Offshore hedge funds
The term ‘hedge fund’ is used to describe a type
of investment organisation that invests money
according to a selected strategy with the intention of
providing high returns for investors. The expectation
of making high returns is often dependent on two
factors: the nature of the investment strategy of
the hedge fund managers and also the use of large
amounts of debt capital (‘high leverage’) in addition
to the equity capital provided by the fund investors.
An offshore hedge fund is one that is established and
operated from an IFC...
Each hedge fund has an investment manager and a
declared investment strategy, so that investors in
the fund know in general terms what the hedge fund
plans to do with any investment capital that it raises.
The legal form of the hedge fund may be a limited
company, a partnership or a trust.
The hedge fund then raises capital from investors and
the capital raised is used by the investment manager
to invest in the manner that has been declared. The
intention is that the declared investment strategy will
provide higher-than-average returns.
A hedge fund will have arrangements to protect
investors from fraud, for example money invested in
the fund should be paid into a bank account that is
the responsibility of an administrator. The money is
then released to a custodian, whose task is to acquire
assets (investments) for the fund as instructed by
its investment manager. The hedge fund manager
is therefore responsible for trading strategy; the
custodian is responsible for acquiring, holding and
disposing of assets in the fund and the administrator
is responsible for the bank account.
A fund charges investors an annual fee, based on a
percentage of the value of the assets in the fund plus
a percentage of the returns from the fund.
There may be restrictions on the amount of money
investors can withdraw from the fund. This is to
protect the fund from large amounts of withdrawals
in a short period of time because the fund may have
invested in assets that cannot easily be converted
into cash at short notice. Restrictions on withdrawals
might take the form of a minimum notice period for
withdrawal. During the financial crisis of 2008, some
hedge funds imposed restrictions on withdrawals,
which meant that investors were unable to terminatetheir investments quickly in spite of their concerns
about the losses that the hedge funds were making.
Some words of warning
It is worth noting some lessons from the banking
crisis of 2008. Some IFCs were heavily involved
in handling investments in collateralised debt
obligations (CDOs), whose collapse in value helped
to initiate the banking crisis. In addition, some IFCs
did not have depositor protection schemes, putting at
risk the bank deposits of investors in those centres.
Although offshore funds are normally located in a
tax-neutral jurisdiction, so that dividends paid by the
fund will not be subject to tax within the IFC:
- income to the investor from an offshore investment vehicle will be subject to tax in the investor’s own country, and
- income received by the fund on its investments in companies and institutions in other countries may be subject to withholding tax in the other country.
The domestic law of a country may restrict the ability of its citizens to invest in offshore investment institutions, or institutions operating in some specific IFCs. It is obviously important to establish what is and what is not permitted by the law before making any decisions to invest offshore.
Trusts (and the status and rights of trusts) are recognised in almost all countries which were formerly or are currently under British rule or those with a system of common law, such as the United States, as well as in many major countries with a civil law system.
Individuals in countries without trust law can use offshore trusts to manage their personal wealth more effectively than by investing it in their own country, through a different financial arrangement.
Trust law and trusts are restricted to certain countries and IFCs. Similar arrangements exist in other countries, although the legal framework differs. In Liechtenstein and Panama for example individuals can make similar arrangements through entities called ‘private foundations’ which are subject to its foundations law.
Giving away money to protect it
Trusts can be difficult to understand, because it can be difficult to recognise their essential characteristic.
Trusts are used by individuals to protect their money (or other assets) by giving away the money to a trust.
- Individuals give their money to a trust to protect it from taxation or to make it safe against certain legal claims.
- Although the money is given away to the trust, the individual is able to control how the money is used, for his own personal benefit or for the benefit of others – for as long as he lives and also after his death.An individual gives his money to a trust to make it safe, and although he is no longer the legal owner he is able to retain full control over how the money is used – for his own benefit or for the benefit of others.
What is a trust?
A trust is a form of legal entity that exists in many IFCs. Trusts originated and developed in the United Kingdom and the United States, where there are well-established systems of trust law. Many IFCs have developed their own trust law, based on the UK or US model.
At one time, offshore trusts were used mainly by wealthy individuals from countries with wellestablished trust law, such as the United States and United Kingdom. However, offshore trusts are now accepted in many countries as a method that individuals can use to manage their wealth.
The settlor
A trust enables an individual or any other ‘legal person’ to use his wealth in a tax-efficient way for a specified purpose. The person who establishes a trust and puts assets into it is called a settlor. The assets put into a trust by a settlor are often money, but they could also be any other form of asset, for example: shares or bonds in a company, an investment portfolio, real estate, jewellery, gold or intellectual property.
The trustees
A trust is a separate legal structure that is owned by one or more trustees. The trustee (or trustees) is appointed by the individual who establishes the trust. The settlor can be a trustee himself if he wishes; otherwise he can appoint anyone he chooses. In IFCs, it usually makes sense to appoint as trustee a local professional person with experience of trusts and trust law.
The trustee (or trustees) is the legal owner of the trust, and has control over the assets that it owns. In trust law he is required to carry out his duties for the trust in the best interests of one or more beneficiaries. A trustee is not permitted to use the assets of the trust for his personal benefit.
The beneficiaries
Beneficiaries are the individuals who benefit from the assets in the trust or the income that these assets provide. It is usual for a trust to name the specific beneficiaries, but the beneficiaries could also be identified as a specific group of people, such as ‘all the grandchildren of the settlor’. It is also possible for the settlor to name himself as a beneficiary, or even the only beneficiary of the trust, but the possible tax implications of this arrangement should be considered.
A trust is therefore set up by a settlor for the benefit of one or more individuals (the beneficiaries) but it is legally owned by the trustees who are legally obliged to act in the best interests of the beneficiaries in accordance with the requirements of the trust.
A common arrangement is for the settlor to put the assets into a company with share capital and then transfer the company into the trust. The trustees are then given the shares in the company, rather than the assets owned by the company.
In some jurisdictions, when the assets of the trust consist of the shares of a company, the trusteesare required to take an active role in the company’s management.
In some countries, the law states that the rights to any property or other form of asset belong to the owner, and it is the owner who has the right to decide what should be done with the asset or how it should be disposed of.
A trust is an entirely different concept. There is a clear separation of the legal owners of the assets (the trustees) from the beneficial owners of the assets (the beneficiaries). The trustee has the formal right to use or dispose of the assets in the trust, but it is the settlor who decides how they should be used and the trustees must comply with the settlor’s wishes, as set out in the trust deed.
However, unlike a company, a trust is a not a ‘legal person’. It cannot own assets in its own legal right. The assets are owned ‘legally’ by the trustees, but they must administer the trust and its assets in accordance with specified rules. A trust is therefore a unique form of legal relationship between the settlor, trustees and beneficiaries.
0 A protector
The trust law of the IFC may allow the settlor to appoint a protector for the trust. The role of the protector would be to supervise the activities of the trustees. The rules of a trust could specify that the trustees should consult the protector before they take certain actions, such as disposing of trust assets. A protector can therefore be used to retain some power or influence over the decisions and actions of the trustees.
A protector might be a close friend of the settlor, or even the settlor himself.
STAR Trusts: an enforcer
Each IFC can have its own distinctive arrangements in trust law. For example, in the Cayman Islands a trust may be established as a STAR trust (under the Special Trusts [Alternative Regime] Law). A feature of a Star trust is that the beneficiaries of the trust do not have any power to enforce their rights under the terms of the trust, which they would have in a normal trust arrangement. Instead, the beneficiaries simply have the right to enjoy the benefits of the trust assets.
The right to enforce the terms of the trust is given to a third party, known as an enforcer. The enforcer can also be a beneficiary of the trust, but this is not necessary.
Although Star trusts may be used for other purposes, they were initially intended to appeal to individuals wishing to leave all the shares in their family company to beneficiaries, such as all the children of the settlor. The beneficiaries would be entitled to enjoy the dividends from the company’s profits, but an enforcer would have powers over how the trustees looked after the assets of the trust.
The trust deed
A trust is a legal arrangement. The arrangements for a trust should be set out in the form of a legal document, a trust deed. This identifies the purpose of the trust, the assets it owns, the trustees and the beneficiaries. It also specifies other details such as the length of time that the trust will remain in existence, and what should happen to its remaining assets when it ceases to exist.
(The trust deed might also include a provision that enables the trustees to terminate the trust at any time, at their discretion. This gives the trustees some flexibility iif unforeseen events occur and the trust arrangement is no longer suitable or required.
How might a trust be used?
There are several ways in which trusts are used. Two common uses are inheritance planning and investment.
Probate (inheritance planning)
Many individuals have used offshore trusts (or personal companies) to organise their affairs after they die. In many countries, when an individual dies his assets are made subject to formal probate procedures to establish what assets exist, their value and the amount of tax payable on them in the form of inheritance tax.
If an individual transfers assets to a trust during his lifetime, for the benefit of named beneficiaries for the rest of their lives, the trust will continue after the death of the settlor. The trust is not affected by the death of the settlor, in the sense that the assets of the trust are not part of the settlor’s estate and so are not subject to death tax or inheritance tax. For the same reason the assets of the trust are not subject to probate procedures in the settlor’s country.
Suppose, for example, that an individual puts money into a trust specifying that the money should be used for the benefit of one or more named beneficiaries after his death. When the settlor dies, the trustees will comply with the requirements of the trust, and are able to use money in the trust for the benefit of the beneficiaries. If the money had been in the personal estate of the settlor, rather than in trust, it would have been ‘tied up’ and unavailable until probate had been completed – a process that could take months.
An individual could own a family business in the form of a company with share capital. He might want the business to continue after his death, but worry that if ownership is divided between different members of his family the business would not survive or would be sold off after his death. One way of keeping the family business together would be for the owner to transfer the company to the ownership of a trust. Members of the family would be identified as the beneficiaries, and the trust deed would require the trustees to pay out profits from the company as dividends to the beneficiaries. In this way the business would be kept together for the benefit of the family members.
Assets held in several countries
Very wealthy individuals often hold assets in a number of different countries. For example, an individual might own real estate in the United States, Australia and Europe. There is a risk that when the individual dies, these foreign assets will become subject to the death tax laws – and death taxes – of the country in which the assets are located. By putting assets into trust, an individual might be able to plan for his death more efficiently so that taxes on his estate could (legally) be reduced or possibly even eliminated altogether.
Domestic laws on inheritance
The laws of a country may impose rules about how some or all of the wealth of an individual should be distributed after death. If these rules are inconsistent with what an individual would actually like to do with his money, he can make arrangements that are more suited to his requirements by setting up a trust.
For example, in some countries the law could specify who the heir to an individual’s assets should be when the individual dies, or that certain heirs should receive a minimum part of the deceased person’s estate. An individual might not want to leave his wealth, or as much of his wealth as the law requires, to a specific heir. If so he can avoid the requirement by setting up a trust with different beneficiaries. The assets of the trust are not included in the estate of a deceased settlor for the purpose of inheritance.
Transferring wealth to a trust gives the trustees ownership, and the use to which the money is put is dictated by the terms of the trust (and so by the settlor). Decisions by the trustees must comply with the terms of the trust. The trust is not subject to the rules of inheritance in the settlor’s country, which means that the settlor can decide without the restriction of domestic law about how the money should be used after his death.
Investment
Individuals can also use offshore trusts to invest their wealth. Money can be transferred to a trust and invested by the trustees. Under the terms of the trust, the trustees are required to make payments to or on behalf of the beneficiaries. The settlor might be the sole beneficiary of the trust.Since offshore vehicles are tax neutral, the wealth (and the income it generates) is not subject to tax in the IFC. However, it will be taxed if and when it is returned to the individual’s own country.
What are the benefits of an offshore trust for investment?
Offshore trusts can be attractive as an investment vehicle for individuals who live in a country where trusts do not exist.
Key advantages of investing through IFCs are privacy and greater freedom of investment. Individuals can invest their money without the need to reveal details regularly to the tax authorities. The range of investments open to them might also be greater than if they were to invest though a domestic investment organisation.
For example, domestic law could restrict or limit the amount of investments that an investment institution can make in unquoted companies. (These are companies whose shares are not quoted or traded on a recognised stock market.) Investment institutions in an IFC might not be subject to such restrictions. The risk of investing in unquoted companies will be higher, but the potential returns are larger.
Inevitably, there are risks in investing in offshore vehicles, but there are also risks with investing through domestic financial institutions. It would be advisable, however, before transferring funds to an offshore bank or other institution, to establish what depositor or investor protection arrangements would apply if the bank or institution were to become insolvent and collapse.
Asset protection and confidentiality
Assets put into a trust are protected against a variety of risks, such as legal, political and economic risks in the settlor’s country.
When a trust has been established, its assets do not belong to the settlor. This means that the settlor is not required to reveal the existence of these assets to the tax authorities. He is only required to reveal any taxable benefits received from the trust, in cases where he is a beneficiary of the trust.
After a trust has been established, the assets that have been transferred are also protected from demands of any creditors of the settlor. They cannot demand payment of a debt by the settlor from the assets of a trust. (However, it is illegal to transfer assets to a trust with the intention of protecting them from existing creditors at the time the trust is established.)
An offshore trust also lets the settlor keep details of his financial affairs confidential because details of private trust arrangements do not have to be recorded in a public trust register.
Tax benefits
Individuals put money or other assets into a trust in order to manage their tax affairs better. By transferring assets to a trust, an individual reduces his personal wealth, and possibly also his personal income, which will reduce his tax liability in his own country.
In an IFC with a zero-tax or no-tax jurisdiction, a trust is not liable for tax on its assets or income. A liability to tax arises only when a beneficiary receives income from the trust, and this income is taxable in the beneficiary’s own country, in accordance with that country’s law.
Depending on the local tax law and the way in which income is paid to the beneficiaries, tax liabilities can be either reduced or postponed.
When a trust is established with the purpose of paying out the assets to one or more named individuals after the settlor dies, the tax will not become payable until after his death.
Protection of assets against the claims of unexpected creditors
In any country or IFC that offers opportunities for establishing a trust, there will be a law to prevent the transfer of money or other assets into a trust to put it out of reach of legitimate creditors of the settlor. It would be improper, for example, to allow an individual to transfer money into a trust that should be paid to a creditor of the settlor, and then prevent the creditor from claiming the money that is rightfully his.
Trust law varies in detail between IFCs but it is normal for the law to provide for a period of time after the creation of a trust, or after the transfer of new assets into a trust, during which a creditor of the settlor can claim a right to some or all of the assets.
However, after this period has elapsed, the law may protect the settlor and the trust against claims of ‘unexpected’ or ‘unforeseen’ creditors who are owed money by the settlor, and who would like to be paid from the money that has been transferred into the trust. As long as the settlor did not transfer the money into the trust with the intent of defrauding creditors, the law will protect the assets in the trust against such claims.
An individual might also transfer assets into a trust with the deliberate intention of protecting the assets from any legal proceedings for divorce by a spouse or proceedings for bankruptcy. In this situation, the courts in the IFC will have powers to make assets of a trust available for the divorcing spouse or the administrator in bankruptcy.
Private trust companies and purpose trusts
An individual (or company) wishing to take advantage of a trust arrangement in an IFC might be required, for tax reasons, to make use of both a private trust company and a purpose trust.
Within the IFC, a licensed trust company may specialise in setting up purpose trusts. A purpose trust cannot have beneficiaries. As its name suggests, a purpose trust is a trust established for a specific purpose, which could be to own the shares of one or more private trust companies.
A private trust company is a company with a board of directors whose purpose is to act as trustee for one or more trusts. By law it cannot offer its services to the general public and can act as trustee of only a limited number of ‘family trusts’ or trusts for individuals.
Professional services and regulation
IFCs are also able to provide specialised professional services, with firms that act as trustees, firms that administer the investments held in trust and firms that deal with trust administration such as maintaining the accounts and preparing any reports required by local government authorities.
To ensure that an offshore trust will achieve its intended purpose, it is vital to obtain specialist legal and tax advice.
Individuals or firms that provide trustee services must be licenced to operate by the local authorities. To obtain and maintain a licence they must demonstrate professional competence, suitable controls against risk and have adequate capital to remain in business. Licensed individuals or firms are then subject to local supervision and regulation.
The quality of professional services and the strength of local regulation are essential for attracting foreign capital to IFCs; consequently government authorities in these centres try to ensure that high standards are maintained.
Types of trusts
There are two main types of trusts. They differ in the way in which the beneficiaries of the trust have a right to the income from the trust assets or the assets themselves and the extent to which the trustees have discretion over how the money in a trust should be used.
Interest-in-possession trusts
With this type of trust the beneficiary is entitled to receive specific benefits from the assets of the trust. The trustees are obliged to give the specified income or benefit to the beneficiary. They have no control over when to pay the benefits or how much to pay at any time. The benefits paid from the trust might take the form of a specified amount of money, possibly in regular monthly or annual payments of a sum of money. Alternatively, a trust might specify that a named individual must be allowed to live without payment of rent in a property owned by the trust.
An example of an interest-in-possession trust is a trust in which an individual leaves assets in a trust, such as shares or a property, and specifies that after his death the benefits of the assets should be enjoyed by his surviving spouse.
For example, the dividends from shares in a company should all be paid to the surviving spouse, or the surviving spouse should be entitled to live rent-free in a property held by the trust. The trust may then provide that on the death of the spouse, the assets or the income from those assets should be paid to other beneficiaries, such as the settlor’s surviving child or children.
Discretionary trusts
With this type of trust, there are specific beneficiaries, but the trustees have some choice in how the assets or benefits of the trust should be shared between them. For example, an individual might put money into a discretionary trust for the benefit of his two grandchildren, and the trustees will then have some freedom to decide how to make the best use of the assets (or income from the assets), how much money each of the beneficiaries should get, and for what purpose or purposes the money should be spent for their benefit.
The trustees usually also have discretion about whether to provide one or more beneficiaries with regular income or one-off capital payments from the money in trust. A discretionary trust allows the trustees to respond to changing circumstances, such as the changing needs of the beneficiaries over time, for example as they grow up.
Setting up an offshore trust
Individuals can set up an offshore trust that is designed to meet his or her particular requirements. Before establishing an offshore trust, however, the individual should check on the status of trusts in relation to the domestic law in his own country, in the event that there is a legal action regarding the assets or income of the trust.
Any person wishing to establish an offshore trust needs legal and professional assistance and advice.
A feature of IFCs which have some form of trust law is that they can provide advice and assistance in setting up a trust to meet the specific requirements of local trust law.It is important that the terms of the trust are written so that the trust achieves the specific purpose or purposes intended by the settlor. Given the complexities of trusts and trust law, this is not something that individuals can do by themselves. (A popular Western adage is ‘He who is his own lawyer has a fool for a client.’)
First, a trust deed must be prepared. This is the legal document that establishes the trust. It identifies the trustees, the beneficiaries and the purpose of the trust. It may also specify details about how the assets of the trust should be managed or invested, and how the benefits should be distributed to the beneficiaries. Each trust deed is a unique document, although it may contain some standard legal language and conditions.
The trust deed must specify who the trustees should be. The settlor himself can be a trustee, and a trustee can be one of the named beneficiaries. However, with offshore trusts it is appropriate to appoint as trustee a specialist professional firm in the IFC.
Selecting a trustee should be done with care. It is essential to appoint one or more people (or a firm) who can be trusted to act properly in the interests of the trust and its beneficiaries.
There will be certain administrative requirements necessary to establish the trust and register it for tax purposes. For example, the trust deed will have to be signed by the settlor and the trustees, and a record of the trust and its assets will have to be prepared and kept on file by an agent in the IFC.
In most offshore jurisdictions, it is not necessary to register a trust with the government authorities. Although an offshore trust is not usually required to provide financial returns to the authorities, there should be proper management of its assets and income. Accounts should be kept for a trust and a register should be maintained of all the assets the trust owns. Without proper records and accountability the potential exists for fraud. Professional services firms in IFCs are able to provide accounting and record-keeping services.
These firms will charge a fee for helping the settlor establish the fund and will also charge for providing tax and legal advice. Once the trust has been set up there will be annual administrative costs, payable to the agent for the trust and the trustees.
