Fund Firms Face Costs of Cost-Basis Reporting
February 8, 2011
The ability to make choices is the pillar of a free market economy. But when it comes to the Internal Revenue Services’ new tax reporting requirements, choices will mean plenty of additional operational and technological headaches for mutual fund companies over the next year.
Mutual funds will be “dealing with soup to nuts changes in books of records, tax reporting systems as well as customer interfaces and communications,” says Nico Willis, chief executive of Networth Services, a Phoenix, Arizona-based software firm specializing in tax-lot accounting.
At the core of the changes will be cost-basis reporting. Beginning January 1, 2011, brokerage firms, mutual fund companies, custodian banks and transfer agents will be required for the first time for equity accounts to track and report the cost of a securities transaction to both the Internal Revenue Service and the investor. Although some firms did so previously, it was only on a voluntary basis and they did not have to guarantee the accuracy of the information.
For mutual funds, the regulations come into effect on January 1, 2012, and for debt instruments, options and other securities on January 1, 2013. Firms may voluntarily decide to follow the rules for securities accounts opened prior to those dates.
Knowing just which accounts must fall under the new cost-basis reporting rules and those which don’t is far more difficult than knowing the year in which the investor opened the account.
“Some exchange-traded funds will be eligible for cost-basis reporting as regulated investment companies for cost basis purposes, which means the January 1, 2012 effective date and averaging basis method is available,” says Stevie Conlon. senior director and tax counsel at Wolters Kluwer Financial Services, which provides the Gainskeeper cost basis reporting service. “Others will be treated as stock subject to the earlier January 1, 2011 effective date and will not be eligible for averaging.”
End result: operations executives at mutual fund companies and their transfer agents will have to read all of the offering documents and make these determinations.”
For starters, mutual funds and their transfer agents must link their corporate actions platforms, subaccounting systems, securities master files and order management systems.
The year-end tax reporting system must also be linked to the tax lot system so that identical results can be produced on forms sent to the investor and the IRS.
Such an integration could take at least four to six months to accomplish, even if the tax lot reporting software offers its own programming hooks, known as application programming interfaces. That’s because of the need to analyze, map and test every data point in a firm’s books and records.
Buying new software to calculate the correct number for the original cost of a tax lot of shares is just the tip of the iceberg in preparations. Mutual funds, which have always relied on average cost accounting, will now be required to give investors the option of deciding which tax lot accounting methodology to use. A customer can select first-in-first out accounting, average cost or the specific identification approach, which allows them to first sell the lot of securities that means paying the least amount of taxes. The investor can also change his or her mind and later select different methodologies for different accounts registered under the same name even after a mutual fund company first selected the mechanism it wants to use.
