Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock

Transcription

1 FINANCIAL SERVICES Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock TAX

2 1 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock On December 16, 2009, the Treasury Department and IRS released proposed regulations (REG ) relating to reporting sales of securities by brokers and determining the basis of securities. 1 A draft of the 2011 Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, also was posted on the IRS Web site: The proposed regulations concern changes made by the Energy Improvement and Extension Act of 2008 (the Act) that require brokers when reporting the sale of securities to the IRS to include the customer s adjusted basis in the sold securities and to classify any gain or loss as long-term or short-term. The Act also generally requires applicable persons 2 to transfer cost basis information to other brokers upon the movement of securities and issuers to provide information to the IRS and investors relating to organizational actions affecting cost basis of securities. A public hearing has been scheduled on the proposed regulations for February 17, Written or electronic comments on the proposed regulations must be received by February 8, 2010, and outlines of topics to be discussed at the public hearing must be received by February 8, See TaxNewsFlash for further background on the Act s cost basis reporting requirements and an earlier request by the IRS for public comments. Given this comment schedule, we do not expect final regulations to be available until mid KPMG Observation Although many brokers and mutual fund sponsors currently make cost basis information available to certain investors on a voluntary basis, mandatory reporting of cost basis as required under the Act reflects a significant departure from current practice. As a fundamental matter, the Act requires that cost basis reporting be provided for all covered securities and that cost basis be adjusted for certain transactions occurring within the same account. Neither of these requirements is uniformly met in today s voluntary reporting environment. In addition, the Act requires a broker to make all permitted lot relief methods available to investors (first-in-first-out or FIFO, specific identification and average cost single category). Under current practice, reporting entities may or may not make all such methods available. 1 The proposed regulations were published in the Federal Register on December 17, 2009, beginning at page Page citations for the preamble to the proposed regulations (the Preamble) will be to this publication in the Federal Register. 2 The proposed regulations define applicable persons and brokers receiving custody of securities in a similar manner to generally include custodians, issuers, and transfer agents. Prop. Treas. Reg A-1(a)(4). Thus, as discussed below, it is important to note the distinction between a receiving broker for purposes of the transfer statement requirement, and a broker responsible for producing Forms 1099 on the sale of covered securities. The proposed regulations have been greatly anticipated by the financial services industry, given that the new requirements for cost basis reporting apply beginning in 2011 for equities, in 2012 for mutual fund stock (also referred to as regulated investment company or RIC stock) and stock in dividend reinvestment plans (DRPs), and in 2013 for bonds, options, commodity derivatives, and for other financial instruments identified by Treasury. To be prepared to meet these fast-approaching deadlines, brokers, mutual fund sponsors, and other affected industry participants are actively engaged in defining business requirements and preparing implementation and customer service plans. Notwithstanding these significant efforts, cost basis implementation has been hampered to date by the lack of IRS guidance. The proposed regulations are an important step forward in this regard. In general, two themes emerge from the proposed regulations. First, the guidance hews closely to the statutory requirements under the Act, and treats as out of scope requested changes to substantive rules in other areas of the Internal Revenue Code intended to simplify and improve the administration of cost basis reporting. An example of an item treated as out of scope relates to comments requesting that non-calendar year end brokers be permitted to allocate a return of capital to

3 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 2 earnings and profits in a manner that would minimize any requirement to amend Forms 1099 issued for the prior calendar year. 3 The guidance also generally requires reporting for transfers of gifted and inherited shares. Second, the guidance creates a framework where a minimum of information must be provided on Forms 1099-B, transfer statements, and issuer statements relating to organizational actions, coupled with the ability of brokers and other applicable persons to provide or accept additional information under certain circumstances. While providing flexibility on the one hand, this approach also creates the potential for enhanced customer confusion and disparate tax reporting policies and procedures across the financial services industry. The following discussion summarizes key aspects of the proposed regulations, including guidance that was largely expected by industry participants and guidance that clarified areas of uncertainty under the Act. The discussion also identifies areas for which guidance is still needed, based on industry feedback to date. Given the breadth of the proposed regulations, the following discussion is a comprehensive, but not a complete, summary of all issues addressed (and raised) under the proposed regulations. However, we have attempted to focus on those items with significant practical impact for the financial services industry. KPMG Observation Key items discussed below that will impact the financial services industry under the proposed regulations include (1) the ability of customers to elect the average basis method at any time, subject to change in method of accounting rules; (2) the lack of any requirement for applicable persons to update transfer statements for corporate actions, with the result that a broker effecting a sale of covered securities will be required to research all prior corporate actions affecting the cost basis of such securities for tax reporting purposes; (3) an affirmative obligation for brokers to issue corrected Forms 1099 for covered securities within 30 days upon the receipt of complete transfer or issuer statements; and (4) the elimination of the eyeball test to identify C corporations exempt from tax reporting for sales of covered securities acquired on or after January 1, Expected Guidance The proposed regulations confirmed several items that were largely expected by the financial services industry. Notwithstanding this expectation, resolution of these guidance issues is important because they will have a critical impact on the implementation of cost basis reporting. First, the regulations did not provide for any postponement of the statutory cost basis reporting effective dates. KPMG Observation While industry participants, the Treasury, and IRS recognize the challenges with being ready to execute cost basis reporting and track the required information beginning January 1, 2011 with final guidance unlikely to be available until mid-2010, the Treasury and IRS are constrained by the statutory effective dates provided by the Act. Any relief from the current effective dates for cost basis reporting by type of security sold will require an amendment to the Act. Second, the proposed regulations confirm that brokers must make all permissible lot relief methods available to customers providing a valid instruction for specific lots to be sold or making a valid election to use the average cost single category method. 4 3 On December 16, 2009, House Ways & Means Committee Chairman Charles B. Rangel introduced H.R. 4337, the Regulated Investment Company Modernization Act of 2009 (the Bill). The Bill does contain return of capital relief, and the exclusion of that topic from the scope of the proposed regulations may have anticipated the Bill s introduction. 4 Section 6045 (g)(2)(b) of the Internal Revenue Code of 1986, as amended (the Code); Prop. Treas. Reg (e)(2) and -1(c). All remaining references to Sections herein are to the Code.

4 3 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock Certain commentators had requested that brokers and customers be permitted to report cost basis using different methods and also that brokers be permitted to report cost basis for all sales using only one lot relief method. The proposed regulations rejected these comments because of the statutory requirements of Sections 1012 and 6045 permitting customers to select any permissible lot relief method and requiring brokers to follow customer instructions regarding their selection of a lot relief method. The preamble also noted that the requested guidance would be inconsistent with the goal of conforming broker reporting with taxpayer basis determination method elections to facilitate and promote compliance in taxpayer reporting of income. 5 Third, the proposed regulations eliminate the average cost double category method for calculating cost basis, as of the date of publication of final regulations. 6 Clarifying Guidance The proposed regulations largely address how the cost basis reporting requirements will apply with respect to (1) particular types of securities (e.g., hybrid securities, DRPs); (2) lot relief selection methods; (3) reporting of adjusted cost basis by brokers; (4) transfers, including of gifted and inherited shares; (5) issuer statements relating to organizational actions; (6) short sales; (7) reporting on Forms 1099; and (8) penalties. The discussion below will address each of these categories of guidance. Application of Cost Basis Reporting Requirements to Hybrid Securities and DRP Shares 5 Preamble at page Preamble at page The effective dates for cost basis reporting apply by type of security. As a result, it is crucial that brokers understand how to classify securities in order to determine the appropriate effective date. For example, under current law, there can be considerable difficulty in determining whether a security is stock (for which basis must be reported for acquisitions beginning in January 2011 or, for RIC or DRP stock, January 2012) or debt (for which basis does not need to be reported for acquisitions until 2013). In

5 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 4 addition, there was uncertainty regarding the scope of stock acquired in connection with a dividend reinvestment plan (DRP), for which basis must be reported for acquisitions beginning in January To resolve the hybrid security dilemma, the proposed regulations provide that any security an issuer classifies as stock is stock. If no issuer classification has been made, then the security is not classified as stock unless the broker knows or has reason to know that the security is reasonably classified as stock under general tax principles. 8 KPMG Observation This approach may give rise to inconsistent reporting among brokers with respect to identical shares. It also is unclear when a broker has reason to know in this context and whether the broker has an affirmative obligation to attempt to determine the tax characterization of a security. As discussed below, the various standards of knowledge that may apply under the proposed regulations for penalty and other purposes are an area where clarification would be helpful. For DRPs, the proposed regulations define a dividend reinvestment plan to include a written arrangement, plan or program administered by an issuer or non-issuer of stock. 9 A plan qualifies as a DRP if the plan documents require that at least 10 percent of any dividend paid be reinvested in identical stock. 10 A plan that holds one or more different stocks may permit a taxpayer to reinvest a different percentage of dividends in the stocks held. Stock may be held in a DRP even if no dividends have ever been declared or paid or the issuer has stopped paying dividends. Stock acquired in connection with a DRP includes the initial purchase of stock in the DRP, subsequent transfers of identical stock into the DRP, additional periodic purchases of identical stock through the DRP, and all identical stock acquired through reinvestment of dividends paid under the DRP. 11 Importantly, shares of stock in a DRP are not identical to shares of the same stock that are not in a DRP, even if the shares have the same Committee on Uniform Security Identification Procedures (CUSIP) number. 12 The proposed regulations do not define dividends for purposes of the DRP rules. Treasury and IRS have requested specific comments on whether and how the regulations should define dividends, including whether the term should be defined by reference to Section 316, or more broadly to include any payment or distribution from stock. 13 KPMG Observation It likely will be challenging for brokers to track and distinguish between DRP and non-drp stock acquired by a customer and subject to different cost basis effective dates. Under the proposed regulations as drafted, for example, it is not clear whether stock with the same CUSIP number will be DRP stock if it is acquired with the cash portion of a dividend on DRP stock, but that stock is not itself enrolled in the plan. We also note that the proposed regulations do not prohibit DRP investors from selecting any permissible lot relief method. Thus, stock may be DRP stock subject to a different effective date for reporting even if the same lot relief selection method applies to the DRP as to the other stock. To minimize customer confusion related to the 2011 effective date for cost basis reporting with respect to acquisitions of non-drp 7 If stock is acquired on or after January 1, 2011 in connection with a DRP, the basis of that stock is determined under one of the basis computation methods permissible for RIC stock. This date would be changed to January 1, 2012, by the Tax Technical Corrections Act of 2009 (H.R. 4169). See TaxNewsFlash Prop. Treas. Reg (a)(14). 9 Prop. Treas. Reg (e)(6). 10 Ibid. 11 Prop. Treas. Reg (e)(6)(ii). 12 Prop. Treas. Reg (e)(4). 13 Preamble at page Other rules for DRP stock affecting primarily the administration of the average basis method are discussed in the text below.

6 5 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock stock, and the 2012 effective date for acquisitions of identical shares of stock in a DRP and for other stock, brokers may decide to implement reporting for DRP stock on the earlier effective date. In that case, brokers will still need to manage customer communication relating to the later effective date for the use of the average basis method, as discussed below. Lot Relief Selection Methods The proposed regulations address a number of issues related to the procedures for customers to select the various lot relief methods and when a broker s default method will apply in lieu of a customer-selected method. In general, the proposed regulations preserve maximum flexibility for customers to select any permissible lot relief method. 14 However, the proposed regulations also require a customer to report gain or loss on its return using the method the customer elects or, if the customer fails to make an election, using the broker s default method. 15 As discussed below, the broker reporting rules appear to require the broker to report on a FIFO basis if the customer fails to elect a method, which may simply reflect a lack of coordination of drafting of the provisions under Sections 1012 and Broker Default Method As an initial matter, the proposed regulations provide that the basis of securities, including RIC and DRP stock, is determined in accordance with the broker s default method, unless the customer elects another permitted method. 16 No particular timing or procedures are provided by the proposed regulations regarding the methodology for a broker to inform customers of its default method. 14 For the purpose, a written confirmation, record, document, instruction, or advice includes a writing in electronic format. Prop. Treas. Reg (c)(9). 15 Prop. Treas. Reg (e)(2)(i). 16 Ibid. KPMG Observation The lack of specific guidance on how to inform customers about a broker s default method is somewhat challenging for brokers since they will not be allowed to assume that a customer has received adequate notice about their default method by following prescribed safe harbor type procedures. Particular problems may be created when the broker s default method is average basis, as discussed below.

7 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 6 Specific Identification Method For the sale of securities acquired on different dates at different prices, but involving less than the entire position of the security held in an account, a broker must report the sale consistent with a customer s adequate and timely identification of the securities sold. 17 The proposed regulations clarify that a customer must identify the stock sold no later than the settlement date for the sale. Revenue Ruling , 18 which permits identification at a later time, will be obsolete when the final regulations are issued. 19 The regulations also provide that taxpayers may establish lot selection by a standing order or instruction, such as highest-in-first-out (HIFO) or last-in-first-out (LIFO). 20 Average Basis Method Existing regulations provide rules for computing the basis of RIC stock by averaging the cost of all shares in the RIC (the average basis method ). 21 The proposed regulations extend the average basis method to shares of stock acquired in connection with a DRP. In addition, the rules for the average basis method under the Act apply differently to RIC stock acquired before and after The key difference is that the Act applies lot relief selection methods on an account-by-account basis (subject to the single account election discussed below), whereas the average basis method applies to all identical shares of RIC stock sold before January 1, 2012, irrespective of account. 22 Under the Act and proposed regulations, any stock that is a covered security is treated as a separate account from any stock that is a noncovered security. 23 Covered securities include stock eligible for the average basis method that is acquired on or after January 1, 2012 or that was transferred into an account as a covered security together with a completed transfer statement, as discussed below. 24 Under the proposed regulations, a customer elects the average basis method for covered shares by notifying the custodian or other agent for the taxpayer s account in writing by any reasonable means. The customer may make the average basis election at any time, effective for sales or other dispositions of stock occurring after the taxpayer notifies the custodian or agent. 25 The customer must make a separate election for each account holding stock for which the average basis method is permissible. KPMG Observation Under the proposed regulations, customers could be required to make multiple average basis method elections for securities held in the same registration at a broker, given that covered and noncovered shares are treated as separate accounts for tax purposes. For example, if shares were transferred into a customer s account without a properly completed transfer statement, those shares would be treated as noncovered and, thus, as a separate account subject to a separate average basis election. These account-based rules for electing the average basis method will be challenging to explain to customers, although perhaps some potential confusion regarding multiple average basis method elections could be mitigated by having a customer provide a standing instruction to the broker to treat 17 Prop. Treas. Reg (d)(2)(ii) C.B Preamble at pages 67018, Prop. Treas. Reg (c)(8). 21 Treas. Reg (e). 22 Prop. Treas. Reg (e)(10(ii). The proposed regulations also apply this rule for sales of DRP stock before January 1, 2012, but in that respect do not reflect the change in the effective date for DRP averaging contained in H.R See note 7, supra. 23 Prop. Treas. Reg (e)(10)(iii). 24 Section 6045(g)(3). 25 Prop. Treas. Reg (e)(9).

8 7 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock all securities as subject to the average cost method. We also note that the proposed regulations do not define an account. We believe that such a definition is needed, particularly given the impact of account status on basis method elections. Under the proposed regulations, a customer may revoke the average basis method election by the earlier of one year from the date of making the election or the first sale or other disposition of stock following the election. 26 A custodian or agent may extend the one-year period, but a customer may not revoke an election after the first sale or other disposition of stock. A revocation applies to all identical stock in an account, and a revocation is effective when the customer notifies the custodian or agent holding the stock by any reasonable means. After revocation, the customer s basis in the stock to which the revocation applies is determined using another permissible basis determination method. In addition, a customer may change from the average basis election to another permitted method prospectively at any time. 27 When there is a change in lot relief selection method, the basis of each share of stock to which the change applies is the basis immediately before the change. 28 Such a change is a change in method of accounting. 29 KPMG Observation -- The Preamble indicates that the IRS may issue guidance of general applicability providing broad consent for taxpayers to change basis determination methods. A potential issue is that method changes generally apply on a calendar year basis. Issues may arise even under an automatic change procedure, unless the procedure specifies that the change in method will not be applicable until the broker receives notification. Perhaps a different approach would be to determine that this is not a change in method but rather a change that is effective prospectively from the notification to the broker. The proposed regulations do not provide similar rules applicable when a broker s default method is average basis. That is, they do not provide how a broker may revoke designation of average basis as its default method or change to a different method after the period for revocation has expired. In some respects, the structure of the proposed regulations seems to assume that the broker s default method simply substitutes for the regulatory FIFO rule so that the investor s lot selection choices remain open and do not address questions that arise if a broker s default method is average basis. 26 Prop. Treas. Reg (e)(9)(iii). 27 Prop. Treas. Reg (e)(9)(iv). 28 Ibid. 29 Prop. Treas. Reg (e)(9)(iv)(b). 30 Prop. Treas. Reg (e)(2). 31 Prop. Treas. Reg A-1(b)(1)(vii). On transfer of RIC or DRP stock to another broker, the customer must notify the receiving broker of its lot selection method for that stock. If no such notice is provided, the customer s stock will become subject to the broker s default lot relief method. 30 As discussed below, if the cost basis of a transferred security is determined using the average basis method, a single transfer statement may be used for any securities acquired more than five years prior to the transfer, but only if the other information provided on the statement applies to all of the securities. 31 KPMG Observation The proposed regulations appear to require the tracking of separate lots for securities subject to the average basis method for at least one year due to the revocation period, which should not be problematic given the mechanics of the average basis single category method. However, the proposed regulations could require that lot level information for shares subject to averaging be retained for up to five years given the above transfer statement requirement. In addition, the requirement for the customer to re-elect the average basis method upon transfer to another broker will be a potential trap for the unwary.

9 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 8 Consistent with the Act, the proposed regulations provide rules permitting a RIC or DRP to elect on a stockholder by stockholder basis to treat all identical stock in the RIC or DRP for which averaging has been elected by the stockholder as one account, without regard to when the stock was acquired (the single account election ). 32 If a broker holds stock as a nominee, the broker, not the RIC or DRP, makes the election. Once made, the single account election is irrevocable. 33 The single account election may only be made for shares of stock for which a RIC, DRP, or broker has accurate information. Information is accurate for this purpose if the RIC, DRP, or broker neither knows nor has reason to know that the basis information is inaccurate. Stock for which accurate basis information is unavailable must be treated as a separate account, irrespective of when shares were acquired. 34 A RIC, DRP, or broker making the single account election must use reasonable means to notify customers of the election. KPMG Observation A customer must make an average basis election separately for each account. From the date of the creation of an additional account for tax purposes, the customer needs to be informed that separate averaging pools exist (as well as separate holding period rules). Presumably, the taxpayer would need to designate which tax account from which any sale is made. Explicit lot selection procedures should be provided for this purpose. In short, these rules will substantially limit the utility of the single account election. Reporting by Brokers As a general matter, brokers are not required to provide Form 1099 reporting to exempt recipients. The proposed regulations change current law 35 with respect to determining whether a corporation is an exempt recipient by eliminating the so-called eyeball test for corporate status for sales of covered securities acquired on or after January 1, Under the proposed regulations, a broker can only treat a corporation as an exempt recipient if it has actual knowledge that the holder is a C corporation exempt from tax reporting or obtains a completed Form W-9 exemption certificate from the corporate holder. 36 KPMG Observation According to the Preamble, the proposed regulations adopt this change due to the requirement under Section 6045(g)(4) to provide tax reporting for sales by S corporations of covered securities acquired on or after January 1, Financial industry participants have not previously been required to distinguish C corporations from S corporations for tax reporting purposes. As a result, the proposed regulations effectively require an affirmative determination of the exempt reporting status for C corporations. This will be a significant operational and customer-facing challenge for brokers. To mitigate the transition impact, some brokers already are beginning to solicit C or S corporation status from customers as part of their account opening procedures. Treasury and IRS also are considering whether to modify Form W-9 to include an indicator of S corporation status. With respect to the identification of securities sold, the proposed regulations require brokers to apply a FIFO identification method unless the customer notifies the broker of another method by an adequate and timely identification of the securities sold. 38 If the average basis method applies, as either the default method of the broker or by 32 Sections 1012(c)(2) and 1012(d)(3). 33 Prop. Treas. Reg (e)(1). 34 Prop. Treas. Reg (e)(11). 35 Prop. Treas. Reg (c)(3)(i)(C). 36 Ibid. 37 Preamble at page Prop. Treas. Reg (d)(2)(ii).

10 9 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 39 Prop. Treas. Reg (d)(6)(v). 40 Prop. Treas. Reg (e)(7)(ii). 41 Prop. Treas. Reg (d)(6)(i). 42 Prop. Treas. Reg (d)(6)(iv). 43 Prop. Treas. Reg (d)(6)(vi), example 6, provides an example involving sales load charges when an investor sells shares in a fund and reinvests in shares of another fund at a reduced load charge because of a reinvestment right. Under Section 852(f), if the sale and reinvestment occur within a specified time period, the investor must exclude the sales load charge from basis in determining gain or loss on the sale; and the sales load charge is added to the basis of the purchased shares. In the example, the purchase and sale occur in different accounts; and the adjustments are not required for cost basis reporting purposes, although the example indicates the fund sponsor may choose to apply Section 852(f). By implication, it appears that if such deferral had occurred in the same account, adjustments to cost basis by the broker would be required, although the adjustment is not one specified by the proposed regulation. 44 See footnote 40 supra. The example does not indicate whether the investor has elected averaging. 45 Prop. Treas. Reg (d)(2)(iv)(A); see also Prop. Treas. Reg (d)(6). customer election, basis will be determined under the average basis method 39 and FIFO will apply to lot selection. 40 KPMG Observation The FIFO default rule in the reporting section of the proposed regulations seems to preclude brokers from adopting a default method other than FIFO. The proposed regulations provide that cost basis to be reported by a broker is the total amount paid by a customer or credited against a customer s account as a result of the acquisition of securities, adjusted for commissions and the effects of other transactions occurring within the same account. 41 A broker must report adjusted cost basis without regard to the constructive sale provisions of Section 1259 or the mark-to-market method of accounting under Section KPMG Observation -- Additional guidance is needed regarding other adjustments to cost basis and holding period that may be required within an account. Potential examples could include straddles, Passive Foreign Investment Company (PFIC) stock subject to a mark-to-market election under Section 1296, or RIC shares on which long-term capital gain dividends are paid immediately before the shares are sold at a short-term loss. 43 Clarification is also needed regarding the definition of an account for reporting purposes and whether that definition differs from the one as used in proposed amendments to the basis determination rules. For example, if a customer elects averaging for different RIC shares held within the same brokerage account, the shares of each RIC will be a separate account for averaging purposes but may be the same account for reporting purposes. 44 Brokers must also adjust reported basis to take into account the information received on a transfer statement (discussed below) in connection with the transfer of a covered security and information received from issuers of stock regarding the quantitative effect on basis of corporate actions unless the broker knows such information is incorrect. 45 Any failure by the broker to report correct information due to such reliance

11 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 10 on a transfer or issuer statement is deemed to be due to reasonable cause for penalty purposes. In addition, a broker is permitted to take into account information received from a customer or third party other than information reflected on a transfer or issuer statement unless the broker knows or has reason to know that the information is incorrect. A broker also may take into account information that the broker has about securities held by the same customer in other accounts with the broker. 46 KPMG Observation The proposed regulations provide limited guidance on how the different standards of knowledge will be applied in this context by cross referencing Treas. Reg (a)(1). For the requirements to be implemented in an administrable manner, brokers need a clear understanding of their obligations to accept and rely on information subject to reporting penalties. In this regard, one model for providing such knowledge standards is provided in Treas. Reg (b) with respect to withholding agents that are financial institutions. In addition, the combined ability of a broker to accept information outside of the transfer or issuer statement and also to provide information on Form 1099 in addition to that required to be reported to customers has pros and cons. On the one hand, this approach provides brokers with increased flexibility. On the other hand, it increases risks to the broker of inadvertently relying on provided information that is subject to penalties and it will require brokers to incur additional costs to respond to customer inquiries and to explain why one broker s cost basis policies differ from another broker s. Under the Act, a broker is required to adjust cost basis within an account for wash sales occurring with respect to identical, covered securities. 47 Commentators had requested various exceptions from a technical application of the wash sale rules in this context, including an exception for de minimis adjustments resulting in wash sales, reinvested dividends triggering wash sales, and for high frequency traders. No such exceptions are provided in the proposed regulations. KPMG Observation Treasury and IRS request additional comments on the treatment of high frequency traders, including how such traders could be identified and the burden imposed by basis reporting in this situation. 48 Some brokers have provided feedback that excluding high frequency trader accounts from cost basis reporting may be more burdensome than reporting wash sales for these accounts. The proposed regulations define identical securities for this purpose as having the same CUSIP number or other security identifier number that the Treasury may designate. 49 KPMG Observation -- Each share class in a single RIC has a separate CUSIP. As a result, the standard for "identical" may need to be clarified in this regard. Stated differently, you should not have a wash sale for tax purposes when you move from one share class of a RIC to another share class in that same RIC. It could be understood that, since no loss (or gain) should be recognized on that transaction for tax purposes, no special rule is needed here. When reporting the sales transaction that triggers a wash sale, brokers must report the amount of the loss that is disallowed on the sale transaction under Section Transfers and Transfer Statements The Act added Section 6045A, which requires an applicable person that transfers to a broker a covered security in the hands of the transferring entity to furnish to the 46 Prop. Treas. Reg (d)(2)(iv)(B). 47 Prop. Treas. Reg (d)(6)(iii). 48 Preamble at page Prop. Treas. Reg (d)(6)(iii). 50 Ibid.

12 11 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock receiving broker a written statement that allows the receiving broker to satisfy the basis reporting requirements of Section 6045(g). Section 6045A(c) provides that such statement generally must be furnished to the receiving broker not later than 15 days after the transfer of the covered security. For this purpose, a broker receiving custody of securities means any person described in (a)(1), any person that acts as a custodian of securities in the ordinary course of a trade or business, any issuer of securities, and any agent of these persons. 51 A broker for this purpose does not include the beneficial owner of the securities, any governmental unit or agency or instrumentality of a governmental unit with respect to escheated securities, or any person acting solely as a clearing organization with respect to the transfer. It is important to note that this definition of a broker for purposes of the transfer statement requirement is broader than the definition of a broker required to file Forms 1099 in connection with sales of securities under Treas. Reg (a)(1). This definition of broker also conforms to the definition of an applicable person required to provide a transfer statement, as discussed below. 51 Prop. Treas. Reg A-1(a)(4). 52 Prop. Treas. Reg A-1(a)(1); Preamble at page Prop. Treas. Reg A-1(b)(2). The proposed regulations create a presumption that every non-sale transfer of custody by an applicable person to a receiving broker of any shares of stock in a corporation on or after January 1, 2011 is a transfer of a covered security subject to transfer reporting. 52 As a result, a transfer statement must be provided for every such transfer, including transfers of noncovered securities or securities treated as noncovered because they were held by recipients exempt from tax reporting at the time of their acquisition. For noncovered securities, the transfer statement only needs to indicate that the securities are noncovered. The applicable person effecting the transfer of a noncovered security is permitted to include information on the transfer statement that would be required for covered securities. In that case, the applicable person will not be subject to penalties with respect to such optional information, provided that the transfer statement indicates that the transfer is a transfer of a noncovered security. 53

13 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 12 The requirement that a transfer statement be provided for both covered and noncovered securities is intended to reduce uncertainty for receiving brokers and custodians. 54 Otherwise, a receiving broker who did not receive a transfer statement would not know whether the failure occurred because the transferred security was not a covered security or because of noncompliance by the transferring entity with the transfer statement requirement. As discussed below, a receiving broker that does not receive a complete transfer statement has a duty to request one. KPMG Observation If an applicable person providing a transfer statement in connection with noncovered securities opts to provide additional information, the receiving broker should not have an obligation to use that information when reporting any subsequent sale of the transferred, noncovered securities under the general reporting rules for noncovered securities. Whether financial industry participants will transfer additional information about noncovered securities likely will depend on agreed industry protocols with respect to the transfer and receipt of this information. Under the proposed regulations, an applicable person means a broker as described in (a)(1), any person that acts as a custodian of securities in the ordinary course of a trade or business, any issuer of securities, and any agent of these persons. 55 An applicable person does not include the beneficial owner of the securities, any governmental unit or agency or instrumentality of a governmental unit with respect to escheated securities, or any person that acts solely as a clearing organization with respect to the transfer. As explained in the Preamble, this definition means that persons responsible for providing transfer statements may not be brokers otherwise required to produce a Form 1099-B with respect to any sale of covered securities. 56 Applicable persons include, for example, issuers, transfer agents, professional custodians, and any other applicable persons that may not effect sales of securities. For these non-broker applicable persons, the Preamble explains that their duty is limited to a duty to receive the statement when receiving custody of transferred securities and then to retransmit the information on the statement when transferring custody of those securities to a broker (or, if no statement is received, to furnish a statement that the securities are noncovered securities). 57 Applicable persons that do not effect sales of securities are not required to update basis information for corporate actions or to compute basis using the average basis method because these calculations apply only to basis reporting at the time of sale. 58 KPMG Observation Treasury has requested comments regarding the scope of the transfer statement requirement. This request is appropriate, given the variety of transfer transactions that may occur within the financial services sector. For example, it is not clear what is meant by a clearing organization exempted from transfer reporting and what is meant by receiving custody of transferred securities. The clearing organization carve-out from the transfer statement requirement could reflect an intention to require transfer reporting only where the transferring entity has information about the underlying beneficial owners for an account and is transferring custody of those securities to a receiving broker. A transfer agent receives regular feeds from The Depository Trust and Clearning Corporatio (DTCC) regarding daily changes in share positions with respect to nominee accounts held through DTCC. Presumably, DTCC itself is not required to provide transfer reporting to the transfer agent. At the same time, assuming a broker is instructing a change of ownership 54 Preamble at page Prop. Treas. Reg A-1(a)(3). 56 Preamble at page Id. 58 Prop. Treas. Reg A-1(b)(1)(vii); Preamble at page

14 13 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock from the transfer agent (from customer to street name, for example), it appears that the broker initiating the instruction also is not required to provide transfer reporting because the transferring broker would be required to produce Forms 1099-B with adjusted cost basis for any sales in connection with these nominee accounts. On the other hand, if a broker is transferring a client position to a transfer agent (for example via DTCC s Direct Registration System) where the beneficial owner s assets will be directly accounted for and held by the transfer agent going forward, transfer reporting would be required. Similarly, a transfer agent would presumably be required to provide transfer reporting for any transfers of securities held in registered form to a receiving broker at a client s request. A transfer statement must be provided in writing, unless both the applicable person and the receiving broker agree to a different format or method prior to the transfer. 59 If a transfer occurs between accounts at the same or affiliated entities, the transfer statement is deemed to have been furnished and received if the required information is incorporated into the records for the recipient account. No format is prescribed for the required information since it will not be reported to the IRS, and an applicable person furnishing the transfer statement and the receiving broker may agree to combine the information in any format. KPMG Observation -- The proposed regulations do not provide any exemption from the transfer statement requirement where the receiving broker does not participate in an electronic cost basis reporting service. The proposed regulations only require that the transfer statement be provided in writing or using any other method agreed prior to the transfer. This means that applicable persons should be prepared to deliver transfer statements to receiving brokers using a variety of methods, including spreadsheets, faxes, or other electronic communications. Having said that, to make the transfer statement obligation administrable across the financial services industry, it will be important to have agreed industry formats and protocols for the transfer statement requirement. Treasury and IRS request comments about the form and format for transfer statements. 59 Prop. Treas. Reg A-1(a)(2). 60 Prop. Treas. Reg A-1(b)(1). 61 Prop. Treas. Reg A-1(b)(7)(i). Any failure to report correct information that arises solely from this reliance is deemed to be due to reasonable cause for penalty purposes. 62 Prop. Treas. Reg A-1(b)(7)(ii). A transfer statement must include prescribed information, including (1) the statement date and the date of any previous statement with respect to the same transfer; (2) the contact details for the broker receiving custody; (3) the contact details including taxpayer identification number and account number for beneficial owners of the security prior to the transfer and, if different, this information for the beneficial owners or owners after the transfer; (4) the CUSIP or other security identifier; (5) the date that the transfer was initiated and the settlement date (if known at the time of transfer); and (6) the total adjusted basis of the security, the original acquisition date of the security, and the date for computing whether any gain or loss on the security is long-term or short-term (as adjusted for wash sales in the same account, for example) upon any subsequent sale. 60 The transfer statement for a covered security also must take into account all information reported on any transfer statement received in connection with a previous transfer of the security to the applicable person, unless the applicable person knows that this information presented on the prior transfer statement is incorrect. 61 An applicable person also is permitted to take into account any other information that is not reflected on a prior transfer statement, including any information that the applicable person has about securities held by the same customer in the custody of the applicable person. For penalty purposes, an applicable person that takes into account such information received from a customer or third party is deemed to have relied upon such information in good faith if the applicable person neither knows nor has reason to know that the information is incorrect. 62

15 Proposed Regulations on Basis Reporting by Securities Brokers and Basis Determination for Stock 14 KPMG Observation Where a broker opts to incorporate information outside of a transfer or issuer statement received from an applicable person on a Form 1099-B, including with respect to wash sales in different accounts, it will be important for the broker to notify the customer so that the customer can properly reconcile the basis to be reported on its tax return with the adjusted basis reported on Form 1099-B. 63 The applicable person providing a transfer statement is not required to update transferred basis information for corporate actions. However, if corporate actions are taken into account, then the transfer statement must include information regarding such actions, including the identifying number of the last issuer statement taken into account. 64 KPMG Observation As drafted, the proposed regulations do not require applicable persons to update transfer statements for corporate actions. Thus, the broker ultimately required to report a sale on Form 1099-B for a covered security will be required to research all corporate actions for that security if not previously included on a transfer statement. This requirement could be very difficult, particularly where a sale of transferred securities subject to prior corporate actions may occur shortly after the transfer, such as where a transfer agent transfers securities to a broker at the request of a holder to effect an immediate sale. A separate transfer statement must be provided for each security, and also for each lot of the same security. 65 An exception is provided from this lot-by-lot statement requirement for transferred securities of a RIC or DRP using the average basis method that were acquired more than five years prior to the transfer. In that situation, the transfer may be reported on a single statement reporting the original acquisition date as VARIOUS, but only if the other information on the statement applies to all of the securities. 66 In the case of a transfer of less than the entire position of a security that was acquired in an account at different times and at different prices, the transfer statement must report the transfer on a FIFO basis within an account, unless the customer notifies the applicable person furnishing the transfer statement of specific lots to be transferred. 67 KPMG Observation We understand that certain applicable persons may not have existing functionality to permit customers to identify particular lots upon transfers of securities. This rule could present significant operational challenges for these industry participants. Where a broker receives custody of a security, but does not receive a transfer statement for that security or receives a transfer statement with incomplete information, the receiving broker must notify the applicable person effecting the transfer and request a complete statement. If the receiving broker does not receive a complete statement in response to this request, the broker may designate the security as noncovered on any subsequent transfer statement. 68 However, if a transfer statement is later received by that broker indicating that the subsequently transferred security is, in fact, a covered security, the broker must issue a corrected statement for the subsequent transfer within 15 days of receiving this information Prop. Treas. Reg (d)(2)(vi), example 6, provides a situation where a customer asks a broker to adjust the cost basis for securities held at the broker for wash sales occurring in another account. The example provides that it is up to the broker to decide whether to take this customer-provided information into account when preparing Forms 1099-B for that customer. 64 Prop. Treas. Reg A-1(b)(1)(vii). 65 Prop Treas. Reg A-1(a)(1). 66 Ibid. 67 Prop. Treas. Reg A-1(b)(6). 68 Prop. Treas. Reg A-1(b)(8). 69 Prop. Treas. Reg A-1(c).