The Next "Taxing" Challenge of Cost-Basis Reporting: Fixed-Income Securities
The operations and IT departments of some of Wall Street's largest brokerages may have diligently spent the past two years preparing for the first wave of new so-called cost-basis reporting regulations from the U.S.' Internal Revenue Service but that won't be enough to get them through the next tsunami, say tax software experts.
The consensus: start preparing now or face the prospect of being caught flatfooted and subject to whopping penalties. Those penalties can easily range up to $3 million a year for filing incorrect tax forms with investors and the IRS.
"My concern is that financial firms are focusing their attentions on how to come up with tax reporting for equities and mutual funds, so they aren't paying enough attention to fixed income and options accounts," says a worried Stevie Conlon, tax counsel and director of Wolters Kluwer Financial Services' cost-basis reporting software Gainskeeper. "Tax accounting systems may not be coded to make the necessary calculations and firms might not have all of the necessary data easily accessible."
The IRS' well-publicized cost basis reporting rules became effective for U.S. equity securities purchased as of January 1, 2011 and for shares inn mutual funds purchased after of January 1, 2012. They will go into effect for fixed-income securities and options acquired as of January 1, 2013. The rules call for financial firms to calculate the actual cost of investors' accounts so they pay the appropriate income tax. Until recently, the IRS relied on investors to do the calculations on their own with the help of some broker-dealers, mutual funds, custodian banks and transfer agents who weren't legally required to do the work.
The IRS has come out with proposed regulations for cost-basis reporting for fixed-income securities and comments are due by February 18. Final regulations might not be issued until June at the earliest, leaving financial firms with just six months or even less time to make the massive array of changes to their front middle and back offices to account for the differences between equities and fixed-income instruments and options. That's a far cry from the eighteen months some operations specialists warn they could need to prepare.
In the case of equities, there are only a few thousawnd popular securities bought and sold by investors and there is plenty of available historical data to indicate how much they may have paid for them because they are exchange-traded. In the case of mutual funds financial firms were also gearing up for changes back in 2011 concurrent with their plans for equities. Financial firms also keep pretty good records on when clients purchased the mutual fund and what they paid for their shares. One of the biggest complications -- how to address the type of cost basis tax methodology clients may have wanted their broker-dealer, mutual fund or bank to use. The alternatives including first-in-first out; average cost basis and tax lot. The latter allowed them to select which of the lots of securities they wanted to select to sell so they could get the most favorable tax treatment. Yet another potential complication: complying with rules on wash sales.
That scenario contrasts vastly with the fixed-income and options market where there may well be hundreds of thousands of different instruments, each with their own attributes. The IRS has made very few exceptions to their cost-basis rules for fixed income instruments and options and even foreign debt instruments bought by US investors are affected. Financial firms are ill-equipped to make the necessary calculations. "It's not a matter of knowing when the investor bought the bonds and options and how much they paid," says Conlon." Financial firms may also have to take into account a number of features, including the maturity of the financial instrument, how long the investor holds it for and its call features. That is when the issuer of the securities has the right to redeem them and what price investors will receive when they tender them.
Some of that information may be held in a firm's order management and portfolio accounting systems, But making tax-correct cost basis calculations is an entirely different matter and easily prone to error. Only one wrong input or a mistake in the formula used under special tax rules that may differ from financial accounting rules and the cost basis figure will be incorrect.
Here are just three of the simplest examples of fixed-income securities which could easily generate errors in calculations:
1- An OID or original issues discount bond: This is a type of bond where the broker-dealer can calculate the difference between the issue price of the debt and the stated redemption price at maturity as an interest payment. Let's say it was issued at an original discount (OID) of $20 at an issue price of $80 and matures in 10 years; and it has a principal payment of $100. One might presume that when the investor sold the bond he or she would pay a capital gains tax on the difference between what was paid - $80 and what the bond was sold for $100 because the cost basis was $80. That would be wrong. The broker-dealer or bank is supposed to accrue the $20 of OID over a period of time and the investor should add the OID to the cost basis of the bonds. Just what should that timeline be? If the bond had a maturity of 10 years, then it should be ten years right? Again, under the new special tax rules this would be an incorrect assumption. The tax rules might require the OID to be accrued over five years if the bond has a five year call feature. If when the investor sells the bond after three years, the cost basis of the bond would be higher than if the OID had accrued over 10 years. The investor will include OID as if it accrues in taxable income. The investor would have capital gains or capital loss depending on the sales price for the bond compared to its adjusted cost basis.
2- A bond premium: In this scenario an investor has bought a bond at a price in excess of its principal amount. Lets assume the investor has paid $103 for a bond that pays $100 at the time it matures. The cost basis is not $103 or $100. The proposed cost basis regulations require that the cost basis be reduced over time by amortizing the $3 bond premium over the remaining term of the bond. So if $1 had been amortized over time and the investor sold the bond at $104, then the investor could have a $2 capital gain because the cost basis has been reduced from $103 to $102.
3- A market discount bond: Under this situation an investor has bought a bond at a price below its stated redempton price or its adjusted issue price (if it is an OID). So let's say an investor bought a $100 bond issued at par for $95. The $5 discount is called the market discount. The proposed regulations require brokers and other financial intermediaries to accrue the $5 market discount over the remaining term of the bond and track it. Assume that after the $2 market discount has been accured the investor sells the bond for $98. The investors cost basis remains at $95. Does the investor then have a capital gain of $3 because it received $98 and the cost basis was $95. That sounds logical but isn't the case. The answer: the investor has $2 of ordinary income and $1 of long-term capital gain. In 1993, Congress extended the market discount rules to tax-exempt bonds.
So what should a brokerage firm do? Conlon recommends that at the very least it reengage the same team which helped prepare for cost-basis reporting rules for equities. That team consists of representative from operations, technology, product managment and compliance. Waiting until the IRS comes up with final guidelines cuts it far too close for comfort. "It will take a lot more than just a few months to get ready and the rules are far more complicated to follow than what the IRS has planned for equities," says Conlon. “That is why Congress left them for last when they wrote the law requiring cost-basis reporting"
Nico Willis, president of Networth Services, a Phoenix-based firm also offering cost-basis reporting software, says that financial firms will need to quickly coordinate with their tax-accounting systems provider to ensure its engine has been correctly coded to do the necessary work. "Many large broker-dealers will likely try to adapt proprietary platforms but those using third-party systems should be able to rely on their software vendor to do any upgrades," he says.
That doesn't mean that the firm should depend entirely on the good graces of its software provider to comply with the new rules. It should ensure the vendor is ready by September so that they can have sufficient time to integrate any upgrades with back-office systems and spend at least a month testing whether the software generates accurate calculations using dummy data.
A report issued late last year by Celent, a New York-based research firm cites Networth Services as being ahead of the pack of software firms prepared for the cost-basis reporting rules for fixed income securities which should give it a competitive advantage. The report cites Wolters Kluwer as having the most diverse set of discount and full-service broker-dealers as well as hedge funds and mutual funds as clients. Wolters Kluwer's GainsKeeper tax reporting engine is also offered as four applications each of which caters to a specific target market.
As is often the case with regulatory change, technology alone isn't a panacea. Financial firms must also train their call centers to prepare for calls from confused investors in the spring of 2014 when they receive their first 1099s reflecting the cost basis of fixed-income securities. In helping customres understand the new cost basis accounting rules for fixed income securities and options, firms will also likely have to change customer reports to provide specific details for OIDs, bond premiums and market discounts.
Six Customer Questions Firms Need to Answer
Technological upgrades are just the tip of the iceberg financial firms must prepare for when complying with the Internal Revenue Service's requirements they calculate the cost of investors' fixed-income and option accounts. Customers are likely to be plenty confused about how the complex new rules work. Willis has come up with the six questions they are most likely to ask and the answers they can provide.
Question: Why will only some of my bond trades fall under the cost-basis reporting rules?
Answer: Fixed-income securities purchased after January 1, 2013 are considered "covered" securities. Prior to the legislation mandating cost-basis reporting adopted in 2008, the investor was solely responsible for reporting cost basis information to the IRS when he or she sold the securities in a taxable account. Although the responsibilities of investors have not changed, we will now track and report on Form 1099B the cost basis on "covered" securities sold after January 1, 2013. Investors are always responsible for accurately reporting cost basis information on tax returns and should always keep copies of trade confirmations and statements to accurately calculate the cost-basis.
Question: What will exactly be reported on the 1099 form for the "covered" bond trades I made in 2013?
Answer: If a debt instrument is acquired on or after January 1, 2013, our firm will be required to determine and account for original issue discount, bond premium, market discount and principal payments to determine the adjusted cost basis of the debt instrument and what if any gain or loss is short term or long term. Our firm will also be required to report the amount of any market discount that has accrued as of the date of a sale or transfer of a debt instrument.
Question: If I sold my bonds before the next payment date where do I find information on acrrued interest?
Answer: For each sale of a fixed-income security prior to maturity our firm will show separately on Form 1099 the amount of accrued and unpaid interest as of the date of sale. This information must be reported by the investor as interest (but not the amount of any market discount on a noncovered security or original issue discount). Such interest information must be shows in the manner and over the time required by Form 1099.
Question: How are you reporting accrued market discount?
Answer: Our firm will report the amount of market discount that has accrued on the debt instrument as of the date of the sale. We will compute the accruals of market discount by assuming the investor elected to use the constant interest rate method for the taxable year in which the client acquired the debt instrument.
Question: How are you reporting original issue discount bonds?
Answer: If a debt instrument is subject to the original issue discount rules, our firm will increase the investor's cost basis in the debt instrument by the amount of original issue discount reported to the investor for each year the debt instrument is held by the client. If the debt instrument is tax-exempt our firm will increase the investor's cost basis by the amount of the original issue discount that is accrued by the debt instrument while held by the investor.
Question: How are you reporting bond premiums?
Answer: If the debt instrument is subject to bond premiums, our firm will decrease the investor's cost basis in the debt instrument by the amount of bond premium allowable to the period the debt instrument is held by the client in the account. In the case of a taxable debt instrument we will compute any basis adjustment for the bond premium by assuming the investor elected to amortize the bond premium for the taxable year in which the invsetor acquired the debt instrument and that such an decision remained in effect for all subsequent years.
Written by Chris Kentouris, Editor-in-chief. (Chris can be contacted through Chris.Kentouris@hotmail.com).
