CFA 2018 r10 estate planning in a global context

Domestic Estate Planning: Basic Concepts Estate: A property a person owns or controls Estate Planning: Process of preparing for disposition of one’s estate Will testament: Rights other

Contents

1 Introduction

2 Domestic Estate Planning: Some Basic Concepts

3 Core Capital and Excess Capital

4 Transferring Excess Capital

5 Estate Planning Tools

6 Cross Border Estate Planning

2 Domestic Estate Planning: Basic Concepts

Estate: A property a person owns or controls

Estate Planning: Process of preparing for disposition of one’s estate

Will (testament): Rights others will have over one’s property after death

Testator: Person who authors the will and whose property is disposed according to the will

Probate: Legal process to confirm validity of the will

A person without a valid will dies intestate

2.2 Legal Systems, Forced Heirship and Marital Property Regimes

Civil Law: Derived from Roman Law Apply rules or concepts to particular cases Deductive reasoning

Common Law: Derived from British Law: Draw rules from specific cases Inductive reasoning

Legal concept of trust is unique to common law

Shari’a Law: More like civil law

Forced Heirship:

Children have a right to fixed share of parent’s estate

Community Property Regime: Each spouse has indivisible one-half interest in income earned during marriage

On death half property goes to spouse Other half divided according to will

Separate Property Regimes: Each spouse is able to own and control property as an individual

Read Example 1

2.3 Income, Wealth and Wealth Transfer Taxes

Taxes levied in four ways: 1) Tax on income 2) Tax on spending 3) Tax on wealth and

4) Tax on wealth transfer

Understand how assets are taxed when their ownership is transferred at or before death

Lifetime gratuitous (inter vivos) transfer: transfer made during life-time of the donor

Tax depends on jurisdiction

Testamentary gratuitous transfer: transfer made upon one’s death

Tax on wealth transfer may be applied to transferor or recipient depending on jurisdiction

Example 2

3 Core Capital and Excess Capital

Assets Liabilities and Equities

Excess Capital Exhibit 1: Hypothetical Life Balance Sheet

Core Capital: Capital required to 1) maintain lifestyle 2) fund primary goals and

3) meet unexpected commitments

Excess Capital

3.1 Estimating Core Capital with Mortality Tables

Simplest approach: Calculate PV of anticipated spending over remaining life expectancy

What is the problem with this approach?

Another approach: multiply each future cash flow by survival probability

If husband/wife are relying on the same core capital…

P (S) = P(H) + P(W) – P(HW)

Embedded example: Ernest, 79 and Beatrice, 68

Probability of survival in year 1: P(E) = 0.936 P(B) = 0.983

What is the probability that either or both survive in year 1?

Annual spending in year 1 = 500,000 What is the expected spending in year 1?

What is the present value using a real risk free discount rate of 2%?

Assume real growth rate of expected spending is 3% What is the expected spending

in year 2?

Core capital requirement = €9.2 million

Why should we discount at risk free rate rather than expected rate of return on

investments?

Refer to Exhibit 2

Safety Reserve

Augment core capital with a safety reserve

This helps address 1) lower asset returns than expected and 2) higher expenditure than expected

Example 4

3.2 Estimating Core Capital with Monte Carlo Analysis

Forget discounting!

This method estimate size of portfolio needed to meet expenses

Captures capital market risks much better than mortality table approach

Forecast portfolio values given statistical properties of underlying asset returns

Forecast spending needs

Calculate sustainable spending rates without simulation

Example 5

4 Transferring Excess Capital

Webster’s have €20,000,000 and need core capital = €9,200,000 What is their challenge?

If inheritance tax  consider gifting

Tax-Free Gifts

In the US a parent can gift $13,000 per child per year

Exhibit 4 13,000/year tax free for 30 years

8% nominal return, tax = 25%, inflation = 2.5%

Relative Value of a Tax-Free Gift:

Taxable Gifts

Relative Value of Taxable Gifts

Location of the Gift Tax Liability

Preceding section assumes tax is paid by recipient

In some countries donor pays tax

Tax benefit of lifetime gift vs bequest increases

Exhibit 6

Example 6

4.2 Generation Skipping

If wealth transfer goals extend beyond second generation…

200,000,000 allocated for third generation 5% growth 35 years 50% gift tax

Scenario 1: Transferred to second generation after 10 years Transferred to third generation after 25 more years

Scenario 2: Transferred to third generation after 35 years

4.3 Spousal Exemptions

UK: Estate less than GBP 312,000 can be transferred to spouse without inheritance tax

4.4 Valuation Discounts

Gift and estate taxes can be mitigated by transferring assets that qualify for valuation discounts

Privately held family business  Discount for lack of liquidity

4.5 Deemed Dispositions

Treat bequest as if the property were sold

4.6 Charitable Gratuitous Transfers

Most charitable donations are not subject to a gift transfer tax

Charitable organizations exempt from paying tax on investment returns

Gifts to charitable organizations are tax deductible

Relative Value:

Example 7

5 Estate Planning Tools

Gratuitous transfers are often implemented through structures that:

1) Maximize tax benefit and/or

2) Produce a non-tax benefit

Common estate planning tools:

1) Trusts (common law concept)

2) Foundations (civil law concept)

3) Life insurance

4) Companies

Trusts

Settlor (or grantor) transfers assets to trustee

Trustee holds and manages assets for benefit of

beneficiary

Revocable trust: Settlor retains right to rescind

Settlor responsible for tax payments

Vulnerable to creditor claims

2) Make resources available to beneficiaries without yielding control

3) Protection from creditors

Foundations

Foundations are set up to hold assets for a particular purpose Example: promote education

Like trusts, foundations survive settlor

Life Insurance

Policy holder transfers assets (premium) to insurer

Insurer has obligation to pay death benefit to beneficiary

Companies and Controlled Foreign Corporations (CFC)

Place income generating assets in CFC

Benefits:

1) Tax deferred until income is distributed

2) Establish in country with no taxes

Many countries have CFC rules designed to prevent tax payers from avoiding taxation

6 Cross-Border Estate Planning

Income generated outside home country may be taxed in both countries

Passing ownership of overseas assets on death might be difficult

Transferring assets to heirs located outside home country might be difficult

The Hague Conference: Intergovernmental organization that works toward the convergence of private

international laws

Tax System

Source jurisdiction = territorial tax system  tax income as a source within borders

Residence jurisdiction  all income, domestic and foreign is subject to taxation

Wealth and wealth transfers may be subject to tax based on source or residence principles

Double Taxation

Two countries might claim to have taxing authority over the same income or assets

Residence-residence conflict

Source-source conflict

Foreign Tax Credit Provisions

Residence country may provide tax-payers relief from residence-source conflicts using:

1) Credit method

2) Exemption method

3) Deduction method

Credit Method: residence country reduces tax payers’ domestic tax liability for taxes paid to foreign country

Exemption method: residence country imposes no tax on foreign sourced income

Deduction method: residence country allows taxpayers to reduce taxable income by amount of taxes paid to foreign government

Double Taxation Treaties

Example 8

Transparency and Offshore Banking

Tax avoidance vs tax evasion

Trend towards increase in information exchange and transparency across countries

This makes tax evasion more difficult

What is needed:

Compliant, tailored and tax-efficient strategies

Review learning objectives

Examples

Practice Problems