The IBA’s response to the war in Ukraine
Family holding structures in the US and Europe
Daniel Bader, Bär & Karrer, Zürich
Jacqueline Duval, K&L Gates, New York
Seth J Entin, Greenberg Traurig, Miami
Alex Jupp, Skadden, Arps, Slate, Meagher & Flom, London
Paolo Ludovici, Gatti Pavesi Bianchi Ludovici, Milan
Vadim Neumann, ZEDRA, Zürich
Tanja Schienke-Ohletz, Flick Gocke Schaumburg, Frankfurt am Main
Hanna Brozzo, Bär & Karrer, Zürich
The session chairs started by providing an overview on what a modern family office might typically look like and discussed some of the functions and characteristics of family offices in general. Based on a typical family office structure (base case), the panellists discussed current issues and structuring trends for domestic family wealth platforms in Germany, Italy, Switzerland, the United Kingdom and the United States, with added gloss offered on the use of Cayman Island trusts. Afterwards, the international aspects were looked at, in particular issues arising when relevant parties or beneficiaries move out of the jurisdiction of the family office. To conclude, the panellists considered issues related to philanthropy, being often a part of or connected with the family office structure and the family business.
The co-chairs Jacqueline Duval and Daniel Bader opened the session and introduced the panellists. Duval then showed a functional slide, showing a typical structure of a modern family office. Bader explained the structure. At the top, there are the family members investing in the holding company (through a trust, optionally). The holding company in turn holds the different assets, such as the operating companies (often the historical family business) and intermediate holding companies for all investments (such as real estate, PE, portfolio investments etc), typically with one separate intermediate holding for each investment category.
Duval added that in a large family office there is usually a separate entity in charge of the asset management. It employs professionals which are remunerated based on their performance. A first trend is that modern family offices act very much like private equity (PE) funds, but unlike a PE fund, family offices typically have no outside investors and are, therefore, very flexible in terms of the investment strategy (long term vs short term, reaction to developments etc).
Duval mentioned that she has observed a shift in the US lately. In an older model, typically there was a liquidity event, for example the sale of the family business. The family then had cash and hired third-party professionals to invest and manage the family wealth for many generations. Now there are often principals who created the wealth by being fund managers themselves and, being professionals in the relevant field, they want to continue to manage the assets themselves instead of hiring third-party managers.
Base case: domestic family holding structure
The panellists started by further discussing the base case, a purely domestic family holding structure. As the first US topic, Duval explained that investment expenses borne by family members are considered as personal expenses, which are not deductible for tax purposes. Duval elaborated that there are ways to create deductibility and presented the ‘lender management case’ in which a family took the position that the family office, which was run in the form of a limited liability company (LLC), was engaged in a trade or business and that all expenses they had were therefore deductible. They won the case. This result was obtained using the following structure: instead of having 100 per cent of the investment income paid to the family members, who in turn paid fees of five per cent to the family office, the family members only received 95 per cent of the investment income and five per cent was directly allocated as carried interest (so called ‘carry’) to the family office. To make the argument on deductibility stronger, a corporation (always deemed to have a trade or business) can be used instead of an LLC. The downside is that a corporation is subject to corporate income tax. A challenge regarding structures with remuneration in the form of carry is the dependency on the investment income, which does not flow regularly and might sometimes involve amounts that are too little or too much. Preferred allocations can help to create a steady cashflow for the family office.
Secondly, Duval touched on a regulatory topic. Parties compensated for investment advice need to be registered in the US. There is an exemption for family offices. However, it only applies if all of the clients receiving investment advice are family clients. The following groups qualify for the exemption:
- family members, up or down ten generations;
- employees of the family office; and
- charitable entities that are exclusively funded by family members. However, as soon as a third party donates as much as one dollar, the exemption does not apply.
Bader took up the case of a family member being a successful investment advisor and explained that the ideal Swiss approach would be for the individual to hold their personal assets directly. This would allow for the generation of capital gains which, in principle, are tax free in Switzerland. However, this is often not possible in reality. If a person manages their assets in a professional way, this is qualified as business activity. Capital gains then qualify as employment income, which is taxable and subject to social security contributions. To protect against the risk of being qualified as a professional, it is common to set-up an investment holding company. Usually, after some time, the structure evolves and different kinds of assets are separated and held in separate entities.
Bader also commented on the topic of deduction of fees from a Swiss perspective. No workaround concerning the carry model is required. Rather, it is typical to set-up a separate service company which hires the asset managers. The service company is remunerated out of the different ‘asset boxes’, where the payments are deductible as expenses.
To conclude, Bader also addressed regulatory requirements. Switzerland has an exemption from the licence requirements in pure family situations. However, as soon as a third party is to be involved in a family office set-up, for example a friend, the regulatory rules kick in.
Tanja Schienke-Ohletz shed light on the situation in Germany, where generally three different structuring options exist for family offices. The choice of option depends on where the assets come from.
The first option is a German limited liability company (GmbH) holding corporation, which is often used as an investment vehicle after a liquidity event (the sale of a family business via the holding company). The holding structure has tax benefits. At company level, the tax is 30 per cent (15 per cent corporate tax and 15 per cent business tax). For distributions, a flat tax of 26 per cent applies. If the parents want to involve the next generation in the structure during their lifetime, this can easily be conducted by gifting shares. There are different possibilities to keep the control at the level of the parents, such as non-voting shares for the children or so-called golden shares for the parents. Another option is the usufruct, which is a completed gift of the shares to the children with the legal property already being passed on to the next generation, while the parents keep the right of use. Later, when the parents die, the usufruct is automatically terminated and there is no applicable taxable event anymore.
A second structuring option is the partnership, typically in the form of a GmbH & Co KG, having a corporation as general partner and the family members as limited partners. Minor children can participate as limited partners and the parents can control the structure over the corporation. For tax purposes, corporations and partnerships are basically the same.
The third structuring option is the family foundation. It is seen more often now and can be deemed as a trend. Due to a recent reform to civil law, the family foundation has become more flexible. However, since the transfer of assets to the foundation is subject to gift tax, it has to be analysed carefully whether the advantages of a foundation structure outweigh the tax consequences. Under certain conditions, it is possible to transfer business assets to the foundation by making use of a gift tax exemption. As for the structure, the founder is allowed to be on the management board and a beneficiary of the foundation at the same time. Other family members can be deprived of possibilities to influence the foundation if they are only beneficiaries receiving distributions, but do not have a say. The family foundation can benefit from an attractive tax rate of 15 per cent for non-business income. Distributions are taxable at 26 per cent in the hands of the beneficiaries. A particularity of German family foundations is that every 30 years, the assets held by the foundation are subject to inheritance tax. Therefore, often German clients use foreign foundations, for example the Liechtenstein foundation, to avoid the recurring inheritance tax burden.
To conclude, Schienke-Ohletz mentioned certain regulatory matters. The situation is the same as in the US and Switzerland. An exemption applies if only family members are involved.
Alex Jupp presented the situation in the UK, where two main structures for family wealth management exist, namely the family investment company (FIC) and the family office (FO). The choice of structure depends on the activity.
The FIC is typically only set-up in purely domestic situations. It makes almost no sense to establish an FIC, which is not a UK tax resident, as there are so many traps. Jupp mentioned that the investment entity in an FIC set-up does not necessarily have to be a company. It can also be, for example, a partnership or a trust, etc. It really depends on how the family wants to organise the structure. There is no single structure that fits all. In the UK, there is currently a fair amount of senior investment professionals who come from the asset management industry. They often use a partnership as a family office advisory company, which has advantages, for example the possibility for the payment of carry instead of remuneration.
Jupp explained that there are no special tax regimes for family offices. The general corporate and individual taxation applies. An advantageous aspect is that there is no wealth tax in the UK.
As a final comment, Jupp pointed out that there is quite a lot of public disclosure required in the UK. For example, persons in control, non-UK participants etc, have to be registered and disclosed.
To start, Paolo Ludovici pointed out that there is no clear definition of the term family office in Italy and that his focus would be on single family offices, ie, a family that had a liquidity event and wants to invest the money.
Firstly, Ludovici discussed structuring scenarios for a person who is subject to the Italian flat tax regime, showing a slide with three possible scenarios:
- In case A, after a liquidity event, the individual hires ten people to manage their assets, which are held directly by the individual. The income would be deemed as business income of the individual and as such would no longer fall under the flat tax regime. As soon as people are hired in Italy for asset management, all income derived in this context becomes taxable as business income in Italy.
- In case B the individual sets up a holding company which hires employees. Also in this case, the income is business income at company level.
- In case C, the individual holds the assets directly and sets up a family office, which manages assets held by the individual. In this situation, generally, the income still qualifies as business income. However, according to a ruling obtained by Ludovici, if the family office is set-up outside of Italy and managed there, the income does not qualify as business income, provided that the managers are remunerated at arm’s length. In that situation, for the individual subject to the flat tax regime the income falls under the beneficial flat tax regime.
Ludovici then commented on the typical structure for Italian family offices. Different investments are often held in different ways, as follows:
- direct investments are typically for startups, venture capital investments or investments eligible for the 26 per cent tax rate (or lower);
- a holding company is mainly used for investments eligible for the participation exemption, investments whose proceeds would be subject to full taxation at progressive rates if made by individuals and certain leverage investments;
- the non-commercial general partnership (società semplice) is helpful for investments in residential real estate directly used by family members, works of art or financial investments whose proceeds are taxed at the 26 per cent rate at the level of the individuals.
Ludovici touched on further aspects. He mentioned legislation which allows full tax exemption for the transfer of company shares to heirs if they keep the ownership for at least five years, provided that the company is engaged in a business activity.
As an important non-tax aspect, Ludovici said that for asset protection, it can make sense to split a company that has a holding part and a business part into two companies, one for the holding activity and one for the business activity.
Use of private trust companies
Vadim Neumann provided some insights from a trustee service provider perspective. He introduced the concept of private trust company (PTC) and explained why they can be beneficial for high net worth (HNW) families:
- A PTC is a limited company with the sole purpose of acting as a trustee for a specific (often discretionary) trust. A registered PTC can be established in one to two weeks. This is much quicker than establishing a trust company with a restricted trust licence.
- The shareholder of a PTC is usually a special purpose trust, in the Cayman Islands often a STAR Trust. By using a STAR Trust to hold the shares in the PTC, it is possible to create a corporate trustee whose shares are not owned by a physical person. This can facilitate the PTC acting as trustee for a trust or trusts, compliant with the local regulations.
- Neumann mentioned the advantages of a Cayman PTC, being control (the PTC allows the settlors to retain an element of control over the trust’s assets and management), flexibility (PTCs can be customised to meet the unique needs of the settlor and beneficiaries), privacy (there is a high level of confidentiality in the Cayman Islands) and tax efficiency (the favourable tax environment in the Cayman Islands with no income, capital gains or inheritance taxes).
Neumann then presented a structure with a PTC, which he described as the most complex situation he has ever seen, but which basically combined all the elements a family can wish for. He further explained that the Swiss connection with PTC structures is often that clients want all points of contact to be in one country and often choose Swiss providers (asset manager, bank, trustee, etc). There can also be both Cayman and Swiss directors at the same time. Neumann pointed out that the board of directors of the PTC can have different committees, such as an investment committee, an advisory committee etc. The family members can be parties to the committees and retain ultimate control and power over the structure.
Seth Entin commented on Neumann’s PTC structure from a US perspective. He explained that the structure would not have adverse consequences for US beneficiaries as long as the trust was qualified as a foreign grantor trust, ie, set-up and controlled by non-US family members. However, if the trust becomes a non-grantor trust and is considered as a separate entity, there could be adverse tax consequences for US beneficiaries.
Duval introduced the next topic, namely international aspects of family offices.
Entin commented on the international aspects from a US perspective. He said that the first question to be asked is whether a family office in the US gives rise to taxation in the US. Unlike in many other jurisdictions, companies managed in the US do not per se give rise to US taxation. Only the place of incorporation is decisive. The second question to ask is whether the activity qualifies as US trade or business. The general rule is that pure investment or administration activities do not give rise to US trade or business. Lending activities, on the other hand, almost certainly qualify as trading business and trigger US tax consequences.
Entin further pointed out that in connection with multinational families, attention has to be paid to shield non-US family members from US estate tax, which is 40 per cent of the fair market value of the US situs assets. This can be conducted by using non-US corporations as a blocker. Furthermore, the structure should be organised in a way that obtains tax benefits available to non-US persons. Additionally, double US taxation can be minimised when using US corporations (typically for US business activities or the ownership of US real estate).
Entin noted that in multinational families with US and non-US family members one has to be aware that what is good for non-US family members might not be good for US family members and vice versa. For example, non-US Cayman hedge fund products can be beneficial for non-US family members, but can have adverse US income tax consequences for US family members.
When passing assets to junior US family members, one should aim to obtain a step-up for the tax basis. With proper planning, it is also possible to set-up structures where the non-US senior family members are protected from US estate tax at their death. However, once the assets pass into the pockets of US family members, they will be subject to US estate tax of 40 per cent when they die. Typically, it is therefore beneficial if assets pass from non-US family members into a trust structure in order to keep them separate from the personal estates of US family members.
Bader continued with Swiss international aspects and mentioned that in almost all Swiss cantons no estate or gift tax applies when assets are transferred from a Swiss tax resident to the spouse or descendants. Hence, from a Swiss perspective, there is usually no need to set-up structures with trusts etc, as such estate planning can simply be carried out as part of the last will. However, in international situations, it is important to take into consideration the estate tax systems in other countries, which often make the situation complicated and requires further planning.
Bader pointed out that Switzerland does not have exit taxation for individuals. Family members can easily move out of Switzerland. However, if companies are moved, an exit tax applies.
To conclude, Bader mentioned the Swiss concept of place of effective management. In connection with foreign structures, it is important to make sure that companies are not effectively managed out of Switzerland. In Bader’s view, this is currently one of the hottest topics at the moment. If a company is managed out of Switzerland, the company itself can become a Swiss tax subject and, maybe even more importantly, distributions by such a company become subject to Swiss withholding tax.
Schienke-Ohletz explained that Germany has an exit tax for individuals. Before 2021, a tax deferral was possible if the relocation occurred within the European Union (EU). As of 2022, regardless of whether the relocation is within the EU or not, the exit tax is triggered if a shareholder with a participation of at least one per cent leaves Germany. The only deferral still available is a payment of the tax in seven instalments over seven years. However, there are no further benefits and a guarantee is usually required in such cases.
The exit tax is not triggered if Germany continues to have a taxation right and the different options to obtain that result were explained. Furthermore, she mentioned that if managers of German companies or foundations move away, there is a risk that a permanent establishment (PE) is established in another country triggering tax consequences there. Generally, tax consequences due to relocations out of Germany need to be analysed very carefully.
Jupp explained that the historic non-dom regime is still in existence. It allows for the non-taxation of non-UK situs assets as long as they are not brought into the UK. For estate planning purposes, it is important to consider that an individual under the non-dom regime can still qualify as ‘deemed domiciled’ for UK estate tax purposes. In this case, the UK estate tax of up to 40 per cent applies on worldwide assets. Therefore, pre-entry planning by international people coming to the UK for a long time is essential.
As a more recent development, Jupp pointed out that shares in UK corporations are UK situs assets, which are taxable for persons under the non-dom regime. Until last year, one technique to avoid taxation was that a non-dom person holding shares in a UK company changed the shares into shares of a non-UK company. This qualified as a tax-free reorganisation. However, this work around does not apply anymore. Since November 2022, such a swap triggers taxation of capital gains. That said, currently it is not yet subject to estate tax.
Ludovici pointed out that as a general rule, Italian holding companies or società semplice with non-resident shareholders/members are not a good idea, since they can lead to adverse tax consequences in Italy.
He mentioned that it is important to carry out planning prior to the relocation when international individuals move to Italy. A typical situation is a person coming from the US. The person can set-up an Italian company and assets can be transferred to the company against a shareholder loan. This is a non-taxable event in the US. In Italy, it is then possible to obtain a step-up at company level. Furthermore, after the relocation, tax-free distributions can be made out of the company as repayment of the shareholder loan.
Another situation Ludovici mentioned is an individual leaving Italy. There is no exit tax for individuals and non-business entities and partnerships. However, there is an exit tax for companies.
Ludovici pointed out that in family situations, instead of having to adjust the structure retroactively, it is important to plan proactively. For example, if there are four children, it might make sense to set-up four trusts, one for each child. This allows more flexibility to consider the individual situation of each child.
Duval moved to philanthropy as the last important topic. All panellists were asked to briefly comment on trends in this field in their jurisdiction.
Duval started with the US and explained that a current trend is so-called ‘impact investing’. Returns might be lower than in other traditional investments, but they provide the ability to invest and do good at the same time.
On the other side of the coin, there are private foundations which make investments. As long as the investment by such foundation has a direct connection to a charitable purpose, the return from the investments can be counted against the five per cent minimum distribution and they do not qualify as ‘risky investments’ under the rules that require private foundations to invest prudently.
Another trend is highlighted by the example of the founders of Patagonia, who basically gifted the returns from the operating company to the charitable entity. In this particular case, the family still retained control over the operating company.
Bader commented on the situation in Switzerland and pointed out that in connection with philanthropy there are several points to consider. He mentioned that there can be regulatory issues if the same persons manage the family assets and the assets of the charitable entity. Another important aspect to consider is that one has to be aware that what qualifies as a charity in one jurisdiction does not necessarily qualify as charity in another jurisdiction. This can, for example, be relevant when trying to obtain a tax exemption. As a last issue, Bader mentioned that often no tax deductions can be claimed for cross-border donations made to charities. Rather, it is often necessary to select a charity in the jurisdiction of the individual or company making the donations in order to be able to claim tax deductions.
Schienke-Ohletz explained that in Germany there are mainly two forms for charitable entities, the charitable foundation and the charitable corporation. The corporation is easier to handle, as it is much more flexible and it can be dissolved anytime. Nevertheless, due to the civil law reform previously mentioned, the trend currently is towards charitable foundations.
Schienke-Ohletz said that charitable foundations have to consider that they need to maintain their capital and must generate revenue to pursue their charitable purpose. If they venture into alternative investments or impact investments, they have to carefully check whether the relevant investment is really possible for them and whether they can derive revenue from it.
Entin pointed out that charitable deductions to non-US charities are not allowed for individuals, unless there is a treaty in place, such as with Canada. When it comes to deductions by US foundations, the rules are less strict. A charitable US trust or US foundation can make distributions to foreign entities under certain conditions.
Jupp said that generally the situation is similar to the US. He further mentioned that Brexit has allowed the UK to restrict deductibility of donations, which are generally only allowed if made to UK charities. A trend that can currently be noted in the UK is that the second or third generation of a family often prefers to invest a part of their time in good causes instead of money.
Ludovici observed that things are generally changing in the field of philanthropy. It used to be a ‘girls’ thing while business was a ‘boys’ thing. Now, philanthropy is more often considered to be a fully valued part of the business. Generally, he has observed that philanthropic investments are more effective if they are made locally and have a close link to the business.