Benjamin Franklin famously said that death and taxes are the two certainties in life. The residents of Monaco may disagree, but for most people tax planning is an integral part of investment management.

A book on investments ignoring tax would be incomplete. With state finances around the world in tatters, taxes are going to be a bigger, not smaller issue. New taxes will be introduced, either to close former loopholes or simply to raise revenues. And with the sentiment in the general population being one of anger towards banks and the wider financial community, taxes will probably go up for this sector and the products it offers. What this means in individual jurisdictions will vary a great deal, but as an investor it’s well worth understanding tax.

Let’s remind ourselves that the point of the rational portfolio is that we have a more optimised, liquid, cheap and risk-adjusted portfolio. Those are undoubtedly good things. But if we construct that portfolio in a tax-inefficient manner, all our good intentions can quickly disappear.

In general the taxes I will refer to are:

• income tax, including taxes on dividends and coupons;
• capital gains tax (CGT): this covers a broad range and depending on jurisdiction will be greatly affected by the holding period and type of asset;
• transaction taxes, such as stamp duty in the UK;
• other taxes such as inheritance tax, corporation tax, taxes on gifts, etc.

Owing to its simple construction with a strong bias towards minimum turnover and very long-term holding periods, the rational portfolio is very tax-efficient for most people. Below are some of the most obvious tax benefits most people would realise from holding a rational portfolio:

Low turnover = less capital gains and transaction tax A passive investment product will have fewer trades than an active fund. This will typically lead to lower capital gains (including short-term ones often taxed at higher rates), but also fewer payments of transaction taxes such as stamp duty. In addition to tax, there are other obvious advantages such as trading costs associated with the low turnover.

Fewer fund changes = defer tax on gains into the future Related to the low turnover of securities in the fund, investors in index trackers also change funds far less frequently than investors in active funds. They are not chasing the next ‘hot manager’. On top of the advantages of not constantly triggering ‘one-off’ or front-loaded charges in some active funds and avoiding higher fees, this has the tax advantage of deferring the tax on the gains.

Diversity of products = getting the right product to help reduce tax As the underlying securities in the rational portfolio consist of an extremely broad and easy-to-construct array of securities, product providers can easily create construct products that cater to specific investor needs. For example, some investors would prefer to have dividends reinvested in the fund rather than paid out. So instead of having an index tracker valued at $100 and receiving a $2 dividend, the index tracker would be valued at $102. For some investors there are large tax advantages with this kind of structuring. It is such dividend versus capital gains advantages that are among the features making some exchange traded funds (ETFs) tax efficient.

Jurisdiction = pick the right one for your investment product Should you be buying an ETF or index fund through a Dublin or Frankfurt listing of the same underlying exposure? Understand the tax implications of your choices as they can be very different for different investors. Since setting up an ETF in a new jurisdiction is not that costly, not that many investors need to demand it before a provider will meet the market demand. This issue of jurisdiction is one that is perhaps of overriding importance for some investors and not a big deal to others.¹

Tax wrappers = because of a simple portfolio, tax wrappers and planning should be cheap Since the underlying product of the rational portfolio is relatively straightforward, potential tax saving wrappers should be more transparent and cheaper. You are not paying for a complicated investment product, even if the specific tax structure is complex. If you find yourself investing in a film project to get a tax saving that may be fine, but it’s probably not an investment you would have made without the wrapper and there is therefore an implicit additional cost of the tax structure. The rational portfolio is so simple and transparent that at least the investing part of your tax wrapper should be simple. This simplicity should give you greater transparency regarding any other charges you face in implementing the tax savings.

My mother bought some insurance-related savings products to reduce tax in the late 1980s. These products invested money in a portfolio of stocks, and had the advantage of saving her about 40% in tax on the money invested. It all looked good at the time, but my mother recently realised that there is absolutely no way to move the tax structure/wrapper away from the large Nordic bank it is with currently. Not that the tax wrapper legally requires it, but because the contract with the bank says so, and they won’t let my mother move her business elsewhere. I think she has been overcharged at about 2.5% a year for over 20 years for a wrapper which consists of very normal equity investments. For decades the bank in question has essentially used the structure to tie in my mother as a very high fee-paying client. If instead she had received only the legal and tax advice and implemented the underlying investment as a separate matter there would have been massive savings relative to the expensive current structure. If my mother had used the rational portfolio as the baseline investment, instead of having the tax structure and investment product bought combined, it would be far more transparent what she is being charged for – in both advice and set-up fees – and she would realise that those costs are a small fraction of what she is being charged now.

Tax adviser or accountant

Tax planning is an area of investing where I highly recommend getting expert advice, if you have enough assets so that the cost of getting advice will be covered by the savings you can hope to achieve from the advice. I am a non-domiciled UK resident, being a Danish national. Over the years I have tried to keep track of applicable tax rules for myself, my family and the businesses I was involved with. After initially fancying myself a bit of an expert on the topic I soon gave up. The rules were changing too quickly and I had a day job to keep. I found myself in the situation where knowing things were ‘sort of OK’ was a bad solution, and that I was either not entirely sure that what I was doing was 100% correct, or I was not being particularly clever about it.

Keep in mind that at the end of the day the rational portfolio consists of a few relatively simple products. While the logic and theory of why it makes sense may be complex, the end result is not: it is simple. Taxes, however, are not simple.

On top of everything, taxes change continuously and it is your responsibility to ensure on-going compliance. By the time you read this, the optimised tax thinking at the time of writing may out of date, or even illegal.

Finding the right tax adviser may seem daunting. Below are a few things to ponder as you look at various candidates.

A friend was making good money in a growing IT business. She paid her taxes and was more concerned with being a successful business woman than a tax planner. In the early days of the business she had been more preoccupied with making sales than optimising her company’s tax structure, which she regretted now things were going well as it was hard to change the tax structure. She recently succumbed to the relentless persistence of some people that wanted to help her minimise taxes. A whole new and complex world showed itself. She knew that it would be a labyrinth of complexity and on-going fees once she entered. But she was also getting to a level of assets and income where the fees were worth it. So she went ahead and hired a tax firm. It made sense now, but it hadn’t earlier.

Ask your adviser

In addition to the tax advantages specific to the rational portfolio outlined above here are a few more potential ways to save money on taxes. Like anything in the area of tax, clear these with a tax adviser, just to ensure that changes in rules have not rendered any of them ineffective or illegal.

Different accounts Many investors will have different accounts that in aggregate add up to their investment portfolio. One may be a fully taxed normal deposit account whereas another is tax-free (e.g. a UK ISA). Generally, different accounts may have different tax characteristics; by putting the high-income generating investments (typically fixed income) in the tax-free accounts you may lower your overall tax burden. Being informed about which investments fit best into various accounts can save you taxes. In the UK, for example, if you pay tax it almost always make sense to have an ISA account and benefit from its tax advantages.

Tax efficient proxies In some countries certain government bonds are tax advantageous. For example, in the US certain municipal bonds are exempt from certain taxes. If you are able to take advantage of such tax relief these bonds may be a more tax-efficient way to gain the virtual equivalent of the minimal risk asset. In other words, in this case you may not be holding US government bonds in the way you would be if there were no tax issues, but the municipal bonds are fairly similar and the tax advantage renders this compromise well worthwhile.

Enterprise Investment Scheme (EIS) or equivalent In the UK there are certain tax advantages or government subsidies in making start-up and certain types of clean-tech investments. Depending on your tax rate these are well worth knowing about. Your tax adviser should know all about them (these are outside the scope of this book).

Gifts Instead of realising a capital gain it may be advantageous to gift securities to your spouse and have him or her make the sale (thus utilising your spouse’s CGT allowance). Likewise, think about gifting relatives instead of them incurring inheritance tax. (You can’t do this just before death so check the rules!)

Realise losses When realising the capital gain on your portfolio you may be able to sell another security at a loss (to offset the gain) and reinvest the proceeds from the sales in a very similar investment. The rules on how similar the investment can be depends on the country, but be sure to stay compliant. You may, for example, sell an investment in the S&P 500 and reinvest the proceeds in the Wilshire 5000 index to get a different product with substantially the same exposure.

Create trading lots Keep track of your investment lots. If you buy 100 shares at £10 and later another 100 at £15 your average price is £12.50. If you later sell 100 shares at £20 you want your tax to be due on the second lot (i.e. a £5 gain) instead of your average gain of £7.50 per share. You can do this by designating each lot you buy separately and making clear that you are selling the lot bought at £15 per share.

Tax schemes If you enter into a tax-saving scheme of some sort, make sure in your planning that you calculate a realistic probability of it being found non-compliant and the fine this implies. Too often I have seen people involved with the tax authorities who find the whole thing incredibly draining both from a financial, emotional and time perspective, far beyond any potential tax savings are worth. Being the protagonist in a Kafka novel is never worth it.

It’s hard to generalise about something as specific as tax. The potential to minimise tax is often very specific to the individual person or institution, but always important. In addition to the points above, you need to keep as much flexibility in your tax planning as possible and avoid locking yourself in. Not only might your individual tax circumstances unexpectedly change, but the tax regimes that you operate under may also change. This ‘option’ on future changes is another reason not to pay your taxes sooner than you have to. It may be difficult to estimate the probability of such events, and some people have no options or flexibility in their tax planning, but for others the advantages could be great.

Rational portfolio adjustment

Throughout this book we have discussed the rational portfolio. While one of its many advantages is its simplicity, taxes can hinder this simple portfolio.

As an unrealistic example, imagine you are a US-based investor who would be taxed at 0% on dividends or capital gains if you invested only in US securities, and 50% tax in the case of foreign investments. Let’s say that there was no way to get around this geographic tax (e.g. by buying US-listed securities that invest abroad). What should you do? It would make sense to create a US-only portfolio, rather than incurring the tax. You could have your minimal risk asset in the short-term US government bonds and your equity exposure in the US equity markets. In this instance you would have compromised on geographic diversification, but since the alternative would be to pay 50% of your profit it would be worth it.

If you consider the equity risk premium to be 4–5% a year in addition to a minimal risk rate of 0.5% and annual inflation of 2% (because we pay tax on nominal amounts, inflation causes us to pay extra tax, you would expect your annual equity return to be around 7% (0.5 + 4.5 + 2.0) and the tax you pay on that is zero in the US and 3.5% abroad after the 50% tax. In simple terms, you would then be deciding if the diversification benefits from investing in the world equity markets as opposed to only the US one would be worth 3.5% tax a year.

A similar argument can be made for expensive tax wrappers. If the only legitimate way to gain the cheap, broadly diversified portfolio was through a complex wrapper, again you would have to consider the all-in costs of a rational portfolio. Did the annual charges from the wrapper in addition to an adverse ruling from the tax authorities really merit the benefits from the rational portfolio? If not, then perhaps we would be better off with an alternative portfolio that did not incur those costs. However, if someone tells you that you can’t have a rational portfolio because of your specific tax or other situation, but suggests what looks like an expensive alternative, then ask: ‘Can I buy quoted securities through this structure?’ If yes, then ask: ‘Is an ETF not just another quoted security even if it represents an underlying exposure to a broader equity or bond portfolio?’ Well, yes it is!

There is a reason that so many product providers offer tax-sheltered or optimised products; many investors are in the same boat. Some of the products charge far too much, particularly in on-going fees, but similarly many would work well for the rational portfolio while being tax optimised. Since many products change frequently, make sure you are up to date on developments in this area.

Those that claim that you should not consider your investments in the context of your tax situation in my view are just plain wrong. Each tax situation is specific but the point applies broadly. There are certainly situations where taxes may mean that it makes sense to have a tax-optimised imperfect portfolio rather than a tax-inefficient perfect portfolio. But hopefully you will be able to have both. Most people can.

1 Some investors see the opportunity to invest in multiple jurisdictions as an opportunity not only to minimise current tax, but also as a way to be less liable to a sudden increase in taxes in one jurisdiction.