The Final Straw of Corporate Actions Reporting

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Brokerages and custodians who manage customer assets on the brokerages' behalf have a critical role in managing the information flow between issuer and customer.

Yet from a data management standpoint, the link between broker and customer is much stronger than that between broker and issuer. Brokers know very well their customers' portfolios, preferences, and plans. By contrast, brokers tend to be in the dark when it comes to figuring exactly what corporate issuers are planning or doing. For that they rely upon market-data intermediaries to capture, scrub, and distribute corporate actions data after it's released to the public in whatever idiosyncratic format the issuer chooses.

Internally, brokerage and custodian IT departments have to implement solutions that consistently cross-reference corporate actions data against their own holdings to figure out who's affected, and then respond accordingly. As an example, suppose a company makes a rights offering where existing shareholders have to decide whether to buy in or not. The custodians and brokers in the middle have to notify anyone who holds that security of the offering, request and capture their election choices, and execute on same.

If the brokerage fails to give the notification or makes a mistake, they're liable for resulting losses and damages. Furthermore, a broker is more than likely to pay up without a fight just to preserve their reputation, even if the error was attributable to a custodian, data provider, or the issuer.

Making the situation even more fraught with peril, recent tax code changes require every broker to maintain a complete dossier on every covered securities sale involving a US taxpayer, taking into account all relevant corporate actions.

Under rules that took effect last year, securities brokers are now responsible for reporting to the IRS the tax status of the sale of covered securities, which include most corporate-issued securities that a US taxpayer might own, including shares in foreign companies. Previously, brokers just had to report the gross proceeds of a sale. Now, brokers have to record, calculate, and report to the IRS the customer's adjusted basis for each sale, whether the gain or loss was short-term or long-term, and any customer instructions provided. With this requirement, the IRS has a way to cross-check what taxpayers are telling them with what their brokers are reporting.

Furthermore, the IRS has also told securities issuers that they must also file a new information return, Form 8937, to report anything that affects the basis of securities. This prevents brokers and their customers from conspiring to cook the books. The IRS will receive information from three sources -- the issuer, the broker, and the customer -- and if something doesn't match up, it'll stick out. As a result, we should expect to see higher compliance rates with capital gains tax payments.

The downside is the increased compliance burden on the securities industry.

Corporate actions processing is already an expensive headache for financial institutions, which they then pass along to their customers. On top of that, brokers now have to quiz their customers on each security in their portfolio, maintain that information for tax purposes, make corrections as needed, and provide extensive reports to the tax authorities. That's a hefty added responsibility with no discernible commercial advantage.

To comply with the IRS reporting requirement calls for an investment in IT and legal support, giving the largest players a scale advantage to the detriment of smaller players. From this, we might expect lower levels of competition in the securities industry, and therefore higher prices to investors.

Adding insult to injury, there's a good technological fix at hand that isn't being adopted fast enough. If issuers of securities were to start sending corporate actions messages using the industry standard ISO 20022 messaging format, everybody touching those securities would benefit immensely from increased efficiency and lower cost.

Yet there's not a strong-enough incentive for issuers to conform to a financial industry messaging standard. The issuers call the tune and everyone else dances. It would be quite a trick to convince CFOs worldwide to pay for ISO 20022 encoding out of their own budgets, even if the total cost is dwarfed by what the securities industry spends collectively on corporate actions processing.

With IRS Form 8937, we have a typical tax form with spaces for typewritten answers, submitted only to the tax authorities, useful to nobody except for the data vendors who get paid to translate corporate actions data into formatted codes.

Instead of requesting paper forms, what if the government required issuers to provide corporate actions data for covered securities in the digital, industry-standard ISO 20022 format? Not only would the IRS receive their information faster, but the entire securities industry would receive some form of belated compensation for having to build an extensive infrastructure to help the IRS catch tax cheats.

Some questions: Is it reasonable for brokerages to take on such extensive reporting requirements? Should issuers have to conform to a certain protocol for corporate actions and other reporting? Or should investors have to pay for the task of scrubbing data? In the comments, let's hear what you think about the intersection between corporate actions and tax reporting for financial IT.