Wealthy families around the world may appear to be facing a barrage of tax increases, but there is positive news if you look carefully, writes Selwyn Parker.
Wealthy families, and especially those with a footprint in several countries, could be forgiven for thinking there's an unspoken conspiracy against them. In quick succession they've been through the wealth-destroying financial crisis, the OECD-led crackdown on tax-avoidance measures once considered legitimate, and the avalanche of sovereign debt issues that could undermine many wealth-preservation strategies. It's many decades since families have had to face such an assault.
And now? Family offices must deal with the prospect of rising headline taxes as governments try and rescue heavily-indebted public finances.
Take Britain. A 50% rate of income tax now applies to anybody earning more than £150,000 a year, while capital gains tax is set to jump from eight percent to 40% at the marginal rate.
And it's not as though Britain's wealthiest don't already pay their fair share. According to statistical predictions from the government tax authority HMRC, just one per cent of taxpayers will account for 27% of total tax revenue collected this year.
Take the US. From next year, barring intervention by Congress, the highest earners will pay income tax at 39.6%, up from the current 35%. As for capital gains, it will rise by a third to 20%. From 2013, it will rise again to 23.8% because of the Medicare tax on unearned income such as dividends, interest, rents, royalties and realised capital gain in order to help pay for president Obama's health care changes.
In the meantime certain US states have increased their claims on the wealthiest citizens, always a convenient method of plugging gaps in their budgets. According to the non-partisan, Washington-based Tax Foundation, nine states including New York, Connecticut and New Jersey have lifted personal income tax rates on the rich in the last year or two.
Simultaneously, something of a revolution is going on in tax structures in the wider world, threatening long-running, stable arrangements. In Switzerland, for example, in a reaction to the financial crisis the influential canton of Zurich voted last year to abolish the flat-rate tax that has long been the preserve of wealthy foreigners.
Amounting to a virtual 90% discount on prevailing rates, the tax has long been an attraction for foreign-born residents of Switzerland who account for over 20% of the population. Henceforth they will be taxed on wealth and income, just like their fellow citizens.
At around the same time, Germany adopted a strict capital gains tax of approximately 28%, mainly applying to financial instruments. The government of Angela Merkel did however retain the zero capital-gains tax on real estate provided the property is held for more than 10 years.
The tax grab on the wealthy has spread to Spain, which plans to hit the highest-earners, and to Scandinavia. In Sweden, the opposition Social Democrat party has promised to restore the wealth tax if it is returned to power.
Taking all these developments together, it looks like there's no escape from significantly higher tax bills for family offices. But, as usual, the picture is more complicated – and brighter – when we look behind the headlines. As an OECD study put it: "[A] point to remember when looking at 'statutory' tax rates, which are the tax rates as set by law, is that many high-income earners actually escape paying them." And, adds the OECD, they may do so quite legitimately.
In Belgium, for instance, the top income tax rate is 60%, a whole 25 points higher than the corporate rate of 35%. As a result, many families have been able to establish structures that partly corporatise their wealth to access the lower tariff.
Despite the general alarm, authorities on tax planning for wealthy families warn against setting too much store on headline rates. As John Bender, the Switzerland-based manager of his family's office, told Campden FO: "If you want to talk on a purely tax basis, a headline level of 50% in the UK does not tell the full story. There are many exceptions, particularly with non-domiciled individuals. Okay, you pay 50% on your UK income but you may have 95% of your wealth offshore and you don't need to bring large remittances into Britain. In this case Britain is actually a far more interesting tax haven than perhaps the Channel Islands, which does have a requirement on global income."
Nor are headline rates rising everywhere. As Alexia Rambosson, head of wealth structure at Switzerland-based Bank Julius Baer, a 120 year-old institution with offices around the world, explains: "There was competition between countries, similar to the one between cantons in Switzerland. However after the financial crisis, finance-raising took priority over tax competitiveness because of the greater outstanding debts of European countries."
The good news is that some observers see that trend making a comeback quite soon, especially in less-indebted nations.
However even in countries with high headline rates, there are usually perfectly legitimate ways of achieving much lower average rates. In Switzerland, for example, income tax is levied at federal, cantonal and communal levels. With federal tax capped at 11.5%, there are wide variations on what rates the cantons vote to apply. The highest earners can pay a total 40% in Geneva, or 22% in the canton of Schwyz.
"In Geneva, you're probably looking at something like 40% tax if you have income over two million Swiss francs ($1.77 million) and the same would apply in Zurich," explains Bender. "But if you go to Zug or Schwyz, you're looking at 23% or down to 19%."
And in certain Swiss cantons, Luxembourg and some other jurisdictions, it is still possible to negotiate lump sum agreements that cap total annual tax paid.
But that's just income tax. Often, say international tax authorities, the rates on investment income are more important than headline rates. "For example, Austria has a top rate of 50%, but interest and dividends are taxed at 25%," points out David R Nave, tax director and senior vice-president of Pitcairn, a multifamily office based in Philadelphia. "Moreover, sales of securities held for more than a year are exempt from taxation."
Investment rates such as these offer interesting opportunities for long-term planning.
Just as importantly, headline rates are not necessarily written in stone. As Julius Baer's Rambosson explains: "Wealth taxes and inheritance taxes might be challenged because of their double-taxation effect [and the fact] they might not be bearable by families, especially if capital preservation cannot be guaranteed any longer."
Put another way, there's such a thing as tax diplomacy. Often, mutually acceptable agreements are reached in negotiations between family offices and tax authorities. Failing that, families may have recourse to the law. And if neither of these work, they may choose to relocate to "more stable tax jurisdictions," adds Rambosson.
And right on cue, there's reportedly been a rush by wealthy Britons to the French-speaking cantons of Switzerland, one of the few places in Europe where top-tier house prices have held up.
The US is witnessing a similar migration of wealth capital, albeit internally to more tax-favourable states. According to a study by the Boston College's Centre of Wealth and Philanthropy, there was a mass exodus from New Jersey between 2004 and 2008 after the state raised taxes on its wealthiest citizens. The culprit, suggests the study, was a 40% hike in New Jersey's top income tax rate to 8.97% from 6.37%, applying to incomes starting at $500,000. Around the same time, estate tax rose to 16% on assets over $10 million.
And where did these families go? Many shifted to Florida, which has no income tax and no estate tax, proving that wealth is highly mobile.
The same trend is apparent on an international scale. "Once tax rates reach a certain level, there's a tipping point when the wealthy say 'this is ridiculous and I'm going somewhere else'", points out John Stone, chairman of Luxembourg-based Lombard International Assurance, which has a fast-growing portfolio of international clients.
Clearly, this is happening right now. "Families are looking at different countries and taking a very broad brush assessment," explains Bender. "They're asking themselves questions like: Where is this country heading? Does it have a future? A country such as the UK is still seen as a very good place to live because it has a certain basic infrastructure and there is a political will to tackle the issue head on, just as there is in the US. It's a very different picture from, say, Greece at the moment where there is a genuine crisis of confidence in the country as a functioning democracy."
But when families do come to evaluate opportunities in different countries, it's important to look at the big picture, especially so for Americans. "The US, possibly the only country in the world to do so, taxes its citizens on their worldwide income," explains Pitcairn's Nave. "Establishing a residency outside the US does not avoid US income taxation. You are subject to US taxation no matter what, so you must examine the tax structure of the foreign country."
Many issues come into play in the evaluation process. "How broad-based is the taxation in the new country? Most countries only tax income that is generated within the country. However, there are some who tax the worldwide income of residents, not just citizens," adds Nave. "So it is important to study the rules to determine what constitutes a resident for income tax purposes. For example, how many days must be spent in a country to establish residency for tax purposes? Are there income tax treaties between the US and the foreign country?"
Of course there's nothing wrong with examining the global options. "It's often overlooked that there's a very large legitimate offshore community. There's nothing illegal about being offshore and there's nothing illegal about living in a tax haven," says Bender. "But you have to restructure arrangements, which may mean physically living in that country."
However a new mood is afoot in cross-border taxation – and it's called compliance. "Wealthy families are well advised to examine the tax conformity of their fortunes on an international scale," warns Fritz Kaiser, executive president of Vaduz, Liechtenstein-based, Kaiser-Ritter Partners, which manages €25 billion euros ($31 billion) mainly on behalf of international families. "Banking secrecy that protects tax evasion is no longer acceptable."
For instance, Liechtenstein in common with other famously benign jurisdictions signed a disclosure accord with the UK in August 2009 that essentially demands total conformity with international law. Similarly, Monaco, which has zero income tax but hefty inheritance taxes, got itself on the OECD's "white list" of compliant regimes late last year.
All this is part of a sea change that has triggered a wave of new business in wealth management. Kaiser-Ritter, for example, says it has been particularly active providing tax-compliant services for US clients after gaining approval from US and Swiss regulatory bodies.
Indeed there's been something of a stampede to regularise suspect tax arrangements, bankers say privately. "Different jurisdictions are competing not on their ability in hiding assets but on how they can manage assets legitimately," summarises Bender. "That's the big change."
The tougher rules have triggered a mounting interest in tax opportunities in Asia, but not the wholesale rush that is often reported. Explains Julius Baer's Rambosson: "Although the changing tax environment in western countries is accelerating this process, families with strong connections to western nations tend to favour proximity over tax considerations."
Levels of taxation, in short, should not be the paramount issue. Most importantly, say tax experts, every family's situation is different and requires tailor-made solutions because of myriad considerations that reach far beyond headline taxes. Such factors include the availability of double tax treaties between countries, the sanctioning or otherwise of particular instruments, rates of investment, inheritance taxes and even of indirect taxes which are often neglected in the overall considerations.
Additionally, many families have highly specific structures that may have a corporate or a fiduciary bias or a combination of the two. Different countries will treat them in different ways. And how about currency risk? "Possibly consider hedging against currency fluctuations if converting dollars into foreign currency," suggests Pitcairns' Nave.
But families may not have to go abroad at all to protect their wealth. "If the wealthy don't want to emigrate, it's possible to arrange for your money to emigrate instead," explains Lombard International Assurance's John Stone. His institution was the first in Europe to launch a life assurance-based instrument that not only preserves wealth but provides for its transmission under extremely flexible terms. Better still, it's fully compliant under EU law.
The structure works by holding invested assets within a life assurance context. As the capital accumulates, it is exempt from capital gain and investment tax. On the expiry date, some tax is likely payable, the amount depending on the laws of the country of residence and the term of the assurance among other factors. In Sweden it's zero, for instance, while in Italy it's 12.5%.
But importantly for succession planning, the structure has become a viable alternative to the long-established trust structure, which has lately come under attack. Highly flexible, the life assurance-based instrument permits assets to be passed on to multiple beneficiaries – often grandchildren – at different times and ages, in lumps sums or drip-fed, or even for the terms to be rewritten in the event of changed circumstances. The assets are accumulated tax-free and passed on largely tax-free. "We call it the legacy plan," explains Stone.
Finally, it's best not to let one's judgement be blinded by headline taxes. Adds Rambosson: "Political stability and the professionalism of the financial sector are the two main factors which should be taken into account."