Why Chinese HNWIs wishing to establish offshore trusts should act now?

Why Chinese HNWIs wishing to establish offshore trusts should act now?

Chinese HNWIs should act now as China may introduce a tax reform with the new estate tax, exit tax on emigration and adopt new rules to tax the contribution of appreciated assets into an offshore trust.

Chinese high net worth individuals (“HNWIs”) are very interested in using offshore trust for wealth planning because of the unique benefits offshore trusts offer and also due to the fact that Chinese domestic trusts are not suitable for wealth planning.  As to the timing, we think Chinese HNWIs should act now so that they could avoid the adverse consequences caused by the next wave of Chinese tax reform.

China may introduce estate tax soon

Estate tax has suddenly become a very hot topic in China recently.  There has been a lot of media coverage on this over the past few months.  In 2004 the Ministry of Finance issued a draft of the Provisional Regulations on Chinese Estate Tax for public comments.  Although the draft was revised again in 2010, it had never become law.

The introduction of estate tax was then repeatedly mentioned as a medium term goal in several important resolutions on reform adopted by the central government over the past few years.  There were even rumors earlier this year that Shenzhen would become the first city to introduce estate tax on a pilot basis, which caused widespread panic among local residents, but those rumors turned out to be a false alarm.

Why estate tax has suddenly become a media focus is the natural result of the widespread frustration and anxiety among Chinese people about the increasing income disparity between the rich and the poor. The people who are in favor of estate tax argue that estate tax can significantly help to solve this income disparity issue.

However, the opponents take the view that it is simply too early to introduce such tax in China because China doesn’t even have the required basic infrastructure for collecting and administrating such tax (e.g. a nationwide asset registration system and a reliable asset valuation system), let alone certain key technical issues that would need great wisdom to figure out the answers for, such as the exemption amount, the tax rate, etc..

Despite of those hurdles such as the infrastructure and the difficulties in working out those technical issues, in my personal view, because generating additional tax revenue from estate tax is not a top goal for China (at least not yet), the timing for the introduction of estate tax in China would mainly depend on whether and how quickly China can have good control over the income disparity issue.  If China fails to do so, estate tax may arrive much earlier than people would anticipate.

Needless to say, if China introduces estate tax, it will automatically introduce gift tax.  So for those who think they could get around with the estate tax by giving wealth to their children or other family members as gift should think again.

China may also introduce exit tax on emigration

Many countries impose an exit tax on persons who cease to be tax residents in those countries.  This often takes the form of a capital gains tax against unrealized gain attributable to the period in which the taxpayer was a tax resident of the country in question.  Exit tax can be assessed upon change of domicile, habitual residence or citizenship.

China also taxes its tax residents on worldwide income, but nonresidents are taxed only on China sourced income. So if a Chinese individual becomes a nonresident from a resident, under current Chinese tax rules, the person will no longer need to pay Chinese tax on non-China sourced income, even if the income represents the unrealized capital gains attributable to the period when the person was still a Chinese tax resident.  The change of such tax residency often takes place when the person emigrates from China to another country.

We may see a change to such rules soon if the current emigration wave continues to rise.  Although there is no official study confirming this, China is now the largest emigrant source country in the world.  While the emigration is generally not Chinese tax-driven, it will be just a matter of time before the Chinese tax authorities realize the resulting permanent tax revenue loss.  At that time, the introduction of exit tax would likely be inevitable.

China may adopt new rules to tax the contribution of appreciated assets into offshore trusts

China currently doesn’t have any specific tax rules on trust.  As a result, in the case of offshore trust, when a Chinese settlor contributes appreciated assets (e.g. company shares) into a trust, people generally would take a position that the contribution should not give rise to any Chinese tax.  If such appreciated assets are offshore assets, when they are disposed of by the trustee, no Chinese tax would apply because the trustee is not a Chinese tax resident.

If the trustee distributes such income to the beneficiary or beneficiaries, under current Chinese individual income tax rules, another position could be generally taken that the distribution should be considered gift and thus not taxable in China.   In other words, the use of offshore trust could minimize the Chinese tax that the settlor should have paid if he or she disposed of such assets directly.  The current capital gains tax rate for individuals is 20%.

China will soon reform its individual income tax law. The trust taxation rules will certainly be part of the reform and it won’t be too difficult for the Chinese tax authorities to detect the loophole mentioned above.  Or they may fix it earlier simply by introducing a deemed sale rule or a general anti-avoidance rule. https://www.zhonglun.com/en/

Legal and Tax restraints for Chinese HNWI Offshore trusts

Legal and Tax restraints for Chinese HNWI Offshore trusts

Issues arising from setting up an offshore trust for a Chinese HNWI include the recognition of the trust itself and other legal and tax constraints.

As more Chinese HNWIs have realized the unique benefits of offshore trust, especially in the areas of asset protection and succession planning, the number of Chinese HNWIs using offshore trust for wealth planning is increasing fast. However, setting up an offshore trust for a Chinese HNWI can be a complex task due to the Chinese legal and tax constrains.

The recognition of offshore trust in China

The first big question about offshore trust is always whether it is even legally recognized in China. Offshore trust is not specifically recognized by any of the written laws including the Chinese Trust Law. There is also no court case providing any guidance or clarification. However, just like that offshore holding companies are recognized in China, the general understanding based on the Chinese legal principles is that offshore trust should be recognized in China if it meets all the legal requirements in the jurisdiction where the foreign trust is formed.

The community property issue

Under the Chinese Marriage Law, the property obtained by a couple or either spouse during their marriage period is generally considered community property. Community property is jointly held by both the husband and the wife, which means that, even if only a small portion of the community property is disposed of by one spouse without the consent of the other spouse, such a transfer would be invalid. There are already enough court cases in China enforcing such rules.

As such, securing the consent of the other spouse is the essential precondition for contributing community property by one spouse to an offshore trust. Without such consent, the contribution could be held invalid under Chinese law (assuming China has the jurisdiction), which means the relevant assets may thus need to be returned by the trustee. This issue normally arises when a husband sets up an offshore trust for the benefit of his second family or when he intends to hide assets from divorce.

A related issue is when the consent of the other spouse is not obtained, whether the trustee shall have any liability. This issue will most likely come up when the trust assets are ordered by a Chinese court to be returned to the couple but the value of such assets under the trustee’s management has decreased significantly. Although there is no clear rule in China and there hasn’t been any court case in China providing any guidance, the answer to that question would likely depend on whether the trustee has acted with malice. Unfortunately, the term “malice” is not defined by Chinese law in the trust context. Trustees thus should exercise enough caution before taking on the trustee role.

The regulatory restrictions on putting assets into an offshore trust

Dependent on the location and type of the asset, there could be Chinese regulatory restrictions on contributing such assets to an offshore trust. For offshore assets, there is generally no Chinese regulatory restriction on the contribution of such assets to an offshore trust. If those assets are onshore assets, the contribution of such assets to an offshore trust is extremely difficult under the Chinese foreign exchange control rules, banking rules, foreign investment rules, and outbound investment rules.

For example, a Chinese individual is legally allowed to remit out only USD 50,000 annually. Another example is that a foreign entity (e.g. a trust company) is not allowed to own real property in China unless it is for self-use (e.g. used as office space for its Chinese representative office). As a result, the offshore trusts we have seen typically do not directly own onshore assets.

The uncertain tax treatment of an offshore trust

There are no specific tax rules on either domestic or offshore trust. By applying the existing general tax rules, until specific rules on trust come out, one could argue that technically a settlor would not be taxed on the contribution of assets to an offshore trust even if such assets have appreciated in the hands of the settlor.

Also, a Chinese non-settlor beneficiary would not be taxed on trust distributions as China doesn’t tax gift income yet. Lastly, the trustee would not be taxed on accepting or holding the trust property as long as it is a non-Chinese entity and operates outside China. However, whether such technical analysis could be respected by the Chinese tax authorities is an open question as, to our knowledge, there hasn’t been any actual administrative case on this.

The uncertainty regarding the withholding and reporting obligations of the trustee

While the existing Chinese anti-avoidance rules apply to enterprises, not individuals, they could come into play in the offshore trust context, especially when a special purpose holding company is formed underneath the trustee and controlled by the Chinese settlor. In that case, the SPV could be considered a Chinese tax resident if it is considered effectively managed in China. If so, the SPV would be subject to Chinese income tax on its worldwide income and need to file a tax return in China.

Even if the SPV is not considered a Chinese tax resident, if the trust property is Red Chip company shares, there could still be a technical requirement under Circular 698 that any transfer of the SPV should be disclosed to the Chinese tax authorities through an information filing. Failure to comply with this reporting requirement would be subject to a fine. In practice, a number of foreign trustee companies are reluctant to follow this rule because they take a position that such Red Chip companies are formed with bond fide business purposes. However, whether the SAT would respect this position has not been tested up till now. https://www.zhonglun.com/

How could PRC community property rules impact offshore trust planning?

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:

  1. Property acquired by a person prior to marriage
  2. Property acquired by gift or inheritance during marriage while the underlying gift agreement or the will specifies that the property belongs to one spouse
  3. 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. https://www.zhonglun.com/en/

Should I use a Liechtenstein foundation as a private trust company for my family?

Should I use a Liechtenstein foundation as a private trust company for my family?

Many families use trusts as an estate planning vehicle and for wealth preservation. Increasingly, instead of using a trustee company owned by a financial service provider, a private trust company (PTC) is appointed as a trustee. The use of a Liechtenstein foundation as such a PTC offers several key advantages.

Advantages of a private trust company

However, there has been a growing trend to create a so-called private trust company (PTC) to act as a privately held trustee company only for the trusts of one family. A key advantage of using a PTC is that instead of transferring the family wealth to a company that acts as a trustee for hundreds of trusts, the family has its own trustee which is not shared with others.

This removes the risk that the trusts of a certain family are affected by problems that have nothing to do with it. In contrast, if a trustee company owned by a financial services provider is used as a trustee, there is a chance that reputational or other issues relating to a specific trust spill-over to the trusts of another family because they share the same trustee.

Moreover, in case of a PTC, the client determines who will act as the PTCs initial directors. If a trust company is owned by a financial services provider, the composition of the board of directors generally cannot be changed.

Furthermore, using a PTC facilitates the transition to another administrator of the family trusts, should this be desired. In a traditional set-up, the trust assets are registered in the name of a trust company which is owned by a financial services provider. If a new trustee is appointed, it is necessary to transfer the legal ownership of the trust assets to the new trustee.

Additionally, in most cases the outgoing trustee company will request an indemnity against any liabilities it may have from acting previously as a trustee. If a PTC is used and it is intended to exchange the administrators of the family trusts, only the directors of the PTC need to be replaced.

A common set-up of a private trust company structure

In a common set-up, the PTC is a company limited by shares. While using a PTC has several benefits, it begs the question who should act as the shareholder of the privately held trustee company. In most cases, the shareholder cannot be the settlor of the trust because then the shares of the PTC would be part of his estate which would frustrate the estate planning purpose of the trusts. A common set-up to solve this problem has been to establish a separate purpose trust whose only purpose it is to hold the shares of the PTC.

The main drawback of this approach is that again a trustee is needed for the purpose trust holding the shares of the PTC. In most cases, a trustee company owned by a financial services company is used for this purpose. This means that the reasons for not using such a company as a trustee of the family trust are still present. However, they are moved to a remoter level and are mitigated because the only assets held by the trustee company of the purpose trust are the shares in the PTC.

Using a Liechtenstein foundation as a PTC

Using a Liechtenstein foundation removes entirely the need for a trustee company owned by a financial services provider and at the same time reduces complexity. The structure then simply consists of a Liechtenstein foundation acting as trustee of one or more family trust.

A Liechtenstein foundation essentially is a fund endowed for a specific purpose which acquires the status of a legal person. It has no shareholders and therefore the question who holds the foundation does not arise. Such a foundation can be established with the sole purpose to act as the trustee of one or more trusts for the benefit of a certain family.

An illustration of this set-up:

It should be noted that when a Liechtenstein foundation acts as a private trust company, generally no special business license is necessary in Liechtenstein. This was clarified recently by a submission of the Liechtenstein government to parliament dealing with an amendment of the Trustee Act. The Liechtenstein Trustee Act deals with the regulatory framework for professional trustees and trust companies. In this submission (BuA 42/2013, p. 40 et seq.), the Liechtenstein government clarified that a PTC does not qualify as a professional trust company and does not require a license under the Trustee Act.

The government noted that a Liechtenstein PTC, like all other Liechtenstein companies without a special business license, requires a member of the board who is licensed as a professional trustee or in an employment relationship with such a professional trustee. According to the Liechtenstein government, no separate regulation of the entity acting as a PTC is necessary.

The government pointed out that the licensing requirement only applies to “professional” trustees and that a privately held trustee company typically does not meet this criterion because it is not used with the goal to create profits. The government also mentioned that the fact that the directors charge a fee to the PTC is not harmful either.

Furthermore, the government stated that even if the Liechtenstein entity charges a trustee fee to the trusts, it still does not need to be regulated because the PTC offers its services only to a closed circle of persons. The government also specifically confirmed that a Liechtenstein foundation can act as a PTC.

Conclusion

In a summary, a Liechtenstein foundation can therefore be used as a private trustee company that acts as the trustee of the trusts for a certain family. This leads to a relatively simple and cost-efficient structure and does not require a special licensing or other regulatory procedure.

The only legal requirement is the need for a local board member of the foundation who has a special business license, i.e. at least one board member of the foundation must be licensed as a Liechtenstein professional trustee or must be employed by a licensed trustee. https://www.marxerpartner.com/details-en/alias/dr-iur-markus-summer

Maintenance for surviving spouse

Maintenance for surviving spouse

This article will explore what happens with the maintenance for surviving spouses after the death of their partner. A surviving spouse, regardless of the matrimonial property regime in terms of which they are married, may have a claim for their reasonable maintenance requirements against the deceased’s estate.

Maintenance for surviving spouses

The Maintenance of Surviving Spouses Act 27 of 1990 (hereinafter referred to as “the Act”) allows, in certain circumstances, widows / widowers to be maintained from their deceased spouses estate. This is obviously in conflict with the common law, which requires that a matrimonial relationship exist between the parties, which gives rise to a duty of support. Death or divorce ordinarily brings that matrimonial relationship to an end. The aforementioned Act therefore altered the common law in this regard.

Section 2(1) of the Act provides that:-

“If a marriage is dissolved by death after the commencement of this Act the survivor shall have a claim against the estate of the deceased spouse or the provision of his reasonable maintenance needs until his death or remarriage in so far as he is not able to provide therefore from his own means and earnings.”

A claim for maintenance by a surviving spouse will compete with a claim for maintenance of a dependant or minor child and will reduce such claims proportionately.  Such a claim for maintenance only arises if the surviving spouse is unable to provide for his/her maintenance needs from his/her own earnings.

The surviving spouse shall not have any recourse against any person to whom money or property has already been paid.

A claim in terms of the Maintenance of Surviving Spouses Ac is deductible for estate duty purposes, provided that such claim is reasonable.

Factors to be taken into account

In terms of Section 3 of the Act the following factors must be taken into account when determining the reasonable maintenance requirements of the surviving spouse:

(a) The amount in the estate of the deceased spouse available for distribution to heirs and legatees;

(b) the existing and expected means, earning capacity, financial needs and obligations of the survivor and the subsistence of the marriage; and

(c) the standard of living of the survivor during the subsistence of the marriage and his age at the death of the deceased spouse.”

Other factors which can be taken into account are: the duration of the marriage, the surviving spouse’s age at the time of the deceased’s death and any other relevant factor.

Oshry NO v Feldman (401/09) [2010] ZASCA 95

The parties in the aforementioned matter married later in life and it was a second marriage for both parties, with both having children from their previous marriage relationships.  The parties were married for some 18 years.

The court found in this matter that the primary obligation of support rests on a spouse, and if deceased, on the estate of the deceased spouse.  The duty of support does not rest on the Respondent’s sons, as submitted by the Appellant’s.

In was stated that the Maintenance of Surviving Spouses Act was intended to ensure that the maintenance obligation of a spouse who owed a duty of support continued after death.

In casu, the court held that the Respondent was in need of maintenance and that there was no reason why a lump sum payment could not be awarded, particularly in these circumstances, where the Respondent had not yet received any maintenance from the deceased’s estate for nearly 5 years.

The appeal was upheld and a limited substituted order put in place which recognized the Respondent’s claim against the deceased’s estate, including a lump sum payment.

Maintenance for surviving children

In terms of the 1906 matter of Carelse v Estate de Vries, it was decided that, in the absence of suitable testamentary provisions in respect of children, the minor children may have a maintenance claim against the parent’s deceased estate.  It was similarly held that major children, who are not yet self-supporting, may also claim against the deceased estate.  The major child would however have to prove that he/she requires financial support and the extent of support which they require.

A minor or dependant child’s claim for maintenance ranks preferent to all other claims against the deceased estate, with the exception of debts owed to creditors. https://za.linkedin.com/in/liesl-rae-fischer-7b287b196