COST BASIS: PHASE III IMPLEMENTATION

A Guide To Understanding and Successfully Meeting Its Challenges

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COST BASIS: PHASE III IMPLEMENTATION

OverviewOn April 18, 2013, the U.S. Treasury Department and IRS released the final regulations for cost basis reporting of debt instruments and options. This is the third and final implementation phase of the cost-basis reporting law, contained within the Energy Improvement and Stabilization Act of 2008. These Phase III final regulations* will begin to take effect on January 1, 2014.

There is no longer any reason to wait to devise and put in place sound compliance solutions and secure or build, test, and refine systems in preparation for complying with this most complex and challenging phase of cost basis reporting law implementation. The issuance of the Phase III regulations was effectively the starting gun for the hard work broker-dealers have ahead—particularly as they simultaneously prepare for compliance with the January 1, 2014, implementation of the Foreign Account Tax Compliance Act (FATCA). Read our white paper on FATCA to learn more. (broadridge.com/taxreadiness)

To help organize your thinking about how best to meet Phase III cost basis reporting challenges, we focus here on:

• Lessons learned from Phases I and II implementation

• Considerations for Phase III compliance

• Important features of the final Phase III regulations

• Keys to successfully meeting Phase III challenges

Phase III implementation—that is, accurately arriving at and reporting cost basis for covered debt instruments as well as cost basis and gross proceeds for options—will involve much more complexity and many more challenges than did complying with Phase I or II regulations, due to the inherently more complex nature of debt vs. equity securities.

The degree to which brokers, trust companies, and other securities custodians found it challenging to comply with Phases I and II of the cost basis reporting law had much to do with the extent to which they had acquired adequate knowledge and completed sufficient compliance-preparation work in advance of scheduled implementation. In addition, the costs of compliance for Phases I and II were exacerbated by false starts toward flawed or failed solutions, reflecting inadequacies in expertise, misjudgment of capability gaps and solutions, and/or sub-par systems.

*You can also read the final Cost Basis Phase III regulations at:

federalregister.gov/articles/2013/04/18/2013-09085/basis-reporting-by-securities-brokers-and-basis-determination-for-debt-instruments-and-options

Phase III implementation of the cost basis reporting law will involve more complexity than Phase I or Phase II.

Cost Basis Reporting Law Implementation Schedule

Phase I Equity Securities: 1/1/2011

Phase II Mutual Funds and Dividend Reinvestments: 1/1/2012

Phase III Debt Instruments and Options: Phased Implementation

• 1/1/2014 or 1/1/2016 (Debt and Options)

• 1/1/2015 or 1/1/2017 (Transfer Statement Enhanced

Information Requirements)

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COST BASIS: PHASE III IMPLEMENTATION

As Glen Bover, Vice President of Broadridge Tax Services recently noted, “Beyond understanding the content of the regulations, you need to also understand how trades and related activity are executed within your platform. This was a real ‘get your hands dirty’ type of process, so if your uniform didn’t have grass or mud stains when the tax season began, chances are you really didn’t know how your basis and reporting platforms were going to work together.” Successful firms will heed the lessons of Phases I and II: Climb the knowledge curve thoroughly and fast; determine your internal capability strengths and gaps; engage the outside expertise you’ll need; define, test, and refine sound compliance solutions and systems that are right for your needs; and, above all, proceed without delay.

A Look at the Phase III Final Regulations As you peruse the important aspects of the newly issued Phase III final regulations that we have highlighted below, consider the compliance demands these and other final Phase III requirements will place on the broker-dealer community, and reflect on your state of preparedness.

Phase III Compliance Considerations:

• In general, how will you identify, access, and accurately assess the data and information necessary to correctly calculate cost basis—and how confident will you be that such data is accurate, reliable and up-to-date?

• Is your security master accurately determining debt instruments’ “covered/uncovered” status—whether they lie inside or outside of the regulations and in which year (2014 or 2016) they are considered covered?

• How will you build calculation models to accurately estimate market discount/premium for each purchase of a debt instrument covered on January 1, 2014?

• Do you have a system in place to store client elections?

• Will you be equipped—and how, and how well—to discover and correctly account for relevant outside-of-transaction factors (e.g., corporate actions, wash sales) that affect cost basis determination?

• How will you pay attention to and adhere to expanded transfer statement and organizational action reporting information requirements as they take effect?

• How will you balance developing resources and preparing for January 1, 2014, compliance with both the advent of Phase III Cost Basis Law reporting requirements and the implementation of the Foreign Account Tax Compliance Act (FATCA) regulations?

COST BASIS: PHASE III IMPLEMENTATION

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Debt Instrument Cost Basis Reporting

Cost basis reporting will commence in general for debt instruments and options purchased on or after January 1, 2014. However, the Treasury Department and IRS have stated their recognition that the inherent complexity of the reporting requirements for certain debt instruments necessitates providing ample time for brokers and others to develop and implement reporting systems that assure compliance. Therefore, the final regulations implement the reporting requirements for debt instruments in phases, as follows.

1. January 1, 2014: Reporting commences for fixed-yield, fixed-maturity-date debt instruments with less-complex feature:

• Issued at 100 or a de minimis discount with a single fixed yield and fixed maturity payment schedule

• Issued at a discount with a single fixed payment at maturity

2. January 1, 2016: Reporting commences for other debt instruments that pose reporting challenges and are acquired on or after January 1, 2016. Examples include:

• PIK (Payment in Kind) Bonds

• Step-Rate Debt

• Convertible Debt

• Contingent Payment Debt

• Inflation-Indexed Debt

• Debt issued in a foreign currency

Debt that is excluded under the final Phase III regulations includes:

• REMIC/WHMTs

• Short-Term Debt (under 1 year)

• Amortizing Debt

Expanded Transfer Statement Information Requirements

Additionally, the final regulations implement an expansion of the information that must be included in a transfer statement for a debt instrument. These expanded transfer-reporting requirements will also be implemented in phases, as follows.

1. January 1, 2015: A transfer on or after January 1, 2015, of:

• an option (linked to equities, dividend yields or interest rates) as defined in §1.6045-1(m)(2),

• a securities futures contract as defined in §1.6045-1(a)(14)(iv), or

• a debt instrument covered in 2014.

Debt that is excluded under the final Phase III regulations includes:

• REMIC/WHMTs• Short-Term Debt

(under 1 year)• Amortizing Debt

Debt instrument cost basis reporting, expanded transfer-statement information requirements, and expanded organizational-action reporting requirements will each be implemented in phases.

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2. January 1, 2017: A transfer on or after January 1, 2017, of a debt instrument that was considered covered in 2016

Expanded Organizational Action Reporting Requirements

The final regulations also implement expanded information-reporting requirements for organizational actions that affect the basis of a debt instrument or option in phases, as follows.

1. January 1, 2014:

• Organizational actions occurring on or after January 1, 2014, that affect the cost basis of debt instruments covered in 2014 (not including debt instruments covered in 2016)

• Organizational actions occurring on or after January 1, 2014, that affect the cost basis of options, such as stock splits

• Organizational actions occurring on or after January 1, 2014, that affect the basis of securities futures contracts described n §1.6045-1(a)(14)(iv)

2. January 1, 2016: Organizational actions occurring on or after January 1, 2015, that affect the cost basis of debt instruments covered in 2016

The final Phase III regulations exclude a compensatory option from the reporting requirements under 26 USC 6045.

Options Cost Basis and Gross Proceeds Reporting

The scope of the provisions in the final regulations are generally the same as the scope in the proposed regulations, except that the final regulations explicitly exclude a compensatory option from 6045 reporting.

In the final regulations, different reporting rules are set out for Section 1256 options [defined in §1256(b)(1)(C)] and non-section 1256 options. However, recognizing the difficulty in making determination of Section 1256 option status, the IRS under the final regulations has granted relief under sections 6721 and 6722 if a broker determines in good faith that an index is, or is not, a narrow-based index described in section §1256(g)(6)(B) and reports in a manner consistent with that determination.

Other Noteworthy Features

Some important features of the final Phase III regulations are noteworthy, as they represent significant changes from or reiterations of the proposed regulations.

• As noted earlier, the final regulations exempt short-term debt instruments (debt instruments with a fixed maturity date not more than one year from date of issue) from cost basis reporting. This is a significant change from the previous proposed regulations.

• With respect to cost basis reporting for a covered debt instrument denomination in a currency other than the U.S. dollar, the final regulations include foreign currency interest and secondary market accruals using a spot rate, which will add another layer of complexity onto an already complex transaction.

• No modification has been made between the proposed and final regulations regarding cost basis reporting of wash sales. In general, a broker must increase the basis of the purchased security by the amount of loss disallowed on the sale transaction.

Debt instrument cost basis reporting, expanded transfer-statement information requirements, and expanded organizational-action reporting requirements will each be implemented in phases.

The final Phase III regulations expand, in phases, organizational action reporting requirements

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• The final regulations require brokers to report information using the default assumptions provided in the relevant statute and regulations, except in the case of the Section 171 election, but require brokers to accommodate elections by taxpayers who choose to depart from the defaults. Under the final regulations, upon written notification (including in electronic form) by a customer, a broker must take into account the following elections for cost basis reporting purposes: the election to accrue market discount using a constant yield; the election to include market discount in income currently; and the election to treat all interest as OID. The final regulations make an exception to the general rule requiring brokers to use the default elections as above in the case of bond premium. Consistent with the previous proposed regulations, the final regulations require brokers to assume that customers have made the election to amortize bond premium provided in Section 171 when reporting basis, unless the customer has notified the broker otherwise. While the IRS has simplified the elections and supplied defaults to be used absent customer-specified elections, the complexity and costliness of implementing the necessary client-communication infrastructure and various processing capabilities to be performed on a transaction-by-transaction basis remain undiminished, due to the mandatory requirement to support the numerous elections clients may or may not actually ever invoke. The IRS also recognizes that supporting customer elections will require additional transfer statement information to advise a receiving broker of any elections that were used to compute the information provided. Hence, the expanded transfer statement information requirements, to be implemented in phases.

• The final regulations contain temporary regulations addressing the reporting of bond premium under Section 6049 to require broker reporting of interest (OID) income to reflect amounts of amortized bond premium or acquisition premium for a covered debt instrument. (See final Phase III regulations* for specifics.)

• The final regulations generally continue the approach taken in the proposed regulations regarding computations that affect the basis of a debt instrument. In particular, the final regulations do not require a broker to compute debt instrument accruals more than once per year unless a transfer takes place during a tax year, in which case the transferring broker must provide a transfer statement to the receiving broker. If a broker’s systems generate more frequent computations to support transfer statements, the broker is permitted to compute the accruals more than once per tax year.

• Under the final regulations, in the case of a sale of a debt instrument, accrued market discount will be reported only on the Form 1099-B, which would associate the accrued market discount with a specific sale of a single security. The final regulations amend the rule in §1.6045-1(d)(3) for reporting accrued stated interest on a Form 1099-INT when a debt instrument is sold between interest payment dates to make it clear that the rule does not apply to accrued market discount. However, this leaves open the question of where the market discount would be reported in cases where the client chose to accrue it currently.erci

* You can also read the final Cost Basis Phase III regulations at:

federalregister.gov/articles/2013/04/18/2013-09085/basis-reporting-by-securities-brokers-and-basis-determination-for-debt-instruments-and-options

The complexities and costliness of implementing the necessary client-communications infrastructure and various processing capabilities to be performed remain undiminished.

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Keys to Overcoming the Challenges of Phase III Cost Basis Reporting

The price of regulatory noncompliance, inaccurate calculations, and mistakes in reporting is not just paid in financial penalties. The price is also paid in damage to a firm’s reputation, damage to its core business capabilities via resource distraction due to flawed compliance solutions, damage to its employees’ confidence, and most important, damage to its customer relationships. Preparing wisely, effectively and efficiently now to competently—and confidently—meet the considerable challenges of Phase III cost basis reporting is critical.

With the recent issuance of the Phase III final regulations, successful system-building can and must begin in earnest.

• Systems testing must then be conducted, and refinements made

• These systems must be able to handle complex transactions automatically, and they must be capable of integrating with existing systems as well as compete for scarce development resources with other IRS requirements, such as FATCA.

• Systems must draw from reliable, accurate data robust enough to ensure regulatory conformance in reporting to the IRS and to the customer—from identifying covered security status to accurately reporting cost basis on Form 1099-B.

Understanding the demands of Phase III of cost basis law implementation, and focusing now on gaining the knowledge and outside expertise needed to fully prepare your firm, will pave the way to achieving compliance.

“Firms are facing a dilemma because of the dueling development priorities of FATCA and Cost Basis Phase III, which both take effect on 1/1/14. As a result, firms are going to be stretched and will need to identify subject matter expertise to ensure a seamless implementation,” said Broadridge Strategic Project Manager Justin Hopkins, Atty. With reliable subject-matter expertise engaged; with sound decisions as to building solutions in-house, securing them from outside, or partnering to achieve a mix of both made; with the right systems for accessing and utilizing reliable data for correct calculations built/acquired, tested, and refined; with employees fully trained and ready; and with appropriate reporting mechanisms in place, organizations can proceed confidently with Phase III cost basis reporting law compliance—on January 1, 2014, and beyond.

“Firms will need to identify subject matter expertise to effectively implement Phase III regulatory requirements.”

—Justin Hopkins, Atty. Strategic Project Manager, Broadridge Financial Solutions

About Broadridge

Broadridge Financial Solutions, Inc. (NYSE BR) is the leading provider of investor communications and technology-driven solutions for broker-dealers, banks, mutual funds and corporate issuers globally. Broadridge’s investor communications, securities processing and operations outsourcing solutions help clients reduce their capital investments in operations infrastructure, allowing them to increase their focus on core business activities. With 50 years of experience, Broadridge’s infrastructure underpins proxy voting services for over 90% of public companies and mutual funds in North America, and processes more than $4.5 trillion in fixed income and equity trades per day. Broadridge employs approximately 6,200 fulltime associates in 13 countries.

Contact us

For more information about Broadridge products and solutions please contact us at taxservices@broadridge.com, broadridge.com, or 800.353.0103.

Glen Bover, Vice President • 201.714.3411Tax Services, Broadridge Financial Solutions, Inc.

Justin Hopkins, Strategic Project Manager • 201.714.3717 Tax Services, Broadridge Financial Solutions, Inc.

Robert Benazzi, Account Manager • 212.981.1386 Tax Services, Broadridge Financial Solutions, Inc.

To ensure compliance with requirements imposed by the IRS, Broadridge Financial Solutions, Inc. informs you that any tax advice contained in this communication (including any attachments or links) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein. (iii) The taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

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