The IRS released the final regulations for Phase III of cost basis reporting of debt instruments, options and single stock futures on April 18, and the tax profession is sorting out what the new rules mean and how they will affect firms and their clients.
This phase generally takes effect beginning Jan. 1, 2014, and is likely to be the most complex of the three phases to implement. More complex debt will be subject to reporting starting on Jan. 1, 2016. The rules require accommodating basis adjustment tax calculations for Original Issue Discount, bond premium and market discount that must be integrated with other basis adjustments for corporate actions and wash sales, as well as the lot relief rules for determining which positions are sold.
Job Dennison, senior vice president of investment reporting at Scivantage, a technology provider for the financial services industry, explained some of the implications of the new regulations.
“There is still some digestion going on,” he said in an interview Monday. “There are two or three points that really stand out as problematic for the industry as a whole and will take some doing to get implemented. One of the bigger things is the identification from a fixed income standpoint of covered versus noncovered. Initially, when they postponed back in 2012 from 2013 to 2014, the indication was that in 2014 it would be all in. All of the fixed income instruments were expected to would be covered. However, they backed off from that position, which is a bit of a mixed blessing, in the sense that they’re taking and categorizing the fixed income universe into simple to complex. Rather than looking at everything as covered, there are going to be subcategories of all the fixed income instruments into whether they are simple or complex. And everybody has to make sure that they have the data available to make that assessment and then indicate that to the cost basis processing engine.”
That could be a challenging aspect for cost basis reporting. “It’s not necessarily inherent in a back office system that you have that clear indication of what that particular fixed income instrument is and whether or not it falls into one category or the other right now,” said Dennison. “They’re going to have to work through that, and those of us who are providing cost basis processing will have our own set of work to do to make sure that we interpret that correctly and process it correctly from the standpoint of day-to-day transaction processing. That’s one of the key elements: basically having a really good taxonomy of the fixed income instruments, and understanding where they are simple or complex as described by the IRS.”
The dividing line between simple and complex isn’t so simple, though. “The main way I would characterize is whether it is consistently adjusted or does it have flexible possibilities in terms of adjustment to maturity. That really seems to be the deciding factor,” said Dennison. “Then there are certain fixed instrument with all entities and categories. There is a kind of laundry list of things we would consider less complex or more complex, things with stepped rates or convertible debts, anything making payments in foreign currency. There’s a large list of conditions essentially that will define whether it’s complex or not. The way I would characterize them is are you getting a fixed yield or fixed maturity? That’s seems to define simple. Anything that is not fixed yield or fixed maturity is complex. That’s a simplistic rule, but that seems to be the breakout to me.”
One of the other bigger surprises within the fixed income and options final regulations was the announcement that client elections would also be supported, according to Dennison. “That came out of the need to kind of balance if one firm was tracking client elections vs. another was not, and the transfer activity between those two firms, you would have inconsistency if you were not tracking that information," he said. "I think the IRS realized that we’re going to have to go all in on that as well. We’re going to need to support these market elections so that the adjustments are computed correctly for when transfers occur. That really came down to the requirement that all the cost basis systems will need to track this information, much like they do for the early release method for cost basis, first in first out, similar to the concept of tracking elections for fixed income instruments at the client level. What are the client elections and what are they selecting? We will ultimately capture that and produce the correct results based on that. But it does mean that now you’re not being expected to produce just one default result for reporting to the IRS. You’re going to have to produce whatever result based on whatever the election is. And that adds complexity and that is something people are probably maneuvering relatively quickly now to make sure that we can address by the 2014 implementation date.”