Cost Basis Regulations Q&A: Interpreting the Final Phase and Reflecting on Industry Impact


On April 18, 2013, the U.S. Internal Revenue Service (IRS) released Phase III of the cost basis reporting (CBR) regulations, completing the final stage for this regulatory initiative. Phase III outlines the mandates for debt instruments, options and security futures contracts, placing added burden on brokers as they work to meet their cost basis reporting obligations. Firms will now need to identify if an instrument is considered debt, categorize it as complex or non-complex, as well as apply certain CBR exclusions for specific areas of fixed income. Furthermore, institutions will be expected to determine if an option is on a narrow- or broad-based index, and that’s just the beginning of the confusion.

We spoke with tax experts Deanna Flores, Principal at KPMG LLP, and Job Dennison, Senior Vice President of Investment Reporting at Scivantage, to discuss the final regulations and interpret how these complex rules will impact the industry.

Q: Was there anything unexpected in the final regulations released by the IRS for Phase III of cost basis reporting?

Deanna Flores, KPMG: After reviewing the final IRS rules, it was clear that the regulators were listening to industry participants and seeking a solution that took into account their concerns. The framework for the final rules was very much in line with what we anticipated and matched the structure that was initially proposed during the planning stages.

Job Dennison, Scivantage: Further to Deanna’s point, while the final regulations are in line with what most of the industry anticipated, we have identified a couple unexpected requirements, including the specifics around customer elections. Most of the industry anticipated that this was going to default to the general standard, but this is not the case now, and firms need to explore how to take those elections into account based on the customer’s election when providing the required reports. Additionally, the extended deadline for transfer statement reporting was an adjustment from the original proposed rules.

Q: What drove the IRS to implement transfer statement reporting in phases?

Deanna: The preamble to the final regulations explained that in order to give brokers ample time to develop and implement reporting systems, the transfer reporting requirements, like the reporting requirements for debt instruments, will be implemented in phases. This is a good example of where the IRS listened to the industry and addressed their concerns to help minimize the impact of these final rules on the marketplace. Cost basis reporting is a complex task and the addition of fixed income and options to the reporting regime will inevitably create challenges for firms seeking to implement comprehensive systems solutions. Also, the new rules for accommodating customer elections added an unexpected wrinkle.

Q: How does this impact financial firms overall? Are firms well prepared and will the extended deadline be enough time?

Job: The addition of cost basis reporting rules has transformed the tax season into a year-long initiative. For firms that have adopted this mentality and engaged with a third-party expert to ensure compliance, the mandates will be manageable. We have been working with our clients to ensure everyone is as prepared as possible and created a smooth transition from each phase of cost basis reporting through our Maxit system. The extended deadline may be a nice cushion, but only for those firms that have already begun preparing for the final regulations. We’ve seen financial institutions struggle to meet the requirements for Phase I and II for cost basis and the issues can pile up quickly, creating a snowball effect and which can wreak havoc on their operations.

Deanna: When looking at firms across the industry, it’s clear some businesses were more proactive than others. This is a very complex set of regulatory obligations for firms to meet, and the final rules have added additional hurdles into the mix. Firms have a long list of new regulations to comply with and when there are extended deadlines, those projects may get shifted lower on their “to do” lists. However, with the clarity provided by the final cost basis regulations, institutions now know what is required of them and should move this regulatory obligation to the forefront and assess their current CBR compliance and systems. Firms should realistically evaluate how prepared they are and create a comprehensive plan, allocating the appropriate resources to achieve compliance ahead of the initial January 2014 deadline.

Q: From an operational standpoint, what do firms need to do to ensure they are compliant by the deadline?

Job: Data accuracy became a crucial focus with regards to getting clients’ cost basis information on time for filing taxes and this will continue to be the case. There needs to be an ongoing dialogue about cost basis in order to continue to educate the industry about the regulations and how to comply. The final phase has added on to the complexity of cost basis and from an operational standpoint, firms must ensure they have proper technology in place in order to achieve compliance. Cost basis data is extremely powerful and impacts various functions throughout an entire organization. As firms continue to face upcoming regulation deadlines, it’s become clear that CBR systems need to move beyond compliance to streamline operations and portfolio reporting and provide a value-add tool for institutions.

Deanna: The uncertainty about the final requirements previously weighed on the industry and any deadline always adds extra pressure. Businesses should make sure that they understand their obligations for cost basis reporting and create a plan of action to comply. The majority of the newly covered securities are extremely complex and classifying them for purposes of the staggered cost basis reporting effective dates will require deep technical tax expertise. Firms may consider leveraging outside tax experts or service providers, such as Scivantage, to streamline and improve their operations while controlling costs.

Q: What technology capabilities should firms look for in preparation to comply?

Job: Cost basis data can and should be leveraged as a value-add for firms. Having a flexible, fully-automated user-friendly system with real-time data is crucial when building your cost basis reporting compliance plan. More specifically, automating the complex tax reporting process has become increasingly important as 1099 volumes continue to grow, especially with the addition of fixed income and options.

Deanna: It takes specialized knowledge and sophisticated technology to properly comply with the cost basis reporting regime. Although larger broker-dealers may have built an in-house system for reporting on stock and mutual fund shares, we anticipate more of these institutions to consider outsourcing the task for fixed income and options to technology firms given the added level of expertise needed to fully understand and apply the rules within the looming reporting deadlines.

Q: Is there anything else in the final regs that firms need to think about over the coming months?

Job: The CBR regulations have been a dark cloud looming over the industry since the legislation was placed on regulators’ agendas in 2008. As institutions continue to peel back each layer of cost basis reporting regulations, there will be new challenges that will arise. Fixed income also has more taxable events than equities and firms should not under estimate the mandates the IRS has imposed on the industry. By planning early and engaging a third-party firm, institutions will be better equipped to comply and minimize the operational impact.

Deanna: I would echo Job’s comment, and highlight that it is also not too early to develop your communication plan. Similar to the earlier phases of cost basis reporting, complying with these rules will directly impact customers receiving IRS Forms 1099-B and customer-facing staff. A successful implementation should include a plan for informing customers and internal staff about cost basis reporting for fixed income and options and, to the extent possible, anticipating likely customer concerns.

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