External Threats To Middle Eastern Family Business

Common flaws in family business legal structures in the Middle East and the resulting risks

Middle Eastern family business legal structures often reflect serious and potentially catastrophic weaknesses through failure to shield and protect the founder and the core assets from serious external threats to the business like legal risks.

There is a strange paradox associated with Middle Eastern businesses. On the one hand, family businesses are the real strength and spine of the Middle Eastern economies. Alongside sovereign enterprises, family businesses dominate the business landscape. On the other hand, close examination of particular Middle Eastern family businesses, even very large ones, frequently reveals frailties and fault lines which expose them to external threats and business risks; and to far less visible threats from the inside.

In many cases these weaknesses will not be obvious to the outside observer, or even to the families themselves.

External Threats

Typically, Middle Eastern family businesses are highly diversified and have many compartments. Unfortunately, the famous 1912 shipwreck the RMS Titanic also had many compartments – but because those compartments were not totally sealed and separated the Titanic sank to the bottom of the ocean when the ship tilted and the rushing waters flooded over the dividing walls into every compartment.

The typical Middle Eastern family business is completely exposed to a disaster in one compartment of the business spreading to the other compartments. Why? The answer is that there are serious weaknesses evident in the most commonly used family business structures, e.g:

businesses are often set up as sole establishments owned by an individual within the family (often the founder) therefore one catastrophe (e.g. a fire in a large building owned by the founder himself) carries financial consequences and exposures directly to the core of the family’s asset base;
many families operate an array of businesses through registering multiple branches of a family “mother company”, a shoddy structure design. Taking this cheap and convenient shortcut means that every liability of every branch is a direct liability of the core mother company (usually the company which owns all the major assets);
failure to have a coherent corporate structure often leads to the twin evils of reliance on borrowings secured by personal guarantees and a failure to track and identify adequately the performance or losses of individual businesses within the family’s portfolio.

For the above reasons, many family businesses in the Middle Eastern inhabit glass villas – and any major hailstorm will prove catastrophic.

What Can Families Do?

Good legal advice can help families. For example:

create a corporate legal structure for the family which has watertight compartments;
isolate “blue chip” investment assets from entities carrying on trading enterprises with business risks and borrowings;
create a corporate legal structure which is both bankable and “deal friendly”;

Conclusion

Many Middle Eastern families run enormously successful and growing enterprises, using “cutting edge” business models and technology. Yet, all too often their legal infrastructure is shoddy, creaky, rusty and dangerous. It is high time families overhauled their legal infrastructure, before a setback in one compartment sinks the entire ship

Note: An extended version of this article was first published in “The Oath”, the Middle East Law Journal for Corporates in May 2014. https://www.linkedin.com/in/gary-watts/?originalSubdomain=au

Liechtenstein foundations and trusts for asset protection and wealth preservation

What benefits do Liechtenstein foundations and trusts offer for asset protection and wealth preservation?

Some of us are in a fortunate position where asset protection and wealth preservation are not much of a concern because we live in countries where corruption is rare, governments are relatively stable and creditworthy, courts and governmental authorities are efficient, crime rates are low and chances that illegitimate claims will be enforced against our assets are remote.

For people living in a country where one or more of these factors are missing, however, the danger to their assets may be real and the fear that their wealth may fall into the hands of others without justification may be well-founded. For those who are legitimately concerned about asset protection and wealth preservation, Liechtenstein foundations and trusts offer distinct advantages which will be described below.

Liechtenstein foundations

Let there be no mistake: Liechtenstein provides legal assistance in criminal matters to other countries and has entered into treaties allowing the exchange of information in tax matters with an increasing number of jurisdictions. Furthermore, the creditors of a founder or settlor of a Liechtenstein foundations or trust are not without protection under Liechtenstein law: any gratuitous transfers to a trust or foundation may be challenged by creditors of the founder/settlor within one year from the transfer. If such creditors can prove intent of the founder/settlor to defraud creditors, the statute of limitations is five years.

However, for those who are looking for a safe haven for their assets without any pressure from existing creditors and want to structure their wealth in a tax-compliant way, Liechtenstein foundations and trusts offer the following advantages:

(1) Protection of privacy

In case of Liechtenstein (private) foundations, registration in the trade registry is voluntary. Even if a private foundation is registered, the identity of the founder or the beneficiaries is not disclosed. The names of the foundation council, however, are mentioned.

In case of Liechtenstein trusts, there is a registration requirement (mainly to ensure the payment of the annual tax of CHF 1,200), but this registration does not include the names of the settlor or beneficiaries.

(2) No pre-trial discovery proceedings

In contrast to a number of jurisdictions, in case of pending or threatened litigation there is no duty to disclose documents to the adversary. The only documents that may need to be disclosed upon a court order in the course of litigation are documents so-called “common documents” of the plaintiff and defendant, such as written contracts between them, or other contracts where there is a preexisting obligation to disclose them.

(3) No enforcement of foreign judgments

Liechtenstein does not enforce foreign judgments without a re-litigation on the merits unless there is an enforcement treaty (or other binding declaration) in place with the country whose courts rendered the judgment. This distinguishes Liechtenstein from a large number of jurisdictions, in particular those influenced by common-law, which often enforce foreign judgments if they were rendered in fair proceedings. Other jurisdictions only enforce foreign judgments if the other country would do the same, but have a presumption of such reciprocity.

So far Liechtenstein has only concluded enforcement treaties with Switzerland and Austria and a multilateral convention on the mutual enforcement of certain child support judgments. Liechtenstein is not a member to the Lugano Convention on Jurisdiction and the Enforcement of Judgments, and EC Regulation 44/2001 on jurisdiction and the recognition and enforcement of judgments does not apply.

In the absence of an enforcement treaty, foreign judgments may be used by a plaintiff to obtain a preliminary court order in Liechtenstein. However, the defendant may bring legal action against such a preliminary order so that the dispute will need to be re-litigated in Liechtenstein in any event.

(4) Short statute of limitations for a challenge of the transfer of assets to the foundation

In order to protect creditors, any gratuitous transfers to a trust or foundation may be challenged by creditors of the founder/settlor within one year from the transfer. The statute of limitations for transfers to the foundation/trust is five years from the transfer of assets to the trust or foundation if creditors can prove intent of the founder/settlor to defraud them.

After the expiry of these deadlines, no challenges of the transfer of assets to the foundation or trust are possible under Liechtenstein law, provided that the Liechtenstein foundation/trust is structured appropriately. In particular, decisions must be taken by the foundation council/trustee, and the foundation should not be seen as the alter ego of the settlor/founder or the beneficiaries.

(5) No attachment of the interest of beneficiaries

Both, Liechtenstein foundation and trust law, grant considerable flexibility when it comes to the determination of the rights of the beneficiaries in the trust or foundation documents. However, when asset protection is a concern, in many cases a discretionary structure with several possible beneficiaries is preferable where distributions of the capital or income of the foundation or trust are left to the discretion of the foundation council/trustee. This will ensure that there are no legal claims of the beneficiaries that can be attached by third parties.

Taxation of Liechtenstein trusts and foundations

Liechtenstein trusts are subject to an annual tax of CHF 1,200. Liechtenstein foundations may apply for the tax status of a “Private Asset Structure”, provided that they only hold private wealth and do not engage in economic activities. A foundation taxes as such a Private Asset Structure is only liable to pay the minimum annual profit tax of CHF 1,200, and no tax filing needs to be made.

However, even without this special tax status, certain types of income, including all dividends and capital gains from participations and any revenue from foreign real estate are exempt from the otherwise applicable 12.5% profit tax. In case of a foundation which only holds the shares of a holding company, it may therefore not be worthwhile to seek the status of a Private Asset Structure because any dividends and capital gains from the participation will be tax exempt even under regular taxation.

Besides the taxation in Liechtenstein, in each case the tax consequences of the establishment of the trust/foundation and any distributions from the trust/ foundation in the jurisdictions of the settlor and the beneficiaries need to be considered carefully with the assistance of local advisers. https://www.marxerpartner.com/

Markus Summer

Marxer & Partner

 

Outbound investments from China

For Chinese individuals making outbound investments, overcoming the obstacles from the aspects of regulatory and foreign exchange control becomes a priority.

As China is now the second largest economy in the world and produces millionaires and billionaires faster than any other country every year, going abroad and investing overseas has become increasingly attractive for Chinese individuals.

While many Chinese high net worth individuals are emigrating from China to other countries such as the US, Canada, the UK, Australia, and Singapore every year, and while the Chinese tourists are now the biggest customer group of luxury goods in Europe, investing overseas by Chinese individuals is still a mission impossible. For example, a Chinese individual cannot remit out cash of more than USD 50,000 a year even for buying a home. In addition to the difficulty in moving money offshore, investing overseas by Chinese individuals requires strict government approval, for which amazingly no clear rules have been issued so far.

Regulatory Approval Requirement for Outbound Investments

From a legal perspective, investment overseas by Chinese individuals mainly involves two big issues – the regulatory approval requirement and the foreign exchange control restriction.

In 2004, the National Development and Reform Commission (the “NDRC”) issued the “Interim Measures for the Administration of Verification and Approval of Overseas Investment Projects” (the “Measures”). The Measures primarily apply to Chinese enterprises. However, Article 26 of the Measures states that “with regard to the verification and approval of a project carried out by an individual or other organization, these Measures shall apply as the reference”.

With that, it seems that the examination and approval procedures for overseas investments by individuals shall be the same as that applicable to Chinese enterprises. However, in practice, this has not been tested so far and we are not aware of any case where a Chinese individual has successfully gone through such approval procedures.

Furthermore, after getting the NDRC approval, an investor needs to get one more round of approval from the Ministry of Commerce (the “MOC”). However, the “Measures for the Administration of Overseas Investment” issued in 2009 by the MOC only set out the specific approval procedures for Chinese enterprises, without any specific references to offshore investments by Chinese individuals. Following the common legal practice in China, no rules usually means not allowed. As a result, the MOC will simply not accept an application for approval for overseas investments by Chinese individuals.

Foreign Exchange Control

The foreign currency used for overseas investments by Chinese individuals is deemed as for capital use, which is currently under strict control. Although the existing foreign exchange control rules seem to allow that overall, there are no operating rules setting out whether and how individuals can apply to the relevant authorities for remitting out cash of more than USD 50,000 every year.

In practice, the foreign exchange authorities will simply use this as a reason for turning down such a request. The annual quota of USD 50,000 is stipulated in the “Administrative Measures for Personal Foreign Exchange”. As such, Chinese individuals often find it impossible to obtain the foreign exchange approval for overseas investments.

How to Get around Those Obstacles

Among many creative ways for getting around the legal obstacles mentioned above, the more straightforward way is for a Chinese individual to use a Chinese company as the investment vehicle. This is allowed although various government approval and registration procedures have to be followed. This structure may have a tradeoff from a Chinese tax perspective though, because it adds one more layer of Chinese tax.

For example, if an individual directly invests in a HK company and sells the HK company later on, the capital gains will be subject to a 20% Chinese individual income tax. If the individual invests in HK company through a Chinese company, the same capital gains will be first taxed at 25% at the Chinese company level and further taxed at 20% at the individual shareholder level (i.e. at an effective tax rate of 40%).

Another way is for a Chinese individual to form an offshore company in one of the traditional offshore financial centers such as the BVI, the Cayman Island and HK and use transfer pricing techniques to move cash from China to that offshore company. For example, the individual may arrange for a Chinese company he or she owns to export products to a HK related company at a relatively low price, which will then sell such products to a third party at a high price. This obviously creates a tax issue as transfer pricing between two related parties is always subject to scrutiny. However, many Chinese individuals tend to ignore such a risk.

A third way is to use a bank product that is called “security onshore and lending offshore” to get a loan overseas. A simple description of that product is that a Chinese individual will arrange for a Chinese company that he or she owns to place a security with a bank in China, which will then instruct an overseas branch to grant a loan to an overseas related party of the Chinese company. Technically speaking, the Chinese company must own the overseas company. In practice, this requirement is not always followed by banks.

Other than those ways of moving cash offshore, which are technically legal, there are other alternatives. But most of those alternatives are within the grey area and some even directly violate the Chinese foreign exchange rules. One example is to move cash offshore by using an underground fund remittance agency. https://www.zhonglun.com/

Why Chinese HNWIs wishing to establish offshore trusts should act now?

Chinese HNWIs should act now as China may introduce a tax reform with the new estate tax, exit tax on emigration and adopt new rules to tax the contribution of appreciated assets into an offshore trust.

Chinese high net worth individuals (“HNWIs”) are very interested in using offshore trust for wealth planning because of the unique benefits offshore trusts offer and also due to the fact that Chinese domestic trusts are not suitable for wealth planning. As to the timing, we think Chinese HNWIs should act now so that they could avoid the adverse consequences caused by the next wave of Chinese tax reform.

China may introduce estate tax soon

Estate tax has suddenly become a very hot topic in China recently. There has been a lot of media coverage on this over the past few months. In 2004 the Ministry of Finance issued a draft of the Provisional Regulations on Chinese Estate Tax for public comments. Although the draft was revised again in 2010, it had never become law.

The introduction of estate tax was then repeatedly mentioned as a medium term goal in several important resolutions on reform adopted by the central government over the past few years. There were even rumors earlier this year that Shenzhen would become the first city to introduce estate tax on a pilot basis, which caused widespread panic among local residents, but those rumors turned out to be a false alarm.

Why estate tax has suddenly become a media focus is the natural result of the widespread frustration and anxiety among Chinese people about the increasing income disparity between the rich and the poor. The people who are in favor of estate tax argue that estate tax can significantly help to solve this income disparity issue.

However, the opponents take the view that it is simply too early to introduce such tax in China because China doesn’t even have the required basic infrastructure for collecting and administrating such tax (e.g. a nationwide asset registration system and a reliable asset valuation system), let alone certain key technical issues that would need great wisdom to figure out the answers for, such as the exemption amount, the tax rate, etc..

Despite of those hurdles such as the infrastructure and the difficulties in working out those technical issues, in my personal view, because generating additional tax revenue from estate tax is not a top goal for China (at least not yet), the timing for the introduction of estate tax in China would mainly depend on whether and how quickly China can have good control over the income disparity issue. If China fails to do so, estate tax may arrive much earlier than people would anticipate.

Needless to say, if China introduces estate tax, it will automatically introduce gift tax. So for those who think they could get around with the estate tax by giving wealth to their children or other family members as gift should think again.

China may also introduce exit tax on emigration

Many countries impose an exit tax on persons who cease to be tax residents in those countries. This often takes the form of a capital gains tax against unrealized gain attributable to the period in which the taxpayer was a tax resident of the country in question. Exit tax can be assessed upon change of domicile, habitual residence or citizenship.

China also taxes its tax residents on worldwide income, but nonresidents are taxed only on China sourced income. So if a Chinese individual becomes a nonresident from a resident, under current Chinese tax rules, the person will no longer need to pay Chinese tax on non-China sourced income, even if the income represents the unrealized capital gains attributable to the period when the person was still a Chinese tax resident. The change of such tax residency often takes place when the person emigrates from China to another country.

We may see a change to such rules soon if the current emigration wave continues to rise. Although there is no official study confirming this, China is now the largest emigrant source country in the world. While the emigration is generally not Chinese tax-driven, it will be just a matter of time before the Chinese tax authorities realize the resulting permanent tax revenue loss. At that time, the introduction of exit tax would likely be inevitable.

China may adopt new rules to tax the contribution of appreciated assets into offshore trusts

China currently doesn’t have any specific tax rules on trust. As a result, in the case of offshore trust, when a Chinese settlor contributes appreciated assets (e.g. company shares) into a trust, people generally would take a position that the contribution should not give rise to any Chinese tax. If such appreciated assets are offshore assets, when they are disposed of by the trustee, no Chinese tax would apply because the trustee is not a Chinese tax resident.

If the trustee distributes such income to the beneficiary or beneficiaries, under current Chinese individual income tax rules, another position could be generally taken that the distribution should be considered gift and thus not taxable in China. In other words, the use of offshore trust could minimize the Chinese tax that the settlor should have paid if he or she disposed of such assets directly. The current capital gains tax rate for individuals is 20%.

China will soon reform its individual income tax law. The trust taxation rules will certainly be part of the reform and it won’t be too difficult for the Chinese tax authorities to detect the loophole mentioned above. Or they may fix it earlier simply by introducing a deemed sale rule or a general anti-avoidance rule. https://www.zhonglun.com/en/

Legal and Tax restraints for Chinese HNWI Offshore trusts

Issues arising from setting up an offshore trust for a Chinese HNWI include the recognition of the trust itself and other legal and tax constraints.

As more Chinese HNWIs have realized the unique benefits of offshore trust, especially in the areas of asset protection and succession planning, the number of Chinese HNWIs using offshore trust for wealth planning is increasing fast. However, setting up an offshore trust for a Chinese HNWI can be a complex task due to the Chinese legal and tax constrains.

The recognition of offshore trust in China

The first big question about offshore trust is always whether it is even legally recognized in China. Offshore trust is not specifically recognized by any of the written laws including the Chinese Trust Law. There is also no court case providing any guidance or clarification. However, just like that offshore holding companies are recognized in China, the general understanding based on the Chinese legal principles is that offshore trust should be recognized in China if it meets all the legal requirements in the jurisdiction where the foreign trust is formed.

The community property issue

Under the Chinese Marriage Law, the property obtained by a couple or either spouse during their marriage period is generally considered community property. Community property is jointly held by both the husband and the wife, which means that, even if only a small portion of the community property is disposed of by one spouse without the consent of the other spouse, such a transfer would be invalid. There are already enough court cases in China enforcing such rules.

As such, securing the consent of the other spouse is the essential precondition for contributing community property by one spouse to an offshore trust. Without such consent, the contribution could be held invalid under Chinese law (assuming China has the jurisdiction), which means the relevant assets may thus need to be returned by the trustee. This issue normally arises when a husband sets up an offshore trust for the benefit of his second family or when he intends to hide assets from divorce.

A related issue is when the consent of the other spouse is not obtained, whether the trustee shall have any liability. This issue will most likely come up when the trust assets are ordered by a Chinese court to be returned to the couple but the value of such assets under the trustee’s management has decreased significantly. Although there is no clear rule in China and there hasn’t been any court case in China providing any guidance, the answer to that question would likely depend on whether the trustee has acted with malice. Unfortunately, the term “malice” is not defined by Chinese law in the trust context. Trustees thus should exercise enough caution before taking on the trustee role.

The regulatory restrictions on putting assets into an offshore trust

Dependent on the location and type of the asset, there could be Chinese regulatory restrictions on contributing such assets to an offshore trust. For offshore assets, there is generally no Chinese regulatory restriction on the contribution of such assets to an offshore trust. If those assets are onshore assets, the contribution of such assets to an offshore trust is extremely difficult under the Chinese foreign exchange control rules, banking rules, foreign investment rules, and outbound investment rules.

For example, a Chinese individual is legally allowed to remit out only USD 50,000 annually. Another example is that a foreign entity (e.g. a trust company) is not allowed to own real property in China unless it is for self-use (e.g. used as office space for its Chinese representative office). As a result, the offshore trusts we have seen typically do not directly own onshore assets.

The uncertain tax treatment of an offshore trust

There are no specific tax rules on either domestic or offshore trust. By applying the existing general tax rules, until specific rules on trust come out, one could argue that technically a settlor would not be taxed on the contribution of assets to an offshore trust even if such assets have appreciated in the hands of the settlor.

Also, a Chinese non-settlor beneficiary would not be taxed on trust distributions as China doesn’t tax gift income yet. Lastly, the trustee would not be taxed on accepting or holding the trust property as long as it is a non-Chinese entity and operates outside China. However, whether such technical analysis could be respected by the Chinese tax authorities is an open question as, to our knowledge, there hasn’t been any actual administrative case on this.

The uncertainty regarding the withholding and reporting obligations of the trustee

While the existing Chinese anti-avoidance rules apply to enterprises, not individuals, they could come into play in the offshore trust context, especially when a special purpose holding company is formed underneath the trustee and controlled by the Chinese settlor. In that case, the SPV could be considered a Chinese tax resident if it is considered effectively managed in China. If so, the SPV would be subject to Chinese income tax on its worldwide income and need to file a tax return in China.

Even if the SPV is not considered a Chinese tax resident, if the trust property is Red Chip company shares, there could still be a technical requirement under Circular 698 that any transfer of the SPV should be disclosed to the Chinese tax authorities through an information filing. Failure to comply with this reporting requirement would be subject to a fine. In practice, a number of foreign trustee companies are reluctant to follow this rule because they take a position that such Red Chip companies are formed with bond fide business purposes. However, whether the SAT would respect this position has not been tested up till now. https://www.zhonglun.com/

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