CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r10 estate planning in a global context IFT notes

Estate Planning in a Global Context IFT Notes Estate Planning in a Global Context Introduction 2 Domestic Estate Planning: Some Basic Concepts 2.1 Estates, Wills, and Probate 2.2 Legal Systems, Forced Heirship, and Marital Property Regimes 2.3 Income, Wealth, and Wealth Transfer Taxes 3 Core Capital and Excess Capital 3.1 Estimating Core Capital with Mortality Tables 3.2 Estimating Core Capital with Monte Carlo Analysis Transferring Excess Capital 4.1 Lifetime Gifts and Testamentary Bequests 4.2 Generation Skipping 4.3 Spousal Exemptions 4.4 Valuation Discounts 4.5 Deemed Dispositions 4.6 Charitable Gratuitous Transfers Estate Planning Tools 5.1 Trusts 5.2 Foundations 5.3 Life Insurance 5.4 Companies and Controlled Foreign Corporations 10 Cross-Border Estate Planning 10 6.1 The Hague Conference 10 6.2 Tax System 10 6.3 Double Taxation 11 6.4 Transparency and Offshore Banking 14 Summary 14 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes Introduction This reading gives an overview of how assets can be transferred to others in the most efficient way Domestic Estate Planning: Some Basic Concepts 2.1 Estates, Wills, and Probate This section covers LO.a: LO.a: Discuss the purpose of estate planning and explain the basic concepts of domestic estate planning, including estates, wills, and probate An estate is all of an individual’s property or assets, which can include:     Financial assets Real estate Tangible assets Intangible assets Estate planning is the process of arranging for our assets to be transferred to others in the most efficient way The transfer of assets to others can take place during an individual’s life or upon his/her death The most basic method of arranging for the transfer of assets is to write a will (or testament), which is a legal document containing an individual’s instructions for the distribution of his property after his death The person transferring assets through a will is known as the testator If an individual dies without leaving valid will – a common occurrence - she is declared to have died intestate and the distribution of her assets is determined by court Probate is the legal process to confirm the validity of a will Individuals, particularly high net worth investors, may wish to avoid the probate process, which can be expensive and time consuming One alternative method for transferring assets is to establish joint ownership of assets with rights of survivorship Upon one owner’s death, ownership of the asset will transfer to the surviving owner(s) and is not subject to a probate challenge Other estate planning tools that avoid the probate process are discussed in section 2.2 Legal Systems, Forced Heirship, and Marital Property Regimes This section addresses the “important non-tax issues” mentioned in LO.b: LO.b: Explain the two principal forms of wealth transfer taxes and discuss the effects of important non-tax issues such as legal system, forced heirship, and marital property regime Tax laws vary from country to country, many of these differences are due to the different law systems IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes used by these countries A Civil law system is derived from the Roman law This system uses deductive reasoning and rules or concepts are applied to particular cases A Common law system is derived from British law This system uses inductive reasoning and it draws rules from specific cases In forced heirship regimes, a certain portion of a parent’s estate must be distributed to his surviving children In Example 1, the Berelli children are entitled to split one-third of their father’s total estate There may be an additional provision that all children are entitled to an equal share of assets Should a parent try to work around this provision by, for example, making lifetime gifts to a favored child, the other children may be able to claim a share of these transfers In community property regimes, both spouses are typically entitled to an equal share of the assets that are acquired during their marriage (common property) For example, if a couple’s combined net worth increased from $0 to $1,000,000 during the course of their marriage, the surviving spouse would automatically receive $500,000 and the remaining share could be freely distributed In separate property regimes, each spouse is able to own and control property as an individual 2.3 Income, Wealth, and Wealth Transfer Taxes This section addresses the “two principal forms of wealth transfer taxes” mentioned is LO.b: LO.b: Explain the two principal forms of wealth transfer taxes and discuss the effects of important non-tax issues such as legal system, forced heirship, and marital property regime As discussed in section of Taxes and Private Wealth Management in a Global Context, taxes are typically applied on income, consumption, or wealth Wealth taxes can be imposed on assets that are held (such as a property tax on real estate) or when assets are transferred This section focuses on wealth transfer taxes A person who wishes to transfer wealth can either so during her lifetime (as a gift) or after her death as part of her estate (as a bequest) Gits are referred to as lifetime gratuitous transfers or inter vivos transfers and can be subject to gift taxes Bequests are known as testamentary gratuitous transfers and can be subject to estate taxes Therefore, the two principal forms of wealth transfer taxes are gift taxes and estate taxes The decision on whether to transfer wealth as a gift during life or as a bequest after death is heavily dependent on how such transfers are taxed, which will be discussed in section Core Capital and Excess Capital Refer to Exhibit which shows a hypothetical life balance sheet of an individual The assets consist of financial and other assets currently held by the individual plus the present value of net employment income expected to be generated over the lifetime, referred to as net employment capital The liabilities consists of mortgage or other loan payments and present value of capital required to maintain the IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes current lifestyle and fund retirement Capital required to maintain your standard of living and fund essential objectives and meet unexpected commitments- is called your “core capital” Any additional capital is called “excess capital” and, as will be discussed in section 4, it this capital that is relevant in the context of estate planning 3.1 Estimating Core Capital with Mortality Tables This section covers LO.c: LO.c: Determine a family’s core capital and excess capital, based on mortality probabilities and Monte Carlo analysis Mortality tables, also known as “life tables” and “actuarial tables”, provide an estimate of an individuals expected life For example, the mortality table in Exhibit reveals that Ernest Webster (who is 79 years old) has a 93.55% probability of living to age 80, an 87.02% probability of living to age 81, and a 0.00% probability of living to age 101 or beyond These are referred to as “survival probabilities” Also in Exhibit 2, we see that Ernest’s wife, Beatrice Webster, is 69 years old and has a 98.31% probability of living to age 70 The one-year survival probabilities for Ernest and Beatrice Webster are 93.55% and 98.31%, respectively The probability that at least one them survives another year – their joint survival probability - can be calculated using the following formula: 𝑝(𝑆𝑢𝑟𝑣𝑖𝑣𝑎𝑙) = 𝑝(𝐻𝑢𝑠𝑏𝑎𝑛𝑑 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) + 𝑝(𝑊𝑖𝑓𝑒 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) − 𝑝(𝐻𝑢𝑠𝑏𝑎𝑛𝑑 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) × 𝑝(𝑊𝑖𝑓𝑒 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) 9355 + 9831 – (.9355 x 9831) = 9989 The joint survival probability for the Websters is 99.89% Put differently, there is just a 0.11% chance that both Ernest and Beatrice will die within the next year Living expenses over the next year are projected to be €500,000 over the next year, which puts their expected spending at €500,000 x 9989 = €499,457 This amount is then discounted back to today using the real risk free rate The couple’s total core capital need can be calculated as the sum of each year’s discounted expected spending: As shown at the bottom of column in Exhibit 2, the Webster’s core capital need – based on their life expectancy and discounted annual spending – is €9,176, 955 Discounting at the risk-free rate One important considerations with this method is the use of the risk-free rate for discounting cash flows While there is definitely risk associated with expected spending, this risk is unrelated to the IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes market and it is therefore unnecessary to add a market risk premium to the risk-free rate Nominal versus real cash flows When projecting and discounting cash flows, it is critically important to be aware of whether the figures being used are stated in nominal or real terms and to remain consistent Note that in Exhibit 2, the Webster’s annual spending (column 7) increases each year As we learn just below Exhibit 2, “The Webster’s inflation-adjusted annual spending needs are calculated based on their current spending of €500,000 per year and are increased annually using a percent real growth rate (that is, percent annual spending growth after inflation).” Therefore, the expected spending figures listed in column are discounted by the real discount rate of 2% 3.1.1 Safety Reserve Determining our core capital requirement could be an exact science if we knew exactly how long we will live, our exact spending needs, and the returns that our investments would generate with absolute certainty In reality, such certainty is difficult to achieve In order to protect against the uncertainties of capital market returns and spending requirements, it is advisable to augment estimated core capital with a safety reserve allocated to cash or highly-liquid, ultra-low risk securities 3.2 Estimating Core Capital with Monte Carlo Analysis Monte Carlo simulation is a very useful tool the process of planning for retirement and the distribution of one’s estate Like the mortality table approach, the Monte Carlo method assumes an average expected rate of return However, unlike the mortality table approach, which assumes a constant (ie riskless) rate of return, the Monte Carlo method assumes a certain level of volatility among returns, which captures the risk that returns will not be sufficient to meet spending needs over a given period of time The output of a Monte Carlo simulation will look like Exhibit 3, which shows the “probability of ruin” for a given level of spending For example, a person who retires at age 60 and has a life expectancy of 83.4 years, has a 1.5% probability of outliving his assets if his annual spending rate starts a 2% of his initial core capital The probability of ruin increases with higher annual spending rates It is therefore important to be able to determine the acceptable spending rate given an investor’s stated risk tolerance In Example 5, we see that Sophie Zang, who is 55 and – based on the data Exhibit – can expect to live to age 83 (i.e., she has a 28-year time horizon) is able to spend SGD 40,000 (or 2%) of her SGD 2,000,000 portfolio if she wants a 98% probability of avoiding financial ruin (in other words, she accepts a 2% probability of ruin), but can increase this spending rate to 3% if she is willing to be accept a 6.3% probability of ruin Transferring Excess Capital Section addressed the calculation of core capital required to meet essential needs during an investor’s lifetime If investors have assets that are greater than their core capital requirement, they have excess IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes capital that can be transferred to others such as family members or charitable organizations For example, if the Websters from section 3.1 have total assets worth €20,000,000 and a core capital requirement of €9.200.000, their excess capital is €10,800,000 4.1 Lifetime Gifts and Testamentary Bequests As mentioned in section 2.3, individuals who wishes to transfer assets can either so during her lifetime as a gift, or after her death as a bequest Sections 4.1.1 and 4.1.2 address LO.d: LO.d: Evaluate the relative after-tax value of lifetime gifts and testamentary bequests 4.1.1 Tax-Free Gifts Certain countries allow for the tax-free transfer of wealth as a gift The exact amounts and applicable periods vary by jurisdiction, but the ability to transfer an asset without incurring an immediate gift tax liability can create significant after-tax value compared to the alternative of transferring the same assets as a bequest that is subject to an estate tax The relative value of a tax-free lifetime gift is captured in Equation 5: The top half of the formula above shows the future value of an asset if it is transferred from the donor’s estate to a recipient (“donee”) such as a child The bottom half of the formula shows the future value of the same asset if it is held until after the donor’s death and transferred to the donee as a bequest Note that the returns (rg) are still taxed at a rate of tig after the asset is transferred to the donee, just as the returns (re) would have been taxed at a rate of tie if the asset had remained in the donor’s estate 4.1.2 Taxable Gifts The relative advantage of a gift versus a bequest is clear when no gift tax is applied However, the advantage can persist even when a tax is applied on lifetime gifts (Tg) The relative value of a taxable gift is shown in the formula below: 4.1.3 Location of the Gift Tax Liability The following section addresses LO.e: LO.e: Explain the estate planning benefit of making lifetime gifts when gift taxes are paid by the donor, rather than the recipient IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes Even when the gift tax rate is equal to the estate tax rate (Tg = Te), and returns are taxed at the same rate whether the asset is held by the recipient or the donor (tig = tie), there can still be an advantage to gifting an asset if the gift tax is paid by the donor By paying the gift tax directly from the donor’s estate, the size of the estate is reduced and will incur a lower tax liability when the remainder of the estate is transferred as a bequest The value of such a strategy is calculated as the size of the gift multiplied by the gift tax rate multiplied by the estate tax rate (or Gift x Tg x Te) To summarize section 4.1, transferring an asset as a lifetime gift is preferable to transferring the same asset as a bequest when:     There is no gift tax The gift tax is lower than the estate tax Returns are taxed at a lower rate when the asset is held by the donee rather than the donor The gift tax is paid by the donor, which reduces the value of assets subject to an estate tax Sections 4.2 to 4.6 address LO.f: LO.f: Evaluate the after-tax benefits of basic estate planning strategies, including generation skipping, spousal exemptions, valuation discounts, and charitable gifts 4.2 Generation Skipping When the first generation transfers assets to the second generation, the assets are taxed Then when the second generation transfers assets to the third generation, the assets are taxed again If a grandparent has sufficient excess capital that his children’s needs are already met, he can avoid this extra layer of taxation by transferring assets directly to his grandchildren This is known as generation skipping 4.3 Spousal Exemptions Many jurisdictions allow for the tax-free transfer of assets (either as a gift or a bequest) from one spouse to another However, it may be unwise to make such transfers if doing so eliminates the opportunity to make a tax-free (or tax-advantaged) transfer to other recipients such as children or grandchildren The specific rules vary by jurisdiction, but the point is that the opportunity to use a spousal exemption to transfer assets should be considered as just one option in the context of a broader estate planning strategy 4.4 Valuation Discounts An estate that is entirely composed of highly liquid assets such as exchange-traded stocks and government bonds will be taxed based on an easily-determined market value Assessing the tax liability for an estate that includes a significant proportion of illiquid assets is a more complicated matter and the owner of such an estate may qualify for a valuation discount For example, imagine that rather than selling IngerMarine, Peter and Hilda Inger (from Managing Individual Investor Portfolios) wished to transfer ownership of the company to their children The intrinsic value of their position is estimated at €61,200,000, but their shares not trade on a public exchange and the relevant tax authority may IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes apply a liquidity discount in the range of 20 to 25 percent when valuing this asset for the purpose of determining the tax liability that is triggered by this transfer Obviously, no such discount would be applied if the Ingers sold their shares for cash and transferred the proceeds to their children 4.5 Deemed Dispositions Certain tax jurisdictions treat (or deem) assets that are transferred as a bequest to have been sold (or disposed) for tax purposed and a tax liability is incurred on any capital gains In countries that apply deemed disposition status to assets transferred after death, but not apply a gift tax, there is a strong incentive to transfer highly-appreciated assets as gifts during the donor’s lifetime 4.6 Charitable Gratuitous Transfers Transferring assets to a charitable organization during the donor’s lifetime can offer several advantages First, charitable donations reduce the size of a donor’s taxable estate and very few countries impose a gift tax on such transfers Second, in almost all jurisdictions, donors are allowed to claim charitable donations as a deduction for income tax purposes Finally, the returns on assets that have been transferred to a charitable organization are allowed to accumulate tax-free Estate Planning Tools As mentioned in section 2, the most basic method of arranging for assets to be transferred is to write a will, which provides for the distribution of assets after the owner’s death However, the process of affirming the validity of a will – known as probate – can be time-consuming and expensive This section considers four alternative estate planning tools 5.1 Trusts This section addresses LO.g: LO.g: Explain the basic structure of a trust and discuss the differences between revocable and irrevocable trusts A trust is a legal arrangement in which a settlor (or grantor) transfers assets into the care of a trustee, who manages these assets on behalf of a beneficiary A common trust arrangement is for a parent to transfer assets into a trust where they are then managed for the benefit of her children Trusts can be customized and it is important to distinguish between various trust structures In a revocable trust, the grantor to allowed to rescind the arrangement (ie reclaim control of its assets) at any time By contrast, the grantor of an irrevocable trust permanently relinquishes her right to take back control of any assets that she has transferred into it This is an important consideration with respect to asset protection (see section 5.1.2 below) A second important consideration when establishing a trust is whether to use a fixed or discretionary structure A fixed trust makes distributions to its beneficiaries according to the specific terms that have been established by the grantor For example, a parent may established a fixed trust that automatically IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes pays $10,000 to each of his children on the first day of January every year By contrast, the grantor of a discretionary trust provides instructions in general terms and allows the trustee to exercise his judgment (or discretion) when make distributions For example, the beneficiaries of a discretionary trust may receive distributions of different amounts at different times as their needs change 5.1.1 Control Transferring assets into a trust allows a grantor to retain a measure of control over his assets even after they have been transferred For example, by established a fixed or discretionary trust, a grantor can ensure that his assets are used according to his wishes, such as to fund his children’s post-secondary education This allows the grantor to maintain control of his assets during his lifetime and avoid the disadvantages of the probate process 5.1.2 Asset Protection Assets that have been transferred into an irrevocable trust are generally considered to be beyond the reach of any creditor’s claims against the grantor 5.1.3 Tax Reduction Depending on applicable tax laws, trusts may provide a tax-efficient method of transferring wealth For example, returns on assets that have transferred into a trust may be taxed at a lower rate than if they continued to be held by the grantor Furthermore, transferring assets into a trust can reduce the size of a grantor’s taxable estate 5.2 Foundations Many civil law jurisdictions not recognize the existence of trusts Investors in these countries can obtain the benefits discussed in sections 5.1 by establishing a foundation 5.3 Life Insurance This section addresses LO.h: LO.h: Explain how life insurance can be a tax-efficient means of wealth transfer The holder of a life insurance policy pays premium periodically (often monthly) to an insurance company, which promises to pay a lump sum to a beneficiary in the event of the policy holder’s death This structure is similar to a trust in the sense that a policy holder transfers wealth in the form of premiums that is subsequently paid out to a beneficiary A life insurance policy also offers many of the same advantages of a trust Control The holder of a life insurance policy is able to transfer wealth (in the form of a death benefit) to a designated beneficiary outside the probate process By naming a discretionary trust as the designated IFT Notes for the Level III Exam www.ift.world Page Estate Planning in a Global Context IFT Notes beneficiary in the event of his death, a life insurance policy holder can assert additional control over the distribution of his assets Additionally, a life insurance policy can be used to transfer wealth without the need to sell illiquid assets at a deep discount Asset Protection As with assets that have been placed in trust, the benefits paid from a life insurance policy are generally considered to be beyond the reach of the policy holder’s creditors Additionally, life insurance policies can also allow for the transfer of wealth beyond the reach of forced heirship rules Tax Reduction Most tax jurisdictions not apply taxes on death benefit payments from a life insurance policy Additionally, the policy holder can effectively transfer assets in the form of premiums in a designated beneficiary without having to pay a gift tax Such payments also reduce the size of the policy holder’s taxable estate 5.4 Companies and Controlled Foreign Corporations The owner of a controlled foreign corporation (CFC) may use this structure as an estate planning tool The tax liability on returns from assets transferred into a CFC is reduced or at least deferred However, many tax authorities take measures to eliminate the tax benefits offered by CFCs Cross-Border Estate Planning Taxation issues are a challenge to understand at the best of times and they become even more complex when more than one jurisdiction is involved Income generated outside home country may be taxed in both countries Passing ownership of overseas assets on death might be difficult Transferring assets to heirs located outside home country might be difficult 6.1 The Hague Conference The Hague Conference on Private International Law is a forum where various countries attempt to establish common standards for laws governing private matters, such as estate planning This initiative is increasingly important as investors continue to take advantage of opportunities beyond the borders of their home country One specific treaty signed under the auspices of this forum allows for a will drafted in one signatory nation to be recognized as valid in all signatory nation 6.2 Tax System This section addresses LO.i: LO.i: Discuss the two principal systems (source jurisdiction and residence jurisdiction) for establishing a country’s tax jurisdiction A source jurisdiction (or territorial tax system) only taxes income that is generated within its borders IFT Notes for the Level III Exam www.ift.world Page 10 Estate Planning in a Global Context IFT Notes Both residents and non-residents are taxed on locally-sourced income, but no taxes are applied on income that is generated outside the jurisdiction A residence jurisdiction taxes its residents on all of their income, regardless of whether it is generated within or outside its borders In practice, most countries are residence jurisdictions The remainder of this section addresses LO.j: LO.j: Discuss the possible income and estate tax consequences of foreign situated assets and foreign-sourced income 6.2.1 Taxation of Income Defining a person’s residence can be surprisingly challenging, as there is no universally-recognized standard for residency However, as mentioned, most countries apply income taxes based on residency, so tax authorities have developed tests such as how many days an individual was physically in the country during the tax year 6.2.2 Taxation of Wealth and Wealth Transfers Applying gift and/or estate taxes on wealth transfers can be very complicated with the donor and recipient reside in different countries The level of complexity increases if the asset that is transferred is located in a third country 6.2.3 Exit Taxation High net worth individuals may try to avoid taxation by renouncing their citizenship and moving to a country with a less onerous tax regime To deal with such cases, countries often impose exit taxation in the form of taxes on unrealized capital gains from assets that are deemed to have been sold when citizenship is renounced 6.3 Double Taxation Double taxation occurs when two jurisdictions seek to tax the same income or assets There are three forms of conflict that can result in double taxation As noted in section 6.2, the two main tax systems are based on source and residency A residenceresidence conflict occurs when two countries both claim an individual as a resident A source-source conflict arises when two countries claim to jurisdiction over the same asset or to both the source of the same income Residence-source conflicts exist when a residence tax jurisdiction seeks to tax a resident who holds assets in or generate income from another country (the source jurisdiction) 6.3.1 Foreign Tax Credit Provisions This section addresses LO.k: IFT Notes for the Level III Exam www.ift.world Page 11 Estate Planning in a Global Context IFT Notes LO.k: Evaluate a client’s tax liability under each of the three basic methods (credit, exemption, and deduction) that a country may use to provide relief from double taxation Resolving source-source and residence-residence conflicts involves legal wrangling that is far beyond the scope of the curriculum For residence-source conflicts, the convention is that the source country has a priority claim to the tax revenues and the onus in on the residence country to provide relief (if any) from double taxation It may be helpful to think of the two countries as creditors, with the source country having a priority claim So the key to answering questions on double taxation relief is identifying the source country Exemption Method If the residence country uses the exemption method, the only applicable tax rate is the one imposed by the source country (TSource), and the residence country’s tax rate (TResidence) is irrelevant Consider the example of an investor who resides in Country R and has earned $100,000 sourced from Country S Case 1: Exemption Method Tax rate in Country S (TSource) Tax rate in Country R (TResidence) Taxes paid to source country Taxes paid to residence country 25% 40% $100,000 x 25% = $25,000 $0 (Exempted) Credit Method If the residence country uses the credit method, the residence country provides double taxation relief by granting a credit for any taxes paid to the source country As a result, the investor will pay the higher of the source country’s tax rate or the residence country’s tax rate Put differently: TCreditMethod = Max[TResidence, TSource] Therefore, the key to determining the payments made using the credit method is to identify which country’s tax rate is higher Case 2: Credit Method (TSource > TResidence) If the source country imposes a higher tax rate (Tsource > Tresidence), the residence country doesn’t apply any additional taxes Consider once again the example of an investor who resides in Country R and has earned $100,000 sourced from Country S As in Case #1, Country S applies a 25 percent tax rate, but Country R’s tax rate in this case is 20 percent Tax rate in Country S (TSource) Tax rate in Country R (TResidence) Income claimed by both countries Taxes paid to Country S Total taxes owed IFT Notes for the Level III Exam 25% 20% $100,000 $100,000 x 25% = $25,000 Max[20%, 25%] www.ift.world Page 12 Estate Planning in a Global Context Tax relief calculation Taxes paid to residence country IFT Notes 20% - 25% = TSource) If the source country applies a lower rate, the investor receives a full credit for the payment of those taxes and pays the difference between the two rates to the residence country As in Cases and 2, we consider an investor with an income of $100,000 that is sourced from Country S, which applies a 25 percent tax rate In this case, the residence country (Country R) applies a higher tax rate (40 percent) Tax rate in Country S (TSource) Tax rate in Country R (TResidence) Income claimed by both countries Taxes paid to Country S Total taxes owed Tax relief calculation Taxes paid to residence country 25% 40% $100,000 $100,000 x 25% = $25,000 Max[40%, 25%] 40% - 25% = 15% $100,000 x 15% - $15,000 If there were no conflict over the income, Country R would have collected $40,000 in taxes ($100,000 x 40%) However, this amount is reduced by the $25,000 that the investor has already paid to Country S Note that the investor pays total taxes of $40,000 as if he had been taxed at Country R’s rate of 40 percent, but $25,000 of this is collected by Country S and Country R collects $15,000 Deduction Method If the residence country uses the deduction method, the investor will pay incur a total tax rate that is calculated using the following formula: 𝑇𝐷𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑀𝑒𝑡ℎ𝑜𝑑 = 𝑇𝑅𝑒𝑠𝑖𝑑𝑒𝑛𝑐𝑒 + 𝑇𝑆𝑜𝑢𝑟𝑐𝑒 (1 − 𝑇𝑅𝑒𝑠𝑖𝑑𝑒𝑛𝑐𝑒 ) = 𝑇𝑅𝑒𝑠𝑖𝑑𝑒𝑛𝑐𝑒 + 𝑇𝑆𝑜𝑢𝑟𝑐𝑒 − 𝑇𝑅𝑒𝑠𝑖𝑑𝑒𝑛𝑐𝑒 𝑇𝑆𝑜𝑢𝑟𝑐𝑒 Case 4: Deduction Method (TResidence > TSource) The deduction method of double taxation relief is demonstrated using the same inputs that were used in cases and above Tax rate in Country S (TSource) Tax rate in Country R (TResidence) Income claimed by both countries Taxes paid to Country S Total taxes owed Tax relief calculation Taxes paid to residence country IFT Notes for the Level III Exam 25% 40% $100,000 $100,000 x 25% = $25,000 40% + 25% – (40% x 25%) = 55% 55% - 25% = 30% $100,000 x 30% - $30,000 www.ift.world Page 13 Estate Planning in a Global Context IFT Notes Using the formula provided above, we calculate that the investor will pay an overall tax rate of 55 percent, which is a total tax liability of $55,000 for the $100,000 of income that is claimed by both Country S and Country R) Country S then applies its full rate of 25 percent and collects $25,000 Country R collects the difference between the total tax liability of $55,000 and the $25,000 that has already been paid to Country S 6.3.2 Double Taxation Treaties Double taxation treaties are agreements between countries that provide an agreed set of rules for resolving some of the double taxation conflicts mentioned earlier in this section The Organization for Economic Co-operation and Development provides a Model Treaty that countries can use as a template and recommends that residence countries used the exemption or credit methods to provide relief from double taxation 6.4 Transparency and Offshore Banking This section addresses LO.l: LO.l: Discuss how increasing international transparency and information exchange among tax authorities affect international estate planning As investors continue to pursue international opportunities, tax authorities are increasingly sharing information The key for those providing estate planning advice is to employ tax minimization strategies that conform to both the spirit and letter of various tax laws This is known as tax avoidance and it is a legitimate method of helping investors achieve their financial By contrast, tax evasion is “the practice of circumventing tax obligations by illegal means or not reporting relevant information to tax authorities”, and it is a completely illegitimate method because it is illegal Summary a discuss the purpose of estate planning and explain the basic concepts of domestic estate planning, including estates, wills, and probate;       Estate planning: Planning the transfer of one’s estate during one’s lifetime and at one’s death Objectives of estate planning: o To minimizing cost of transferring property to heirs o To transfer estate assets to the desired beneficiaries o To plan for efficient use of estate assets Will (testament): Legal document containing instructions for the distribution of one’s property after death Testator: A person transferring assets through a will Testate/intestate: A person who dies with (without) a will is said to have died testate (intestate) Probate: Legal process to confirm the validity of a will IFT Notes for the Level III Exam www.ift.world Page 14 Estate Planning in a Global Context IFT Notes Advantages of Probate Disadvantages of Probate Ensures disposition of assets to heirs according will and in orderly manner Relatively costly and time consuming process Protects creditors by ensuring payments of debt Compromises privacy of decedent and heirs Tools to avoid probate process: i Joint ownership ii Partnerships iii Living trusts iv Retirement plans v Life insurance b explain the two principal forms of wealth transfer taxes and discuss effects of important non-tax issues, such as legal system, forced heirship, and marital property regime; Two principal forms of wealth transfer: Gifts: lifetime gratuitous transfers or inter vivos transfers Bequests: testamentary gratuitous transfers Legal systems:  Common law system: uses inductive reasoning and it draws rules from specific cases  Civil law system: uses deductive reasoning and rules or concepts are applied to particular cases Regimes: a) Forced heirship: children have right to fixed share of parent’s estate b) Community property: each spouse has indivisible one-half interest in income earned during marriage On death half property goes to spouse Other half divided according to will c) Separate property: each spouse owns and controls property as an individual Example 1: When a country has both community property and forced heirship regimes, surviving spouse has a right to receive the greater of his/her share under community property or forced heirship rules c determine a family’s core capital and excess capital, based on mortality probabilities and Monte Carlo analysis;   Core capital: minimum amount of capital required to maintain lifestyle and fund essential and emergency needs Excess capital: capital in excess of core capital There are two ways of estimating core capital: 1) Mortality tables and 2) Monte Carlo analysis Mortality tables use the risk-free rate to discount spending needs Core capital is estimated using the formula IFT Notes for the Level III Exam www.ift.world Page 15 Estate Planning in a Global Context Core capital = ∑N j=1  IFT Notes P (Survival)×Spendingi (1+r)i Monte Carlo analysis forecasts spending needs and then estimates size of portfolio needed to meet forecasted spending needs o The forecasts are based on statistical properties of the underlying asset returns o It captures capital market risks much better than mortality table approach d evaluate the relative after-tax value of lifetime gifts and testamentary bequests;    The choice between a lifetime gift and a testamentary bequest depends on the future value under each option This is captured using relative value If the relative value is > 1, then making a lifetime gift is beneficial If tax is paid by recipient  If the tax is paid by the donor: e explain the estate planning benefit of making lifetime gifts when gift taxes are paid by the donor, rather than the recipient; Gifting is more tax-advantage if the gift tax is paid by the donor even when the gift tax rate is equal to the estate tax rate (Tg = Te), and returns are taxed at the same rate whether the asset is held by the recipient or the donor (tig = tie) because by paying the gift tax directly from the donor’s estate, the size of the estate is reduced and will incur a lower tax liability when the remainder of the estate is transferred as a bequest The value of such a strategy is calculated as the size of the gift multiplied by the gift tax rate multiplied by the estate tax rate (or Gift x Tg x Te) f evaluate the after-tax benefits of basic estate planning strategies, including generation skipping, spousal exemptions, valuation discounts, and charitable gifts;  Generation skipping: Transferring capital in excess for both the first and second generations directly to the third generation IFT Notes for the Level III Exam www.ift.world Page 16 Estate Planning in a Global Context IFT Notes Relative value of generation skipping = (1−tax rate of capital transferred from 1st to 2nd generation)     Spousal exemptions: Tax-free transfer of assets (either as a gift or a bequest) to spouse Valuation discounts: Transferring assets that are subject to valuation discounts reduce the basis of transfer tax Deemed dispositions: Bequest/transfer is treated as if the property were sold  tax is levied only on the value of unrecognized gains rather than on the total principal value Charitable gratuitous transfers to charitable organizations offer the following advantages: a) Donations are not subject to gift transfer tax b) No taxes on investment returns c) Donations are income tax deductible g explain the basic structure of a trust and discuss the differences between revocable and irrevocable trusts;  Trust: Legal arrangement in which a settlor (or grantor) transfers assets into the care of a trustee, who manages these assets on behalf of a beneficiary Trust can be revocable or non-revocable Revocable Trust Irrevocable Trust Yes No Grantor Trustee No Yes Grantor can rescind/revoke the arrangement Tax and other liabilities responsibility Assets are protected from creditors’ claims against a settlor    Fixed Trust: distributions are made to beneficiaries according to the specific terms established by the grantor Discretionary Trust: trustee has the discretion to determine the amount and timing of distributions Objectives of a trust:  Control over assets  Asset protection  Tax reduction  Avoidance of probate process h explain how life insurance can be a tax-efficient means of wealth transfer; Life Insurance • Policy holder transfers assets (premium) to insurer • Insurer has obligation to pay death benefit to beneficiary Benefits: • Lower taxes • Avoid probate • Protection from creditors i discuss the two principal systems (source jurisdiction and residence jurisdiction) for establishing a IFT Notes for the Level III Exam www.ift.world Page 17 Estate Planning in a Global Context IFT Notes country’s tax jurisdiction; Source jurisdiction Residence jurisdiction Income tax Tax income sourced (generated) within country’s borders Tax based on residency (regardless of whether income is generated within or outside its borders) Gifts and bequests Tax only domestic wealth transfer Tax all wealth transfer (domestic and foreign) Exit Taxation: Taxes charged on unrealized gains accrued on assets that are removed from taxing jurisdiction j discuss the possible income and estate tax consequences of foreign situated assets and foreignsourced income; Double Taxation: When two jurisdictions seek to tax the same income or assets Three forms of tax conflicts in double taxation: 1) Residence-residence conflict: Two countries claim residence of the same individual 2) Source-source conflict: Two countries claim source jurisdiction of the same asset For example, income earned on investments that are located in country A but are managed from country B 3) Residence-source conflict: One country claim residence jurisdiction on individual’s worldwide income whereas other country claim source jurisdiction For example, a person is a resident of country B but has investment property in country A k evaluate a client’s tax liability under each of three basic methods (credit, exemption, and deduction) that a country may use to provide relief from double taxation; Methods used to provide double taxation relief Tax liability Example: Tax imposed by a residence country on worldwide income is 40%; tax imposed by foreign government on foreign-sourced income is 30% Credit method Max [TResidence, TSource] Max [40%, 30%]  Tax-payer will pay 40% Out of 40% • 30% will be paid to foreign-government • 10% will be paid to domestic government Exemption method TSource 30% collected by foreign government Deduction method TResidence + TSource – (TResidence × TSource) 0.40 + 0.30 – (0.40 × 0.30) = 58% Out of 58% • 30% will be paid to foreign-government • 28% [i.e 0.40 – (0.40 × 0.30)] will be paid to residence or domestic country Double taxation treaties may help resolve residence-source and residence-residence conflicts but not IFT Notes for the Level III Exam www.ift.world Page 18 Estate Planning in a Global Context IFT Notes source-source conflict l discuss how increasing international transparency and information exchange among tax authorities affect international estate planning    With an increase in information exchange and transparency across countries, it is becoming difficult to locate undeclared funds in offshore savings accounts and other offshore structures to avoid detection by home country tax authorities The key to providing estate planning advice is to use compliant, tailored, tax-efficient strategies – Tax avoidance: a legal method used to minimize taxes using legal loopholes in the tax codes – Offshore banking centers Tax evasion is avoiding or minimizing taxes through illegal means e.g misreporting or hiding relevant information from tax authorities IFT Notes for the Level III Exam www.ift.world Page 19 ... increasing international transparency and information exchange among tax authorities affect international estate planning    With an increase in information exchange and transparency across countries,... international estate planning As investors continue to pursue international opportunities, tax authorities are increasingly sharing information The key for those providing estate planning advice... for the Level III Exam www .ift. world Page Estate Planning in a Global Context IFT Notes capital that can be transferred to others such as family members or charitable organizations For example,