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Cost-Basis Reporting Getting Ready for Prime Time

Information on the original cost basis of stocks purchased by investors can now be transferred automatically in roughly 97% of cases.

That's because fund firms are moving quickly to adopt electronic reporting services offered through the Depository Trust & Clearing Corporation.

But there remain a host of issues that are making it difficult for mutual funds to begin properly reporting the original cost of investments they hold in their portfolios, These range from relatively simple matters such as figuring out what securities are covered by the new IRS roles that take effect in 2012 for mutual funds-to more difficult challenges, such as figuring out, for instance, when a stock is a stock and when it ought, instead, to be defined as a piece of debt. Or vice versa.

There's been a "big uptick" in adoption of the DTCC's Cost Basis Reporting Service, according to Kevin McCosker, a director at Pershing, who delivered a report on adoption of the service by fund firms at the Securities Industry and Financial Markets Association 2011 Operations Conference earlier this month.

At the end of 2010, roughly 60 member SIFMA firms had adopted use of the electronic means of distributing information in a consistent fashion on what investors had first paid for securities, McCosker said.

The DTCC, though, broadened the use of the service by moving its operation from the National Securities Clearing Corporation, which serves brokers, to a new entity called DTCC Solutions, which could provide the service to transfer agents and other parties.

The result: 201 firms had signed up to use the service. That included 98 brokers, 31 banks, 71 transfer agents and one mutual fund.

Of those, 105 firms are in production with the use of the service. These include 67 brokers, 16 banks and 22 transfer agents, according to McCosker and Ellen Bocina, vice president of product development at Fidelity Investments.

Among the transfer agents signing up are the two biggest: Computershare and BNY Mellon. This has helped push up usage to cover 97% of all transfers of customer account information, electronically, from 95%, McCosker said.

Transfers of information on paper almost never work, he said. The information on the receiving account or the customer almost never matches up. Which means, at this point, he rejects almost everything at Pershing that is not transferred electronically.

Electronic transfers have to replace paper transfers, Bocina said, because mail is not effective.

In Fidelity's case, its transfer department is in Dallas, and the cost-basis department is in Jersey City, N.J. Figuring out "where to send the paper is hard" and, even if you get the right address for now, that changes.

"It's snail mail that you have to rely on, and it's just going to be completely ineffective," Bocina said.

"If you're not sending cost basis electronically, I don't really see how ultimately it's going to work," McCosker said.

But sending information on the original cost basis of investments may be the easiest part of compliance with the new IRS rules.

Figuring out the tax classification for a security is likely to be a lot tougher, in many cases, according to Stevie D. Conlon, director and tax counsel for Securities Tax Solutions at Wolters Kluwer Financial Services.

There are stocks with firm payouts that, in the eyes of the IRS, more resemble debt and will be classified as such. There are some exchange-traded funds that have been classified for securities operations purposes, for long periods of time, as stock even though some might be considered mutual funds eligible for basis averaging, because they had been a new form of investment when first introduced, without a ready classification of their own. And there are some exchange-traded funds, based on investing in commodities, which are partnerships for tax purposes are currently not subject to cost basis reporting at all, Conlon said.

It's as if some securities, such as ETFs, get stuck in the "stocks drawer," because the person sorting out the socks (or, rather, stocks) didn't know where else to put them, she said. Which makes it tough to then figure out the right tax classification, later on, to actually file the investment under for cost basis purposes.

"It's kind of like not knowing what your blood type is," Conlon told Money Management Executive.

At present, there is no unified, universal list of financial instruments that establishes how a particular security must be classified for cost-basis reporting. Companies such as Wolters Kluwer Financial Services and Thomson Reuters are developing their own classification databases, for their customers to use.

As 2012 approaches, mutual fund companies that provide cost-basis information to their investors are facing confusion among customers about what to report-and fear that penalties are a likely result of failure to report original cost information correctly.

Some fund customers will likely be confused regarding why cost basis is reported on Form 1099-B for some securities but not for others, according to Wolters Kluwer Financial Services.

This confusion may persist due to the law's phased coverage of additional asset classes over the next two years.

These include shares in cost basis-eligible regulated investment company and dividend reinvestment plans that are acquired on or after Jan. 1, 2012, and options and debt securities acquired on or after Jan. 1, 2013.



Top 10 Cost-Basis Reporting Issues

1. Customer confusion involving covered versus noncovered securities

2. Determining whether choosing cost averaging is allowed

3. Determining if lots are eligible for single account election

4. No lot selection after settlement date cutoff

5. Frustration about wash sales disallowance reporting

6. Holding period required instead of "holding date"

7. Additional broker burdens for gifted and inherited shares

8. 3-year and 18-month cutoffs for corrected 1099-Bs and transfer statements

9. Customer confusion involving exchange-traded funds and unit investment trusts

10. Potential issuer reporting obligations for corporate actions


Source: Wolters Kluwer Financial Services,