Delay in Final Phase of U.S. Cost-Basis Reporting Rules Isn't Panacea
An extra year to prepare for any new regulatory requirements sounds great.
Except when it comes to the final phase of the Internal Revenue Service's cost basis reporting rules, that is.
The U.S. tax authority wants financial firms which hold investor accounts to adjust for the cost basis for just about every fixed-income and option instrument under the sun.
Responses to the IRS' request for comments late last year on rules affecting debt and options accounts show that Wall Street has plenty of reasons to worry. Financial firms wanted an even longer delay than the IRS' new 2014 deadline and exemptions for some financial instruments. And for good reason.
Complying comes with some hefty data management and operational requirements. Building or licensing new tax accounting and reporting software won't cut it without the necessary data and proper testing of middle and back office systems that must be integrated with the core tax-related software.
"Planning development and testing of systems requires a minimum of 18 months lead time from the issuance of final regulations," say global custodian banks Bank of New York Mellon, State Street and Northern Trust in a joint letter to the IRS. They asked for a postponement of the rules for options to January 1, 2014 and for fixed income instruments to January 1, 2015.
Also seeking the same timetable were the Securities Industry and Financial Markets Association, the trade group representing broker-dealers, some individual broker-dealers and the American Bankers Association the trade group representing U.S. banks. The Financial Industry Forum, a New York based trade group specializing in data management and technology issues, didn't specify a timetable when it asked for its delay but cited similar reasons. .
The US tax authority appears to be taking the middle ground in deciding last week that financial firms can begin providing investors with the adjusted cost basis for accounts in options and fixed-income instruments purchased as of January 1, 2014, instead of January 1, 2013. But at least for now, it doesn't appear willing to make any further concessions when it comes to exempting some types of bonds from the roster of covered instruments. The proposed rules affecting fixed income and options accounts have not been finalized
The 2014 timetable represents the third phase of the rollout of the cost-basis reporting rules which initially took effect for equities purchased as of January 2011 and for mutual funds and dividend reinvestment plans as of January 2012. As of January 1, 2014 financial firms also be prepared to transfer that data to other firms should investors change the bank or brokerage firm holding their fixed-income and options accounts.
"The tax treatment for fixed-income instruments and options is quite different than for equities," explains Stevie Conlon, senior director and tax counsel in Bostson for Wolters Kluwer Financial Services which provides cost-basis reporting software. "It is uncertain whether all financial firms can find the data and adjust their tax accounting systems to make the more complex calculations in time."
In the case of equities, financial firms can rely on the price of the share when it was bought to come up with the adjusted cost basis. Not so when it involves debt instruments. Financial firms must make potentially complex cost basis adjustments that take into account the maturity of the debt instrument; how long it was held; the price at which it was bought and the call features. That data might be available from data vendors so it will likely already be found in the order management and portfolio accounting systems.
But that's the tip of the iceberg in the required data elements. Reference price; bond premium; original issue discount; market premium or discount; and the date of amortization or accretion of interest could also become important and if that information hasn't been made public by either the issuers of the fixed-income instruments or IRS publication 1212, operations executives better get ready to make lots of calls. Issuers aren't obligated to provide the cost-basis data the same way they are for corporate actions for equities. That's why the FIF and other firms asked the IRS for exemptions to the rules for some debt instruments -- such as contingent debt, foreign currency denominated bonds and some original issue discount bonds.
The transfer of cost basis information will also require firms to do a bit of systems changes to incorporate differences between how firms calculate amortization or accretion, warns the FIF. They might eed to go back to the original financial intermediary holding the assets to ask for extra data attributes for options or payment data for variable rate notes.
Preparing for the final phase of the cost-basis reporting rules is a double or even triple whammy for financial firms. They are still feeling the brunt of resolving any glitches in preparing new 1099B forms indicating the cost basis of equity accounts so they can do the same for mutual fund and dividend reinvestment accounts come the 2012 tax season. Several operations directors at broker-dealers contacted by www.iss-mag.com last week concede they are still fixing inaccuracies on the 1099B tax forms and dealing with confused customers wanting to know how to reconcile different cost basis calculations on those forms with ones they have to send the IRS separately.
Financial firms must take all the glitches into consideration in preparing the final touches on systems changes required to ensure the correct cost-basis for investments in mutual fund shares and dividend reinvestment plans. Last but not least, there are also new tax reporting and withholding requirements for U.S. persons living abroad looming on the horizon from a controversial piece of legislation coined FATCA; that's short for Foreign Account Tax Compliance Act.
In its letter to the IRS, SIFMA warned there might not be enough tax operations experts to go around. "There is limited expertise that can be tapped.. and the qualified personnel are the same ones working on [other legislation] such as FATCA," says the broker-dealer trade association.
As is typically the case with any regulatory change, the key to successful compliance with cost-basis reporting rules is preparing early. "Having an honest talk with your software provider as to when they will be ready to implement the new rules for fixed income and options instruments so that integration with internal applications and testing can be planned way ahead of time can go a long way to reducing errors which can often occur in last minute planning," says Cameron Routh, svp at Scivantage, a Jersey City, New Jersey firm which also offers cost basis reporting software.
Among the questions financial firms need to ask themselves to to assess just how prepared they are, says Conlon: do you currently perform basis adjustment calculations that take into effect the purchase price for each tax lot; do you calculate basis adjustments for municipal bonds and complex debt securities such as contingent debt or foreign currency denominated debt; are your calculations of basis adjustments for debt integrated with wash sales and lot relief; and does your system permit you to calculate cost-basis on any day of the year to support transfer reporting A tax lot generally refers to a quantity of securities such as 100 shares of stock acquired at the same day at the same price.
If the answer to any of the questions is no, the IRS' one year delay for implementing cost-basis reporting rules for fixed-income instruments and options might not be enough. Financial firms might just need to speed up the timetable for attacking how they will develop and implement systems requirements.
Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)