Thursday, 19 April 2018
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Getting Brokers and Dealers Ready for the Next Cost Basis Reporting Challenge

What is Cost Basis?

The cost basis of an investment is the original value of an asset adjusted for stock splits, dividends and capital distributions. It is used to calculate the capital gain or loss on an investment for tax purposes.It can be stated either in terms of the dollar amount of the investment, or the effective per share price paid for the investment. The calculation of tax basis can be quite complicated due to the many changes that are likely to occur in the financial markets such as splits and takeovers.

Statutory Regulations

The US Internal Revenue Service (IRS) recent cost basis reporting rules have made cost basis calculation both cumbersome and extremely complicated. Their implementation is being phased over a four-year period. They became effective for US equity securities including foreign securities and American Depository Receipts (ADRs) purchased as of January 1, 2011, and for shares in mutual funds purchased after January 1, 2012. They will go into effect for fixed-income securities, options, warrants and rights acquired as of January 1,2013. The regulations exclude IRAs and other non-taxable accounts.

The rules require that financial firms calculate the actual cost of investors' accounts so that they pay the appropriate income tax. Till fairly recently, the IRS depended on investors to do the calculations on their own with the help of some broker-dealers, mutual funds, custodian banks and transfer agents who were not legally required to do the work. Mutual fund companies and brokerage firms are now required to report clients' cost basis and holding period to the IRS when covered securities are sold.

Comments in respect of proposed regulations for cost-basis reporting for fixed-income securities are due by February 18. Final regulations may not be issued until June at the earliest; financial firms that have barely six months or less to make the massive changes to their front and back offices to account for the differences between equities and fixed-income instruments and options instead of at least eighteen months which some operations specialists had warned would be needed.

Waiting for the regulations to completely come out will not be a good idea. Firms, therefore, should get a head start. Some of the largest brokers have had their operations and IT departments diligently spend the past two years preparing to face the challenges posed by the implementation of the IRS regulations. However, a far greater challenge going forward is equipping brokers and dealers so that they will be ready to face the next stock cost basis round of calculations in respect of options and fixed income securities.


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