Reading 10 Estate Planning in a Global Context

Question 1

Estate, definition

Answer 1

An estate is all of the property a person owns or controls

Question 2

Estate planning

Answer 2

Estate planning is the process of preparing for the disposition of one’s estate (e.g., the transfer of property) upon death and during one’s lifetime.

Question 3

Will, testator

Answer 3

A will (or testament) outlines the rights others will have over one’s property after death.

A testator is the person who authored the will and whose property is disposed of according to the will.

Question 4

Probate

Answer 4

Probate is the legal process to confirm the validity of the will so that executors, heirs, and other interested parties can rely on its authenticity.

Question 5

Intestate decedent

Answer 5

A decedent without a valid will or with a will that does not dispose of their property is considered to have died intestate. In that case, a court will often decide on the disposition of assets under applicable intestacy laws during the probate process.

Question 6

Sole ownership property

Answer 6

Assets held in sole ownership are typically considered part of a decedent’s estate. The transfer of their ownership is dictated by the decedent’s will (or, in the absence of their disposition under the decedent’s will, applicable intestacy law) through the probate process.

Question 7

Joint ownership property

Answer 7

In some jurisdictions, assets held in joint ownership with right of survivorship automatically transfer to the surviving joint owner or owners, as the case may be, outside the probate process.

Question 8

Civil law vs. Common law

Answer 8

Civil law, which is derived from Roman law, is the world’s predominant legal system. In civil law states, judges apply general, abstract rules or concepts to particular cases.

Common law systems, which usually trace their heritage to Britain, draw abstract rules from specific cases. The distinction is arguably analogous to the distinction between deductive and inductive reasoning. Put differently, in civil systems law is developed primarily through legislative statutes or executive action. In common law systems, law is developed primarily through decisions of the courts. Judges play very important roles in common law system by refining any existing laws to meet particular situations. Once made by a judge, the decision become precedent to be applied in future cases.

Countries following Shari’a, the law of Islam, have substantial variation, but are more like civil law systems especially in regard to estate planning.

Question 9

Forced heirship rules

Answer 9

• Under forced heirship rules, for example, children have the right to a fixed share of a parent’s estate.
• This right may exist whether or not the child is estranged or conceived outside of marriage.
• Wealthy individuals may attempt to move assets into an offshore trust governed by a different domicile to circumvent forced heirship rules.
• They may alternatively attempt to reduce a forced heirship claim by gifting or donating assets to others during their lifetime to reduce the value of the final estate upon death.
• In a number of jurisdictions, however, “clawback” provisions bring such lifetime gifts back into the estate to calculate the child’s share. If the assets remaining in the estate are not sufficient to cover the claim, the child may be able to recover his or her forced share from the donees who received the lifetime gifts.

Question 10

Community property regime

Answer 10

Under community property regimes, each spouse has an indivisible one-half interest in income earned during marriage. Gifts and inheritances received before and after marriage may still be retained as separate property. Upon death of a spouse, the property is divided with ownership of one-half of the community property automatically passing to the surviving spouse. Ownership of the other half is transferred by the will through the probate process.

Question 11

Separate property regime

Answer 11

In separate property regimes, prevalent in civil law countries, each spouse is able to own and control property as an individual, which enables each to dispose of property as they wish, subject to a spouse’s other rights.

Question 12

In general, taxes are levied in one of four general ways

Answer 12

In general, taxes are levied in one of four general ways:

• Tax on income
• Tax on spending
• Tax on wealth
• Tax on wealth transfers

Question 13

Net worth tax or net wealth tax

Answer 13

Tax based on one’s comprehensive wealth is often referred to as net worth tax or net wealth tax

Question 14

Lifetime gratuitous transfers

Answer 14

• In an estate planning context, lifetime gifts are sometimes referred to as lifetime gratuitous transfers, or inter vivos transfers, and are made during the lifetime of the donor.
• The term “gratuitous” refers to a transfer made with purely donative intent, that is, without expectation of anything in exchange. Gifts may or may not be taxed depending on the jurisdiction.
• Where gift tax applies, taxation may also depend on other factors such as the residency or domicile of the donor, the residency or domicile of the recipient, the tax status of the recipient (e.g., nonprofits), the type of asset (moveable versus immovable), and the location of the asset (domestic or foreign).

Question 15

Testamentary gratuitous transfer

Answer 15

• Bequeathing assets or transferring them in some other way upon one’s death is referred to as a testamentary gratuitous transfer.
• The term “testamentary” refers to a transfer made after death.
• From a recipient’s perspective, it is called an inheritance.
• Similar to lifetime gifts, the taxation of testamentary transfers (transfers at death) may depend upon the residency or domicile of the donor, the residency or domicile of the recipient, the type of asset (moveable versus immovable), and the location of the asset (domestic or foreign).

Question 16

Human capital or net employment capital

Answer 16

A notable implied asset for many is the present value of one’s employment capital (net employment income expected to be generated over the lifetime), often referred to as human capital or net employment capital.

Question 17

Core capital

Answer 17

The amount of capital required to fund spending to maintain a given lifestyle, fund these goals, and provide adequate reserves for unexpected commitments is called core capital.

Question 18

Excess capital

Answer 18

An investor with more assets than liabilities on the life balance sheet has more capital than is necessary to fund their lifestyle and reserves and therefore has excess capital that can be safely transferred to others without jeopardizing the investor’s lifestyle.

Question 19

Survival probability

Answer 19

Another approach is to calculate expected future cash flows by multiplying each future cash flow needed by the probability that such cash flow will be needed, or survival probability.

Specifically, the probability that either the husband or the wife survives equals:

p_Survival=p_{Husband survives} + p_Wifesurvives − (p_{Husbandsurvives}×p_Wifesurvives)

assuming their chances of survival are independent of each other. The present value of the spending need is then equal to:

PV(Spendingneed)=∑_j(1…N)[p(Survival)_j×Spending_j/(1+r)^j]

Question 20

Safety reserve

Answer 20

One way to adjust for this underestimation is to augment core capital with a safety reserve designed to incorporate flexibility into the estate plan.

Incorporating flexibility in this way can be important for at least two reasons:

1. It provides a capital cushion if capital markets produce a sequence of unusually poor returns that jeopardize the sustainability of the planned spending program.
2. It allows the first generation to increase their spending beyond that explicitly articulated in the spending program. In this way, the safety reserve addresses not only the uncertainty of capital markets, but the uncertainty associated with a family’s future commitments.

The size of the safety reserve can be based on a subjective assessment of the circumstances

Question 21

Monte Carlo simulation

Answer 21

Monte Carlo simulation gives the expected portfolio value and distribution of possible values at retirement. The probability of running out of money is known as the probability of ruin. Level of spending and probability of ruin are usually positively correlated.

Question 22

Tax-free gift

Answer 22

Question 23

Taxable gift

Answer 23

Question 24

Taxable gift, donor pays

Answer 24

Question 25

Skiping a generation

Answer 25

Skipping a generation can avoid double taxation of assets that are transferred by two generations: FV_{no skipping} = PV [(1+r)ⁿ¹(1-t)]x[(1+r)ⁿ²(1-t)] FV skipping = PV [(1+r)^N(1-T_e)] (N=n1+n2) Skipping a generation increases the future value of the gift by a factor of 1/(1-t) Transferring assets to the second generation would incur transfer taxes. A second layer of taxes would be assessed when assets are transferred from the heir to the second generation heir. The generation-skipping strategy through a direct gift to the second layer of heir avouds this double layer of taxation, thereby reducing oberall taxes.

Question 26

Spousal Exemptions

Answer 26

* Most jurisdictions with estate or inheritance taxes allow decedents to make bequests and gifts to their spouses without transfer tax liability. * In these situations, it is worthwhile to note that a couple actually has two exclusions available—one for each spouse. * As a result, it is often advisable to take advantage of the first exclusion when the first spouse dies by transferring the exclusion amount to someone other than the spouse.

Question 27

Valuation discounts

Answer 27

Can be emplyed to reduce the taxable value of gifts and estate

Question 28

Deemed dispositions

Answer 28

* Rather than impose an estate or inheritance tax on the amount of capital bequeathed at death, some countries treat bequests as **deemed dispositions**, that is, as if the property were sold. * The deemed disposition triggers the realization of any previously unrecognized capital gains and liability for associated capital gains tax. * The tax is therefore levied not on the principal value of the transfer, but only on the value of unrecognized gains, if any.

Question 29

Charitable Gratuitous Transfers

Answer 29

A donor is allowed to take a tax deduction in the amount of charitable gift. Value of a gift to charity relative to leaving it in a bequest:

Question 30

Trust

Answer 30

A **trust** is an arrangement created by a **settlor** (or grantor) who transfers assets to a trustee. Trust can be either revocable or irrevocable: * in a **revocable trust** arrangement, the settlor (who originally transfers assets to fund the trust) retains the right to rescind the trust relationship and regain title to the trust assets. * alternatively, where the settlor has no ability to revoke the trust relationship, the trust is characterized as an **irrevocable trust**. In an irrevocable trust structure, the trustee may be responsible for tax payments and reporting in his or her capacity as owner of the trust assets for tax purposes. Trusts can be structured to be either fixed or discretionary: * Distributions to beneficiaries of a **fixed trust** are prescribed in the trust document to occur at certain times or in certain amounts. * In contrast, if the trust document enabled the trustee to determine whether and how much to distribute based on Conner’s general welfare and in the sole and uncontrolled discretion of the trustee, the trust would be called a **discretionary trust**. A **spendthrift trust** is used to transfer assets ti a beneficiary who is too young or is otherwise unable to manage assets

Question 31

Foundations

Answer 31

* A **foundation** is a legal entity available in some jurisdictions. * Foundations are typically set up to hold assets for a particular purpose—such as to promote education or for philanthropy. * When set up and funded by an individual or family and managed by its own directors, it is called a **private foundation**. * Similar to trusts, foundations survive the settlor, allow the settlor’s wishes to be followed after the settlor’s death, and can accomplish the same types of objectives as a trust * A foundation is based on civil law and, unlike a trust, is a legal person

Question 32

Life Insurance

Answer 32

* Premiums paid on life insurance are not usually considered part of the grantor`s estate for tax purpuses but are sometimes considererd gifts to the beneficiary * In most jurisdictions, life insurance proceeds pass to beneficiaries without tax consequences, and, depending on jurisdiction, the policy might provide tax-free accumulation of wealth and/or loans to the policy holder on beneficial terms. * By establishing a trust on behalf of beneficiaries and making that trust the direct beneficiary of a life policy, the policy holder transfers assets to young, disabled, et cetera, beneficiaries *outside the probate process*.

Question 33

Companies and Controlled Foreign Corporations

Answer 33

* Companies may also be a useful tool in which to place assets. For example, a **controlled foreign corporation (CFC)** is a company located outside a taxpayer’s home country and in which the taxpayer has a controlling interest as defined under the home country law. A possible benefit of placing income generating assets in a CFC is that tax on earnings of the company may be deferred until either the earnings are actually distributed to shareholders or the company is sold or shares otherwise disposed. In addition, a CFC may be established in a jurisdiction that does not tax the company or its shareholders. * Many countries have CFC rules designed to prevent taxpayers from avoiding the taxation of current income by holding assets in a CFC. CFC rules can be triggered if a taxpayer owns more than, say, 50 percent of the foreign company’s shares, although the ownership threshold will vary from one jurisdiction to the next. CFC rules may also look beyond direct ownership of CFC shares and consider beneficial ownership in a trust, for example, or even ownership attributed to related parties, such as a taxpayer’s family members. Therefore, CFC rules may tax shareholders of a CFC on the company’s earnings as if the earnings were distributed to shareholders even though no distribution has been made. This treatment of earnings is called a **deemed distribution**.

Question 34

The Hague Conference on Private International Law

Answer 34

**The Hague Conference on Private International Law** is an intergovernmental organization that works toward the convergence of private international law.

Question 35

Source and residence jurisdiction countries

Answer 35

* A country that taxes income as a source within its borders is said to impose **source jurisdiction**, also referred to as a **territorial tax system**. * This jurisdiction is derived from the relationship between the country and the source of the income. Countries imposing income tax exercise source jurisdiction. * Countries may also impose tax based on residency, called **residence jurisdiction**, whereby all income (domestic and foreign sourced) is subject to taxation. In this case, the jurisdiction is derived from the relationship between the country and the person receiving the income. Most countries use a residential tax system.

Question 36

Exit taxation

Answer 36

* In response to citizens whou renounce their citixenship to avoid taxes, some residendce jurisdictions impose an **exit tax**, usually based on the gains on assets leaving, as if they were sold (deemed disposition). * This could include a tax on income earned for a shadow period

Question 37

Double taxation conflicts

Answer 37

* **Residence–residence conflict** - a tax conflicts in which two countries claim to have taxing authority over the same income or assets. This conflict can relate to either income tax or estate/inheritance tax and arise in a number of ways. For example, two countries may claim residence of the same individual, subjecting the individual’s worldwide income to taxation by both countries. * Alternatively, two countries may claim source jurisdiction of the same asset (i.e., **source–source conflict**). This conflict can arise, for example, on income from a company situated in Country A but managed from Country B. Both countries may claim that the company income is derived from their jurisdiction. * In other situations, an individual in Country A may be subject to residence jurisdiction and, therefore, taxation on worldwide income. Some of the individual’s assets may be located in Country B, which exercises source jurisdiction on those assets, creating a **residence–source** conflict.

Question 38

Foreign Tax Credit Provisions

Answer 38

* In the **credit method**, the residence country reduces its taxpayers’ domestic tax liability for taxes paid to a foreign country exercising source jurisdiction. The credit is limited to the amount of taxes the taxpayer would pay domestically, which completely eliminates double taxation. T_CreditMethod = Max[T_Residence,T_Source] ! The method provides *complete resolution* of the residence-source conflict * In the **exemption method**, the residence country imposes no tax on foreign-source income by providing taxpayers with an exemption, which, in effect, eliminates the residence–source conflict by having only one jurisdiction impose tax. T_{ExemptionMethod} = T_Source ! The method provides *complete* resolution of the residence-source conflict * Under the **deduction method**, the residence country allows taxpayers to reduce their taxable income by the amount of taxes paid to foreign governments in respect of foreign-source income (i.e., provides a tax deduction rather than a credit or exemption). T_{DeductionMethod}=T_Residence+T_Source(1−T_Residence)=T_Residence+T_Source−T_ResidenceT_Source ! The method provides *only partial* resolution of the residence-source conflict

Question 39

Tax avoidance and tax evasion

Answer 39

* **Tax avoidance** is developing strategies that conform to both the spirit and the letter of the tax codes of jurisdictions with taxing authority. * **Tax evasion**, on the other hand, is the practice of circumventing tax obligations by illegal means such as misreporting or not reporting relevant information to tax authorities. Many countries enter into global treaties which provide for the sharing of information. QIs collect all the information required by the United States but provide the information on their US customers only. A similiar agreement exists in the European Union, by which EU member banks exchange customer information with each other.

Question 40

The size of tax deduction when an investor makes a gift of appreciated securities to a charitable organization?

Answer 40

When an investor makes a gift of appreciated securities to a charitable organization, in most countries the investor is able to take a deduction in the amount of the current *fair market value of the gift* (_not in the amount of the capital gain!_)

Question 41

Benefits of trust

Answer 41

A trust would provide with the following benefits: 1. Avoidance of publicity associated with probate (privacy) 2. Protection of the assets within the trust from claims (claims frm outside) against grantor and his relatives (heirs) both now and in the future. 3. Avoidance of disputes within the family (the heirs) 4. Responsible stewardship of assets while the heirs are minors and afterwards if they are unable to manage the assets themselves