CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r10 estate planning in a global context summary

Estate Planning, Wills, and Probate Estate planning: Planning the transfer of one’s estate during one’s lifetime and at one’s death.. Objectives of estate planning:  To minimizing cost

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Level III

Estate Planning in a Global Context

Summary

Estate Planning, Wills, and Probate

Estate planning: Planning the transfer of one’s estate during one’s lifetime and at one’s death

Objectives of estate planning:

 To minimizing cost of transferring property to heirs

 To transfer estate assets to the desired beneficiaries

 To plan for efficient use of estate assets

Will (testament): Legal document containing instructions for the distribution of one’s property after death

Testator: A person transferring assets through a will

Testate/intestate: A person who dies with (without) a will is said to have died testate (intestate)

Probate: Legal process to confirm the validity of a will

Estate

Financial assets Tangible

personal assets

Immoveable property

Intellectual property

Ensures disposition of assets to heirs according

will and in orderly manner

Relatively costly and time consuming process

Protects creditors by ensuring payments of debt Compromises privacy of

decedent and heirs

Tools to avoid probate process:

i Joint ownership

ii Partnerships iii Living trusts

iv Retirement plans

v Life insurance

Wealth Transfer Taxes; Effects of Legal System, Forced Heirship, Marital Property Regime

Legal systems:

Common law system: uses inductive reasoning and it draws rules from specific cases

Civil law system: uses deductive reasoning and rules or concepts are applied to particular cases

Regimes:

a) Forced heirship: children have right to fixed share of parent’s estate

b) Community property: 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

c) Separate property: each spouse owns and controls property as an

individual

Two principal forms of wealth transfer:

1 Gifts: lifetime gratuitous transfers or inter vivos transfers

2 Bequests: testamentary gratuitous transfers

Example 1: When a country has both

community property and forced heirship regimes, surviving spouse has a right to receive the greater of his/her share under community property or forced heirship rules

Example 2: Paul leaves an estate worth 600,000 for his

children Inheritance tax is 40% of amount above a threshold of 312,000 Inheritance tax is 40% of (600,000 – 312,000) = 288,000

Example 3: Progressive estate tax Chao leaves 2 million

for his children First 600K taxed at 2%, next 900K taxed

at 4%, remaining 500K taxed at 7%

Core Capital and Excess Capital

Core capital: minimum amount of capital required to maintain lifestyle and fund essential and emergency needs

Excess capital: capital in excess of core capital

Two ways of estimating core capital: 1) mortality tables and 2) Monte Carlo analysis

Mortality tables use the risk-free rate to discount spending needs Core capital is estimated using the formula:

Core capital = 𝑵𝒋=𝟏𝐩 𝐒𝐮𝐫𝐯𝐢𝐯𝐚𝐥 ×𝐒𝐩𝐞𝐧𝐝𝐢𝐧𝐠𝟏+𝐫 𝐣 𝐣

Monte Carlo analysis forecasts spending needs and then estimate size of

portfolio needed to meet forecasted spending needs

– Forecasts based on statistical properties of underlying asset

returns

– Captures capital market risks much better than mortality table

approach

Retire-ment Age

Life Expectancy $2 $3

50 78.1 1.8 6.4

55 83.0 1.8 6.3

60 83.4 1.5 5.2

65 83.9 1.1 4.0 Ruin probabilities for a balanced portfolio

Spending per $100

Relative After-Tax Value of Lifetime Gifts and Testamentary Bequests

The choice between a lifetime gift and a testamentary bequest depends on the future value

under each option This is captured using relative value

If the relative value is > 1, make a lifetime gift

These formulas assume that tax is paid by recipient

If the tax is paid by the donor:

Gifting is better even when gift tax rate = estate tax rate and returns are taxed at the same rate because gift tax paid by the donor reduces the size of donor’s taxable estate, resulting in decrease in donor’s estate tax

After-tax benefits of basic estate planning strategies

 Generation skipping: Transferring capital in excess for both the first and second generations directly to the third

generation

Relative value of generation skipping = (1 − tax rate of capital transferred from 1st to 2nd generation) 1

 Spousal exemptions: Tax-free transfer of assets (either as a gift or a bequest) to spouse

 Valuation discounts: Transferring assets that are subject to valuation discounts reduce the basis of transfer tax

 Deemed dispositions: Bequests/transfer is treated as if the property were sold  tax is levied only on the value of

unrecognized gains rather than on the total principal value

 Charitable gratuitous transfers to charitable organizations offer the following advantages:

a) Donations are not subject to gift transfer tax

b) No taxes on investment returns

c) Donations are income tax deductible

Estate Planning Tools

Common estate planning tools: 1) trusts, 2) foundations, 3) life insurance, 4) companies

Trust: Legal arrangement in which a settlor (or grantor) transfers assets into the care of a trustee, who

manages these assets on behalf of a beneficiary Trust can be revocable or non-revocable

Revocable Trust Irrevocable Trust

Assets are protected from creditors’ claims against a settlor No Yes

Objectives of a trust:

• Control over assets

• Asset protection

• Tax reduction

• Avoidance of probate process

Fixed Trust: distributions are made to beneficiaries according to

the specific terms established by the grantor

Discretionary Trust: trustee has the discretion to determine the

amount and timing of distributions

Estate Planning Tools

Foundation

• Legal entity, set up to hold assets for a particular purpose

• Like trusts, foundations survive the settlor

Life Insurance

• Policy holder transfers assets (premium) to insurer

• Insurer has obligation to pay death benefit to beneficiary

Benefits:

1) Lower taxes

2) Avoid probate

3) Protection from creditors

Controlled foreign corporation (CFC): a company in which the taxpayer has a controlling interest (as per home

country law) but the company is located outside a taxpayer’s home country Transferring assets to a CFC helps to defer taxes on earnings of the company until the earnings are actually distributed to shareholders or the company is sold

Forced heirship can be avoided by:

a) moving assets into an offshore trust governed by a different jurisdiction;

b) gifting or donating assets to others during their lifetime; c) purchasing life insurance;

Tax Jurisdiction

Source jurisdiction (territorial tax system) Residence jurisdiction

Income tax Tax income sourced (generated) within

country’s borders

Tax based on residency (regardless of whether income is generated within or outside its

borders)

Gifts and bequests Tax only domestic wealth transfer Tax all wealth transfer (domestic and foreign)

Exit Taxation: Taxes charged on unrealized gains accrued on assets that are removed from taxing jurisdiction

Double Taxation: When two jurisdictions seek to tax the same income or assets

Three forms of tax conflicts in double taxation:

1) Residence-residence conflict: Two countries claim residence of the same individual

2) Source-source conflict: Two countries claim source jurisdiction of the same asset

3) Residence-source conflict: One country claim residence jurisdiction on individual’s

worldwide income whereas other country claim source jurisdiction

Income earned on investments are located in country A but are managed from country B

A person is a resident of country B but has investment property in country A

Double Taxation Relief

Methods used to

provide double

taxation relief

Tax liability

Example: Tax imposed by a residence country on worldwide income is 40%; tax imposed by foreign government on foreign-sourced income is 30%

Max [40%, 30%]  Tax-payer will pay 40%

Out of 40%

• 30% will be paid to foreign-government

• 10% will be paid to domestic government

Exemption

Deduction

0.40 + 0.30 – (0.40 × 0.30) = 58%

Out of 58%

• 30% will be paid to foreign-government

• 28% [i.e 0.40 – (0.40 × 0.30)] will be paid to residence or domestic country

Double taxation treaties may help resolve residence-source and residence-residence conflicts but not source-source conflict

Impact of increasing international transparency and information exchange among tax

authorities on international estate planning

 With an increase in information exchange and transparency across countries, it is becoming difficult

to locate undeclared funds in offshore savings accounts and other offshore structures to avoid detection by home country tax authorities

 The key to providing estate planning advice is to use compliant, tailored, tax-efficient strategies

– Tax avoidance: a legal method used to minimize taxes using legal loopholes in the tax codes

– Offshore banking centers

Tax evasion is avoiding or minimizing taxes

through illegal means e.g misreporting or hiding

relevant information from tax authorities