THINKING ALOUD (BusinessLaw) BUSINESS MODEL: Trusts & Foundations
“I want to leave my children enough that they feel they can do anything, but not so much that they do nothing.”— ~ Warren Buffet
Offshore Trusts: Technically Abroad
Nicholas Shaxon’s book: Treasure Islands
Nicholas Shaxson in his book “Treasure Islands” included a chapter – Technically Abroad – to explain the setting up of offshore trusts. He uses a story-telling style to explain how such legal relationships can get murky.
Many people think that the best way to achieve secrecy in your financial affairs is to shift your money to a country like Switzerland, with strong bank secrecy laws. But trusts are, in a sense, the Anglo-Saxon equivalent. They create forms of secrecy that can be harder to penetrate than the straightforward reticence of the Swiss variety. Trusts are powerful mechanisms, usually with no evidence of their existence on public record anywhere. They are secrets between lawyers and their clients.
Trusts emerged in the Middle Ages when knights leaving on the Crusades would leave their possessions in the hands of trusted steward, who would look after them to provide benefits to the knights’ wives and children when were away or if they never returned. These were three-way arrangements binding together the original owners of the properties (the knights), with the beneficiaries (their families), via an intermediary (the trustees). Over the centuries, bodies of law grew up to formulae these three-way arrangements, and today you can enforce these things in the courts.
What a trust does, at heart, is to manipulate the ownership of an asset. You might think ownership is a simple thing: you have, say, a million dollars in the bank; you own it, and you can save it, or spend it, or take it out in ten-dollar bills and put it in your bathtub. But ownership can, in fact, be unbundled into separate strands. This happens, for example, when you buy a house with a mortgage: Until you repay the loan, the bank has some ownership rights over your house and you have other rights.
A trust unbundles ownership into different parts very carefully. When a trust is set up the original owner of the asset in theory gives it away into a trust. The trustee becomes the legal owner of the asset – though this person is not free to spend or consume it – for they must legally obey the terms of the trust deed, the instructions that tell them exactly how to share out the benefits to the beneficiaries. The trustee must obey these instructions, and apart from fees he or she may not receive any of the benefits. So a rich old man with two children might put $5 million into a bank account owned by a trust, and then appoint a reputable lawyer as the trustee, instructing him that when the son is twenty-one he should receive half the money, and when the daughter later becomes twenty-one she should get the rest. Even if the wealthy man dies before the money is paid out the trust will survive, and the trustee is bound in law to pay out the money as he is told. It is very hard indeed to break a trust.
Trusts can be legitimate. But they can be used for more nefarious purposes, like criminal tax evasion. When a trust sets up solid legal barriers separating out the different components of ownership of an asset, these barriers can become unbreakable information barriers too, shrouding the assets in secrecy.
Imagine that the assets in a trust are shares in a company. The company may register the trust – the legal owner – but it will not register the beneficiaries – the people who will be getting and enjoying the money – anywhere. If you have a million dollars in an offshore trust in the Bahamas and the tax inspectors come after you, it will be hard for them to even start their inquiries. Trust instruments in the Bahamas are in no official register. Even if the tax inspectors or police get lucky and find out the identity of a trustee, that is likely to be simply a Bahamas lawyer who does this for a living, who may be the trustee for thousands of trusts. She may be the only other person in the world who knows you are the beneficiary, and he or she is bound by professional confidentiality to keep your secrets safe. The tax inspector has hit a stone wall.
You can make this secrecy deeper still, of course, by layering one secrecy structure on another. The assets in the Jersey trust may be a million dollars in a bank in Panama, itself protected by strong bank secrecy. Even under torture the Bahamas lawyer could never reveal the beneficiaries because he or she would not know. Such intermediaries merely send the checks to another lawyer somewhere else, who also is not the beneficiary. You can keep on going: layering the Jersey trust on another trust in the Caymans, itself perched on a secret company structure in Nevada. If Interpol comes looking they must go through difficult, slow, and costly court procedures, in country after country, and face the “flee clauses” that mean the asset automatically hops elsewhere at the first sign of investigation.
Real Estate Investment Trusts (REITs)
Writer: Chén Róng
The 102-storey Empire State Building (ESB) was completed in 1931 and last sold in 1961, when shares were offered to working-class New Yorkers at US$10,000 each in a partnership. Late last year, The Malkins family, as its manager, spearheaded a sales process and rolled up the building with twenty of its other properties into a new real estate investment trust (REIT) known as Empire State Realty Trust.
Some partners were against the consolidation process because they were convinced that their shares are worth more through a building sale than selling their shares to a REIT. So, were the shareholders in the ESB short-changed? We will come to that a little while later.
Is REIT a traditional trust? No, it is not a trust you would normally understand it to be – trust that is gratuitous or not involving a return benefit like leaving assets to children and next of kin. But a REIT structure is in the form of a commercial trust (a special purpose entity or vehicle) with an independent trustee (trust entity) holding assets on behalf of shareholders as beneficiaries. The trustee's duties can be found in a Trust Deed for protection of certain rights of its shareholders. Commercial Trusts use the trust form to diversify lending risks. The subtle similarities end there between a trust for gratuitous transfers and one for non-gratuitous commercial purpose.
As said in the above paragraph, REITs are special purpose vehicles (both public-listed and privately owned entities) structured for commercial transactions by owners of real estate assets. These owners or sponsors (as generally called under REIT structures) will set up REITs to hold assets they are selling. REITs will generally finance the purchase of these assets either privately or publicly through initial public offerings (IPOs), that is, listing of entity on a stock exchange. The REIT-sponsors, like all other investors, are shareholders. One catch for investors is: Their sponsors generally get a higher purchase price for their assets than if these properties were sold through a more cumbersome process in the open market. Some market observers have actually accused greedy property owners of selling second-rate assets in expensive IPOs.
REITs operate much like companies as they use the same valuation and accounting rules as commercial enterprises, except that instead of passing through profits, REITs pass cash flow directly to shareholders which invariably increases dividend pay-outs. REITs are more akin to funds that operate like Unit Trusts. While Unit Trusts raise funds to invest in stocks and shares, REITs specialise in income-generating real estate assets, such as shopping malls, offices, industrial buildings and warehouses.
REITs are regulated by different laws from those on traditional trustee companies or private trusts. A number of Asian countries, including Hong Kong, Singapore, India, Japan, Malaysia, the Philippines, Pakistan and India have REIT-type legislation, taking cue from similar laws in more developed countries in Europe and USA. Rules regulating trusts do differ from country to country.
Putting our focus back on the Empire State Realty Trust, were shareholders of the original partnership being short-changed by The Malkin family as the manager turned REIT sponsor. It did have the support of at least 80 per cent of the shareholders before spearheading the sale process with an independent valuation on the Manhattan building and rolling it up with other twenty properties in New York.
It may be true that the Malkins refused to meet with any of the bidders and, never had one substantive dialogue with any one of them to ascertain whether they might be willing to offer an even higher price. They may have breached their fiduciary duties but such acts may be actionable. Nevertheless, it does not defeat the mandate they have from other shareholders to get the proposed REIT off the ground which they eventually succeeded with an IPO. Empirical evidence has it that assets generally get higher prices than private sales, although in this case, owners of inferior assets may get a free ride on a premium asset like the Empire State Building. According to CNN Money, ESB raked in US$92 million in sales from its observation decks in 2013, and this amount was for over 40 per cent of total revenue. As pastry lovers know, they cannot have the cake and eat it too. Shareholders do enjoy deferred taxation on shares which they find ready buyers and liquidate in tranches at favourable market prices over time. In other words, REIT shares provide liquidity and probable capital gains in the long term.
One big selling point of a big public-listed REIT emphasized by the Malkins is that obtaining ready financing is made much easier. REITS are becoming less reliant on traditional bank loans secured against specific assets. Instead these REITS are taking to using Medium Term Note (MTN) as an alternative source for financing their real estate portfolio. MTNs issued bonds guaranteed by the REITS Trustee. They are unsecured against specific assets. This provides an alternative source of debt which enables the manager to grow the REITS asset base and keeping a relatively stable gearing at the same time. Even closely held real estate companies which generally have to depend on property-specific mortgages for deals, still find a REIT structure more in tune with today's business environment than partnership structures, which are kind of anachronistic.
A REIT’s other major advantage is its tax exempt status at the trust level as long they distribute at least 90% of their income to their unit holders. In other words, the current income distributed to shareholders is not taxable to the REIT but tax exempt in the hands of resident shareholders in some countries.
There are gains and pains in investments. In many cases, REITS are run by an external manager -- a company fully owned by the sponsor. There may be questions over fees paid out and the quality and price of assets acquired, especially on properties owned by the sponsor. This is a potential conflict of interest between the manager and shareholders of the REIT. In other cases, if the manager is a direct employee of the REIT, he has a greater alignment of interest with shareholders. But the REIT may lack a pipe-line of assets for acquisition without an established sponsor.
There is no one-size-fits-all solution. Investors have to decide which model is suitable for their own requirements. They probably need a mensch manager.
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Trusts and Foundations
Writer: Chén Róng
Business owners with wealth running into hundreds of millions in major currencies are better off not wasting their time on following the writer's thoughts. Other less wealthy business people may want to lend a listening ear because of some lingering doubts in their minds. Do remember nevertheless, the writer himself is the writer of his own thoughts. The views expressed are personal. Go talk with the bank manager in charge of wealth management or a trust lawyer. These professionals are the experts. Certainly, there are rich Asians who prefer more discreet-type services such as independent trust companies (not owned by banks) for comprehensive wealth administration. Their records do not show names and address of their clients, but referring to them as 'Client A or Client B etc., as a way to shield them from prying eyes. The trust company or its subsidiaries are generally the director and secretary of every client's trust. There are no real directors or owners on record. Such artful crafting adds another vital layer of secrecy to the structure.
Should small private businesses with growing family wealth use trusts and foundations to manage their money?
Trust-structures generally are for legitimate purposes - as in family estate planning. Trusts are used when a wealthy person wants to pass ownership of his assets, which would otherwise form part of his estate. He could not be said to have set up a trust to avoid tax, especially when estate duty has been abolished in a number of Asian countries. If he is also a successful entrepreneur, the use of a trust will ensure stable management of business, especially when handing over control to the next generation. A badly managed transition is the biggest threat to the survival of family companies through the generations. One reason trusts are a useful succession planning instrument is their long life-span; they can be as long as a hundred years, depending on a country's law.
Nevertheless, it has not precluded some wealthy people from using this legal structure to hide money (included ill-gotten gains) from laws of their home country. This is made possible by the trust laws of some countries allowing a high level of secrecy with no requirement for registration of their existence. When companies grow their business, they use offshore companies for tax reduction and increase in profits. Some use offshore trusts for their illicit financial outflows. Offshore companies and trusts are non-resident entities. They do not come within the purview of home government. Nevertheless, some countries tax individuals and resident companies on their worldwide income. But lots of wealth can be found in tax havens in tiny South Pacific islands that require no registration or offering a high level of anonymity that frustrates governments. There are faux-directors and shareholders --- proxies who serve as stand-ins when the real owners of companies do not want their identities known. The writer offers no opinion on this issue.
Are trusts and foundations different?
Trusts and foundations are like office chairs, if you do not mind this simple illustration. They serve the same function to provide comfortable seating for long hours of office drudgery work. Nevertheless, the choice of one chair over another is a matter of status symbol, price and personal requirements especially for people with backaches -- an ergonomic chair is a health investment property. Certainly, one can choose to own both an ergonomic chair and a common executive swivel comfy seat in manner one thinks fit.
We will now get back to our discussion on trusts. Trust is a common law concept. A foundation is its equivalent in civil law countries. Today, almost all countries follow one of two major legal traditions: common law or civil law. The common law tradition emerged in England, and that of the civil law was developed in continental Europe.
Regardless of their origins, both structures exist alongside one another especially in European Union -- the home to a majority of users of trusts and foundations in places close to common law jurisdictions. Such civil law countries have developed approaches to deal with trusts such as becoming a party to the Hague Convention (an international treaty) on trust laws. For instance, a few signatory countries in Europe have recognised English trust laws in Great Britain. It is a smart national commercial strategy. Switzerland takes the lead position. But in France, beneficiaries of a company must be identified. Trusts are not recognised as a legal structure.
A Foundation structure
In terms of usage, trusts and foundations are not interchangeable terms. There are subtle differences. For a wealthy family managing a global business, foundations in some offshore locales may be the preferred choice. A foundation combines the benefits of a trust with those of a company. While no shareholder takes ownership of a foundation, a board controls its direction. Unlike a trust, a foundation can own property and better manage tax liabilities because it has its own legal personality.
Foundations are suitable to people less familiar with the workings of private trusts; or they may be unwilling to let go in the management of their assets. In fact, the activities that a foundation can carry out are wide in range and flexible at the same time. Activities can be created to bear resemblance to running a company.
However, some big business titans have both trusts and foundations working side-by-side. The good Samaritans have their foundations experiment intractable problems --- poverty and unproven cures for diseases - hoping that their success will induce followers. Private companies are unlikely to take on similar financial risks. These philanthropy-capitalists are a different breed. They want their money to create social impact.
From a commercial perspective, a big family enterprise with companies in Europe and USA will most likely set up a foundation in a European country - such as the Netherlands. It will then set up a trust in USA (probable Delaware) to counter any problematic legislation in Europe. With this arrangement, a Dutch foundation has the power to assume control of assets of American companies the business owns. Similarly, the Delaware trust may take control of European assets. Basically, the complementary structures serve to ring-fence against undesirable regulatory moves by governments.
Foundations and trusts are mostly exempt from the national registers and even if they are not, registers may not be open for public viewing. Frankly, people who want to hide their money will never hold funds in their own name these days. Even if one gets access to national registers, there may be labyrinthine-combinations of anonymous shell companies in the form of trusts and foundations. Business people have known to have sent thousands of dollars in cash stuffed into envelopes to pay for maintaining the trust companies, instead of sending through easy-to-trace wire transfers or bank cheques. Moreover, with layering of structures, it is a tough nut to crack trying a break-through to expose real or beneficial ownership.
From the writer's perspective, well publicised foundation-of-foundations such as that of the Ikea family are unlikely to get the wraiths of governments. They have found ways to enhance transparency into their operations, and in seeking public goodwill. At the same time, the family enterprise has relentlessly created enormous job opportunities globally. The Ikea structure -- splitting the company and its business into two groups - designed to protect the brand and to ensure its long-term success. Moreover, the entrepreneurship spirit that these family-dynasties created has boded well for the economies of their homeland. They support national projects that foster creativity and promote well-being such as conservation of natural resources.
For many other less transparent structures, their maze-like layers of companies often frustrate tax investigators who might just give up trying. It is only when dirty linens get cleanse in public; when warring siblings squabble in courts of law unravel huge hidden wealth not fairly distributed to family members that arouse the attention of tax authorities. It then prompted the authority to investigate by focusing on these events to find the missing link in the chain.
Fighting tooth and nail in full public view is never a wise thing to do.
A trust structure
For business people living in jurisdictions (not necessarily common law ones) where trust structures are legal arrangements, a trust is just a vehicle through which they can hold assets. The settlor - the person who creates the trust -- transfers certain assets that he or she owns to the trustee, who will then assume legal ownership of the assets on behalf of beneficiaries.
Except for some complex interlocking structures, most trusts are for legitimate purposes. It is in the interest of trustees that tax is paid, because if it is not, they are to pay out of their own pockets. Trustees must also know full details of beneficial owners and stand ready to pass on these information to relevant authorities when asked.
Hence, Ms Lian and Mr Beng can set up their home renovation business (Lian Beng Home Renovation Private Limited) through a family trust so that their children can take over their business without the need for a change of ownership. Each year, the trust receives income from the business and distributes this income to Lian and Beng who pay tax on it at their marginal rates. A trustee runs the trust and determines how much income beneficiaries receive each year. Penalty tax rates may apply if the trust does not distribute all its income to its beneficiaries.
Trusts have an advantage over companies as owners of the assets in that most trusts are discretionary. It means the trustee can decide who gets the income and any other trust benefits.
Trusts were used since feudal times by landowners so that feudal lords would not benefit from the land after their death. In its modern form - the discretionary trust - assets that may increase in value were sold into this family trust set up to benefit the beneficiaries of the person owing the assets. One of the benefits of such a trust is it enables the trustee to distribute income, both business and investment income, among the family members or beneficiaries of the trust. The trustees distribute the income of the trust based on the Trust Deed. It is rule-book of the family trust. By using a trust, the family business operates through it so that in case of a claim against the business, their personal assets get protected. In today's highly litigious times, the danger of losing business properties is real and the costs of protecting them can bankrupt the enterprise when assets remain unprotected.
With a discretionary trust, assets sit in a kind of no man's land. In such an arrangement, money has been given away, legally speaking, but nobody has received it because the beneficiaries have not been determined. They may include children who are yet to be born. In theory, the trustee has discretion over who gets what, but in practice, the original owner in a side-agreement known as a "letter of wishes" makes all decisions. He regains control of assets which, in law, he has given up ownership. This makes discretionary trusts an important and tricky issue for tax authorities.
For small family businesses to create a trust can be a costly matter. Even more expensive is the cost of compliance – the writer can exactly put it down to an exact figure but it will definitely cause more pain than a needle prick.
There exist jurisdictions that are friendly to family business trusts. These havens will exempt enterprises from tax charges and reduces compliance costs. They have to tread warily, nevertheless. Governments running deficits are looking closely at family-enterprises putting up with less transparent jurisdictions. It is not game-over yet. Ever-inventive trust providers will doubtless concoct new products -- shareholder-less or orphan entities - with particularly attractive tax advantages, whose beneficiaries can be another foundation or trust.
Little Davids may be no match for mighty Goliath. Family-enterprises are better off keeping themselves away from trouble with tax issues.
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Little English-Chinese Dictionary
- dirty linens get cleanse in public = jiā chǒu wài yáng
- fighting tooth & nail = měng liè sī dǎ
- tread warily = xiǎo xīn chǔ lǐ
- mighty Goliath = yǐ qiáng shēng ruò
- have the cake and eat it too. = liǎng quán qí měi
- one-size-fits-all = yī gè biāo zhǔn
A tribute to National Library, Singapore.
Last year, when the writer read a book review on TREASURE ISLANDS by Nicholas Shaxson, he recommended this offshore banking and tax havens publication be bought by the National Library, Singapore, for its central library. The recommendation was immediately accepted.
Certainly, the writer was the first person to read it when the book was purchased within less than three months. Singapore is a place with a large population of international banks and multinational companies; TREASURY ISLAND – uncovering the damage of offshore banking and tax havens - comes handy.
The writer makes no warranty of any kind with respect to the subject matter included herein or the completeness or accuracy of this article which is merely an expression of his own opinion. The writer is not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Without limiting the above the writer shall have no responsibility for any act or omission on his part. Readers should take specific advice from qualified professionals when dealing with specific situations.