The cost-basis reporting requirements are going to be a quagmire for shareholders and fund complexes alike.
"Many mutual fund shareholders are invested in more than just mutual funds," said Jeff Cook, director of regulatory compliance at DST Systems. "These new rules bring every existing shareholder into play."
The changes to the Internal Revenue Service's Form 1099-B represent an entirely new method of managing accounts and are intended to curtail what is thought to be widespread tax avoidance. Cost basis is the original price of an asset, usually the purchase price, and is used to determine capital gains. The IRS is concerned that current cost-basis accounting rules allow investors to dodge hundreds of millions of dollars in taxes each year.
Under the new rules, stocks acquired after Jan. 1, 2011 will be subject to mandatory cost-basis reporting. Mutual funds and dividend-reinvestment plans will be subject to the new rules starting in 2012, while everything else must comply by 2013. The new rules don't apply to investors in tax-deferred 401(k) retirement accounts.
Mutual funds' one-year lag behind equities should give shareholders a better sense of what to expect 18 months from now when 2012 rolls around, but some confused shareholders may start calling their mutual funds as early as 2011, said Charles Hawkins, vice president and senior director at PNC Global Investment Servicing. He said it's important get a head start on training call center operators for such questions.
Hawkins was speaking at a recent Industry Town Hall Meeting, "Cost Basis Implementation Challenges: Will You Be Ready?" sponsored by Cisco Systems, DTCC, the Money Management Institute, The Securities Transfer Association and others.
Cook referred to "information trickle-down effect," and said DST is encouraging their clients to get out in front of this early and inform shareholders of the upcoming changes.
"Mutual fund firms need to communicate to shareholders early on what they must do and how do deal with their funds in an effective way," Hawkins said.
Congress has decided that the best way to close what it calls gaps in the tax structure is to take the burden of computing the tax basis away from the average investor and place it on the broker.
The new IRS rules define both broker/dealers and mutual funds as brokers, said Jeff Naylor, vice president of distribution services at SunGard.
The mutual fund industry is already a little ahead of the curve because funds have been voluntarily providing cost-basis information to investors since the early '90s, most commonly in the form of average-cost reporting, said Nino Palermo, a vice president at American Funds.
Under the new rules, customers will need to declare their methodology when they open a new account, rather than when they submit their taxes. Customers can choose from the first-in, first-out methodology, which assumes they will sell their oldest shares first; an average cost methodology, which calculates the average cost of all their shares; or they can choose to specify which individual shares they want to sell.
"Average cost makes a lot of sense for the vast majority of mutual fund shareholders, as they tend to purchase shares over time and reinvest their dividends," Palermo said.
One drawback to selecting the average cost option is that it is currently irrevocable without special consent from the commissioner, he said.
While the IRS is expected to come out with final regulations this summer or fall, there are still a number of operational and customer service issues that concern the fund industry, said Karen Gibian, associate counsel of tax law at the Investment Company Institute.
"The proposed regulations require shareholders to elect the average cost method in writing," she said. "The industry thinks the writing requirement should be eliminated. The ICI feels strongly that shareholders should be able to easily switch to another method, and it is proposing default rules for gifted and inherited shares."
Experts say that determining the proper default options should be focused around helping the greatest number of shareholders, but there is no cookie-cutter answer for every situation.
"As a group, we spent considerable time examining calculation methodologies and how lot selection comes into play," Naylor said. "To assume that the default should include first-in-first-out seems a bit strong, particularly in cases of partial transfers."
Another major challenge for the fund industry is finding a standardized way to pass information.
"Mutual funds may already calculate cost basis, but they don't pass this information," said Kevin McCosker, director of custody and alternative investments at Pershing LLC. He said the fund industry needs to develop a standardized, automated method for passing cost basis.
The Depository Trust and Clearing Corp.'s automated customer account transfer service has a cost-basis reporting system that could solve this problem, but the current system will need to be greatly expanded if it is to handle its new role, said DTCC Product Manager Joe Clemente.
"DTCC could become the hub for cost-basis movement," he said.
"It is critically important for the industry to adopt automated solutions in order to shorten the time between transactions and transfers," Naylor said. "We encourage all parties to participate in an automated solution, although manual transfers will probably still be an unfortunate reality."
Gibian said there are sure to be other transition issues that pop up before 2012 and the ICI has asked the IRS for penalty relief for a few months after the rules take effect, although fund firms should not count on getting relief.
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