Sea change

PUBLISHED : Tuesday, 10 June, 2008, 12:00am
UPDATED : Tuesday, 10 June, 2008, 12:00am

Succession planning

One crucial question in any preliminary discussion about succession planning still surprises many high-net-worth individuals in Hong Kong. It is about citizenship, rather than nationality, and concerns, in particular, which family members or intended beneficiaries are, for official purposes, citizens of the United States.

The financial implications can be huge because the answers, once clearly established, have a significant bearing on tax status and, therefore, the choice of structures used to transfer wealth to the next generation.

The element of surprise often springs from a failure to realise that being a US citizen is not simply a matter of having a US passport or green card.

The prevailing rules entail other layers of complexity, variously relating to place of birth, parents' status, registration of birth and time spent in the country.

One outcome is that people can find their children or nominated heirs have qualified as US citizens almost inadvertently and, as a result, are liable for US taxation on their worldwide income.

Mimi Hutton, a Hong Kong-based partner with law firm Withers who specialises in advising private clients on succession planning and cross-border wealth structuring, says: 'There's the issue. Quite often we see families who are a mix of US and non-US citizens. Sometimes it is planned that way carefully, but sometimes they do not realise and it is quite a shock.'

That shock reverberates once they learn what it may mean financially.

Most significantly, a 'US person' will generally have to pay estate tax on any inheritance - now at a rate of 45 per cent - in addition to income tax assessed on their global earnings. The laws relating to inheritance have been designed to guard against 'skipping over' a generation.

That means that a high-net-worth individual or successful entrepreneur may not expect to leave the majority of assets to grandchildren who are not US citizens, rather than to children who are, in the hope of avoiding estate tax payments.

Ms Hutton says, though, that several perfectly legitimate options exist, which allow for an effective transfer of wealth to family members who are US citizens and, at the same time, can keep their tax liabilities to a minimum.

Prominent among these is the use of a grantor trust. Typically, such a structure is set up in an administration such as the Cayman Islands, British Virgin Islands, Guernsey, Singapore or Bermuda, with a reputable financial institution providing trustee services.

A grantor trust can be established in such a way that rights are initially retained by the person setting up the trust - a non-US grantor - and made sufficiently flexible to allow for new investments or alterations to the disbursal arrangements.

From the legal perspective, the assets are held in the trust, and the trust 'doesn't die', a principle fully accepted by the US tax authorities. Therefore, if the assets 'start' with a non-US person it is possible to avoid US estate taxes on what the trust administers when he or she passes away because the actual assets are not transferred to a US citizen.

The trust continues to operate essentially as before with family members or other beneficiaries still able to receive benefits either through regular distribution or by having agreed payments - perhaps university fees and expenses - made on their behalf.

Ms Hutton says that a grantor trust has other potential advantages. It allows the named beneficiaries to receive benefits straightaway (the structure used is normally revocable) and there is an opportunity to spell out conditions or incentives. This gives the senior generation in wealthy families the scope to 'write the rules' in general requirements or individual expectations, which their heirs must then fulfil.

That may be to get a degree or work in various capacities in the company business. Alternatively, it may stipulate that distribution from the trust should match any salary earned elsewhere, but such formulas are not necessarily as viable as they seem at first glance.

For example, if one beneficiary chooses to spend time doing voluntary work in Africa that person will - quite unintentionally - miss out.

'Our job is to look at the long view and see what can go wrong,' Ms Hutton says. 'So we do a lot of listening at the beginning.'

She says that a financial institution will take over the day-to-day management of assets and investments, but the family can still get involved. They may want to have input on new issues that arise from the running of the trust or suggest that it invests in buying a golf course or a hotel as a means of diversifying.

However, the financial institution and legal advisers purposely keep control over the trust so that the US Inland Revenue Service (IRS) will have no reason to doubt that the grantor is still the owner of the assets.

'The way we plan for our clients is always on the basis that everything could be fully disclosed to the IRS, and probably would be at some stage,' Ms Hutton says.

She says that other techniques can be used in parallel to allow flexibility and account for different needs.

One option becoming more popular in Asia is to establish a charitable foundation, with family members on the board, to support preferred causes. Another is to create a testamentary trust as part of one's will. It will only be set up after probate and, while the terms typically include fewer details or conditions, it is a viable alternative for protecting wealth and making bequests with certain strings attached. 'There are always benefits to passing some assets down via a trust,' Ms Hutton says.

Kurt Rademacher, also a partner with Withers, says that if an Asia-based client is already a US citizen there are other possibilities to limit tax exposure relating to succession planning. One is expatriation - choosing to relinquish a US passport or green card and, therefore, citizenship. Doing this involves completing a specific series of documents and declarations, but does not mean you are then automatically out of the US tax net.

You will still be subject to modified US income tax, estate tax and gift tax for 10 years, but liable to pay only on your US - not worldwide - assets. After 10 years you will be taxed like any other non-US person - on US-sourced income, and subject to estate tax on US situated property and real estate.

Mr Rademacher says that a new bill now going through Congress may cause many people to review the pros and cons of expatriation. The US presidential election may delay its passage, but most experts in the tax community believe it will become law within the next few months.

A key provision will allow someone to 'expatriate' by paying an exit tax to the US authorities. In principle, the amount assessed will be calculated as if the person has sold all their worldwide assets on the day they give up their passport.

Some uncertainties remain, but Mr Rademacher suggests that anyone thinking about expatriation will do well to study the various thresholds.

They should also assume that the bill will be effective on the date of enactment, and remember that, under the proposed legislation, if a person gives up US status and then passes property to a US person there will still be estate or gift tax applied at a standard rate.

'Tax is assessed on the recipient, not the person expatriated,' he says.