CFA CFA level 3 CFA level 3 CFA level 3 CFA level 3 CFA volume 2 finquiz smart summary, study session 4, reading 10

2018 Study Session # 4, Reading # 10 B.S = Balance Sheet CF= Cash flow “ESTATEPLANNING IN A GLOBAL CONTEXT” DOMESTIC ESTATE PLANNING: SOME BASIC CONCEPTS 2.1 Estates, Wills, and Probate Estate ⇒ all of the property a person owns or controls Estate planning ⇒ process of preparing for the disposition of one’s estate Will or testament ⇒ rights other will have over one’s property after death Testator ⇒ person whose property is disposed of according to the will Probate ⇒ legal process to confirm validity of a will Individuals wish to avoid probate because of the associated sizeable court fees & other issues 2.2 Legal Systems, Forced Heir ship, and Marital Property Regimes Legal System Civil Law Common Law Developed primarily through legislative statutes or executive action May not recognize trust Developed primarily through decisions of courts Trace their heritage to Britain Forced heirship rules ⇒ children have a right to a portion of a parent’s estate Wealthy individuals might try to avoid forced heir ship rules (through gifting assets or moving them into a trust) Claw back provisions are used to prevent this practice Community property rights regimes ⇒ each spouse is entitled to one-half of the estate earned during the marriage Separate property regimes ⇒ each spouse owns & controls his/her property, separate from the other 2.3 Income, Wealth, and Wealth Transfer Taxes Taxes are levied in one of the four general ways: Income tax Tax on spending Wealth tax Tax on wealth transfer Gift taxes or lifetime gratuitous transfers⇒ apply to lifetime gifts Testamentary gratuitous transfer ⇒ transferring assets upon one’s death Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 10 CORE CAPITAL AND EXCESS CAPITAL Life B.S ⇒ comprehensive accounting of an investor’s explicit & implied assets & liabilities Implied assets ⇒ PV of one’s employment capital & expected pension benefits Implied liabilities ⇒capitalized value of the investor’s desired spending goals Core capital ⇒ amount of capital to fund spending, to maintain a give lifestyle, fund goals & adequate reserves for unexpected commitments Excess capital ⇒ capital that can be transferred to others without jeopardizing the investor’s lifestyle 3.1 Estimating Core Capital with Mortality Tables Core capital can be estimated in the following ways: Forecast nominal (real) spending needs & discount these using nominal (real) discount rates Spending needs can be forecasted by multiplying each CF with survival probability ߩሺ‫ݏ݈ܽݒ݅ݒݎݑݏ‬ሻ = ߩ ሺℎ‫ݏ݁ݒ݅ݒݎݑݏ ܾ݀݊ܽݏݑ‬ሻ + ߩ ሺ‫ݏ݁ݒ݅ݒݎݑݏ ݂݁݅ݓ‬ሻ − ߩሺℎ‫ݏ݁ݒ݅ݒݎݑݏ ܾ݀݊ܽݏݑ‬ሻ × ߩ (‫)ݏ݁ݒ݅ݒݎݑݏ ݂݁݅ݓ‬ PV of the spending needs is equal to: ே ܸܲ ሺ‫݀݁݁݊ ݃݊݅݀݊݁݌ݏ‬ሻ = ෍ ௝ୀଵ ߩ൫‫݈ܽݒ݅ݒݎݑݏ‬௝ ൯ × ܵ‫݃݊݅݀݊݁݌‬௝ ሺ1 + ‫ݎ‬ሻ௜ Sum of each year’s PV of expected spending represents the investor’s core capital 3.1.1 Safety Reserve PV of spending needs underestimates the true core capital needs (no guarantee that capital markets will produce return>RF) Solution ⇒incorporates a safety reserve Size of reserve can be based on a subjective assessment of circumstances 3.2 Estimating Core Capital with Monte Carlo Analysis Estimate the size of a portfolio needed to generate sufficient withdrawals to meet expenses (inflation adjusted) Provides a range of possible outcomes & hence captures the risk more appropriately Ruin probability of depleting one’s financial assets before death return improves sustainability & requires core capital to generate same level of spending Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 10 TRANSFERRING EXCESS CAPITAL 4.1 Lifetime Gifts and Testamentary Bequests 4.1.1 Tax-Free Gift Tax reliefs may apply to gifts from donors Gifts can escape transfer tax by falling below periodic or lifetime allowances Appreciated assets can effectively be transferred, if subject to exclusions or tax reliefs Relative after-tax value of a tax-free gift: ்ܴܸ௔௫ ி௥௘௘ ீ௜௙௧ = ௡ ‫ீܸܨ‬௜௙௧ ൣ1 + ‫ݎ‬௚ ൫1 − ‫ݐ‬௜௚ ൯൧ = ሾ1 + ‫ݎ‬௘ ሺ1 − ‫ݐ‬௜௘ ሻሿ௡ ሺ1 − ܶ௘ ሻ ‫ܸܨ‬஻௘௤௨௘௦௧ where ܶ௘ = estate tax if asset is bequeathed ‫ݎ‬௚ & ‫ݎ‬௘ = pretax return to the gift recipient & the estate making the gift ܶ௜௚ &ܶ௜௘ = effective tax rates on investment returns (both recipient & estate making the gift) n = time until the donor’s death If pretax return & effective tax rates are equal, the relative value reduces to ଵ ଵି்೐ 4.1.2 Taxable Gifts Value can be added even when a lifetime gift is taxable After-tax future value of the gift: ௡ ‫ீܸܨ‬௜௙௧ ൣ1 + ‫ݎ‬௚ ൫1 − ‫ݐ‬௜௚ ൯൧ ൫1 − ܶ௚ ൯ = ‫ܸܨ‬஻௘௤௨௘௦௧ ሾ1 + ‫ݎ‬௘ ሺ1 − ‫ݐ‬௜௘ ሻሿ௡ ሺ1 − ܶ௘ ሻ Assumes that gift tax is paid by the recipient rather than the donor If after tax returns gift = return of assets to be bequeathed, the value of a taxable gift reduced to ்ܴܸ௔௫௔௕௟௘ ீ௜௙௧ = ൫ଵି்೒ ൯ ሺଵି்೐ ሻ Another strategy ⇒ gift asset with E(R) to the 2nd generation 4.1.3 Location of the Gift Tax Liability If the tax liability is imposed on the donor’s taxable estate, the size of the estate & hence the ultimate estate tax Relative after-tax value of the gift when the donor pays gift tax: ்ܴܸ௔௫௔௕௟௘ ீ௜௙௧ = ௡ ‫ீܸܨ‬௜௙௧ ൣ1 + ‫ݎ‬௚ ൫1 − ‫ݐ‬௜௚ ൯൧ ൫1 − ܶ௚ + ܶ௚ ܶ௘ ൯ = ሾ1 + ‫ݎ‬௘ ሺ1 − ܶ௜௘ ሻሿ௡ ሺ1 − ܶ௘ ሻ ‫ܸܨ‬஻௘௤௨௘௦௧ 4.2 Generation Skipping Transferring assets directly to the third generation or beyond may reduce transfer taxes (avoid layer of double taxation) ܴ݈݁ܽ‫݁ݑ݈ܽݒ ݁ݒ݅ݐ‬௚௘௡௘௥௔௧௜௢௡ ௌ௞௜௣௣௜௡௚ = ଵ ଵି்భ where ܶଵis tax rate on 1st generation Some jurisdictions discourage generation skipping transfer tax 4.3 Spousal Exemptions Allow decedents to make bequests & gifts to their spouses without transfer tax liability It is advisable to transfer the exclusion amount to someone other than the spouse ( the taxable value of the surviving spouse’s estate) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 10 4.4 Valuation Discounts Taxes might also be mitigated by transferring assets that qualify for valuation discounts Valuation discounts can be: Illiquidity discount Discount for lack of control 4.5 Deemed Dispositions Some counties treat bequests as deemed disposition (as if the property were sold) Tax is levied on the value of unrecognized gains 4.6 Charitable Gratuitous Transfers Two forms of tax relief: Most donations are not subject to a gift transfer tax Most jurisdictions permit income tax deductions Non-profit making organizations may also be exempt from taxation Relative after-tax future value: ‫ܸܨ‬஼௛௔௥௜௧௔௕௟௘ ீ௜௙௧ ൫1 + ‫ݎ‬௚ ൯ + ܶ௢௜ ሾ1 + ‫ݎ‬௘ ሺ1 − ‫ݐ‬௜௘ ሻሿ௡ ሺ1 − ܶ௘ ሻ = ሾ1 + ‫ݎ‬௘ ሺ1 − ‫ݐ‬௜௘ ሻሿ௡ ሺ1 − ܶ௘ ሻ ‫ܸܨ‬஻௘௤௨௘௦௧ Toi = tax rate on ordinary income ௡ ܴܸ஼௛௔௥௜௧௔௕௟௘ ீ௜௙௧ = ESTATE PLANNING TOOLS 5.1 Trusts An arrangement created by a settlor or granter who transfers assets to a trustee Trust document ⇒ document containing terms of the trust relationship Trusts can be used to reduce taxes, to protect assets & to retain control over assets even after transfer Categories of Trust Revocable Trust Settlor retain the rights & responsible for tax payment Creditor can claim trust assets Irrevocable Trust Fixed Trust Settlor has no ability to revoke the trust relationship Trust assets are protected against creditors’ claims Trustee pays tax Distributions to beneficiaries are prescribed in the trust document (amount & time) 5.2 Foundations Mostly act similar to trusts: Allow settlor’s wishes to follow after settlor’s death Asset protection Tax minimization Copyright © FinQuiz.com All rights reserved Discretionary Trust Trustee determines whether & how much to distribute 2018 Study Session # 4, Reading # 10 5.3 Life Insurance Policy holder transfer premium to an insurer who has a contractual obligation to pay death benefits to the beneficiary Death benefits & premium paid are tax exempt in most jurisdictions Also serve as a liquidity planning technique & offer asset protection Insurance policy can assign a discretionary trust (if beneficiaries are unable to manage the assets themselves) 5.4 Companies and Controlled Foreign Corporations Controlled foreign corporation (CFC) ⇒ a company located outside a tax payer’s home country (tax payer has a controlling interest) Benefits of placing income generating assets in CFC include: Tax Deferrals Tax avoidance CROSS-BORDER ESTATE PLANNING 6.2 Tax System Source jurisdiction or territorial tax system ⇒ country that taxes income as a source within its borders Residence jurisdiction ⇒ taxes based on residency Tax System 6.2.1 Taxation of Income Individuals subject to residence jurisdiction are taxed on their worldwide income Residency tests may consider subjective as well as objective standards 6.2.2 Taxation of Wealth and Wealth Transfers Source principle ⇒ tax assets that are economically sourced or transferred within a particular country Residence principle ⇒ imposes transfer tax on all assets transferred by donor 6.2.3 Exit Taxation Tax on unrealized gains accrued on assets leaving the jurisdiction May also include an income tax on income earned over a fixed period after expatriation called “shadow period” 6.3 Double Taxation Residence-residence conflict ⇒ two countries may claim residence of the same individual Source-source conflict ⇒ two counties may claim source jurisdiction of the same asset Residence –source conflict is most common source of double taxation Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 10 6.3.1 Foreign Tax Credit Provisions Residence-source conflict can be resolved using one or more of the following methods: Credit method ⇒ܶ஼ெ = ‫ ݔܽܯ‬ሾܶܽ‫ݔ‬௥௘௦௜ௗ௘௡௖௘ , ܶܽ‫ݔ‬௦௢௨௥௖௘ ሿ Exemption method ⇒ܶாெ = ܶܽ‫ݔ‬௦௢௨௥௖௘ Deduction method ⇒ܶ஽ெ = ܶܽ‫ݔ‬௥௘௦௜ௗ௘௡௖௘ + ܶܽ‫ݔ‬௦௢௨௥௖௘ − ܶܽ‫ݔ‬௥௘௦௜ௗ௘௡௖௘ ܶܽ‫ݔ‬௦௢௨௥௖௘ 6.3.2 Double Taxation Treaties Intended to facilitate international trade & investment by eliminating double taxation DTTs typically not resolve source-source conflict 6.4 Transparency and Offshore Banking Tax avoidance ⇒ legal tax minimizing or tax avoidance strategies Tax evasion ⇒ illegal means to circumvent tax obligation Copyright © FinQuiz.com All rights reserved  ... sustainability & requires core capital to generate same level of spending Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # 10 TRANSFERRING EXCESS CAPITAL 4.1 Lifetime Gifts... conflict is most common source of double taxation Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # 10 6 .3. 1 Foreign Tax Credit Provisions Residence-source conflict... reserved Discretionary Trust Trustee determines whether & how much to distribute 20 18 Study Session # 4, Reading # 10 5 .3 Life Insurance Policy holder transfer premium to an insurer who has a contractual