Introduction

Illinois has become the first state to adopt legislation banning interchange fees on the tax amount and gratuity (tip) amount of a credit or debit payment transaction. The Illinois Interchange Fee Prohibition Act (IFPA)ⁱ, expected to be signed into law by Illinois Governor J.B. Pritzker, prohibits the assessment of interchange fees on the portion of a card-based payment on the tax amount and gratuity amount of a transaction.

Over the last year Texas, Florida, and other states have been considering similar regulations regarding the assessment of interchange on sales taxes, but the Illinois legislature is the first to pass such legislation. General Counsel Doug Kantor of the National Association of Convenience Stores states that “Driving the trend is a realization that businesses shouldn’t have to reach into their own pockets to pay the swipe fees when they’re collecting money on behalf of others.”

For example, assuming a merchant’s interchange cost for a transaction is 3.25% and the sales tax on a $100 transaction is $7.25 using a sales tax rate of 7.25%, the merchant processing the transaction would subsidize about $0.235 of the sales tax since the full tax amount must be submitted to the taxing agency and the interchange is collected from the merchant. This cost reduces revenue margins and burdens the merchant with a portion of the sales tax that was paid by the customer initiating the transaction.

The IPFA act would require a way to break out sales tax in the transactions submitted to Visa, MasterCard, and the other card networks to provide the ability to separate the core transaction, sales tax and gratuity amounts to allow the assessment of interchange and processing fees. The current message formats used by the card networks and many other points of touch in the transaction do not pass this information from the start to the finish of the transaction, so updates to the technical specifications and systems are needed to facilitate the act’s provisions.

Since merchants may not have Point of Sale (POS) systems that support these capabilities, the IPFA has provisions for merchants that do not submit the tax or gratuity amount to submit tax documentation of the acquirer (the vendor that handles the merchant’s card payment transactions) to obtain a credit for interchange fees assessed on the full amount of a transaction that includes sales tax or gratuity amounts that are not broken out in the transaction.

The IPFA act provides significant penalties for not complying with its provisions. Each violation of the Interchange Fee Prohibition Act is “subject to a civil penalty of $1,000 per electronic payment transaction, and the issuer must refund the merchant the interchange fee calculated on the tax or gratuity amount relative to the electronic payment transaction.”

Background

Interchange fees are charged by card issuers to merchants for the privilege of accepting card payments. These fees are designed to cover the costs associated with processing transactions, mitigating fraud risks, and providing rewards and benefits to cardholders. Eliminating interchange fees on the sales tax portion would disrupt the issuer revenue model, potentially impacting the financial stability of card issuers and the services they provide and certainly imposing significant costs across the entire payment’s ecosystem to make the required change.

Interchange is a significant component of the fees assessed to merchants accepting Visa, MasterCard, and other card network transactions. These fees are assessed against credit, debit and prepaid card transactions, and typically range from 1.6% to 3.25% or more. Interchange rates for debit card transactions can be significantly lower than for credit card transactions. Interchange fees are collected by the merchant’s payment processor and paid to the issuer of the card by the card network that handled the transaction. The assessment of interchange fees on sales tax has garnered significant attention for many years, and one of the key arguments against it is that the merchant ends up subsidizing the amount paid to the levying tax agency for the amount of the tax that is assessed interchange.

While the elimination of interchange costs on sales tax seems like a fair practice for merchants, the implementation of the processing and support systems to make the changes and have an alternative refund process is complex and must be well considered before implementation to avoid significant unintended consequences. The solution will require support for new technologies to break out sales taxes in all the systems handling the transaction or provide an option for merchants to contact their processor for a refund of the collected interchange on the sales tax amount. This process is intricate, time consuming given the number of systems, organizations and processed involved, and involves multiple stakeholders that must work together to implement, test and certify the changes required to support the change to interchange calculations. The following sections aim to shed light on the challenges, costs, and potential implications associated with the act.

While the elimination of interchange costs on sales tax seems like a fair practice for merchants, the implementation of the processing and support systems to make the changes and have an alternative refund process is complex and must be well considered before implementation to avoid significant unintended consequences.

The Payment Ecosystem: A Complex Web of Participants

The payment ecosystem comprises a vast network of players, including merchants, payment processors, payment gateways, point of sale terminal vendors, cash register and point of sale software, mobile telephone applications, websites, check out carts, recurring transaction systems, card issuers, and financial institutions. Each entity plays a crucial role in facilitating seamless transactions, and any change to the existing system has far-reaching consequences.

The changes made to not assess sales tax begins at the initiation of the transaction, where amount fields containing the base transaction amount, sales tax amount, and gratuity amount must be incorporated in the software and streamlined prompting for terminals and appropriate APIs updated to collect the required tax and gratuity data and send it to the payment processor. The same types of changes need to be made to ecommerce systems, web payment pages, the APIs used to collect processing data, reporting systems, settlement and collection systems, and many other systems used by the merchant to process transactions.

Before the systems that collect the initial transaction have been updated, processors and software developers must develop plans to implement the changes, publish processing specification changes, develop internal capabilities (programming) to support the changes, and update documentation, testing systems, and certification processes to ensure the changes have been successfully made by the organizations handling the card payment transaction.

These changes to support not charging sales tax must start at the card networks, including Visa, MasterCard, American Express, and Discover. Each network has their own processing specifications, message formats, analytical and accounting calculation systems, and many other system modules that are used by payment processors and other organizations that connect to them. All system specifications must be updated and published, a process that is complex, resulting in risks that a critical system that will be impacted by the sales tax change will be missed and the end-to-end process needed to properly process the transaction and assess interchange will be broken.

Once the card networks publish changes outlining the changes to their specifications and systems, all the connected upstream organizations (card issuers, card processors, and more), and all downstream organizations (gateways, third party processors, payment processors, terminal software developers, point of sale system vendors, and everyone else impacted by the change must also make system changes to support the change. If any party in the payments processing chain has not made the required changes, or if an error in programming is made, merchants will be unable to successfully process transactions that do not charge interchange (by including the appropriate amount fields) on sales tax.

Technological Hurdles

Due to the complexities of the systems that handle card payments, implementing changes to eliminate the collection of interchange fees on sales tax portions will require a range of technological upgrades and modifications across the payment ecosystem. Payment processors, point-of-sale systems, and accounting software would need to be reconfigured to accurately calculate and separate sales tax from the total transaction amount.

The process of eliminating the assessment of interchange on sales tax amounts, and in Illinois on gratuities, will be complex and time-consuming, potentially taking several years to implement across the industry.

The process of eliminating the assessment of interchange on sales tax amounts, and in Illinois on gratuities, will be complex and time-consuming, potentially taking several years to implement across the industry. Similar changes to other processing requirements requiring changes across the entire payment processing infrastructure have taken 18 to 48 or more months. These changes must start with the card networks and work across the payment processing architecture to the payment gateways, point-of-sale systems, card acceptance terminals, card processors (card issuers), reconciliation, accounting, and reporting systems, and other tools supporting card payment transactions.

Cost Implications

The costs associated with such an undertaking are multifaceted and substantial. Payment processors and merchants would need to invest in upgrading their systems, which could run into hundreds of millions of dollars collectively. Additionally, card issuers may need to adjust their revenue models, potentially leading to increased fees or reduced benefits for cardholders. Merchants will need to update their terminals, point-of-sale (POS) systems and other tools to support the required changes.

While many merchants will be able to take advantage of a change in the assessment of interchange against sales tax through a software upgrade (which typically require a maintenance plan or update cost, there are merchant POS systems that are no longer supported by vendors, and these systems cannot be updated by the merchant. Even in 2024 there are POS systems that operate on the DOS operating system, a relic from the early days of computing. While these merchants could use a back-up refund process to be reimbursed, such a process would be burdensome, time consuming, and prone to error and fraud. The purchase of a new POS system could cost between $2,500 and $100,000 or more depending on the industry and processing environment(s) supported by the merchant.

Revenue Claw back Considerations

If a merchant uses an after-the-fact manual refund process to reclaim interchange paid on sales tax and tip amounts, there are several financial accounting considerations related to recorded revenue for card issuer, card processors, and merchant payment processors since interchange revenue for the transaction has already been recorded for the transaction. When a request to refund the interchange on sales tax and tips is made using a manual request, the processing systems need to be able to process a reimbursement request for the interchange.

There is no process in place today for such a reimbursement to occur, this event is not like a payment refund which can, for credit cards, result in interchange being returned to the merchant processor (and hopefully to the merchant). Refunds would not work since only the interchange is being requested, not a portion or entire amount of the transaction.

While there are card network-initiated adjustments that can be processed in the end-to-end card network system when interchange is not processed correctly, this adjustment process does not cover a scenario in which a merchant contacts their merchant processor to request a refund of interchange paid on sales tax since the merchant’s systems do not support the required capabilities to pass the data needed to correctly calculate interchange only on the purchase amount of the transaction, not the sales tax or tip amount.

Rewards Program Impacts

Cardholder reward programs are also impacted by an after-the-fact reimbursement of interchange. If the rewards calculation includes the tip and sales tax amount and no interchange is collected on these amounts, then the rewards system will need to be updated to reflect the appropriate tracking of incoming revenues and posted rewards to participating accounts. A reduction in interchange would most likely result in an adjustment to the rewards amount that is posted to the account.

For example, if a rewards program offers a 2% cash back reward and a $150 meal is purchased with an 8% sales tax and a 22% tip, then the total transaction amount, the total transaction amount would be $195.00. If rewards are paid on the total transaction amount, then the posted reward would be $3.90. Since no interchange is earned, the revised rewards program would likely only pay rewards on the base $150 purchase amount. The revised reward would be $3.00. The systems would need to be updated to reflect the revised calculation.

If the merchant does not have the appropriate processing capabilities to send in the tax and tip amount, then a manual refund request for the interchange would be needed. As with interchange refunds, there are no processes in place to claw back rewards that have been paid but should have been processed on the base amount of the transaction without tax or tip. A processing flow involving multiple partners would likely be required to allow a return of the rewards. Reward systems do reclaim rewards paid on transactions that are refunded, but with a manual interchange refund request the transaction is not handled as a refund, so most likely there is not an automated process to reduce paid reward amounts.

Regulatory and Legal Considerations

While the concept of eliminating interchange fees on the sales tax portion of purchase transactions may seem appealing from a consumer and business perspective, it is a complex issue that could face legal challenges and opposition from various stakeholders within the payment ecosystem. The Illinois IPFA act is one of several bills introduced by various states. As written, the act does not provide for the complexity of the implementation, the administration of the manual refund process, the protection against refund fraud, and the overall need to initiate such a process in a top-down process to ensure standards are updated, processes are outlined, and testing and certification processes are in place. Refunds across thousands and thousands of merchants cannot be supported in a cost-effective manner, and such processes penalize payment processors that do not benefit from the interchange nor the collection process.

As written, the act does not provide for the complexity of the implementation, the administration of the manual refund process, the protection against refund fraud, and the overall need to initiate such a process in a top-down process to ensure standards are updated, processes are outlined, and testing and certification processes are in place.

Fraud Opportunity

The elimination of interchange on sales tax and gratuities provides an opportunity for dishonest individuals and businesses to “game” the system for their gain, and the IPFA act provides no penalties for fraud and dishonest practices that could be used to unfairly avoid interchange or claim false interchange refunds. There are several ways the act creates an opportunity for fraud, including:

• Restaurants, salons, spas, and many other businesses have tipping and process gratuities as part of the transaction. Under the IPFA act, the gratuity amount would not be assessed interchange fees. Dishonest businesses could manipulate their processing to shift a greater portion of the transaction amount from goods or services to the gratuity amount, effectively reducing their payment processing costs by shifting more revenues to non-interchange assessed transaction amounts. While there would be “reasonableness” checks possible to detect issues, it would be relatively simple to shift 15% to 25% of a transaction value to a gratuity field in a payment transaction, resulting in a discounting of processing fees for portions of the transaction that should have been assessed payment fees.

  For example, a business that wants to reduce costs could shift 20% of a $150 transaction from the core transaction amount to a gratuity amount even when the actual gratuity was less than 20% or non-existent. Assuming a discount rate of 3.25%, shifting $30 of the example transaction to gratuity would reduce payment costs by $0.97, and changing their effect payment cost from 3.25% to 3.19% (assuming there was no legitimate gratuity). This practice would be an abuse of the intent of the act, but as with many processes, if there is an opportunity to exploit a weakness in the system, dishonest people will use the new no-discount provisions to their advantage. 
   

• Submitting false refund requests using a manual refund process creates an opportunity for fraud. Any process based on after the fact submission of records to claim refunds is subject to fraud abuse. While processors could implement “reasonableness” tests, such as ensuring the amount of the refund does not exceed the sales tax amount multiplied by the merchant’s discount rate, there are no systems in place in any segment of the payment processing infrastructure today that makes this information available to an agent that would process the refund. It also requires implementation of a sales tax rate tracking process, something that is certainly possible since taxes are calculated in the check-out process of a transaction, but these tax rate lookup systems are not part of any back-office process that could be used to confirm the refund request amount.

  Manual interchange refund processes create another opportunity to “shift” processing amounts from legitimate sales amounts to gratuity amounts to obtain a greater refund amount, as described in the prior issue. Customer service representatives handling a refund request would not be in a position to dispute such a dishonest claim for a refund.

Antitrust and Competition Concerns

One of the primary legal challenges to eliminating interchange fees on sales tax portions could stem from antitrust and competition laws. Card issuers and payment networks may argue that such a move would unfairly disadvantage them and disrupt the competitive landscape within the payment industry. The collection of interchange on taxes has existed for over 50 years, and changes to the processes, systems, and procedures handling billions of transactions and trillions of dollars in payment cannot be taken lightly and rushed without due consideration.

The collection of interchange on taxes has existed for over 50 years, and changes to the processes, systems, and procedures handling billions of transactions and trillions of dollars in payment cannot be taken lightly and rushed without due consideration.

The existing interchange fee structure is a carefully balanced system that enables card issuers to recoup costs associated with processing transactions, mitigating fraud risks, and providing rewards and benefits to cardholders. Eliminating fees on the sales tax portion could be perceived as an anticompetitive practice that undermines the ability of card issuers to compete effectively in the market.

Furthermore, payment networks and card issuers may argue that such a change would violate existing contractual agreements and disrupt the established rules and practices that govern the payment ecosystem. This could potentially lead to legal battles over breach of contract claims and challenges to the legality of the proposed changes.

Time Frame for Implementation

Given the complexities involved, the implementation of eliminating interchange fees on sales tax portions is likely to be a multi-year endeavor. Industry experts estimate that it could take anywhere from three to five years, or even longer, to fully implement the changes across the payment ecosystem. This timeline accounts for the necessary technological upgrades, regulatory approvals, and the coordination required among multiple stakeholders.

Processors could argue that they should not bear the cost of significant changes to systems that have been in place for half a century. Arguments can be made in a variety of ways challenging rapid changes to the tax collection process. These arguments could tie up any changes for a long period.

Estimated Costs

While precise cost estimates are difficult to determine due to the scale and complexity of the undertaking, industry analysts suggest that the total costs could range from hundreds of millions to upwards of a billion dollars or more.

Making some assumptions just for Illinois reveals some of the costs of implementing changes. There are more than 1,300,000 small businesses in Illinois. Assuming 50% of them accept card payments and 50% of them have POS terminals, there are 325,000 POS terminals that must be updated. For large retailers with multi-lane environments like supermarkets, there are likely another 1,000,000+ POS terminals that must be updated. Assume nearly 1,250,000 terminals must be updated. If each update costs $20-$35, the typical cost of updating a terminal based on time, implementation, employee expense, and vendor charges, then just this portion of the update would incur costs exceeding $43,750,000. These are just the terminal costs. The point of sale software of 10,000 to 30,000 or more businesses would need to be updated at some cost, and all other components of the payment infrastructure must be updated.

These costs would be borne by various stakeholders, including payment processors, merchants, card issuers, and potentially even consumers through increased fees or reduced benefits. There are likely a variety of unintended consequences that will also have some costs and impact to consumers, businesses, and the overall regulatory process.

Conclusion

Eliminating interchange fees on sales tax portions of transactions is a complex endeavor that would have far-reaching implications for the payment ecosystem. While the concept may seem straightforward, the implementation process involves significant technological, legal, and financial challenges. It is crucial for policymakers, industry stakeholders, merchants, consumers, and other stakeholders to carefully weigh the potential benefits against the substantial costs and disruptions that such a change would entail.

Howard W. Herndon is a Partner with Womble Bond Dickinson (US) LLP in the firm’s Fintech Practice. He focuses his practice on the electronic transaction industry. For over two decades, he has represented public and private payments companies in significant industry transactions ranging from US $100 million to over US $1 billion. He is also a Managing Director and Founder of Prescentus, a subsidiary of Womble Bond Dickinson (US) LLP that offers full-service strategic business guidance for Fintech companies.

John Romer is a veteran fintech professional with a broad knowledge of payment processing across many industry segments and serves as a Managing Director with Prescentus. He brings extensive experience advising retailers, restaurants and other merchants, as well as card networks, acquirers/processors, and related payment vendors.

References

ⁱ (a) An issuer, a payment card network, an acquirer bank, or a processor may not receive or charge a merchant any interchange fee on the tax amount or gratuity of an electronic payment transaction if the merchant informs the acquirer bank or its designee of the tax or gratuity amount as part of the authorization or settlement process for the electronic payment transaction. The merchant must transmit the tax or gratuity amount data as part of the authorization or settlement process to avoid being charged interchange fees on the tax or gratuity amount of an electronic payment transaction.

(b) A merchant that does not transmit the tax or gratuity amount data in accordance with this Section may submit tax documentation for the electronic payment transaction to the acquirer bank or its designee no later than 180 days after the date of the electronic payment transaction, and, within 30 days after the merchant submits the necessary tax documentation, the issuer must credit to the merchant the amount of interchange fees charged on the tax or gratuity amount of the electronic payment transaction.

(c) This Section does not create liability for a payment card network regarding the accuracy of the tax or gratuity data reported by the merchant.

(d) It shall be unlawful for an issuer, a payment card network, an acquirer bank, or a processor to alter or manipulate the computation and imposition of interchange fees by increasing the rate or amount of the fees applicable to or imposed upon the portion of a credit or debit card transaction not attributable to taxes or other fees charged to the retailer to circumvent the effect of this Section.

Section 150-15. Penalties. (a) An issuer, a payment card network, an acquirer bank, a processor, or other designated entity that has received the tax or gratuity amount data and violates Section 150-10 is subject to a civil penalty of $1,000 per electronic payment transaction, and the issuer must refund the merchant the interchange fee calculated on the tax or gratuity amount relative to the electronic payment transaction. (b) An entity, other than the merchant, involved in facilitating or processing an electronic payment transaction, including, but not limited to, an issuer, a payment card network, an acquirer bank, a processor, or other designated entity, may not distribute, exchange, transfer, disseminate, or use the electronic payment transaction data except to facilitate or process the electronic payment transaction or as required by law. A violation of this subsection constitutes a violation of the Consumer Fraud and Deceptive Business Practices Act.