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Tuesday, February 18, 2025

Legislators Tell Credit Card Issuers to Stay Out of Merchant Tip Jars

Laws May Cut Tips And Taxes From Card Processing Fees
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For nearly 20 years, Andrew has worked for financial institutions ranging from regional investment organizations to some of the largest banks in the world. At Wells Fargo, Andrew was a Consultant within the Insight and Innovation division. A graduate of the University of Georgia’s Terry College of Business, Andrew’s goal has been promoting personal financial wellness and solid money decisions. As a Staff Writer for CardRates, Andrew seeks to inform readers of solutions to help them on their path to financial freedom.

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  • States have introduced legislation to restrict the fees merchants pay card issuers on the gratuity and tax portion of a customer’s bill.
  • Interchange on sales tax is relatively small on a per transaction basis, but it amounts to trillions of dollars per year in the aggregate.
  • Experts have opposing viewpoints regarding the viability of excluding gratuity and tax amounts from interchange charges.

The fees issuers charge merchants for processing credit and debit card transactions may be at risk, thanks to legislative efforts that seek to put restrictions on which portion of a card transaction issuers can extract fees from.

When issuers process a credit or debit card transaction, they charge merchants a fee, known as interchange. Issuers impose interchange charges based on the entire cost of a purchase, including any tips, gratuities, and sales tax. Interchange fees can vary based on factors such as the type of merchant where the purchase is being made and whether a cardholder’s credit or debit card was physically present at the time of the transaction. 

Issuers can use revenue collected from interchange charges to cover the expense of processing card transactions, but interchange revenue also helps issuers pay for the costs of managing rewards programs and combatting fraud.

The Illinois Interchange Fee Prohibition Act (IFPA), passed in 2024, aims to exclude the sales tax and gratuity portions of a credit or debit card transaction from interchange charges.

Initially set for a July 2025 start date, bank and credit union representatives have challenged different aspects of the Interchange Fee Prohibition Act in court, which has led to a temporary injunction that could delay the implementation of the law. But that likely won’t stop other states from trying to pass similar legislation.

Lawmakers in Maryland and Washington state have also introduced plans to prevent interchange charges on sales tax and gratuities. 

The Maryland legislature recently held a hearing to discuss legislation aimed at the issue. Doug Kantor, a member of the Merchants Payments Coalition and general counsel for the National Association of Convenience Stores, spoke at the hearing, highlighting the burden merchants face with interchange fees.

“The merchant collects sales tax for the state, but interchange is taken out of the amount on the receipt, which creates a shortfall the merchant must cover,” Kantor said at the hearing. 

Expect lawmakers in more states to introduce legislation similar to the Interchange Fee Prohibition Act if proposed bills in Maryland and Washington move forward. 

Relatively Small Fees Amount to Big Bucks

Interchange fees are relatively nominal, consisting of approximately 2% of a transaction’s total cost for a credit card purchase and even less for purchases conducted with a debit card. Gratuities and sales tax charges are often just a fraction of a transaction’s total cost. But interchange fees on even these fractional components can add up quickly for merchants who process hundreds or thousands of credit and debit card purchases daily.

A payments consultancy known as CMSPI estimates interchange paid on sales tax across applicable states. In 2023, merchants in Maryland paid more than $156 million in interchange on state sales tax. And in larger states such as California and Texas, the interchange merchants pay on sales tax extends into the billions, per CMSPI estimates.

If merchants are spending that much in interchange on sales tax, consider how much money businesses that call for a gratuity charge must pay on that portion of a bill. Sales tax rates vary by state, but even the most tax-happy states only impose sales tax rates in the single digits.

tipping guidelines
Source: UCLA’s Dashew Center for International Students and Scholars

According to UCLA’s Dashew Center for International Students and Scholars, tips to restaurant servers who provide standard service should start at 15% of the total bill, an amount greater than two or more times that charged on sales tax.

Issuers Mount Their Defense

With a significant amount of money at stake, it’s no surprise that legislators are encountering opposition in Illinois. Other states that seek to put guidelines on tax and gratuity interchange should also expect resistance from card issuers desiring to protect revenue.

So far, critics of interchange-restricting legislation haven’t focused their arguments on whether it’s fair to charge a merchant fees on money they don’t pocket. But some experts believe issuers have a reasonable chance of skirting interchange restrictions by arguing that they’re impossible to implement.

“The rails are not in place at scale to enable issuers to remove interchange fees from the tip component of a card transaction,” Oliver Pugh, Founder of payment processing platform Yetipay, told us. 

Kantor contested the veracity of that stance when speaking in front of Maryland lawmakers.

“The industry has admitted it can be done,” Kantor said. “Even a senior Visa executive told the Georgia legislature this can be done — he just didn’t see the value in doing it.” 

With big money at stake, the issue of whether merchants should be forced to continue to pay interchange fees on taxes and gratuities likely won’t be settled soon.

If issuers ultimately lose out on tax and gratuity interchange, they’ll be without revenue they’ve been accustomed to receiving. 

Card issuers must plan for how they’ll protect profits if lawmakers are successful in passing legislation that curtails interchange. These plans may include cost-cutting measures that change the credit card landscape, including increasing fees to cardholders and offering reduced rewards programs.