Reading 9

Taxes and Private Wealth Management in a Global Context

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CFA Level III Item-set - Solution
Study Session 4
June 2018

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Reading 9

Taxes and Private Wealth Management in a Global Context

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FinQuiz Level III 2018 – Item-sets Solution
Reading 9: Taxes and Private Wealth Management in a Global Context
1. Question ID: 12500
Correct Answer: C

Larson’s marginal tax rate is 46% as the portfolio’s income is above $45,000 but below
$70,000. Her next $1 of income would be taxed at 46%.
2. Question ID: 12501

Correct Answer: B

Larson’s tax liability at the end of the year would be $15,650 + 0.46 ($65,000 – $45,000) =
$24,850. Thus the average tax liability would be approximately 38% ($24,850/$65,000).
3. Question ID: 12502
Correct Answer: C

The formula for calculating the expected after-tax accumulation after a period of n years is as
follows:
FVIFTAXABLE = (1 + r*) n (1 – T*) + T* − (1 – B)tcg
Prior to calculating this value, it is necessary to calculate r*.
The after-tax annual return (r*) earned on Larson’s portfolio at the end of the year is
calculated as follows:
r* = r(1 – piti - pdtd – pcgtcg)
= 7.5% [1 – (0.2 × 0.14) – (0.5 × 0.14) – (0.15 × 0.12)]
= 6.63%
The effective capital gains tax rate on Larson’s portfolio is calculated as follows:
T* = tcg(1 – pi – pd – pcg)/ (1 – piti - pdtd – pcgtcg)
= 0.12 (1 – 0.2 – 0.5 – 0.15)/ [1 – (0.2 × 0.14) – (0.5 × 0.14) – (0.15 × 0.12)]
= 0.02036 or 2.036%
FVIFTAXABLE = $500,000 [(1 + 6.63%) 20 (1 – 2.036%) + 2.036% − (1 – 1)(12%)]
= $1,778,759.95 ≈ $1,780,000
4. Question ID: 12503
Correct Answer: C

The accrual equivalent after-tax return on Larson’s portfolio is calculated as follows:
$500,000 (1 + RAE) 20 = $1,778,759.95
RAE = 0.0655096 or ≈ 6.55%

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Reading 9

Taxes and Private Wealth Management in a Global Context

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5. Question ID: 12504
Correct Answer: A

The after-tax market values and after-tax weights for the $200,000 portfolio is calculated
after deducting 40% taxes from the TDA account.
Account Type

Pre-tax
Market
Value ($)
TDA
60,000
Tax-Exempt
140,000
Total Portfolio
200,000
*60,000 (1 – 0.4) = $36,000

Pre-Tax
Market
Weights (%)
30%

70%
100%

After-Tax
Market Value
($)
36,000*
140,000
176,000

After-Tax
Weights
(%)
20.5
79.5
100.0

6. Question ID: 12505
Correct Answer: C

Amongst the three regimes (Heavy Interest Tax, Common Progressive, Light Capital Gain
Tax), the Light Capital Gain tax regime is a progressive tax regime taxing dividends and
interest income at ordinary rates and capital gains at favorable rates.
7. Question ID: 11239
Correct Answer: B

The effective capital gains tax rate can be found using the following formula:
(૚ିࡼ`ࡵ ାࡼࡰశ ࡼ࡯ࡳ )
ࢀࡱ࡯ࡳ = ࢀ࡯ࡳ ૚ି(ࡼ ࢀ ାࡼ


ࢀାࡼ ࢀ )
ࡵ ࡵ

ࡰ

࡯ࡳ ࡯ࡳ

ሺ૚ି૙.૚૙ି૙.૜૙ି૙.૜૛ሻ

= (૙. ૚૙) ૚ିሺ૙.૚૙×૙.૜૙ା૙.૜૙×૙.૛૙ା૙.૜૛×૙.૚૙ሻ
૙.૛ૡ

= ૙. ૚૙ × ૙.ૡૠૡ
= 3.189%
8. Question ID: 11240
Correct Answer: B

First, we will calculate the effective tax rate for Harris’ portfolio using the following
formula:
ܶா஼ீ

(ଵି௉`಺ ା௉ವశ ௉಴ಸ )

= ܶ஼ீ ଵି(௉

಺ ்಺ ା௉ವ ்ା௉಴ಸ ்಴ಸ )



ሺଵି଴.ଵ଴ି଴.ଷ଴ି଴.ଷଶሻ


= (0.10)ଵିሺ଴.ଵ଴×଴.ଷ଴ା଴.ଷ଴×଴.ଶ଴ା଴.ଷଶ×଴.ଵ଴ሻ
଴.ଶ଼

= 0.10 × ଴.଼଻଼
= 3.189%
Now we can calculate the return after realized taxes using the following equation.
Value in 10 years = $500,000 (1 + R ୅ୖ୘ )ଵ଴(1–T୉େୋ ) +T୉େୋ –(1–B)Tେୋ
$1,503,400 = $500,000 (1 + R ୅ୖ୘ )ଵ଴ (1–0.03189) +0.03189– (1–0.75)0.10
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Reading 9

Taxes and Private Wealth Management in a Global Context

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Solving the above equation we get,
ܴ஺ோ் = 12%
9. Question ID: 11241
Correct Answer: B

A heavy dividend tax regime has a progressive income tax structure. It has a favorable
treatment for interest income and capital gains.
A light capital gain tax regime has a progressive income tax structure and a favorable
treatment for capital gains.
A flat and heavy regime has a flat income tax structure and a favorable treatment for interest
income.
10. Question ID: 11242

Correct Answer: A

Anderson’s first statement is correct. Accrual taxes are paid periodically. The tax drag
increases as the time horizon increases and as the investment return increases. Return and
investment horizon have a multiplicative effect on the tax drag associated with future
accumulations. The impact of return is greater for long investment horizons, and the
impact of investment horizon is greater for higher returns.
Anderson’s second statement is incorrect. The proportion of investment growth consumed
by wealth based taxes decreases as return increases.
11. Question ID: 11243
Correct Answer: C

Using the tax rate of 30% given in option C we can perform the following calculations:
The after tax value of the TDA account is $170,000(1– 0.30) = $119,000
The after-tax value of the tax-exempt account is $70,000
The total after-tax value of the portfolio is $189,000.
Stocks represent 37% of the portfolio whereas bonds represent 63% of the portfolio.
Alternatively, the tax rate can be calculated as follows:
37% x X = $70,000
X = $189,000
Where X = After tax portfolio value.
$189,000 – $70,000 = $119,000
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Reading 9

Taxes and Private Wealth Management in a Global Context

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$119,000 = $170,000(1 – tax rate)
Tax rate = 30%
12. Question ID: 11244
Correct Answer: B

Smith is incorrect in agreeing with Anderson’s first statement. Tax savings realized in a
given tax year from the 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.
Smith is incorrect in disagreeing with Anderson’s second statement. The efficient frontier
of portfolios should ideally be viewed on an after-tax basis. Furthermore, because the
tax status of an investment depends on the type of account it is in, the same asset could
appear on the efficient frontier in both taxable and non-taxable form.
13. Question ID: 19036

Correct Answer: A
The capital gains on Jones’ portfolio were A$1,500,000 × 0.25 = $375,000.
If losses are not realized, capital gain tax will be A$112,500 (A$375,000 × 30%).
The same year, unrealized capital losses were A$100,000 – A$70,000 = A$30,000.
If these securities are sold in 2010 and the capital losses are realized, the capital gain will
reduce to A$345,000 (A$375,000 – A$30,000). The new capital gain tax is:
A$345,000 × 30% = A$103,500
Tax savings = A$112,500 – A$103,500 = A$9,000

14. Question ID: 19037

Correct Answer: C
Harvesting losses is not an optimal strategy when the investor currently faces a relatively low

tax environment and will face higher taxes in subsequent periods. In this scenario, the best
strategy will be to defer harvesting losses.
A is incorrect. Tax loss harvesting has more value when securities have potentially high
volatility.
B is incorrect. Cumulative tax alphas from tax loss harvesting will increase over time.

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Reading 9

Taxes and Private Wealth Management in a Global Context

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15. Question ID: 19038

Correct Answer: C
The after-tax value of the TDA account is 0.6 × A$5,000,000 × (1 – 0.4) = A$1,800,000.
After-tax value of the tax-exempt account = A$5,000,000 × 0.4
= A$2,000,000
Total after-tax value of the portfolio = A$1,800,000 + A$2,000,000
= A$3,800,000
Stock represents A$2,000,000/A$3,800,000 = 52.6% of the total after-tax value.
Bonds represent A$1,800,000/A$3,800,000 = 47.4% of the total after-tax value.
16. Question ID: 19039

Correct Answer: B
In a deferred capital gain taxation environment, the future value of an accumulation equals:
FV = (1 + r)n(1 – tcg)+ tcg

The future accumulation of Po’s portfolio in a deferred capital gain taxation environment is:
250,000[(1 + 0.08)15(1 – 0.25) + 0.25] = A$657,281.71
In an annual taxation environment, the future value of an accumulation equals:
FV = [1 + r(1 – ti)]n
The future accumulation of Po’s portfolio in an annual taxation environment is:
250,000[(1 + 0.08(1 – 0.25)]15 = A$599,139.55
The deferred capital gain environment accumulates to A$657,281.71/A$599,139.55 = 1.097
times the amount accumulated in an annual taxation environment.

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Reading 9

Taxes and Private Wealth Management in a Global Context

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17. Question ID: 19040

Correct Answer: C
Comment 1 is incorrect. In a deferred capital gains environment, tax drags remain constant
regardless of the time horizon. This is because, according to the formula for calculating the
future value accumulation, in such an environment, after-tax investment gain is equal to the
pre-tax investment gain multiplied by one minus the tax rate.
Comment 2 is incorrect. The advantages of tax deferral can be offset or eliminated if
securities taxed on an accrual-basis have greater risk-adjusted returns. That is, the greater the
risk-adjusted returns on assets taxed on an accrual basis, the lower the relative
accumulations. Therefore, the greater the future value of the accumulation in an annual
taxation environment, the greater the chances that the advantages of tax deferral may be lost.

18. Question ID: 19041

Correct Answer: A
A$80,000 of Po’s income will generate taxes of A$17,550. The remaining A$70,000
(A$150,000 – A$80,000) will generate taxes of A$25,900 (A$70,000 × 0.37). The average
tax rate is equal to (A$17,550 + A$25,900)/A$150,000 = 28.97%
Marginal tax rate is the Tax rate paid on highest dollar of income, that is, 37% here. The
marginal tax rate exceeds the average tax rate by 8.03% (37% – 28.97%).

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