Phase 3 Cost Basis Reporting: Top Challenges for Brokers

Stevie_Conlon_updateGuest Contributor: Stevie Conlon, Senior Director & Tax Counsel, Wolters Kluwer Financial Services

Meeting the upcoming tax reporting requirements for the last phase of the cost basis law likely requires significant system overhauls for all brokers. Phase 3 debt reporting requirements present the most difficult system and tax data challenges yet. Given the complexity of calculations for debt required under Phase 3, firms that have not started developing these rules may be at risk of not meeting the Phase 3 requirements on time. Significant financial penalties could result from failing to meet these requirements.

On April 17, 2013 the IRS released final cost basis reporting regulations outlining the requirements for Phase 3 covered securities – debt instruments and options. Most of these go into effect on Jan. 1, 2014 (although basis reporting for complex debt begins on Jan. 1, 2016) and introduce significant additional reporting responsibilities and requirements for brokers.

The challenges brokers face are daunting. They must quickly learn complicated and specialized tax rules for different types of debt instruments, some of which seem contrary to financial modeling and current practices. They must then develop or test cost basis software that has to perform the calculations and provide understandable client reporting and customer support. Brokers must also assess whether their existing system and vendors are capable of performing the required calculations. And they must do all of these things while managing cost-cutting mandates and larger operational and technology system goals. Unfortunately, the failure to timely comply with the new tax rules and meet the upcoming reporting deadlines could be catastrophic, particularly considering the reputational and financial penalty risks.

Here are the top challenges brokers face in Phase 3 compliance:

1.   Fixed income segregation. Brokers will have to adequately segregate all debt, options, and structured products/investment units in order to apply the proper tax rules for computing basis and holding period for basis reporting purposes. Brokers will incur significant tax penalty risk if calculations are not made correctly or if incorrect cost basis is reported on Form 1099-B.

 Data requirements of the tax rules. In order to apply the proper tax rules, brokers will have to obtain information about the classification and data attributes of debt instruments and options which is likely beyond what is currently available in existing operating systems.

3.   Special calculations for debt. Corporate actions and wash sales are just a couple of the many factors that have to be taken into consideration when calculating debt. The rules and requirements generally used by portfolio systems or financial analysts will not be adequate for analyzing and calculating complex basis adjustments for debt instruments relating to the time value of money. Brokers will have to develop or obtain expertise and systems capable of making these special required calculations.

 4.   Customer elections. The new regulations require brokers to obtain direction from customers as to which of five different elections are to be used in calculating their cost-basis adjustments for debt. Systems must be able to accommodate ten different possible customer elections that relate to these special tax calculation rules. Brokers will have to be able to effectively communicate these choices to customers and electronically capture their elections.

5.   Events and corporate actions affecting debt. Correctly determining the impact of corporate actions and other events affecting the basis and holding period of transformed debt securities can present special challenges. In addition, tender offers, consents, and other changes to the term of a debt instrument may affect basis, holding period, or trigger basis reporting. Reorganizations and workouts pose additional challenges.


Attend CAPCon New York on October 9, 2013 to hear more from Stevie Conlon of Wolters Kluwer.   Leading corporate action experts will discuss key issues such as corporate actions data, leveraging emerging partnerships among corporate actions vendors, and keeping up with the latest pitfalls and benefits to adoption of ISO 20022.  Stevie Conlon will be featured on the session Staying Focused on Ops Issues When Dealing with FATCA and CBR.

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