2019 CFA level 3 qbank reading 11 taxes and private wealth management in a global context answers

Study Session 5, Module 11.5, LOS 11.e Related Material SchweserNotes - Book 2 Question #2 of 33 The tax drag from both longer investment horizons and higher investment returns: A have a

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Question #1 of 33

Which of the following moves by a government would most likely lead to the government taking

on more investment risk?

A) Tax regimes cannot shift investment risk.

B) Moving from a common progressive tax regime to a heavy dividend tax regime.

C) Moving from a heavy dividend tax regime to a common progressive tax regime.

Explanation

Moving from a common progressive tax regime to a heavy dividend tax regime would

increase the tax on dividends, which are taxed annually, and this would shift some of the

investment risk to the government

(Study Session 5, Module 11.5, LOS 11.e)

Related Material

SchweserNotes - Book 2

The tax drag from both longer investment horizons and higher investment returns:

A) have a multiplicative e ect, so that the tax drag amount increases rapidly as the

investment horizon and the returns increase

B) are unrelated, and each has a linear relationship with cash drag that is independent

of the other

C) have an o setting e ect, so the tax drag can be zero in some cases where the

investment horizon and returns are greater than zero

Explanation

They are multiplicative in the formula Thus, when both are increased, the tax drag amount

rapidly increases

(Study Session 5, Module 11.2, LOS 11.c)

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In a tax-exempt account, contributions to the account are made with:

A) after-tax funds and reduce the investor’s current tax bill.

B) after-tax funds and do not reduce the investor’s current tax bill.

C) pre-tax funds and reduce the investor’s current tax bill.

Explanation

The tax bene t for a tax-exempt account occurs when the funds are withdrawn

(Study Session 5, Module 11.4, LOS 11.d)

In applying e cient frontier analysis for an investor who uses both taxable and tax-advantaged

accounts, the mean-variance optimization:

A) would simultaneously determine both the weights in the available assets and their

location in the various accounts

B) cannot simultaneously determine both the weights in the available assets and their

location in the various accounts, but it can be done in a step-wise fashion Usually

C) cannot simultaneously determine both the weights in the available assets and their

location in the various accounts, but it can be done in a step-wise fashion Usually

Explanation

The mean-variance optimization should optimally allocate assets and determine the optimal

asset location for each asset Substitution of adjusted returns would allow the process to be

done in one step

(Study Session 5, Module 11.6, LOS 11.h)

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Which of the following has favorable tax treatment under a " at and heavy" tax regime?

A) Interest income.

B) Capital gains.

C) Dividend income.

Explanation

The tax on ordinary income is at and there is not a favorable tax treatment for dividend

income and capital gain income Interest income has a favorable treatment

(Study Session 5, Module 11.1, LOS 11.a)

A stock is expected to increase in value from $500 to $1,000 over a ve-year period The

applicable capital gains tax rate is 28% What is the expected after-tax value in ve years?

A) $552.00

B) $860.00

C) $781.00

Explanation

The pre-tax investment return is 14.87% =($1,000/$500)(1/5) – 1

The formula for the future-value interest rate factor is FVIFCGT = [(1 + R)N(1 – TCG) + TCG]

1.72 = [(1.1487)5 (1 – 0.28) + 0.28] Thus, the after-tax value in ve years is expected to be

$860 = $500 × 1.72

(Study Session 5, Module 11.1, LOS 11.b)

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Among global tax regimes, the common progressive tax regime has a favorable tax treatment

for:

A) interest income and dividend income but not capital gain income.

B) interest income, dividend income, and capital gain income.

C) dividend income and capital gain income but not interest income.

Explanation

The common progressive tax regime tends to have a favorable tax treatment for all three

Which type of equity investor recognizes all gains in the short term?

A) Traders.

B) Active investors.

C) Exempt investors.

Explanation

Traders forgo the tax advantages associated with equity, and therefore all gains are

recognized in the short and term and taxed on an annual basis Active investors trade less

frequently than traders, so they recognize gains in the long term and are taxed at lower

rates Exempt investors avoid taxation altogether and hold all of their stock so no gains are

recognized

(Study Session 5, Module 11.5, LOS 11.f)

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An investor has €600,000 invested in equity in a TDA and €400,000 invested in bonds in a

tax-exempt account The relevant tax rate is 35% What is the investor's asset allocation on an

after-tax basis?

A) 49.4% in stocks and 50.6% in bonds.

B) 69.8% in stocks and 30.2% in bonds.

C) 44.9% in stocks and 55.1% in bonds.

Explanation

The investor has €390,000 [(€600,000 × (1 – 0.35)] invested in equity on an after-tax basis The

bonds in the tax-exempt account are not subject to taxation On an after-tax basis, the

investor has 49.4% in equity [390,000 / (390,000 + 400,000)] and the other 50.6% in bonds

[400,000 / (390,000 + 400,000)]

Sam Conner and Bill Pope live in di erent countries In Conner's country, there is a light capital

gain tax regime In Pope's country there is a heavy capital gain tax regime They both are

building diversi ed portfolios that hold non-dividend-paying growth stocks, dividend-paying

stocks, and coupon-paying bonds They both have a buy-and-hold strategy Which, if either,

would probably bene t the most from a tax-deferred account (TDA)?

A) Conner would bene t more than Pope.

B) Neither would bene t because tax-deferred accounts do little to enhance the

returns of diversi ed portfolios

C) Pope would bene t more than Conner.

Explanation

Conner would bene t more In a light capital gain tax regime, dividends and interest do not

receive favorable tax-treatment There would be an advantage to having them in the TDA In

the heavy capital gain tax regime, interest and dividends receive tax advantages

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On a graph where the risk is on the horizontal axis and the returns are on the vertical axis, the

existence of taxes on investment returns would probably shift the mean-variance optimization

portfolio:

A) down and to the left.

B) down only, and there would not be a shift left or right.

C) down and to the right.

Explanation

Taxes lower returns, but they also shift some of the investment risk to the government

(Study Session 5, Module 11.6, LOS 11.h)

Assume that €125,000 is invested in a tax-exempt account What is the after-tax balance in the

account after 15 years if the tax rate is 28% and the pre-tax return is 11%?

A) €465,613.

B) €392,138.

C) €598,074.

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The balance in the account in 15 years uses the future value interest factor for a tax-exempt

account (FVIFTEA)

No taxes are due on the future accumulation

FVIFTEA = (1 + R)N

FV = 125,000[FVIFTEA]

FV = 125,000[(1.11)15]

FV = 598,074

The response of €392,138 is the future accumulation for an account taxed annually The

response of €465,613 is the future accumulation for an account with tax deferred capital

gains and a basis of €125,000

Chris Manning, CFA is advising a client concerning harvesting tax losses The client expects that

her tax situation will not change over the next few years She asks about incurring a given loss

in the current year or waiting a few years to incur the loss She asks how the decision will a ect

the total taxes she pays over her life Manning should advise her that:

A) she should not incur the loss this year because the HIFO principle means her total

taxes will be higher if she incurs the loss this year

B) she should incur the loss this year because the HIFO principle means her total taxes

will be lower if she does

C) the total tax bill over her life will not change if her tax status does not change.

Explanation

Under the indicated conditions, i.e., the tax rate not changing in the foreseeable future, the

total tax burden will be the same It is better to take losses early only to reap the gains earlier

and be able to invest the gains earlier

(Study Session 5, Module 11.6, LOS 11.g)

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If an investment is held in a tax-exempt account, then the investor bears:

A) all of the investment risk.

B) none of the investment risk.

C) some of the investment risk.

Explanation

In a taxable account, losses realized result in a reduction in taxes that serve to o set the

magnitude of the loss Thus, some of the downside risk is transferred to the government In a

tax-exempt account, the variability of returns is not a ected by the taxes

With respect to traders and active investors, which of the following statements is the most

accurate?

A) Active investors trade more frequently than traders so that many of their gains are

taxed at lower rates

B) Active investors trade as frequently as traders but they use strategies that lead to

their gains being taxed at higher rates

C) Active investors trade less frequently than traders so that many of their gains are

taxed at lower rates

Explanation

Traders trade more frequently Therefore, traders generally pay higher tax rates

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An investor faces the periodic payment of investment income taxes With respect to the

relationship between investment horizon and investment return, the tax drag is:

A) negatively related to both the horizon and investment return.

B) positively related to both the horizon and investment return.

C) positively related to the horizon and negatively related to the investment return.

Explanation

Both a longer horizon and a higher return will increase the tax drag

An investor holds the same investment in three di erent accounts Which of the following

accounts will have the lowest risk?

A) A taxable account.

B) A tax-exempt account.

C) A TDA.

Explanation

The taxable account will have the lowest risk because the government essentially shares the

risk of the investment with the investor when it is taxed annually When taxed annually, the

standard deviation of the investment returns is reduced by (1– TI)

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All else being equal, which of the following investors will have the highest future

accumulations?

A) An active investor.

B) A trader.

C) A passive investor.

Explanation

The passive investor will pay a low tax rate on a deferred basis and have the highest

accumulation of the three investors The active investor will have the next lowest future

accumulation because although gains are taxed at a lower rate, the gains are taxed every

year The trader will have the lowest future accumulation because her capital gains will be

short-term and taxed at a high rate The gains will also be taxed every year

Of traders, active investors, and passive investors, which probably forgo the most tax

advantages of equity?

A) Passive investors.

B) Traders.

C) Active investors.

Explanation

Traders trade the most frequently, and would forgo the tax-deferred properties of equity that

is allowed to grow in value over a long period Active investors trade less frequently than

traders

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If the tax rate is positive and there is periodic payment of investment income taxes, then which

of the following relationships is most accurate?

A) Tax drag < tax rate.

B) Tax drag > tax rate.

C) Tax drag = tax rate.

Explanation

Under the given conditions: tax drag > tax rate This is because the tax rate is being applied

periodically to a value (the taxable gain or investment income) that is increasing at a

compound rate

With respect to the "heavy dividend" tax regime and the "heavy interest" tax regime, which if

either usually has a progressive ordinary income tax structure?

A) The heavy interest tax regime only.

B) The heavy dividend tax regime only.

C) Both.

Explanation

Both have progressive tax structures for ordinary income They di er on having a less

favorable tax structure for the indicated source of income

With respect to active investors and the tax structure in many countries, which of the following

is the most accurate?

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A) As a result of their lower taxation, active investment managers can remain in

business even when they generate lower pre-tax returns

B) To o set their higher taxation, active investment managers must generate higher

pre-tax returns

C) To o set their higher taxation, active investment managers must use tax-exempt

accounts

Explanation

To o set their higher taxation, active investment managers must generate higher pre-tax

returns This is also true for mutual funds, especially those with high turnover, because in

many countries, long-term capital gains are taxed at a lower rate and accumulate tax-free

until the gains are realized

An individual, aged 40, is currently in the 25% marginal tax bracket, and expects to be in the

15% bracket when he retires Making contributions today to a tax-deductible individual

retirement account is an example of:

A) minimizing the amount of the tax payment.

B) both minimizing the amount and deferring the timing of the tax payment.

C) deferring the timing of the tax payment.

Explanation

The investor's action is an example of both minimizing and deferring He will minimize taxes

by converting income that would have been taxed at a 25% rate today to a lower 15% rate in

the future He will defer taxes payable until the funds are withdrawn from the account in the

future

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