After-Tax Accumulations and Returns for Taxable Accounts This section addresses the following: LO.b: Determine the effects of different types of taxes and tax regimes on future wealth a
Trang 1Taxes and Private Wealth Management in a Global Context
1 Introduction 3
2 Overview of Global Income Tax Structures 3
2.1 International Comparisons of Income Taxation 4
2.2 Common Elements 4
2.3 General Income Tax Regimes 4
2.4 Other Considerations 5
3 After-Tax Accumulations and Returns for Taxable Accounts 5
3.1 Simple Tax Environments 5
3.2 Blended Taxing Environments 9
3.3 Accrual Equivalent Returns and Tax Rates 10
4 Types of Investment Accounts 10
4.1 Tax-Deferred Accounts 11
4.2 Tax-Exempt Accounts 11
4.3 After-Tax Asset Allocation 11
4.4 Choosing Among Account Types 11
5 Taxes and Investment Risk 12
6 Implications for Wealth Management 12
6.1 Asset Location 12
6.2 Trading Behavior 12
6.3 Tax Loss Harvesting 13
6.4 Holding Period Management 13
6.5 After-Tax Mean-Variance Optimization 14
Summary 14
Examples from the Curriculum 17
Example 1 Tax Rates 17
Example 2 Accrual Taxes 18
Example 3 Deferred Capital Gains 19
Example 4 Cost Basis 19
Example 5 Wealth Tax 20
Example 6 Blended Tax Environment 20
Example 7 Blended Tax Environment: After Tax Return 21
Example 8 Blended Tax Environment: Future Long Term Accumulation 22
Example 9 Accrual Equivalent Return 23
Example 10 Comparing Accumulations of Account Types 23
Example 11 Choosing Among Account Types 24
Example 12 Tax Loss Harvesting: Current Tax Savings 25
Example 13 Tax Loss Harvesting: Tax Deferral 26
Example 14 Tax Loss Harvesting: Adding Net-of-Tax Principal 27
Example 15 Long-Term Gain 28
Trang 2This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright
2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute
Trang 31 Introduction
The topic of taxes is complicated and tax laws vary from country to country In this reading we will address some of the more common and basic concepts of taxation This will help us learn the fundamental building blocks that are needed to evaluate taxes and calculate after-tax investment returns This reading will also help us develop a framework with which advisors can communicate the impact of taxes on portfolio returns
2 Overview of Global Income Tax Structures
Broadly speaking, there are three kinds of taxes:
investor’s Investment Policy Statement (IPS), which is the subject of Managing Individual Investor
Portfolios This reading is primarily concerned with investment income, of which there are three
sources:
1 Interest Income
2 Dividend Income
3 Capital Gains
There are two further categories of capital gains:
1 Unrealized – the amount an investment appreciates above its purchase price before it is sold
2 Realized – the difference between an investment’s sale price and its purchase price
It is therefore more accurate to say that there are four sources of investment income:
1 Interest Income
2 Dividend Income 3a Capital Gains (Unrealized) 3b Capital Gains (Realized)
As will be discussed in the next section, the distinction between unrealized and realized capital gains is particularly important from a tax perspective
Wealth-based Taxes
Wealth-based taxes come in two forms:
1 Taxes on transferring wealth
Trang 42 Taxes on holding wealth
An investor who wishes to transfer wealth can do so either as gift during his lifetime, or after his death Therefore, the two major forms of wealth transfer taxes are gift taxes and estate taxes These will be
covered in section 4.1 of Estate Planning in a Global Context This reading, specifically section 3.1.4, is
concerned with taxes on holding wealth, such as property taxes on real estate
Taxes on Consumption
Consumption taxes, such as sales taxes or value added taxes (VAT) are paid when people purchase goods or services
The focus of this reading is on taxes on investment income and wealth-bases taxes
2.1 International Comparisons of Income Taxation
Sections 2.1 to 2.3 report findings from a survey of tax laws in over 50 countries around the world 2.2 Common Elements
Progressive tax systems apply increasingly higher marginal tax rates to higher levels of income In Example 1, Vanessa Wong lives in a jurisdiction that applies the following marginal tax rates:
20% on the first €30,000 of taxable income
30% on income above €30,000, up to €60,000
40% on income above €60,000, up to €90,000
50% on income above €90,000
Refer to Example 1 from the curriculum
The alternative to a progressive tax system is to apply a single, flat tax rate to all levels of income In the real world, progressive tax systems are far more common than flat tax systems
Investment income is often taxed differently based on the nature of the income – interest, dividends, capital gains It is possible that a country may have different tax rates for each of these sources of investment income
2.3 General Income Tax Regimes
This section addresses LO.a:
LO.a: Compare basic global taxation regimes as they relate to the taxation of dividend income, interest income, realized capital gains, and unrealized capital gains
Tax regimes can be classified into the following seven categories:
Trang 5Tax Regime Tax system for
ordinary income
Favorable treatment for interest?
Favorable treatment for dividends?
Favourable treatment for capital gains?
2.4 Other Considerations
This section introduces the impact of tax-deferred savings accounts and wealth taxes This will be covered in detail in later sections
3 After-Tax Accumulations and Returns for Taxable Accounts
This section addresses the following:
LO.b: Determine the effects of different types of taxes and tax regimes on future wealth accumulation
LO.c: Explain how investment return and investment horizon affect the tax impact associated with
an investment
3.1 Simple Tax Environments
The examples discussed in this reading assume that income is taxed at a single flat rate, rather than at a series of progressive rates This simplifying assumption is made, in part, because it is very complicated to design models that accommodate multiple tax brackets
3.1.1 Returns-Based Taxes: Accrual Taxes on Interest and Dividends
The future value of an investment can be determined by multiplying the original investment by a future value interest factor (FVIF) If an investment’s returns are taxed annually, as is often the case for when returns are received in the form of interest or dividend income, its future value interest factor (FVIFi) calculated as follows:
FVIFi= [1 + r(1 − ti)]n
To understand the formula above, consider the following two scenarios from the curriculum In Scenario
1, an investment of €100 is made today and returns are allowed to compound tax-free In Scenario 2, the returns on the same €100 investment made today are subject to a 30% annual accrual tax
Trang 6Original investment €100 €100
FVIFi [1 + 0.06(1 – 0.00)]10 = 1.7908 [1 + 0.06(1 – 0.30)]10 = 1.5090
Future value of investment €100 x 1.7908 = €179.08 €100 x 1.5090 = €150.90
Gain on investment €179.08 - €100 = €79.08 €150.90 - €100 = €50.90
The €50.90 gain in Scenario 2 is €28.18 less than the €79.08 gain in Scenario 1 Put differently, €28.18 of
a potential €79.08 gain was lost due to taxes This loss of potential gains is called “tax drag” and is expressed as a percentage of the gain that would have been realized if the investment had been allowed
to grow tax-free In the example above, the tax drag is 35.6 percent (€28.18/€79.08)
Tax Drag relationships
Exhibit 2 shows the effect of taxes on capital growth for across different investment horizons and rates
The data in Exhibit 2 allows us to draw four conclusions:
1 The tax drag of annual accrual taxes will always be greater than the nominal tax rate
2 As investment horizon increases the tax drag increases
3 As investment returns increases the tax drag increases
4 Return and investment horizon have a multiplicative effect on the tax drag
Refer to Example 2 from the curriculum
3.1.2 Returns-Based Taxes: Deferred Capital Gains
In section 3.1.1, we considered the effect of taxing returns annually, as is typically done for investment that provide income in the form of interest or dividends In this section, we consider the effect of taxing capital gains, which can be either realized or unrealized
Trang 7Imagine that an investor paid €20 last year for a stock that is currently trading at €100 If the investor sells that stock today, she will have realized a capital gain of €80 (€100 sale price - €20 purchase price) If she continues to hold the stock (i.e., does not sell it), she will still have a €80 capital gain, but it will
remain unrealized As noted in the curriculum, “it is very rare for unrealized capital gains to be taxed.”
The future value interest factor for an investment that remains untaxed until capital gains are realized (FVIFcg) is calculated using either of the formulas below:
FVIFcg= (1 + r)n− [(1 + r)n− 1)]tcg
Which can be further simplified to:
FVIFcg= (1 + r)n(1 − tcg) + tcg
Note that both of these formulas yield identical results
Recall that in Scenario 1 in the previous section, a €100 investment grew to a value to €179.08 if its 6 percent annual returns were allowed to compound tax-free The €100 investment in Scenario 2 grew to
a value of €150.90 if the same 6 percent annual returns were taxed at a rate of 30 percent In Scenario 3,
we consider the impact of a 30 percent tax on deferred capital gains (tcg)
Scenario 3
Tax rate on deferred capital gains (tcg) 30%
Future value of investment €100 x 1.5536 = €155.36
The €55.36 gain in Scenario 3 is €23.72 less than the €79.08 gain in Scenario 1 This tax drag in this case
is exactly 30 percent (€23.72/€79.08), which is identical to the nominal tax rate on deferred capital gains
Tax Drag relationships
Compared to the three relationships we saw for accrual taxes, the relationships for deferred capital gains taxes are quite different:
1 Tax drag percentage is equal to the nominal tax rate
2 As the investment horizon increases the tax drag is unchanged
3 As the investment return increases the tax drag is unchanged
In addition, when taxes are deferred:
4 As investment horizon increases, the value of the tax deferral increases
Trang 85 As investment return increases, the value of the tax deferral increases
Refer to Example 3 from the curriculum
3.1.3 Cost Basis
Cost basis is an investment’s original purchase price The future value interest factor of an investment with a cost basis below current market value (FVIFcgb) is calculated using either of the formulas below: FVIFcgb= (1 + r)n(1 − tcg) + tcg− (1 − B)tcg
FVIFcgb= (1 + r)n(1 − tcg) + tcgB
Note that the term B represents the ratio of the purchase price (i.e., cost basis) to the current market
price If the same investment from Scenarios 1, 2, and 3 that has a current market value of €100 was originally purchased for €80, its future value could be calculated as follows:
Scenario 3
Unrealized capital gain €100 - €80 = €20
Pre-tax rate of return (r) 6%
Tax rate on deferred capital gains (tcg) 30%
FVIFcgb (1 + 0.06) 10 (1 – 0.30) + (0.30)(0.8) = 1.4936
Future value of investment €100 x 1.4936 = €149.36
As shown in the table below, the after-tax future value of the investment in Scenario 4 (€149.36) is less than the after-tax future value of the same investment in Scenario 3 (€155.36) In both cases, the investment was sold for €179.08 However, in Scenario 4, the capital gain (and capital gains tax liability)
is greater because the purchase price is lower
Scenario Sale Price Purchase Price Capital Gain Taxes Paid (30%) After-tax Future Value
Trang 9collect wealth taxes on the value of financial assets
The future value interest factor of an investment subject to a wealth tax (FVIFw) is calculated using the formula below:
FVIFw = [(1 + r)(1 − tw)]n
With an annual wealth tax rate (tw) of 2 percent, a €100 investment with annual pre-tax growth of 6
percent will have an after-tax value of [(1 + 0.06)(1 – tw)]10 = €146.33 at the end of 10 years Note that a
2 percent wealth tax imposes a greater tax bite than a 30 percent tax on returns This is because wealth taxes are applied to the entire value of an asset and not simply its returns
Tax drag relationships:
For wealth based taxes, the three primary relationships can be summarized as:
1 Tax drag percentage is greater than the nominal tax rate
2 As the investment horizon increases, the tax drag increases
3 As investment return increases, the tax drag decreases
Refer to Example 5 from the curriculum
3.2 Blended Taxing Environments
Because countries typically apply different tax rates to different sources of income, portfolios are taxed
at a blended rate that reflects the share of returns attributable to interest, dividends and realized capital
gains The annual after-tax return (r *) for a portfolio with multiple sources of income is calculated as follows:
r∗= r × (1 − piti− pdtd− pcgpcg)
In the formula above, pi is the proportion of returns derived from interest income, pd is the proportion derived from dividend income, and pcg is the proportion derived from realized capital gains When taxes
are paid, the after-tax return will always be lower than the pre-tax return In Example 7, we see that an
8 percent pre-tax return becomes a 7.02 percent return after adjusting for taxes paid on interest and dividend income as well as realized capital gains Note that taxes on unrealized capital gains have been deferred
Refer to Example 6 from the curriculum
Refer to Example 7 from the curriculum
In situations where a portion of capital gains are unrealized and not taxed immediately, the effective
capital gains tax rate (T * ) will be less than the nominal capital gains tax rate (tcg) The formula below calculates T * by multiplying tcg by the ratio the share of returns represented by unrealized capital gains
Trang 10to the proportion of the pre-tax return that remains after taxes have been paid:
T∗= tcg× (1 − pi− pd− pcg)
(1 − piti− pdtd− pcgtcg)
Note that T * will be higher (and closer to tcg) when an unrealized capital gains account for a greater
proportion of pre-tax returns
Having calculated a blended after-tax rate of return (r * ) and a blended tax rate (T *), it becomes possible
to determine the future value interest factor for a portfolio when different sources of income are taxed
at different rates
FVIFTaxable= (1 + r∗)n(1 − T∗) + T∗− (1 − B)tcg
Refer to Example 8 from the curriculum
3.3 Accrual Equivalent Returns and Tax Rates
Determining the overall effect of taxes on portfolio returns can be challenging in blended tax environments In such cases, it is helpful to have simple measures such as the accrual equivalent return and accrual equivalent tax rate
3.3.1 Calculating Accrual Equivalent Returns
The accrual equivalent return (RAE) is simply the rate (I/Y) that links a portfolio’s final after-tax value (FV) with the value of the original investment (PV) over an investment horizon of N periods
3.3.2 Calculating Accrual Equivalent Tax Rates
The accrual equivalent tax rate (TAE) is the tax rate that links the accrual equivalent return (RAE) with the pre-tax return (r) and can be calculated with the formula below:
TAE = 1 −RAE
r
Example 9 demonstrates how to calculate both RAE and TAE As shown in Exhibit 9 (in Section 6.2), a higher accrual equivalent tax rate results in a lower accrual equivalent return
Refer to Example 9 from the curriculum
4 Types of Investment Accounts
This Section and Section 6.1 address:
LO.d: Discuss how the tax profiles of different types of investment accounts and explain their effects
on after-tax returns and future accumulations
Trang 11To this point, we have discussed investments that are held in regular taxable accounts However, many countries create tax-advantaged accounts to encourage investors to save for purposes such as retirement or education Two common account structures are discussed below
4.1 Tax-Deferred Accounts
Tax-deferred accounts (TDAs) allow investors to reduce taxable income today and defer paying taxes until funds are withdrawn The future value interest factor for funds invested in a TDA is calculated as follows:
Refer to Example 10 from the curriculum
4.3 After-Tax Asset Allocation
The decision on whether to invest in a TDA or a tax-exempt account has implications for an investor’s asset allocation Taxes have already been paid on assets held in a tax-exempt account, whereas assets held in a TDA have yet to be taxed As shown in Exhibit 6, bonds worth €500,000 have an after-tax value
of €500,000 if they are held in a tax-exempt account By contrast, stocks worth €1,500,000 have an after-tax value of just €900,000 (assuming a flat 40 percent tax rate) if they are held in a TDA Investors need to make allocation decisions based on after-tax asset values
4.4 Choosing Among Account Types
Refer to Example 11 from the curriculum
As shown in Example 11, investors should be indifferent between investing in a tax-exempt account or a TDA if tax rates are expected to remain at their current levels However, if an investor believes that tax rates will increase, it is better to pay taxes at the current lower rate and invest in a tax-exempt account
By contrast, if tax rates are expected to decrease, it is better to invest in a TDA, which will defer the payment of taxes until after lower rates have taken effect
Trang 125 Taxes and Investment Risk
This section addresses:
LO.e: Explain how taxes affect investment risk
A fundamental principle regarding taxes and risk is that, by taxing investment returns, a government shares risk as well as return with the investor
For assets in taxable accounts, the taxing authority shares the investment risk with the investor Hence, taxes can reduce investment risk
For assets in TDA’s and tax exempt accounts, investor bears all risk associated with returns
6 Implications for Wealth Management
The value created by using techniques that effectively manage tax liabilities is called tax alpha This section discusses tax-planning opportunities to maximize the after-tax accumulation of wealth
6.1 Asset Location
The three types of accounts available to an investor are: taxable, TDA and tax exempt The choice of where to place the specific assets is called the asset location decision
The general rules for after-tax asset allocation are:
1 Heavily-taxed assets should be held in tax-sheltered accounts
2 Lightly-taxed asset should be held in taxable accounts
In Example 7, interest income is taxed at 35 percent, while dividends and capital gains are taxed at 15 percent An optimal after-tax asset allocation would put interest-paying bonds, which are relatively heavily-taxed, in a tax-sheltered account and dividend-paying stocks, which are relatively lightly-taxed,
in a taxable account
6.2 Trading Behavior
This section addresses:
LO.f: Discuss the relation between after-tax returns and different types of investor trading behavior
Consider four individuals who invest €1,000 in non-dividend paying stocks that earn 8 percent annually for 20 years Capital gains realized within a year are taxed at 40 percent and gains realized after at least one year are taxed at 20 percent As shown in the table below, investors who trade (and realize capital gains) more frequently pay more in taxes and have lower accrual equivalent returns Investors who trade less frequently have longer holding periods and are able to derive more benefit from deferring taxes on unrealized capital gains
Trang 13Investor Type Future
Accumulation (€)
Equivalent Return (%)
Accrual Equivalent Tax Rate (%)
6.3 Tax Loss Harvesting
This section addresses:
LO.g: Explain tax loss harvesting and highest-in/first-out (HIFO) tax accounting
Tax authorities typically allow investors to reduce taxable income by the amount of realized capital losses This practice is called tax loss harvesting
Refer to Example 12 from the curriculum
In Example 12, the investor has €100,000 worth of capital gains, which translates into a tax liability of
€20,000 based on a 20 percent flat tax rate By offsetting these gains with a realized loss of €60,000, taxable income is reduced from €100,000 to €40,000 and taxes owed are reduced from €20,000 to
€8,000
While investors who practice tax loss harvesting may ultimately pay the same amount of taxes in the long-term, the payments will be made in later years Therefore, “the value of tax loss harvesting is largely in deferring the payment of tax liabilities.” By reducing tax obligations in the short-term, tax loss harvesting makes more funds available to be invested
Refer to Example 13 from the curriculum
Refer to Example 14 from the curriculum
By using highest-in/first-out (HIFO) accounting, investors who have purchased a security at multiple prices can sell those units with the highest purchase price first, which results in a lower capital gain The payment of taxes on the units with lower purchase prices (and greatest tax liabilities) can be deferred Note, however, that deferring taxes may not be a desirable strategy if tax rates are expected to increase from their current levels
6.4 Holding Period Management
If short-term capital gains are taxed at a higher rate than long-term capital gains there is an obvious
Trang 14incentive to hold securities over a longer time horizon Additionally, this relative advantage is greater for higher rates of return
Refer to Example 15 from the curriculum
6.5 After-Tax Mean-Variance Optimization
This section addresses:
LO.h: Demonstrate how taxes and asset location relate to mean-variance optimization
Ideally, the traditional mean-variance optimization should be modified to accommodate after-tax risk and return While constructing the efficient frontier, the before tax returns should be substituted with accrual equivalent after tax returns, and the before tax risk should be substituted with risk on an after tax basis
Summary
a compare basic global taxation regimes as they relate to the taxation of dividend income, interest
income, realized capital gains, and unrealized capital gains;
Regime Common
Progressive
Heavy Dividend Tax
Heavy Capital Gain Tax
Heavy Interest Tax
Light Capital Gain Tax
Flat and Light
Flat and Heavy
or exempt
Taxed favorably or exempt
Taxed at ordinary rates
Taxed at ordinary rates
Taxed favorably
or exempt
Taxed favorably
Taxed favorably or exempt
Taxed favorably or exempt
Taxed at ordinary rates
Taxed favorably
or exempt
Taxed at ordinary (flat) rates
or exempt
Taxed at ordinary rates
Taxed favorably or exempt
Taxed favorably or exempt
Taxed favorably
or exempt
Taxed at ordinary (flat) rates
b determine the effects of different types of taxes and tax regimes on future wealth accumulation;
Future value factor Example