READING 11: TAXES AND PRIVATE WEALTH MANAGEMENT IN A GLOBAL CONTEXT

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1 READING 11: TAXES AND PRIVATE WEALTH MANAGEMENT IN A GLOBAL CONTEXT Introduction Taxes have a significant impact on net performance and affect an adviser s understanding of risk for the taxable investor. Tax rates, particularly those for high-net-worth (HNW) individuals, are non-trivial and typically affect returns more than portfolio management costs. Despite a long history of high tax rates on investment returns, most modern portfolio theory is grounded in a pretax framework. This phenomenon is understandable because most institutional and pension portfolios are tax-exempt. As more wealth becomes concentrated with individuals, it is important to examine the impact of taxes on risk and return characteristics of a portfolio and wealth accumulation. The purpose of this reading is to outline basic concepts that serve as the foundation for building tax-aware investment models that can be applied in a global environment. A- Overview of Global Income Tax Structures Major sources of government tax revenue include: Taxes on income. These taxes apply to individuals, corporations, and often other types of legal entities. For individuals, income types can include salaries, interest, dividends, realized capital gains, and unrealized capital gains, among others. Income tax structure refers to how and when different types of income are taxed. Wealth-based taxes. These include taxes on the holding of certain types of property and taxes on the transfer of wealth. Taxes on consumption. These include sales taxes and value-added taxes 1- International Comparisons of Income Taxes We reviewed the taxation of different types of income, particularly investment income, around the world in order to summarize the major tax regimes. 2- Common Elements i. Income and interest income tax In most tax jurisdictions, a tax rate structure applies to ordinary income (such as earnings from employment). Other tax rates may apply to special categories of income such as investment income/capital income. Investment income is often taxed differently based on the nature of the income: interest, dividends, or capital gains and losses. Most of the countries examined in our review have a progressive ordinary tax rate structure where the tax rate increases as income increases. In tax planning for investments, it is useful to think about how much tax would be paid on additional income, known as the marginal tax rate. Some countries do not have a progressive tax system and instead impose a flat tax structure where all taxable income is taxed at the same rate. 1

2 Many countries provide special tax provisions for interest income. These special provisions included an exemption for certain types of interest income, a favorable tax rate on interest income or an exclusion amount where some limited amount of interest income is exempt from tax. Some fixed income instruments are indexed for inflation and this inflation adjustment may not be subject to taxation in some jurisdictions. Similarly, dividend income may have special provisions. In some cases there are exemptions, special tax rates, or exclusions as described above for interest income. In other cases, there may be provisions for mitigating double taxation because dividends are a distribution of company earnings and the company may have already paid tax on the earnings. Tax credits can be used to mitigate the effects of double taxation. ii. Capital Gains Capital gains (losses) may have special provisions or rates. These often vary depending upon how long the underlying investment has been held. Generally, long term gains are treated more favorably than short term gains. Long term is defined differently in different jurisdictions; for example, in the data examined, we observed required holding periods of six months, one year, two years, and five years Special provisions observed included total exemption of capital gains or long-term capital gains from taxation, exemption of a certain percentage of gains from taxation, a favorable tax rate on capital gains, or indexing the cost of the investment for inflation. In some cases, countries provided more favorable provisions for domestic companies or companies traded on a local exchange. In most cases, only realized gains were taxed. In rare cases, countries impose a tax on unrealized gains either annually, upon exiting the country to relocate domicile, or upon inheritance. 3- General Income Tax Regimes Each country s income tax structure can be classified as either progressive or flat. Income tax regimes can be further distinguished based on the taxation of investment returns. Seven different tax regimes were observed in the sample of countries examined: 1) Common Progressive Regime: This regime has progressive tax rates for ordinary income, but favorable treatment in all three investment income categories: interest, dividends, and capital gains. This was the most common regime observed. Even though categorized as common, there is variation within this regime with some countries treating some interest income as ordinary and other interest income as tax exempt, while other countries provide for exemption or special treatment for all interest. 2) Heavy Dividend Tax Regime: This regime has a progressive tax system for ordinary income and favorable treatment for some interest and capital gains but taxes dividends at ordinary rates. 3) Heavy Capital Gain Tax Regime: This regime has a progressive tax system for ordinary income and favorable treatment for interest and dividends, but taxes capital gains at ordinary rates. 2

3 4) Heavy Interest Tax Regime: This regime has a progressive tax system for ordinary income and favorable treatment for dividends and capital gains, but taxes interesasezx3w4edt income at ordinary rates. 5) Light Capital Gain Tax Regime: This regime has a progressive tax system for ordinary income, interest, and dividends, but favorable treatment of capital gains. This was the second most commonly observed regime. 6) Flat and Light Regime: This regime has a flat tax system and treats interest, dividends, and capital gains favorably. 7) Flat and Heavy Regime: This regime has a flat tax system for ordinary income, dividends, and capital gains. It does not have favorable treatment for dividends and capital gains, but has favorable treatment for interest income. 4- Other Considerations Some countries permit the use of tax deferred retirement accounts. A tax deferred account: Defers taxation on investment returns within the account May permit a deduction for contributions May occasionally permit tax free distributions On the other hand, a few countries impose a wealth tax on accumulations on a periodic basis which reduces after-tax returns and accumulations similar to income taxes. B- After-Tax Accumulations and Returns for Taxable Accounts This section develops models to estimate the tax impact on future accumulations in various tax environments. These models enable the investment adviser to evaluate potential investments for taxable investors by comparing returns and wealth accumulations for different types of investments subject to different tax rates and methods of taxation (accrued annually or deferred). 1- Simple Tax Environments Models that accommodate multiple tax brackets grow in complexity very quickly. Also, investors are often subject to a single rate on the margin, limiting the usefulness of an analysis based on multiple tax brackets. Finally, much of the intuition and analysis that is derived in a flat tax framework applies in a setting with multiple tax brackets. a. Returns-Based Taxes: Accrual Taxes on Interest and Dividends One of the most straightforward methods to tax investment returns is to tax an investment s annual return at a single tax rate, regardless of its form. Accrual taxes are levied and paid on a periodic basis, usually annually, as opposed to deferred taxes that are postponed until some future date. When returns are subject to accrual taxes, the after-tax return is equal to the pretax return, r, multiplied by (1 ) where represents the tax rate applicable to investment income. For the 3

4 purposes of this section, we consider an investment with a return that is entirely taxed at a single uniform rate. The amount of money accumulated for each unit of currency invested after n years, assuming that returns (after taxes at rate are paid) are reinvested at the same rate of return, r, is simply: [ ] Equation 1 Notice that taxes reduce the potential gain on investment by more than the ordinary income tax rate. This suggests that the tax drag on capital accumulation compounds over time when taxes are paid each year. Tax drag refers to the negative effect of taxes on after-tax returns. By contrast, when taxes on gains are deferred until the end of the investment horizon, the tax rate equals the tax drag on capital accumulation. The impact of taxes on capital growth for various investment horizons and rates of return and demonstrates several conclusions: 1) When investment returns are taxed annually, the effect of taxes on capital growth is greater than the nominal tax rate as noted above. 2) The adverse effects of taxes on capital growth increase over time. That is, the proportional difference between pretax and after-tax gains grows as the investment horizon increases. 3) The tax drag increases as the investment return increases, all else equal. 4) Return and investment horizon have a multiplicative effect on the tax drag associated with future accumulations. Conceptually, this framework could apply to securities, such as fixed-income instruments or preferred stock, in which most or possibly all of the return is subject to annual taxes. b. Returns-Based Taxes: Deferred Capital Gains Another straightforward method of taxing returns is to focus on capital gains, the recognition of which can usually be deferred until realized, instead of interest income and dividends, which are generally taxable each year. If the tax on an investment s return is deferred until the end of its investment horizon, n, and taxed as a capital gain at the rate, then the after-tax future accumulation for each unit of currency can be represented in several ways, including the following: [ ] Equation 2-a 4

5 The first term of the equation represents the pretax accumulation. The bracketed term is the capital gain (i.e., future accumulation less the original basis), while the entire second term represents the tax obligation on that gain. ( ) Equation 2-b Viewed differently, the first term of the equation represents the future accumulation if the entire sum (including the original basis) were subject to tax. The second term returns the tax of the untaxed cost (also known as cost basis or basis) associated with the initial investment. The after-tax investment gain equals the pretax investment gain multiplied by one minus the tax rate. Whereas the tax drag on after-tax accumulations subject to annual accrual taxes compounds over time, the tax drag from deferred capital gains is a fixed percentage regardless of the investment return or time horizon. In other words, when deferral is permitted, the proportion of potential investment growth consumed by taxes is always the same as the tax rate, which is less than when there was annual taxation. In certain cases, even if the tax rate on deferred capital gains is greater than the tax rate on interest income, the value of the deferral can more than offset a lower tax rate on annually taxed income, especially over time. It is important to note, however, that the advantages of tax deferral can be offset or even eliminated if securities taxed on an accrual basis have greater risk-adjusted returns. c. Cost Basis In taxation, cost basis is generally the amount that was paid to acquire an asset. It serves as the foundation for calculating a capital gain, which equals the selling price less the cost basis. An investment with a low cost basis has a current embedded tax liability because, if it were liquidated today, capital gain tax would be owed even before future capital growth is considered. Newly invested cash has no such current tax liability. If the cost basis is expressed as a proportion, B, of the current market value of the investment, then the future after-tax accumulation can be expressed by simply subtracting this additional tax liability from the expression in either Equation 2-a or 2-b. In other words: ( ) The lower the cost basis, however, the greater the embedded tax liability and the lower the future accumulation. Distributing and canceling terms produces: ( ) Equation 3 5

6 This form resembles Equation 2b, and the last term represents the return of basis at the end of the investment horizon. The lower the basis, the lower is the return of basis. d. Wealth Based Taxes Some jurisdictions impose a wealth tax, which is applied annually to a specific capital base. Often the wealth tax is restricted to real estate investments but sometimes it is levied on aggregate assets including financial assets above a certain threshold. In any case, the wealth tax rate tends to be much lower than capital gains or interest income rates because it applies to the entire capital base i.e., principal and return rather than just the return. If wealth is taxed annually at a rate of, then after n years each unit of currency accumulates to [ ] Equation 4 Because wealth taxes apply to the capital base, the absolute magnitude of the liability they generate is less sensitive to investment return than taxes based on returns. Consequently, the proportion of investment growth that it consumes decreases as returns increase. Viewed differently, a wealth tax consumes a greater proportion of investment growth when returns are low. In fact, when returns are flat or negative, a wealth tax effectively reduces principal. Like the previous two types of taxes, however, the wealth tax consumes a greater share of investment growth as the investment horizon increases. 2- Blended Taxing Environments Portfolios are subject to a variety of different taxes depending on the types of securities they hold, how frequently they are traded, and the direction of returns. The different taxing schemes mentioned above can be integrated into a single framework in which a portion of a portfolio s investment return is received in the form of dividends ( ) and taxed at a rate of ; another portion is received in the form of interest income ( ) and taxed as such at a rate of ; and another portion is taxed as realized capital gain ( ) at. The remainder of an investment s return is unrealized capital gain, the tax on which is deferred until ultimately recognized at the end of the investment horizon. In this setting, the annual return after realized taxes can be expressed as: Equation 5 In this case, r represents the pre-tax overall return on the portfolio. The effective annual after-tax return, r*, reflects the tax erosion caused by a portion of the return being taxed as ordinary income and other portions being taxed as realized capital gain and dividends. It does not capture tax effects of deferred unrealized capital gains. One can view this expression as being analogous to the simple expression in which after-tax return equals the pretax return times one minus the tax rate. A portion of the investment return has avoided annual taxation, and tax on that portion would then be deferred until the end of the investment horizon. Holding the tax rate on capital gains constant, the 6

7 impact of deferred capital gain taxes will be diminished as more of the return is taxed annually in some way. Conversely, as less of the return is taxed annually, more of the return will be subject to deferred capital gains. One can express the impact of deferred capital gain taxes using an effective capital gain tax rate that adjusts the capital gains tax rate gain to reflect previously taxed dividends, income, or realized capital gains. The effective capital gains tax rate can be expressed as ( ) Equation 6 Percentage unrealized capital gain Leftover unrealized capital gains and taxed gains The adjustment to the capital gains tax rate takes account of the fact that some of the investment return had previously been taxed as interest income, dividends, or realized capital gain before the end of the investment horizon and will not be taxed again as a capital gain. The future after-tax accumulation for each unit of currency in a taxable portfolio can then be represented by Where: annual return after realized taxes effective capital gains tax rate basis cost headline capital gain tax Equation 7 Equation 6 Although this formulation appears unwieldy, is analogous to the after- tax accumulation for an investment taxed entirely as a deferred capital gain in Equation 3. The only difference is that r* is substituted for r, and T* is substituted for in most places. Different assets and asset classes generate different amounts of return as interest income, dividends, or capital gain, and will thus have different values for,, and. Moreover, Equation 5 can replace the equations introduced in the previous sections. 3- Accrual Equivalent Returns and Tax Rates A useful way to summarize the impact of taxes on portfolio returns is to calculate an accrual equivalent after-tax return. An accrual equivalent after-tax return is the tax-free return that, if accrued annually, produces the same after-tax accumulation as the taxable portfolio. 7

8 a. Calculating Accrual Equivalent Returns The accrual equivalent return is found by solving for the return that equates the standard future value formula to the after-tax accumulation and solving for the return. The accrual equivalent return incorporates the impact of deferred taxes on realized gains as well as taxes that accrue annually. The accrual equivalent return is always less than the taxable return, r. It approaches the pretax return, however, as the time horizon increases. This phenomenon demonstrates the value of tax deferral. b. Calculating Accrual Equivalent Tax Rates Equation 8 Equation 6 The accrual equivalent tax rate is derived from the accrual equivalent return. It is the hypothetical tax rate,, that produces an after-tax return equivalent to the accrual equivalent return. It is found by solving for in the following expression: The accrual equivalent tax rate can be used in several ways: Equation 9 Equation 6 1) It can be used to measure the tax efficiency of different asset classes or portfolio management styles. 2) It illustrates to clients the tax impact of lengthening the average holding periods of stocks they own. 3) It can be used to assess the impact of future tax law changes. C- Types of Investment Accounts The impact of taxes on future accumulations often depends heavily on the type of account in which assets are held. Many countries have account structures with different tax profiles designed to provide some relief to the taxable investor. These structures are often intended to encourage retirement savings, but may also accommodate savings for health care and education. Most industrialized and developing countries have tax incentives to encourage retirement savings. Most types of investment accounts can be classified into three categories: The first type is taxable accounts, studied in the previous section. A second class of accounts can be called tax-deferred accounts, or TDAs. Contributions to these accounts may be made on a pretax basis, and the investment returns accumulate on a taxdeferred basis until funds are withdrawn at which time they are taxed at ordinary rates. As such, these accounts are sometimes said to have front-end loaded tax benefits. 8

9 A third class of accounts has back-end loaded tax benefits. These accounts can be called tax exempt because although contributions are not deductible, earnings accumulate free of taxation even as funds are withdrawn, typically subject to some conditions. 1- Tax-Deferred Accounts Assets held in a TDA accumulate on a tax deferred basis. Tax is owed when funds are withdrawn at the end of an investment horizon at which time withdrawals are taxed at ordinary rates or another rate,, prevailing at the end of the investment horizon. The future after-tax accumulation of a contribution to a TDA is therefore equal to: Note here that the totality of the funds are taxed, not just the gain. Equation 10 Equation 6 2- Tax-Exempt Accounts Tax-exempt accounts have no future tax liabilities. Earnings accumulate without tax consequence and withdrawals create no taxable event. Therefore, the future accumulation of a tax-exempt account is simply: Assets in a TDA have a built-in tax liability whereas assets in a tax-exempt account do not. It can be shown that the value of an asset held in a TDA measured on an after-tax basis is therefore equal to ( times the value of the same asset held in a tax-exempt account. 3- After-Tax Asset Allocation The notion that a TDA is worth times an otherwise equivalent tax-exempt account has implications for after-tax asset allocation, which is the distribution of asset classes in a portfolio measured on an after-tax basis. The after-tax value of taxable accounts may depend on an investor s time horizon, which can be difficult to estimate and may change over time. Therefore, estimating an investor s time horizon presents a potential impediment to incorporating after-tax asset allocation in portfolio management. Another challenge is improving client awareness, understanding, and comfort with asset allocation from an after-tax perspective. Suppose an adviser increases pretax equity exposure to achieve a target aftertax asset allocation. Her client may have difficulty accepting the notion of after-tax asset allocation, especially in a bear market when the extra equity exposure would hinder performance. 4- Choosing Among Account Types Equation 11 Equation 6 A euro invested in a tax-exempt account always has a higher after-tax future value than a euro invested in a TDA, all else equal. Based on this, one may infer that it is always better to save in a tax-exempt account instead of a TDA. That conclusion would be premature, however, because the comparison 9

10 overlooks the fact that contributions to TDAs are often tax-deductible whereas contributions to the tax-exempt accounts considered here generally are not. The tax-exempt account is taxed at today s rate,, while the TDA is eventually taxed at the tax rate in the withdrawal year,. Therefore, comparing the attractiveness of the two types of accounts reduces to comparing the tax rate today to the expected tax rate when funds are withdrawn. If the prevailing tax rate when funds are withdrawn is less than the tax rate when they are invested, the TDA will accumulate more after-tax wealth than the tax-exempt account, and vice versa. D- Taxes and Investment Risk By taxing investment returns, a government shares risk as well as return with the investor. Because the returns on assets held in TDAs and tax-exempt accounts are not currently taxed, investors bear all of the risk associated with returns in these accounts. Even in the case of TDAs in which the government effectively owns of the principal, the variability of an investor s return in relation to the current after-tax principal value is unaffected by the tax on withdrawals. Because the returns on assets held in taxable accounts are typically taxed annually in some way, investors bear only a fraction of the risk associated with these assets. Suppose asset returns are taxed entirely as ordinary income at a rate of. If the standard deviation of pretax returns is, returns are fully taxed at ordinary rates, then the standard deviation of after-tax returns for a taxable account is. That is, an investor bears only ( of the pretax risk. This concept has implications for portfolio optimization. E- Implications for Wealth Management The value created by using investment techniques that effectively manage tax liabilities is sometimes called tax alpha. 1- Asset Location Investors, often have multiple types of accounts when tax advantaged accounts are permitted. An interaction exists between deciding what assets to own and in which accounts they should be held. The choice of where to place specific assets is called the asset location decision. A well designed portfolio not only prescribes a proper asset allocation but simultaneously tells the portfolio manager the proper location for those assets. Much of the intuition is based on an arbitrage argument developed for corporate pension fund policy. Suppose contributions to a pension plan are tax-deductible and the returns on pension assets are exempt from tax, much like a TDA for an individual investor. The basic idea behind the arbitrage argument is that a company should place assets that would otherwise be heavily taxed assets within the tax shelter of the pension fund, and locate more lightly taxed securities outside the pension fund. Other factors that go into the asset location decision include: 10

11 behavioral constraints access to credit facilities age time horizon investment availability planned holding period 2- Trading Behavior Trading behavior affects the tax when held in taxable accounts. For assets held in taxable accounts, portfolio turnover generates taxable gains that might otherwise be deferred. Research suggests that active managers must earn greater pretax alphas than passive managers to offset the tax drag of active trading. Other research suggests that mutual fund rankings change significantly depending on whether performance is measured on a pretax or after-tax basis. 3- Tax Loss Harvesting Not all trading is necessarily tax inefficient. Jurisdictions allow realized capital losses to offset realized capital gains but limitations are often placed on the amount of net losses that can be recognized or the type of income it can offset. The practice of realizing a loss to offset a gain or income and thereby reducing the current year s tax obligation is called tax loss harvesting. The tax savings realized in a given tax year from tax loss harvesting overstate the true gain. Selling a security at a loss and reinvesting the proceeds in a similar security effectively resets the cost basis to the lower market value, potentially increasing future tax liabilities. In other words, taxes saved now may be simply postponed. The value of tax loss harvesting is largely in deferring the payment of tax liabilities. A subtle benefit of tax loss harvesting is that it increases the amount of net-of-tax money available for investment. Realizing a loss saves taxes in the current year, and this tax savings can be reinvested. A concept related to tax loss harvesting is using highest-in, first-out (HIFO) tax lot accounting to sell a portion of a position. When positions are accumulated over time, lots are often purchased at different prices. Depending on the tax system, investors may be allowed to sell the highest cost basis lots first, which defers realizing the tax liability associated with lots having a lower cost basis. Opportunities to create value through tax loss harvesting and HIFO are greater in jurisdictions with high tax rates on capital gains. Studies have shown that a tax loss harvesting program can yield substantial benefits. Although cumulative tax alphas from tax loss harvesting increase over time, the annual tax alpha is largest in the early years and decreases through time as deferred gains are ultimately realized. The complementary strategies of tax loss harvesting and HIFO tax lot accounting have more potential 11

12 value when securities have relatively high volatility, which creates larger gains and losses with which to work. 4- Holding Period Management Many jurisdictions encourage long-term investing (or equivalently discourage short-term trading) by reducing tax rates on long-term gains. Depending on the magnitude of gain from waiting, short-term trading can be difficult to justify on an after-tax basis. Another aspect of holding period management is more tactical in terms of which tax year the tax is due. If a taxpayer subject to taxation on a calendar year basis is contemplating an asset sale in December, it may be wise to defer the sale until January if there is a built-in capital gain or sell the asset in December if there is a built-in loss. Of course the timing of taxation is not the only consideration. The attractiveness of this investment relative to alternative investments must be considered 5- After-Tax Mean Variance Optimization Pretax efficient frontiers may not be reasonable proxies for after-tax efficient frontiers. An important concept supporting those methods is that the same asset held in different types of accounts is essentially a distinct after-tax asset because it will produce different after-tax accumulations. An important element in developing an after-tax mean variance optimized (MVO) model is to substitute accrual equivalent returns, like those introduced above, for pretax returns in developing return expectations. Similarly, a portfolio manager would substitute the asset s after-tax standard deviation of returns for pretax standard deviations in the optimization algorithm. 12