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A Taxing Basis for Transferring Agents

Used to be you picked the transfer agent who had the most efficient system for maintain records of shareholder accounts, calculating and disbursing dividends, mailing shareholder statements and sending out tax notices.

No more. In 2011, taxation is supplanting technology as a determining factor in what transfer agent to sign up with, if your existing contract is running out.

In the past, "it would be kind of an operations exercise,'' says Stevie Conlon, senior director and tax counsel for Securities Tax Solutions at Wolters Kluwer Financial Services. "Does the transfer agent have the technology and tools to track my holders and handle things? Taxes were a small component."

What's changed?

Rules on reporting of the original cost of mutual funds that investors have acquired. Or, really, the so-called cost basis for any security that has been acquired.

In the past, the Internal Revenue Service only required that brokers report the proceeds of a sale on a 1099 form. This year, the cost of a security will have to be reported, not just the proceeds. Next year, the original cost of shares in a mutual fund will have to be reported. This is designed to make it impossible for a taxpayer to cheat on taxes owed for capital gains.

And the nuances will make this a potentially decisive factor, at this point, in selecting a transfer agent that will keep reliable track of what shareholders choose to do. Because there are multiple methods for calculating the original cost of a 100-share lot of shares. And, for each lot, an investor will have three days after closing a position to declare the method used for calculating the cost of each lot.

Taxation, until now, wasn't a significant factor in picking a transfer agent. Or the number of methods of calculating the cost of purchasing a mutual fund.

"Up until now, if I offered you one method and it was a take-it-or-leave-it, that was good enough,'' said Conlon. "Now, it really matters."

Under the new regime, mutual fund companies have to make sure that a transfer agent can handle a wide variety of options that will be given to investors on picking which lots they are selling.

There are three basic methods: FIFO, averaging and Specific ID.

The first method is perhaps the most well-known principle in inventory accounting: First In, First Out. That simply says that the first lot of an asset that was purchased is the first lot sold.

The second method is nearly as straightforward: averaging. The average cost is the purchase price of all shares divided by the number of shares owned, at the time shares are sold.

But even this is not as simple as it sounds. Averaging, as Conlon points out, is only allowed for shares of stock in a regulated investment company - and stock that, at the same time, is part of a dividend reinvestment plan (aka, a DRiP).

That makes it important for a mutual fund company to make sure that a transfer agent, in this new era of taxation, is able to determine if a given company is a regulated investment company and if the stock in question is inside, not outside, a dividend reinvestment plan.

But the one method that, by Conlon's assessment, "is really getting all the attention" is Specific ID.

And that's because it's not one method. It's a catch-all for any method of accounting for the original cost of an investment that is not FIFO or averaging.

This could be lowest-in, first-out; highest-in, first-out; minimum tax, or, any other method that is embedded in a formula that can be automatically repeated in an algorithm designed to execute it.

"Tracking all the lots, then giving the multiple options for choosing how they receive it" is becoming a "paramount" consideration in picking a transfer agent, said Craig Hill, vice president for sales and marketing at Boston Financial Data Services. "People can switch how they get it and what the method is. It's not straightforward. It's turned into quite a complicated process."

And nothing else in the transfer agent selection process, at this moment, "packs the wollop of cost-basis accounting,'' he said.

Which means that transfer agents have to upgrade their accounting and reporting systems. Or lose out, when contract time comes.

"Either this transfer agent can accommodate the method I want to use or they'll agree to do the development work to accommodate the method I want to use or I am not going to use them,'' said Conlon.