Reading 11

Question 1

Three primary categories of tax

Answer 1

1. Taxes on income
   - individuals, corporations, other legal entities
   - waves, interest, dividends, capital gains
2. Wealth based taxes
   - Pain on value of assets held and on wealth transfers
3. Taxes on consumption
   - Sales taxes
   - Value-added taxes

Question 2

Compare basic global taxation regimes as they relate to the taxation of dividend income, interest income, realised capital gains and unrealised capital gains

Answer 2

Common progressive
Heavy dividend tax
Heavy capital gain tax
Heavy interest tax
Light capital gain tax
Flat and light
Flat and heavy

Question 3

Accrual equivalent after-tax return

RAE

Accrual equivalent tax rate

Answer 3

Annual return that produces the same terminal value as the TAXABLE portfolio

The tax rate that makes the pretax return equal to the accrual equivalent after-tax return

Accrual taxes = periodic tax (usually annual) at a single tax rate on income or return

Question 4

Explain how investment return and investment horizon affect the tax impact associated with an investment

1) Accrual taxes

Answer 4

• If n > 1, tax drag percentage > t

- If n and/or r increase, tax drag and amount increase

Question 5

Explain how investment return and investment horizon affect the tax impact associated with an investment

2) Deferred capital gains taxes

And reference Base cost

Answer 5

• As n and/or r increase, tax drag amount increases
• If B = 1.0, tax drag percentage = t
• If B < 1.0, tax drag percentage > t
• If B > 1.0, tax drag percentage < t

Question 6

Explain how investment return and investment horizon affect the tax impact associated with an investment

3) Annual wealth taxes

Answer 6

• Tax effects are more onerous as the tax rate applies to total value, not just return
• As n increases, tax drag amount and percentage increases
• BUT as r increases, tax drag percentage decreases even as amount increases
• Tax drag amount is lower at moderate time horizon and return

Question 7

Talk about TDA and TEA

Answer 7

Both TDA and TEA provide tax deferred compounding of return

TDA: Tax-deferred account

• contributions provide a front-end tax advantage
• i.e. contributions are pre-tax
• but all withdrawals are taxed

TEA: Tax-exempt account

• contributions provide a back-end tax advantage
• i.e. contributions are after-tax
• but all withdrawals are NOT taxed
• If the current and the expected future tax rate are equal, TDA and TEA provide equal future value
• If the future tax rate is expected to be lower, use the TDA
• If the future tax rate is expected to be higher, use the TEA

Question 8

Explain how taxes affect investment risk

Answer 8

After-tax return is less variable than pretax return as taxes take a portion of the upside and reduce the downside

Question 9

Discuss the relation between after-tax returns and different types of investor trading behaviour

Answer 9

High turnover lowers tax alpha as the benefits of tax-deferred compounding are lost.

In addition, more gains are taxed at higher short-term rather than lower long-term rates.

Lowest tax alpha (highest turnover) to highest tax alpha (lowest turnover)

1) traders
2) active investors
3) passive investors

Question 10

Explain tax loss harvesting and highest-in / first-out (HIFO) tax lot accounting

Answer 10

Tax loss harvesting uses investment losses to offset investment gains or income, resulting in a tax saving.

This initial tax savings is overstated because the tax savings is taken now and low cost basis is not available in the future. Harvesting = deferral of taxes

• Investors often accumulate a position through a series of trades, each occurring at different points in time and at different prices.
• If a partial sale of the position is being made, it is generally best to designate the highest cost basis lot as being sold first (HIFO) to minimize the tax gain or maximize the tax loss.
• If future tax rates are expected to be higher than current rates, designating the lowest cost basis as being sold (LIFO) may be better as it accelerates tax payments to the present and lowers them in the future

Question 11

Demonstrate how taxes and asset location relate to mean-variance optimisation

Answer 11

Ideally, the efficient frontier of portfolios should be viewed on an after-tax basis. For example, an investor holds both stocks and bonds in both taxable and tax-exempt accounts. In this case, there are four different assets that could appear on the efficient frontier.

Of course, the optimisation process would have to be constrained to account for limits on the amount of funds that can be placed in tax-advantaged accounts and the types of assets that an be allocated to them.

The mean-variance optimisation should optimally allocate assets and determine the optimal asset location for each asset.