Sunday , December 8, 2024

The Prairie State’s National Challenge

What happens in Illinois won’t stay in Illinois, whose new law exempting merchants from card interchange on sales tax and tips poses a whole host of technical and operational questions for processors nationwide.

Bills that would exempt merchants from paying interchange on sales tax for credit card purchases have been bouncing around statehouses for years, while getting nowhere. But that losing streak came to an end in June when Illinois became the first state in the union to pass such a law.

The law, known as the Interchange Fee Prohibition Act, exempts merchants in the state from paying interchange on sales tax and gratuities linked to credit and debit card transactions. In exchange, the state will cap what merchants earn for collecting sales tax at $1,000 per month.

Prior to passage of the law, which goes into effect July 1, 2025, Illinois merchants were allowed to keep 1.75% of the sales tax collected per month as compensation for acting as agents of the state. The deal was reportedly one of the most generous sales-tax discount programs in the country for local merchants.

The bill was crafted as a compromise to enable merchants to recover lost revenues from that cap on what the state pays merchants to collect sales tax. For Illinois, capping what it pays merchants to collect sales tax, allows the state to effectively increase sales-tax revenues without a sales-tax increase.

Illinois legislators viewed the interchange exemption as an attractive proposal that would win merchant support for the bill, according to payments experts. Merchants across the country have been battling Visa Inc. and Mastercard Inc. for years over interchange rates, with the argument growing especially heated in recent years.

The cause of the acrimony isn’t hard to perceive. U.S. merchants paid more than $100 billion in interchange fees in 2023, according to the Merchants Payments Coalition, which lobbies on behalf of merchants on interchange and related matters.

But banks and the card networks aren’t backing down, and, while passage of the Illinois law was hailed nationwide by supporters as a win for Illinois merchants, the victory may turn out to be short-lived. As expected, several organizations representing banks and credit unions in August fired a salvo of their own challenging the new law.

Brought by the Illinois Bankers Association, the American Bankers Association, the Illinois Credit Union League, and America’s Credit Unions (formerly the National Association of Federally-Insured Credit Unions), the lawsuit was filed in the United States District Court for the Northern District of Illinois.

Such is the vital importance of interchange to card-issuing economics that rumblings to the effect that groups representing financial institutions and the payments industry would challenge the law in court began almost immediately after it was passed.

In the complaint, the plaintiffs allege that if the law is allowed to take effect it “would not only throw well-operating payment card systems into chaos, it would also undermine the significant benefits, safety, and security that payment card systems provide to all participants.”

The complaint also alleges that the law “usurps” the federal government’s regulatory authority over federally chartered financial institutions and runs counter to “multiple provisions” of federal and state laws that ensure a level playing field for financial institutions so that they are not treated “in a discriminatory manner.”

“Our membership collectively believes the law takes the wrong direction,” says Ben Jackson executive vice president of government relations for the Illinois Bankers Association. “Our members have given us a clear directive to overturn the law through legislative and other measures. The complaint, which speaks for itself, is one of those other measures.”

Rob Karr, president and chief executive of the Illinois Retail Merchants Association, which lobbied on behalf of the Interchange Fee Prohibition Act, said the lawsuit was expected.

“It’s no surprise credit card companies would do all they can to undermine this law and maintain their ability to unilaterally impose exorbitant processing fees on workers’ tips and taxes on consumer purchases,” Karr says.

Systemwide Upgrades

The driving force behind the legal challenge is that it creates a slew of issues with which card networks, processors, and software vendors must grapple, making it unlikely they will be able to implement the necessary technical changes in time to meet the law’s start date.

The most immediate problem is how processors will isolate sales tax and gratuities and securely exchange that data with merchants. As things have stood for years, merchants pay interchange on the transaction total, which includes sales tax and tips.

That means the message formats used by the card networks and processors do not pass this information as part of the transaction.

Breaking out sales tax and gratuities will require systemwide upgrades at the network and processor level, payments experts say. It’s also expected that software vendors will have to modify existing programs to calculate and break out such data from the total transaction amount.

On top of that, if a merchant’s point-of-sale terminal can’t accommodate the apps needed to comply with the new law, that seller will have to buy a new one unless it wants to manually provide the necessary documentation to the processor, experts say.

In the latter case, the law contains a provision that allows merchants to manually submit data within 180 days from the time of the transaction. Card issuers are required to refund to the merchant the total interchange paid on sales tax and gratuities.

Indeed, the technical challenge posed by the Illinois law flummoxes at least some payments-technology providers and experts who could face operating under one set of rules for 49 states and another set for Illinois.

“Currently, the payments ecosystem is not set up to handle the flow of sales tax and gratuity data from end to end for a transaction, and the technology to do it doesn’t exist, which means the true cost of implementation [is unknown],” argues John Romer, managing director for Prescentus LLC, a Nashville, Tenn.-based technology firm and regulatory consultancy to fintechs.

“If you don’t have sales tax and gratuity data flowing end-to-end, interchange can’t be calculated on the core transaction amount when the transaction is processed,” he adds.

In addition to the technology challenges, the deadline for compliance many observers consider the compliance deadline too short for such a complex undertaking.

“For simple updates, you can expect a 12-month timeline for implementation. For tech changes, 12 to 36 months, and that can stretch out years longer with deadline extensions,” Romer says. “Look at how long it took to roll out chip readers. There are still gas stations not compliant after years of deadline extensions.”

To date, the Electronic Transactions Association, whose membership includes payment processors, says it knows of no processor that is in a position to comply with the Illinois law.

“Legislation can pass easily, but that doesn’t mean anyone did a deep dive on what it would to make the change,” Romer adds.

‘A Herculean Task’

As if clearing those hurdles weren’t challenging enough, concerns are also growing that the law has opened a new front in merchants’ decades-old battle over interchange by providing to other states a blueprint for similar legislation.

Indeed, several states have unsuccessfully introduced legislation exempting sales tax from interchange on credit card purchases as a way to avoid penalizing merchants with fees for collecting sales tax.

Pennsylvania was the latest state to introduce such legislation. The bill stalled this year in the state’s House of Representatives before the legislature adjourned for its summer recess. It appears unlikely the bill will come up for a vote when the legislature reconvenes for its fall session in September, says Scott Talbott, executive president for the ETA, which lobbied against the bill.

The Pennsylvania bill may be stalled, but Talbott expects more states to introduce similar legislation. Prior to Pennsylvania, Florida and Texas weighed similar proposals in the past year, and Georgia last year introduced like legislation. About a dozen other states are reportedly considering similar bills, according to payments experts.

“The complexity of separating out sales tax alone creates an immeasurable hurdle, but many states tax different products, such as alcohol and tobacco, at different rates from staples such as food and gas, which create even more hurdles for implementation,” says Talbott. “Implementing this would be a Herculean task.”

If more states do introduce similar legislation, that would significantly widen merchants’ long war on interchange, a war that has extended to the national level.

In the latest battle, merchants are actively campaigning to enact the Credit Card Competition Act, a bill in the U.S. Congress that if passed would require financial institutions with $100 billion or more in assets to enable at least one network other than Visa or Mastercard for credit card processing.

In addition to facing legislative challenges to interchange fees, the card networks in June were dealt a blow in the courts when Margo K. Brodie, U.S. District Court Judge for the Eastern District of New York, nullified a proposed settlement of merchants’ years-old litigation with Visa and Mastercard over interchange costs. Brodie’s decision is expected to send the case to trial.

‘Unintended Consequences’

Despite claims the Illinois law would throw a massive monkey wrench into the payments ecosystem, merchants argue that processors can meet the compliance deadline. One reason is that sales tax is separated on purchases made with business-to-business cards, says Karr of the Illinois Retail Merchants Association.

“Scrutiny is going to fall on processors to make this happen as they are already doing it [for business transactions],” Karr says.

While it is true that processors can separate out sales tax for business transactions, that volume is modest compared to consumer payment card volume, points out the ETA’s Talbott.

“It’s difficult to extrapolate from a handful of [business] transactions to the broader consumer market,” Talbott says. “There are also a lot of other questions around the law, such as how will chargebacks and returns be handled, that need to be addressed.”

Indeed, the law would introduce a dizzying array of complexities, some experts contend. In a June article in the National Law Review, Howard Herndon, senior counsel for Womble Bond Dickinson LLP and managing director for Prescentus, a subsidiary of that firm, says:

“As written, [the Illinois Interchange Prohibition 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.”

Another gray area in the law is that a so-called entity, such as a processor, payments network, or financial institution, would be prohibited from using card-transaction data for any purpose other than processing the transaction. It is not uncommon for processors and other entities to use anonymized, aggregated card-transaction data for benchmarking, research, or other commercial purposes, but in Illinois, doing so would be a violation of the law, according to Herndon.

“Illinois legislators may not have intended the law to read this way, but that’s the way it does,” says Herndon. “There are potential unintended consequences in this law that lawmakers didn’t necessarily see.”

One way to clarify the gray areas would be to bring lawmakers and payments-industry stakeholders together to address perceived difficulties in the law and run a cost-benefit analysis, Herndon adds.

“This is a law challenged by the realities of an existing system, and it will require all parties to work together to ensure proper implementation,” he says.

‘A Layer of Complexity’

With the Interchange Prohibition Fee Act now facing a challenge in court, the chance of the two sides coming together with legislators to address their concerns appears unlikely. This is despite Illinois Governor J.B. Pritzker’s stated willingness to revisit the law, if need be, after the state legislature reconvenes in November, according to payments experts.

Until the lawsuit is resolved, or the Illinois legislature amends the law, the payments industry well beyond that state will have to live with the measure’s potential complexities and drawbacks.

“The idea, in theory, is great, but I doubt it will deliver the desired results,” says Michael Seaman, cofounder and chief executive for Swipesum, a Clinton, Missouri-based processor.

“I can confidently say,” he adds, “that the implementation is going to be challenging…[as] this unique stance by Illinois will create compatibility issues with global payment systems and add another layer of complexity.”

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