US Cost-Basis Reporting: Pay Up Now or Pay A Lot More Later

US tax experts are sounding a loud alarm bell for financial-firm clients this tax season. They had better be prepared to comply with the Internal Revenue Service’s new cost-basis reporting rules for debt instruments, or be prepared to face the music.

They won’t like the tune. The IRS will fine not only investors, but also financial firms — banks, broker dealers and fund managers for any miscalculations and erroneous reports, even if unintentional. The penalty could come to millions of dollars a year for a large bank or broker-dealer, should the US tax agency believe it was intentionally fraudulent.

Financial firms and investors evidently aren’t ready for what’s ahead, as suggested by requests sent to the IRS by two influential trade groups to delay the implementation date of its rules for simple debt instruments and options from January 1, 2014 to January 1, 2015 and for complex debt instruments from January 1, 2016 to January 1, 2017.

Two major trade groups, the Securities Industry and Financial Markets Association (SIFMA) representing broker-dealers and the American Institute of CPAs or US certified public accountants, have separately asked for a further one-year postponement of the rules on the grounds it will be operationally cumbersome for their members to implement. They are simply too complicated and even unclear at times, particularly when it comes to wash sales and market discount bonds. Wash sales refer to the sale and repurchase of an asset while market discount bonds are those purchased in the secondary market at less than par value.

“Two particular areas of concern to the AICPA are the inconsistency among brokers in reporting the disallowed loss from a wash sale and the fact there are different views among experts on how to properly account for market discount bonds that are not subject to the current inclusion election,” says the AICPA, the trade group representing tax preparers, in its March 4 letter to the IRS. Without clarification and consistency, discrepancies could easily crop up between what financial firms calculate and report as the correct cost basis of an account and what investors do.

“It is unlikely the IRS will extend the date further, so financial firms will need to have already begun to test their internal or external software packages,” cautions George Michaels, chief executive of G2FinTech, vendor of tax analysis and compliance software. “They won’t be able to meet the IRS timetable if they aren’t at that phase already.”

The January 1, 2014 date, a one-year delay from the original schedule, isn’t exactly the implementation date practically speaking. It reflects the timetable when cost-basis reporting rules became effective for simple debt instruments; any ones purchased after that date will fall under their jurisdiction. Banks, broker-dealers, fund managers and transfer agents are left with less than a year to make the necessary operational and technological changes so they can correctly calculate and report in 2015 the cost-basis of investors’ debt accounts for simple debt — an asset class the IRS defines as fixed rate debt with fixed maturity dates; fixed rate debt with alternative payment schedules; demand loans; and short-term fixed rate debt with original terms of more than a year.

The inclusion of debt accounts in cost-basis reporting rules represents the final implementation phase of mandates tacked on to a 2008 law — the Energy Improvement and Extension Act . The new rule became effective as of January 1, 2011 for equity accounts and January 1, 2013 for dividend reinvestment and mutual fund accounts. Complex debt instruments– variable rate debt; inflation indexed debt; and contingent payment debt — must be covered in January 2016.

Readiness for Uncommon Options

If financial firms thought meeting the requirements for equities, dividend and mutual fund accounts were hard, doing so for fixed-income instruments is far worse due to the number of variables involved. “There are hundreds of different types of debt. Investors can buy them at a premium or discount to face value, sell them before they mature, as well as instruct their brokers regarding certain elections that can affect when they are taxed on market discount and how it is computed,” explains Stevie Conlon, senior director and tax counsel at Wolters Kluwer Financial Services in Minneapolis, which offers the Gainskeeper Suite of applications for cost-basis reporting.” Just one change in any of those categories can result in a different figure — and increase the potential for error.

Options always sound ideal for investors. Not so for operations and technology specialists who must make the necessary adjustments to an array of front, middle and back-office applications such as order handling, portfolio accounting, securities master, customer account, tax calculation, investor reporting, and tax reporting. It doesn’t matter whether only a handful of the thousands of customers of a bank or brokerage purchase a particular type of debt instrument or make a rare choice on when interest is to be taxed or how it is calculated.

Financial firms must be ready for any election, however rarely used. And they must also have a “default” or backup decision in mind, should the investor not pick any of the available choices. The result: hundreds of permutations must be addressed. The IRS is allowing investors to select one of the following five ways to have the brokerage or bank calculate their interest payments for purposes of calculating the cost-basis of their accounts: amortize or not amortize bond premiums for taxable bonds, include accrued market discount in income, accrue market discount using constant yield method instead of straight-line method, treat all interest payments as original issue discount, or translate nonfunctional foreign currency interest income and expense at the spot rate on the last day of the accrual period or tax year.

Making the election process more difficult for financial firms to process is that they must take into account the possibility that an investor can change its mind or can make its choice at the end of a calendar year. In either instance, the financial firm will have to redo the cost basis calculations sent to investors and the IRS and resend both new tax documents.

Here is just one example provided by Michaels, showing just how mindboggling it can be to fulfill the calculations for cost-basis reporting of debt instruments: Presume an investor bought a bond at US$90, instead of its face value of US$100, and sells the bond at US$95 a few years later but before it matures. Before the IRS cost basis rules were adopted, a broker-dealer or bank merely had to inform the taxpayer that the proceeds from the sale were US$95. Under the new cost-basis reporting rules, the broker-dealer or bank must report to the IRS and the investor the following: the accretion of interest at say US$2 from the time the bond was bought to the time it was sold, the adjusted cost basis of US$92, and the sale proceeds of US$95. End result: the taxpayer must pay taxes on a long-term capital gain of US$3.

Even such a complicated scenario is simple as it does not incorporate wash sales or corporate actions and there are dozens of different types of corporate actions for bonds whose rules differ from those of equities.

Test, Correct, Test Again

For financial firms, installing a software package to make the calculations is just the beginning of the story. “They have to separate the debt instruments affected — or covered — by the January 2014 deadline from other debt instruments, and then ensure the accuracy of the reference data they have about the debt instruments before they can begin to make any cost-basis calculations,” explains Conlon. “Just one mistake on the terms of the debt instrument could lead to a bad calculation.”

Deciding which debt instruments are covered under cost-basis reporting timetable is also harder than it sounds. The IRS rules apply only to assets that are treated as debt for tax purposes. Back-office systems at banks and brokerages may classify preferred stock, exchange-traded notes and certain other structured products and derivatives as debt when they should be categorized as exempt from the cost-basis rules, says Conlon. Financial firms must also have more details about the affected bonds than what is typically stored in back-office systems. Case in point: the entire call schedule must be used when making cost-basis calculations, not just the next one.

Once the accuracy of all the data on hand is verified, only then can testing begin on the tax calculation engine. This presumes that the firm has already licensed either a third-party platform or upgraded an inhouse system. Most large banks and broker-dealers have chosen an external platform to reduce the time to market and cost, says Michaels — a stance confirmed by industry research reports.

Software firms that offer packages for meeting cost-basis reporting rules for equities, dividend reinvestment plans and mutual funds are also under the gun in terms of IRS deadlines for debt and options.. They claim to have already made or are in the process of making the necessary changes to accommodate additional asset classes, although it is unclear just how well each has managed the process. “Testing is needed to ensure the answers the software generates match up with those which the financial firm has calculated itself or hired an auditing firm to calculate,” explains Michaels, whose firm offers the TaxGopher cost basis reporting application for hedge funds.

That testing can’t be done overnight or even in a month. Hundreds of different scenarios must be played out. It is not enough to pick a random sampling of several dozen fixed-income instruments purchased and sold by investors to see if the software works. A financial firm might accidentally select the most popular choices made by investors on when they want to pay the tax and how it is to be calculated.

“Financial firms should worry a lot less about whether they can handle the common ones,” says Michaels. “They should focus their attention on the rare ones, because that is where the highest percentage of mistakes will likely occur.”

Financial firms which have chosen to upgrade internal tax engines rather install than a third-party system will have a higher risk of uncaught errors, insists Michaels. The reason: third-party systems developers have the advantage of multiple firms testing the same platform with various data sets.  With so many users testing with their own unique data sets, glitches in the calculation engine are more likely to be identified and corrected.

Making this more complicated is that mistakes may emerge from faulty reference or corporate actions data. Whatever the cause, it will come down to more labor in data correction or IT changes, and then further testing until the numbers come out right. Michaels recommends that all testing be completed before October 2014 at the latest for practical reasons. Financial firms typically shut down IT work in December, so they won’t have enough time to make any necessary changes before the calculations and reports are due to investors and the IRS.

The Previous Broker’s Data

Even if all goes well with a firm’s own procedures, one unforeseen shortcoming could come from the outside. Another firm might not be on the ball and send it the correct information for an account it is transferring over to the new firm. Investors do like to shift acccounts from one financial firm to another. When that happens, the original firm must forward the correct information on the investor’s account to the other. Ideally, they will transmit it in a standardized automated fashion, and not rely on email or fax which adds risk of human error.

The US market infrastructure Depository Trust and Clearing Corp. (DTCC) does provide such an automated platform, but officials were unavailable at press time to respond to any questions on the system’s preparedness to accommodate fixed-income instruments. Status of the DTCC’s Cost Basis Reporting Service (CBRS) aside, financial firms must still complete the documentation necessary for onboarding and test their connectivity, if they aren’t existing customers. Those which are using CBRS for other product lines will likely have an easier time adjusting for debt instruments, say tax operations specialists. However, financial firms may still be forced to reconcile information sent through the CBRS with that sent through fax or email. Discrepancies could occur due to different mapping codes or simple input errors.

The SIFMA made no mention of the DTCC’s CBRS in its October 2013 letter to the IRS, but wrote that it is concerned about how to interpret “customer elections” or decisions on how to tax debt accounts, when transferring customer debt accounts from one financial firm to another. As a result, SIFMA requested a one-year delay in implementing cost basis rules for such transfer reporting.

Based on SIFMA’s “literal reading” of the IRS’ rules, the transferee broker, or the financial firm receiving the account, cannot consider the customer election on the transfer document as valid. The reason: it didn’t obtain that information directly from the customer. Therefore, the transferee bank or broker-dealer must get yet another form signed by the customer on its election.

“We request that Treasury make clear in regulations or otherwise that upon receiving a transfer statement indicating that a valid customer election has been made, the transferee broker be allowed, but not required, to continue to treat the securities transferred as if a valid customer election has been made,” writes the SIFMA. “We would also note that a delay in the effective date of such guidance would be necessary in order to implement the systems changes and provide necessary client education.”

Regardless of how well financial firms prepare for cost-basis reporting rules for debt instruments, they will still have to prepare for the onslaught of customer inquiries and disputes, says Conlon. Some investors may decide to trust their bank or broker-dealers, while others may resort to doing the math on their own because they are ultimately on the hook for any errors made by their financial firms. If investors come up with different figures, they may want to battle it out with their financial firm and IRS as to which calculation is accurate. Likewise, should the financial firm fix the error and file a new tax form with the IRS, the investor will have to do so as well.

“To prepare for customer service questions financial firms need to begin training their customer service and support teams soon, so they will be ready to respond during the crush of the tax reporting and filing season,” recommends Conlon.