How could PRC community property rules impact offshore trust planning?

Property acquired during marriage will be presumed as community property if not otherwise structured. Property planning helps to obtain clean title to the assets that a PRC settlor wishes to contribute to an offshore trust, and thus prevents potential risks and claims.

With the rapidly growing number of PRC high net worth individuals (“HNWIs”) and their increasing awareness of wealth planning, the use of an offshore trust by these HNWIs as a vehicle of wealth protection and preservation is becoming more and more popular in the PRC.

Setting up an offshore trust for a PRC HNWI could be a complicated task not only because of the PRC legal and tax constraints, but also as a result of the potential impact of the PRC community property rules. Under the PRC Marriage Law, any property acquired during marriage is presumed to be jointly owned by both spouses, i.e. community property. Therefore, a spouse contributing community property to a trust without the consent of the other spouse could face serious legal risks. The trustee in such a case may be exposed to certain liabilities as well if there is a lack of due diligence.

PRC Community Property Rules

Under the PRC Marriage Law, any property acquired by a couple or either spouse during marriage is presumed to be jointly owned by both spouses, unless there is specific evidence that would point to a contrary conclusion. Community property includes but is not limited to salaries and wages, bonuses, business income, investment income, income related to intellectual properties and gift income acquired by either spouse during marriage.

 

In comparison, separate property mainly refers to the following:

(i) Property acquired by a person prior to marriage;

(ii) Property acquired by gift or inheritance during marriage while the underlying gift agreement or the will specifies that the property belongs to one spouse; and

(iii) Property agreed to be one spouse’s separate property in a pre-nuptial or post-nuptial agreement.

With the broad definition of community property, as a practical matter, most of the PRC HNWIs would be subject to the community property rules, especially those who are in their 40s or 50s and created their family wealth over the past two decades during which the PRC achieved record-high economic growth. To them, almost all their family wealth would theoretically be community property, even though some assets may have been recorded under one spouse’s name for title recording purposes.

One important question is whether the income generated from the investment of one spouse’s separate property during marriage would be community property or not. The answer is generally yes, with the exception that bank interest earned on separate property remains as separate property.

Because of the PRC community property rules, when community property is contributed by one spouse into an offshore trust without the consent of the other spouse, the contribution would be held invalid, which means that such property may thus need to be returned to the claimant spouse. One tricky related issue here is whether the trustee would be held liable to the other spouse, especially in the event where the trust assets have depreciated in value. While there are no clear rules in the PRC dealing with such an issue, based on the general legal principles, a PRC court would likely base its decision on whether the trustee acts in good faith or with malice. Since the term “malice” is not clearly defined by the PRC laws, a PRC court may exercise extensive discretion on the interpretation. A trustee should thus conduct sufficient due diligence regarding the ownership of the assets in question and enough care must be taken to minimize such risks.

How to Best Deal with PRC Community Property Rules

A married couple can try to use pre-nuptial or post-nuptial agreements to work around the community property issue. The pre-nuptial or post-nuptial agreement is gradually becoming the most efficient way for spouses to determine their desired ownership entitlement to their community property, which is legally allowed under the PRC Marriage Law. A legally enforceable pre-nuptial or post-nuptial agreement preempts the application of the default community property rules.

Such an agreement can be executed either before marriage, at the point the couple get married or during the course of their marriage. And it can cover any property already owned by the couple and even their prospective property. It can also have the retroactive effect as long as that is a manifestation of the spouses’ genuine intent.

A common question asked by some US tax practitioners is whether the execution of a post-nuptial agreement would be treated as a gift from one spouse to the other spouse, which could potentially create certain US tax issues. A typical scenario is where the wife, a US citizen or green card holder, enters into a post-nuptial agreement with her husband, a Chinese citizen, under which she agrees that certain assets would belong to her husband. The theoretical view in the PRC currently seems to be that this should not be treated as a gift.

In the context of offshore trust, another common question is whether a consent letter signed by the other spouse, instead of a formal post-nuptial agreement, would be sufficient under the PRC laws. The current view of many practitioners in the PRC is that a carefully drafted consent letter based on the full knowledge of the other spouse should be sufficient.

Conclusion

Obtaining clean title to the assets that a Chinese HNWI wishes to contribute to an offshore trust is far more complex than it appears. Without proper planning or care, the contribution would be problematic to both the settlor and the trustee. Therefore, both of them are highly recommended to seek sufficient professional legal advice before taking the first step.