the credit card program derived from four sources: (1) Merchant discounts, (2) interchange fees, (3) interest charges paid by cardholders with outstanding (revolving) balances, and (4) the annual fees paid by cardholders. In 1979, the year prior to the institution of the annual fee, 66 percent of petitioner's Visa revenue came from interest charges, 33 percent from merchant discounts and interchange fees, and the remaining 1 percent from other sources. The issuing banks have never placed any restrictions on their use of the annual fees for any corporate purpose.

Usual Banking Practices

Under ordinary commercial banking practices, borrowers of money are charged interest based on the amount of money borrowed. Loan commitment fees are charged for the privilege of having a fixed sum of money available to be borrowed for a given period of time. The amount of a loan commitment fee is almost always based on the amount of credit made available.

The banking industry normally and customarily treats annual credit card fees as service income, not as interest or loan commitment fees. If annual fees were considered as interest and were then combined with finance charges on outstanding (revolving) balances, the total interest would have exceeded the maximum rate allowed under the usury laws of many States, including the State of Florida. There is no correlation between the amount of the annual fee and the amount of the cardholder's credit line or outstanding balance. Nor is there any commitment on the part of the issuing banks to make use of the card available for a given period of time, since the issuing banks may cancel the cards at any time.

For bank regulatory accounting purposes, banks are required to amortize the annual fees over the period to which the fees relate. These fees were excluded from the definition of finance charges under the Truth in Lending Regulations, 12 C.F.R. secs. 226.4 and 226.407, as in effect for 1980 and 1981.7

Petitioner's Accounting Method

For 1980 and 1981, petitioner's issuing banks recorded the annual fees in their books ratably over 12 months. When the annual fee was assessed, the issuing banks established a credit card receivable and made an offsetting credit entry to the deferred income account corresponding to the calendar month of the assessment. They then recognized the annual fees as income ratably over the ensuing 12-month period.8

For financial accounting purposes and bank regulatory accounting purposes, for the year 1980 and all years thereafter, petitioner ratably allocated its annual fees over 12 months. For Federal income tax purposes, for the taxable years 1980 through 1985, petitioner ratably allocated the annual fees over 12 months. Petitioner has maintained adequate books and records of the annual fees so that the amount deferred on its Federal income tax return for each of the taxable years 1980 and 1981 can be verified from such books and records.

Respondent determined that the annual fees assessed in taxable years 1980 and 1981 should be included in income in the year of receipt for Federal income tax purposes, and increased petitioner's income by $2,962,829 and $1,010,872, for 1980 and 1981, respectively. In addition, respondent adjusted petitioner's income for the taxable years 1976 through 1982 in accordance with a schedule of agreed adjustments executed by petitioner on April 12, 1993. Respondent allowed petitioner a net operating loss carryback from 1982 to 1980, adjusted the investment credit recapture for 1981, and recomputed the investment and other tax credits as well as the minimum tax for several of the taxable years from 1970 through 1982. Respondent's adjustments resulted in deficiencies in Federal income tax in the amounts of $1,299,

712 C.F.R. sec. 226.407 (1980) (special ed.) and 12 C.F.R. sec. 226.407 (1981) (special ed.). 8 In stip. 16 the parties have set out the details of this accounting system.