China’s rapid path to economic development over the past 40 years is well documented by the accumulation of its wealth, as well as the emergence of an entrepreneurial population with strategic foresights. Today, many of the first generation of Chinese entrepreneurs have reached their 60s, and the demand for wealth planning is consequently stronger than ever. Starting a business is hard work, maintaining and growing it, however, requires even more efforts. Managing and planning the family estate to span generations have thus become an issue of great concern to many successful entrepreneurs.
1. What risks should high net worth clients mitigate in wealth planning?
Couples enter marriages with the expectation of a long-lasting relationship, but disputes often arise while the family wealth accumulates. Financial consequences of divorce are the first major risk that high net worth individuals need to mitigate when planning wealth management, especially for those who own family businesses. There are three kinds of family businesses that may suffer financially from divorce. The first is when both husband and wife are deeply involved in running the family business. This is common for family enterprises, and some retain this operation mode even after they grow into scaled and successful businesses. Because of how both husband and wife are deeply involved in the establishment and development of the business, they often tend to fight for more corporate control and economic interests when there is a rift. The second one is when only one spouse is directly involved in the family business, but the couple do not have a separation agreement in place. The spouse who has not participated in the operation of the business could argue that the enterprise is marital property at the time of the split and claims half of it under the default marital property rules in China. For many years, the older generation of Chinese entrepreneurs have only focused on building and maintaining their business. Few have entered into prenuptial or postnuptial agreements. This creates space that could lead to unstable corporate and shareholder structures of the company, leading to a decline in the share prices of listed companies, and eventual loss of corporate control over the companies they built from scratch. The third one is when the family business is passed on to second-generation owners, the marital status of the latter could have a negative impact on the business. According to relevant provisions of the marriage law and the new civil code, if there is no special arrangement, the property gifted to and/or inherited by the second generation is generally classified as marital property of the second-generation couple. This is a matter to which practitioners need to pay attention when planning for succession.
Limitation on Intestate Succession and Testamentary Will
Dying without a will would not be ideal unless the heritage is minimal, or the default intestate succession order is identical to the preferences of the deceased, which is rarely the case. A testamentary will is a common estate planning tool, but it is not omnipotent. A will usually lists the property subject to inheritance, specifies the beneficiaries and dictates the way of distributing the property among beneficiaries. The newly promulgated civil code provides for several different types of wills, which include holographic will, will written by a someone on behalf of the testator, notarized will, printed will, audio will, video will, and nuncupative will (or oral will). For high net worth individuals, risks are that wills can be invalidated or contested. The grounds for such a challenge may vary from lacking requisite formalities to claims of insufficient testamentary capacity. Disputes could also arise as a result of “missing assets”, lack of rigorous wording, or language ambiguities, and mistakes caused by inappropriate division methods. The problem can be even more complicated when multinational assets are involved. It is therefore advisable for high net worth individuals to seek expert advice when drafting a will. Making a valid and effective will is only the beginning, and more problems could arise when it comes to implementing the will and distributing the property in the future. It therefore takes wisdom for entrepreneurs to plan for their wealth management.
Claims on Assets
“Unexpected” debts may completely defeat the goals of a family wealth inheritance plan for high net worth individuals. From establishing to growing the family business, risks always coexist with opportunities. Many first-generation entrepreneurs put everything they had into building their business, and therefore unintentionally incurring financial burdens upon their families. The rise and fall of the company have a direct impact on their personal life. This family structure is more susceptible to financial risks. Other debt disputes arise as a result of systematic and long-standing business risks, such as market risk, business decision-making risk, investment failures, risks as guarantors, and criminal prosecutions, which all enterprises must face and plan for at some point. The entrepreneurial spirit that made success with businesses at an early stage may not fit when the business has become mature and the family has accumulated considerable wealth. Whether the business and the family can maintain long-term stability depends on their ability to improve standardized business operation, disperse risks, maintain investment protocols, adhere to moral and ethical principles and observe strict self-discipline.
Mismanagement risk is crucial to high net worth entrepreneurs. Traditional wills can only specify the beneficiaries but cannot ensure the estate is kept in good hands. From a micro-level perspective, different properties need different management methods. Artworks and collectibles, for example, need to be carefully maintained under specific conditions. However, heirs or legatees who do not appreciate such collections may not manage them in the desired way, and sometimes these once invaluable heirlooms get bartered away easily. At the “macro” level, not every child is a competent successor of the family business. The next generation of the family may not be able or willing to manage their family business, and an inappropriate “leader” will obviously be a disaster for the enterprise. Therefore, although “succession planning” may not appear significant at the beginning, it is key to a lasting success.
Erosion of Wealth by Taxation
China carried out a reform of its individual income tax system in 2018. At the same time, the Common Reporting Standard (hereinafter referred to as “CRS”) has been widely implemented worldwide. China is also one of the endorsing countries of CRS. It is safe to say that countries are paying more attention to their tax mechanisms, boosting transparency and combating cross-border tax evasion. The possible tax risks of high net worth individuals come from four aspects: firstly, domestic assets need to be assessed and planned accordingly; secondly, if assets are held in multiple countries or have multiple tax status, tax planning should be carried out globally, including compliance planning and double taxation avoidance planning; thirdly, because of CRS and/or other tax agreements, some taxpayers worry that information get exchanged back to the tax authorities of their home countries, which may lead to exposures of their existing problems and even prosecution by local authorities; fourthly, the emigration of entrepreneurs’ family members without professional tax and legal review could lead to unexpectedly large tax burdens, especially when immigrating to high tax countries such as the United States, Canada and the United Kingdom. These countries not only have higher tax rates, but also impose taxes not found in China yet, such as inheritance tax or wealth tax; the overall tax rate of which can be as high as 70%. Possible results include not only the curse of “being rich for no more than three generations”, but also significant fines and even imprisonment because of tax evasion and non-compliance.
2. What major benefits can trusts do for clients?
Achieving Tax Planning Benefits
Trusts are vastly recommended for wealth planning and tax planning purposes. However, the idea that a trust can be always used for tax planning could be misleading. Holding, disposing or distributing assets through a trust do not necessarily save money on taxes. Such tax planning opportunities may be contingent on variables such as: applicable tax codes, the tax status of the asset owner, the status of specific assets, the way assets are to be disposed of in the future and the amount of income to be generated, as well as the tax liability of the trustee or the trust itself, the beneficiary’s country of nationality, habitual residence, permanent residency and so on. For China’s high net worth clients, the tax planning benefits obtained from the establishment of a family trust may include the following: first, families, through proper trust structuring only, may benefit from deferred tax payments or de facto tax-free treatment on certain investment returns largely due to the fact that there is, at the moment, no clear regulation or implementation guidance on taxing trust investment returns and distribution in China; second, the reasoning above could also apply when assets overseas are placed in an offshore trust and obtain de facto tax-free treatment under specific circumstances in certain jurisdictions; third, when high net worth clients and/or their descendants emigrate, according to the relevant provisions of trust taxation in the destination country, tax benefits may arise as a result of setting up domestic and/or overseas trusts before assets become taxable in the destination country. In general, setting up trusts for tax planning purposes is by no means straightforward, and needs to be carefully and professionally taken care of according to specific situations from tax planning and compliance perspectives.
There are other commonly used vehicles for wealth planning such as the agency/nominee arrangements. The arrangement itself relies on the entrepreneur’s “trust” and “control” over the agents. It certainly solves many problems for the principal, but at the same time, brings challenges for them. It is recommended that all entrepreneurs consider trusts as the alternative.
Equitizing and distributing assets on a multi-level and multi-national basis disperses risks. Isolating debts through trusts provide institutional advantages by setting up protective barriers at the top level. The benefits of asset segregation through overseas trusts are obvious, but for entrepreneurs whose interests and assets cannot or would not leave the country, setting up a domestic trust can also be effective in terms of asset protection. Chinese law has clearly provided for the asset protection function of trust: trust property is independent from the property of the grantor, trustee and beneficiary. Unless the debtor has a priority claim over the trust property before the establishment of the trust, trust property shall not be enforced due to debts of the grantor or the beneficiaries.
Enabling Orderly Succession
Wealth of high net worth individuals often comprises various types of assets which may be complex and foreign-related, and thus requires a more durable, flexible and orderly inheritance scheme. For example, as parents, many entrepreneurs wish their heirs to be well supported, but would not take the money for granted; they want their next generation to stay wealthy and live a stable life, and at the same time fight for their own lives. These dilemmatic wishes, together with keeping the business sustainable and healthy are some of the common challenges faced by entrepreneurs all over the world. The advantage of a trust system is that it provides a mechanism that separates “ownership”, “managerial interest” and “economic interest”, and coordinates them with each other. It makes it possible, for example, to grant ownership of property to the integrous and trust-worthy members of the family, managerial rights to the able ones who are willing to take over the family business, and likewise distribute economic interests according to the specific situation. A small leak will sink a great ship. The disintegration of a family often begins with unfair and rigid wealth distribution, heirs or legatees’ capability unworthy of their ranks, and distrust. Separation of rights thus provides the possibility of control and balance. In addition, trusts can not only provide necessary support and protection for family members and future generations, but also guidance and regulations. It disciplines and prevents the beneficiaries from wanton spending and undesirable behaviors and could also positively encourage them to be diligent and helpful. Utilizing a trust for “separation of powers” helps keep the family wealth inside the family for generations to come.
3. Advantages, challenges and prospects of cooperation between commercial banks, private banks and trust companies
In the current market, the participating institutions of family trust business mainly comprise private banks, trust companies, insurance companies, as well as wealth companies transformed from securities companies, and other wealth management institutions, supplemented by lawyers, accountants, tax experts, notaries and other professionals or institutions. In general, most participating institutions are focused on managing customers’ cash and financial assets. Among them, only trust companies are “licensed” in a sense they have “trust company licenses.” Although domestic trust companies’ license is actually a financial license, not a permission for “affairs entrusted”, and some trust companies also have access to a small number of direct customers. The role of private banks in family trust business is prominent in that it introduces clients to the business. The client base of private banks are large and come from a wide range of backgrounds, and the banks do have some service abilities. Insurance companies that participate in trust business mainly promote sales of financial products and provide additional solution to customers’ problems. Lawyers, accountants, tax collectors and notaries assist financial institutions review relevant project structure, prepare drafts of trust documents, issue legal and tax opinions, especially when dealing with cross-border legal and tax issues. At the same time, they also help explore ways to hold non-financial assets through trusts and other matters related to succession.
We believe that the main challenges for the development of domestic family trust business come from the following aspects: first, most family trusts in the market mainly focus on the management of cash assets, and the rate of return is still a key consideration for clients, which could be a double-edged sword for professionals, who expect the roles of the “trustee” on the transaction end and the “investment and wealth manager” on the asset end be further separated. Secondly, due to the different approaches and sizes of institutions in the family trust business, there will be a natural process of competition and elimination in the market. It remains to be seen whether there will be more trust professionals and whether the trust system can develop healthily after this embryonic stage. Thirdly, China has not yet imposed inheritance tax, so many believe there is a lack of urgency and necessity to set up trusts for tax planning purposes. Fourth, the asset protection function of domestic trusts depends on the design and operation of trust structure, domestic political and legal enforcement environment and judicial policies, which is still volatile. Fifth, although we have general legislation relating to tax and registration of trusts, in practice there is little guidance. This to an extent limits the development of the industry but also creates space for exploration and innovation.
We would like to thank Candice Wang, Linna Lin, Baidu Xu, and Lachlan Wolfers for their tremendous contributions to the article.