For this reason, DST and its clients chose to fall in line with the ‘compounding accruals’ default option. But the major backoffice challenge, according to David Rhind, who led the TOFA project at DST, is ensuring that clients’ assets can be moved smoothly between custodians. Because tax will now be taken at regular intervals, custodians must provide extensive records detailing the transaction histories of assets. “It’s about getting ready to hold and process client information, but also about being able to take on new assets,” Rhind says. “But if you can’t get the information from [the former] custodian, where can you get it?” Initially complying with TOFA – or “transitioning in” to the new regime – will also demand more from administrators. For example, to apply TOFA to their existing portfolios, administrators must spread the potential gains from assets until they reach maturity. And if they sell assets before maturity, they must still keep the tax liability on their books.

“Transitioning in, and swapping assets between one administrator and another are the most tricky areas.” In a white paper on TOFA, DST states that the laws will force backoffice operations to introduce “specific data and calculation requirements that may not be catered for in existing trading, asset management, accounting and tax systems”. Not only are these changes to IT systems necessary, but they should be made early to allow for testing and implementation before TOFA becomes compulsory. But there is some upside. At State Street, Khoury says the incremental taxation of assets under TOFA will be more manageable because large tax events will become less common. The new rules also provide guidance on the taxation of derivatives, and eliminate some of the “guesswork” for investors.

“It makes it easier for people to recognise different investment instruments, and bring these to account in a timely manner.” In the run-up to TOFA, State Street’s role is not to provide back-office solutions to investors, but supply them with the information they need to decide which default or elective option best suits them. “Managers can look at their baskets of securities and determine whether it’s advantageous to go through a portfolio elective, and then consider their mandates, which will determine the types of securities going into their portfolio.” This need for analysis and forecasting has ensured that TOFA has drawn the “largest single effort” from Khoury and his team this financial year.

The laws have been gestating for many years. But now that default and elective options have been defined, “it is the first time we’ve had clarity over the requirements,” Khoury says. Toe -to -TOFA What TOFA will not deliver is a hoped-for change in the tax treatment of currency forwards, to better align them with the equities they often hedge. Despite TOFA, the “mis-match in the tax treatment” of equities and derivatives in hedged global equity portfolios has not been remedied, says Raewyn Williams, director of aftertax investment strategies with Russell Investments. “It is one thing that should have been fixed by TOFA but hasn’t.” This is because the ‘hedging’ elective within TOFA keeps equities on capital account, and currency derivatives on revenue account, which results in the assets generating tax liabilities at different times. Whenever equities are traded, tax gets paid. But currency forwards incur tax when they expire at the end of their contracts, when they are ‘rolled over’. “The tax rules mean that you can’t offset the two.