Without proper planning, many high-net-worth Chinese families may struggle to retain their wealth and maintain family harmony across multiple generations. To ensure proper planning, this article addresses how to provide a grantor and his or her family the tools to develop a family governance structure that is tailored to their needs.
The Family Trust
Characteristic and Advantages of Foreign Grantor Trusts
A trust is one of the most effective and efficient structures used by families to retain wealth and provide financial governance. Specifically,a trust can be settled to own family assets, including family businesses and holding companies (Family Trust). By transferring the interests held in the family businesses and the family's other assets to the Family Trust, the Family Trust can be used as the vehicle for tax planning and succession planning while also providing confidentiality and asset protection from claims by third-party creditors.
The Family Trust can either be governed by U.S. domestic law or the laws of an offshore jurisdiction. The determination of the appropriate governing jurisdiction will depend on the goals of the family and the jurisdiction of the appointed trustee. Other considerations will include which jurisdiction provides the best tax planning, and sufficient asset protection for the family. Additionally, if the family decides to establish a private family trust company (PFTC), consideration will need to be given to the PFTC legislation in the different jurisdictions.
A trust is a "domestic trust" (aka U.S. Trust) if 1) a court within the United States has the ability to exercise primary supervision over the trust's administration (the "court test"), and 2)U.S. persons have the authority to control all substantial decisions of the trust,which include the authority to remove and replace the trustee, to direct investments, to amend or revoke the trust, etc. (the "control test").If either of the foregoing requirements is not met, the trust at issue is a "foreign trust" for U.S. federal tax purposes. In order to establish a foreign trust, the trust would intentionally fail to meet one of the above requirements.
Once a determination has been made as to whether a trust should be a "domestic trust" or a "foreign trust," the next step is to determine whether the trust should be a "grantor trust" or a "non-grantor trust." It is often advantageous to structure the Family Trust as a foreign grantor trust. If the grantor is a non-U.S. tax resident and the trust does not earn any income that would subject such an individual to U.S. tax liability, there should be no U.S. tax liability associated with the contemplated foreign grantor trust structure.
Specifically, there are two approaches to ensure that the Family Trust is classified as a foreign grantor trust for U.S. federal tax purposes.The first method of achieving foreign grant trust status is for the grantor of the trust to retain the power to re-vest trust assets without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the grantor. The second approach to obtain "grantor trust" status is to limit the beneficiaries of the Family Trust to the grantor and his or her spouse during the grantor's lifetime. Upon the grantor's death, the Family Trust would become a non-grantor trust with family members as beneficiaries. As a foreign non-grantor trust, the Family Trust should only be subject to U.S. income tax on certain types of U.S. sourced income, similar to the taxation of a non-U.S. tax resident individual; any distributions of foreign source income from a foreign non-grantor trust to non-U.S. tax residents should generally not subject such beneficiaries to any U.S. income taxes. Following the passing of the grantor, the Family Trust will become a foreign non-grantor trust and should only need to file a U.S. income tax return if the Family Trust earns U.S. sourced income that would subject them to U.S.tax liability.
The U.S. wealth transfer taxation system is comprised of three primary taxation schemes: 1) the gift tax, 2) estate tax and 3) generation-skipping transfer (GST) tax. When they apply, these taxes tax the transfer of wealth. The gift tax is a tax on the transfer by gift of property by one individual to another; the tax applies regardless of whether the donor intends the transfer to be a gift. The estate tax is a tax on one's right to transfer property at one's death. The GST tax is a tax that results when there is a transfer of property by gift or inheritance to a beneficiary who is at least 37½ years younger than the donor.
With respect to foreign grantor trusts, the GST tax only applies to transfers by non-U.S. tax residents 1) at death, to the extent that the transferred property is U.S. situs and is subject to the estate tax, and 2) during life, to the extent that the transferred property is U.S. situs and is subject to the gift tax, regardless of the beneficiary's residency or citizenship.
In other words, the GST tax will only apply to the extent that the transfer is subject to the federal estate or gift tax. For example, if a non-U.S. tax resident gives stock in a U.S. corporation to a grandchild,there is no GST tax because gifts of intangibles are exempt from U.S. gift tax.However, if the same non-U.S. tax resident bequeaths the U.S. stock in his will to a grandchild, then that transfer would be subject to GST tax because the bequest is subject to estate tax under the Internal Revenue Code.
If a foreign grantor does establish a trust in the U.S.,the grantor must be mindful of the rule against perpetuities, which, in the trust context, prevents people from using trusts to exert control over the ownership of property for a time long beyond the lives of people living at the time the instrument was written. Because the rule against perpetuities varies per jurisdiction, the Family Trust should be drafted in such a way to allow it to move among jurisdictions to ensure that the family's long-term goals and objectives are met (see the discussion regarding Decanting below).
In summary, the tax advantages of establishing a foreign grantor trust are twofold. During the life of the grantor, the grantor will be subject to U.S. income tax only on certain types of U.S. sourced income. Any distributions of foreign source income from a foreign non-grantor trust to non-U.S. tax residents should generally not subject such beneficiaries to any U.S.income taxes. Following the passing of the grantor, the trust has the potential to be a GST tax-exempt dynasty trust that could live in perpetuity, depending on the jurisdiction in which the trust is settled.
Miscellaneous Issues Regarding Foreign Grantor Trusts
If any of the family members were to become U.S. tax residents,such beneficiaries could become subject to an unfavorable regime known as the "throwback rules." Accordingly, the trust should be drafted to allow for flexibility to transfer some or all of the assets to another trust or to change the jurisdiction of the trust itself.
Additionally, because there is no private or public register of beneficial owners for trusts in the U.S., the Family Trust can bean effective means of achieving privacy and confidentiality. Notwithstanding,it is possible that the beneficial ownership of any financial assets owned by the Family Trust directly or indirectly may be reportable under the Common Reporting Standard (CRS). If any beneficiary becomes a U.S. tax resident in the future, the beneficial ownership of such financial assets could in the future become reportable under the Foreign Account Tax Compliance Act (FATCA).
A PFTC is an attractive option when one or more closely held businesses are owned by one or more trusts for the benefit of family members because it permits the ownership interests of the closely held businesses to be managed by multiple family members and advisors chosen by the family without involving public financial institutions or unrelated individuals. PFTCs are often created when a family needs an independent trustee, but does not believe that an individual or public trust company is the best fit for their specific circumstances. Two key benefits of a PFTC structure that are appealing to the grantor and his or her family are the PFTC's perpetual life and its flexibility. Additionally, the grantor's desire to have family members act as stewards for the family businesses and assets can be achieved by customizing roles and responsibilities in the PFTC.
PFTC Legal and Ownership Structure
In the United States, a PFTC can either be regulated or unregulated. Regulated PFTCs are established under a state charter and operate pursuant to the state's regulatory requirements. Although unregulated trust companies do not need to operate within a state's regulatory framework, they are subject to risks associated with operating as a fiduciary without regulatory oversight. A regulated trust company tends to provide additional flexibility in dealing with multi-jurisdictional issues, while also providing an additional degree of legitimacy.
Generally, PFTCs do not have many compliance requirements other than annual renewals of its license and meeting the qualification requirements under local laws (e.g., appointing directors or managers with local regulators, providing reports that certify bond and insurance requirements, etc.).
If owned by an individual, a succession plan must be developed for the PFTC to transfer ownership interests upon the individual's passing. Alternatively, a special purpose trust, which can exist in perpetuity, can own a PFTC and thereby eliminate succession problems. The role of the special purpose trust would be limited to owning the shares of the PFTC and appointing the PFTC's directors. A U.S. professional trust company generally serves as the trustee of the special purpose trust under the oversight of a trust protector or trust enforcer. The trust protector or enforcer can be a family member, a committee of family members or a trusted advisor that can remove the trustee and appoint a new trustee.
The articles of organization and bylaws will be required to provide for a board of directors for the PFTC. The board of directors may be established to handle daily management and administration of the PFTC and the underlying trust assets (if desired). The PFTC governing documents can also establish different organizational committees to form an efficient governance structure within the PFTC.
For example, the PFTC can create a Distribution Committee to determine when distributions from the trust(s) to beneficiaries are appropriate while also determining the amount of such distributions, an Investment Committee to manage how the underlying assets of the trust(s) are invested and coordinate the voting of the family's shares in family business holding companies,and an Amendment Committee to determine whether any changes should be made to the composition of the other committees or to the PFTC structure.
Although the members appointed to the Amendment Committee are generally independent advisors in order to provide a degree of independence between the family and the trust assets, family members may serve on each of the above committees, provided that the tax law does not require otherwise. Apart from these governance roles, the PFTC can hire a professional trust company, as an agent, to handle back office trust administration.
The Family Trust should be drafted to be as flexible as possible in order to best facilitate the goals of the family. The process of decanting affords a high degree of flexibility by giving the trustee the power to transfer assets from one trust to a subsequent trust, which generally contains more desirable provisions to achieve an intended goal or purpose. Circumstances where decanting may be appealing could be when there is a family disagreement with respect to the management of a specific business or asset, or a situation where the PFTC is comfortable transferring funds to a trust for the benefit of a family member who wants to grow a new business.
The power to decant also provides family members with flexibility as to their choice of tax residency. For instance, if a beneficiary were to decide to become a U.S. person, the contemplated Family Trust may not be the ideal structure for them to receive distributions as a beneficiary.Through the decanting process, such beneficiary's share of the Family Trust assets could be decanted to a new trust (with the PFTC as trustee) that would make distributions more tax efficient.
A trustee's ability to decant a trust's assets to a new trust generally depends on the trustee's powers under the trust instrument and local law. U.S. jurisdictions that permit trust decanting generally allow such trust-to-trust transfer without gift tax consequences as long as the trustee has discretionary distribution powers that can be exercised in favor of the trust's beneficiaries. The Family Trust would initially be drafted to provide for the trustee's ability to decant the trust assets to another trust in the future, including one governed by the laws of another jurisdiction.
As discussed throughout this article, establishing a foreign grantor trust and PFTC structure, while considering the implementation of other family governance mechanisms, may be a suitable strategy to accomplish the grantor's goals of family harmony and sustainable stewardship of the family's wealth for multiple generations.
Generally, non-U.S. tax residents are only subject to U.S. tax on any income effectively connected with a U.S. trade or business (ECI) and U.S. source fixed or determinable, annual or periodical gains, profits or income, which includes certain types of passive income, such as interest, dividends, rents and royalties (FDAP).