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Family wealth: a matter of trust

Roundtable: Trusts

There have been a number of changes to trust laws recently, in particular to inheritance tax in the UK. How important are these and what impact have they had?

Shân Warnock-Smith: They are hugely important. We've had a relatively easy run in the UK over the past few years with the changes being mainly technical in nature. But nothing like the bombshell that was dropped last March with regards to inheritance tax. I think it is the advisors who continue to suffer more than the client who, to a large extent, has been completely confused by what has happened. There was also outrage at the way it was announced – it was legislation by press release. It talked about the "alignment" of trusts, as if this wasn't the fundamental shift that it really is, and "simplification", when in fact it made things much more complex. It is now becoming clearer and there has been improvement, but the UK government has this idea that if you're old enough to fight wars, somehow you're old enough to handle millions of pounds – it's a nonsense.

Caroline Butler: I agree, receiving a substantial amount of money at 18 was a recipe for fortunes to be dissipated early. Luckily the government recognised this and moved the age limit to 25.  

Wilson Cotton: It did have the curious side effect, however, of actually reducing the overall tax bill of the very wealthy (over a 40–50 year period). In the long-term, it is now cheaper to buy a house for your children (albeit with 10-year charges) than it would be to give them the money outright.

Friedrich Schwank: In Austria we had a different problem in that there was a lot of wealth leaving the country 10–15 years ago, which was naturally a concern to the government. To keep wealth inside the country they created a structure that works like a trust, but is effectively a for-profit foundation. To incentivise the scheme there was no entry tax for those relocating foreign trusts, which encouraged quite a few families. There was also the possibility to undo the new structure quite easily with few tax consequences. It has proven very popular since its inception in 1993, and today there are more private foundations registered than stock corporations. Foreign families have discovered the benefits; the Italians in particular like it because their inheritance tax laws are very strict. Now, we have a number of other nationalities using it like a holding structure. As it is a corporate vehicle it fits into the corporate tax system so dividends received by the foundations are completely tax free.

Cotton: This is one of the fundamental differences between continental European and the UK economies. In the UK, most trading businesses are owned by publicly quoted companies where the shareholders are insurance companies and pension funds. In Europe there is a huge amount of wealth tied up in private companies.

Are families changing their trust structures/portfolios as a result of these changes?

Cotton: I don't think as much as we originally feared, but it's going to take a while for new structures to become better known. The obvious one is the limited liability partnership (LLP) and I suspect that as a vehicle for the management of family wealth it will come into its own in five to ten years time.

Warnock-Smith: I think that's right. As lawyers we are very cautious about a structure or vehicle that's not traditional. For example, foundations are the current flavour of the month, but any common law lawyer is sceptical of them as we don't know how the courts will respond.

Cotton: Also, when you see financial products advertised as LLPs, such as film partnerships, I can't understand how losses are allocated for tax purposes but not for accounting purposes – there's a horrible mismatch and things are bound to go wrong.

Butler: Yes, if the income tax rate increases over the period, then you will have a mismatch on the income streams in these film schemes to the client's detriment. As far as efficient structures to run family wealth are concerned, after the government's latest tax changes, UK clients may need to consider whether insurance wrappers can provide some of the advantages in investment terms which the old trust structures used to.

Cotton: It depends on whether you're dealing with a continental European family for whom the wrapper is a well-known product, or a UK family for whom it's an alien concept. Another interesting trend that has emerged, especially in the UK, is that the government is taxing its own citizens more highly than international families who are coming to live in the UK. The non-domiciled are treated very well, but the increase in fiscal creep – the rate at which families are being pulled into higher rates of taxation – is alarming.

Butler: The Swiss are also starting to question, albeit very mildly, the disparity between non-doms and Swiss nationals for the first time. In the UK, however, the government  recognises how valuable non-doms are to the economy and does not appear currently to be interested in discouraging them by changing the 17-year rule. However, from a UK-domiciled family's point of view, trying to plan generations ahead is becoming impossible. Tax structures are being reformed retroactively with no warning or consultation.

With all these changes, is there a feeling that family wealth is under threat in 2007?

Cotton: Family wealth is always under threat, it's just that the threats change. Even in the 1800s excessive (ie, indefinite) accumulation of wealth was considered a threat to national security. The Inland Revenue's recent report into trusts couldn't get an accurate answer to the question, "Why are trusts set up?" because there were so few responses. If you look at the performance statistics for professional trustees compared to individual lay trustees, the professionals perform five times as well purely because no one has the right figures. A lot of regulation is driven by needing or wanting to know, but nobody knows how big trusts are or exactly what they are doing. This is going to be a big issue over the next decade, particularly for international families, as new forms of regulation come in.

There are also developments in regard to how family offices are structured and staffed to best deal with what families need. But what exactly are clients looking for?

Butler: We think they are looking for expert investment advice that is free from conflict of interest; in other words an adviser sitting on the same side of the table as the family.  Lord North Street was created to act as an independent and professional investment adviser to wealthy families and thus break the vicious circle of conflict of interest.

Traditionally, wealthy families receive advice from their accountant and their lawyer who are independent. But when it comes to investments, the advisor tends to be the broker or the fund manager with their own products to sell. We know that asset allocation accounts for most of your investment return, so no manager's skill will bail you out if his or her asset class is falling like a stone. Asset allocation advice needs to be provided by an expert advisor who has no in-house product, has no financial link to any selected manager, does not receive more if the family is more heavily in one asset class rather than another and is really thinking about what that family's needs are today and for the future generations.

The Lord North Street model has been very successful and is focused on these independent principles. It is curious that that the model is still rare in the industry, but perhaps clients are not always aware of the conflicts. In my experience clients always want to know how much their business is going to cost them, but they do not realise how much their advisor is making from their business in other ways. This is one of the key questions to ask in order to check an advisor's true independence.

Cotton: It's fascinating how, in a very short space of time, we have seen so many different business models emerging for wealth management: there's your model, Caroline; the one family model; and the multidisciplinary model such as at Smith & Williamson where, uniquely, we provide accounting, private banking and investment business management in one package. Every family is different and this area is a very dynamic one.

How clued-up are clients regarding the changes in trust laws?

Butler: Some families are extremely sophisticated and read the papers they are sent by their lawyers, but for others it is incredibly boring and they expect their advisors to advise. As Wilson says, all families have a different approach.

Cotton: Clients are not only better informed today, but they are also better educated and to a higher level, particularly the younger generations. They are more demanding as a result.

Are people asking today more about wealth creation than wealth preservation or management?

Butler: To give you an example, we have one multi-generational relationship where the parents wish to preserve capital, invest only in bonds in order to hand over exactly the same amount of wealth to their children as was inherited by them. The children are much  greater risk takers and want to invest in equities. So it's very natural for the younger generation to want growth, but it's very difficult to generalise. If you lose money at whatever age you may feel more like going for wealth preservation.

Divorce is having an increasingly significant impact on the way family trusts are organised. Complicating things further are the differences between matrimonial laws in Europe and the US. What is the current situation?

Donald Schiller: It is an interesting time. The UK, for example, used to be reluctant to enforce Premarital Agreements (PMAs), but that is now changing. According to solicitors I have spoken to, judges are looking at how fair they are and they may actually enforce them. Unfortunately, what is fair to one person may not be fair to another.

Warnock-Smith: Quite. It is also a question of the way the agreement is negotiated and the power and quality of representation.

Schiller: When people think of the US, they often think of a single law, but that is far from the truth. The US has 50 states and each has a different way of looking at PMAs. Even though the US has allowed PMAs for many years in many states, it was illusory because courts used to let people out of them very easily. Since 1983, however, we have had the Uniform Premarital Agreements Act, which, as of now, half of the states have passed, and PMAs have become very enforceable.

Cotton: In Europe you used to get every husband wanting to get his divorce heard in an English court, assuming that the husband is the wealthy party. Now it's every wife. Do you get forum shopping between states as well as countries?

Schiller: Yes, but it's complicated. For example, people take risks to make a pretence of residence. However, US courts require not only personal jurisdiction but also subject matter jurisdiction. One kind of jurisdiction is the way our courts and states look at divorce as a status, and the other concerns the people involved. To get jurisdiction over the status somebody has to be a bone fide resident of that state for a particular period of time. However, sometimes you don't need any particular period of time before filing, but you do need a specified period of time to get the judgement of dissolution. So one of the spouses will move to a state that's better for them and file for divorce, suing the other party to get the benefit of that forum.

But we also have the concept of personal jurisdiction where just because you serve someone with a summons doesn't mean that the court will take personal jurisdiction over that person unless there is some minimal contact between that state and the person to justify the court bringing orders against that person. The spouse who moves to a particular state to get the benefit of that forum could get a divorce, but she won't get property or alimony unless that court of that state also has jurisdiction over the individual defendent. I had a case involving some very substantial people where they had a homes in Florida and in Illinois, and they freely went between the homes. It was to my client's advantage to sue in Illinois even though she spent most of her time in Florida, and it was to his advantage to sue in Florida even though he spent most of his time in Illinois. We eventually negociated a settlement and proceeded in Illinois.

How important are PMAs and how important are they to a wealthy family when their child is getting married?

Schiller: Very important. In the US they are as important as a will. When you rely on state law you rely on a default system and on what will be imposed on you when you don't come to a divorce agreement. In divorce there is so much judicial discretion and you are subject to the whims of the particular judge who is hearing your case – it's a large, grey area. With PMAs you can clearly structure what's going to happen in the event of a divorce; the property aspects in particular are very often enforced. The problems occur more with regard to alimony. If the wife is going to be left with harsh financial circumstances then the PMA may not be upheld regarding her support, but that is determined by the court. Also, it doesn't matter where you marry, it's where you get divorced that counts, so even if you move you need a binding PMA that moves with you.

As a concept, is a PMA something that you would recommend to European-based clients, given that they are not guaranteed to be enforced in their country?

Warnock-Smith: You won't find any English matrimonial lawyer today who will suggest getting married without one, whether they are enforceable or not.

Butler: It is a very tricky and private question. As we don't give legal advice we would suggest to families with children who asked us that it is something that they should discuss with their lawyers.

Cotton: The odd thing is we have already partly signed up to them in the UK because the Civil Partnership Act introduces, in effect, a pre-nuptial agreement. It'll be very interesting to see what will happen.

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