Offshore Wealth Adapting to New Complexities

The family office concept, once almost exclusively available to the wealthy families in Europe and the United States, is quickly migrating to new pockets of wealth in places like Brazil, Australia and Singapore. Only a few years ago, a wealthy family or ultra-high-net worth individual would be hard pressed to find a customized family office wealth management solution; now, there are hundreds family offices operating throughout the world and the number of single and multi-family offices is only expected to increase in the coming years. Here are some thoughts regarding the developing trend in this segment. 

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How families can solve the Gordian knot of wealth

Much ink has been spilled in the financial press recently over the bad finances of Europe’s periphery, and of Greece in particular. The country’s level of debt appears like an unsolvable problem. It resembles another apparently unsolvable issue, which is described in the country’s mythology.

The issue relates to a peasant farmer named Gordias, who became king of Phrygia after the event was predicted by an oracle. Gordias’ ox cart, on which he was travelling to Phrygia when the town’s population proclaimed him king, became a symbol. It was subsequently placed in the centre of the acropolis, yoked to a pole with a large knot, with no end to it: the Gordian knot. The tale says that whom ever managed to untie the knot would become king of Asia, which Alexander the Great did, by a straight and brutal sabre cut.

While too much indebtedness, such as Greece’s, may be considered as a Gordian knot, exceptional levels of wealth often become extremely difficult to manage in a way that satisfies all members of a family as well. Hence wealth sometimes becomes a Gordian knot too. For wealthy families, untying such a knot translates into matching financial objectives and creating an appropriate structure.

For most families, wealth was created from not much, by an entrepreneur. Over time, its value sometimes becomes significant. Financial affairs and commercial affairs represent two of the most important components making up the wealth of families. Whilst in most cases wealth creation initially originates from commercial assets, wealth preservation is generally granted through financial assets. Both types of assets behave differently though, and have their own characteristics. As a result, they should have different governance structures.

The Gordian knot story from Greek mythology provides a lesson about practical problem solving. In the family governance concept however, family councils and/or boards must be created, covering both aspects of corporate governance and financial governance. The former is often well put into practice, whilst the latter less so. In that regard, advisers often hear the following kind of observations: “My financial affairs are unattended. I have too many bankers and I have no time to assess nor answer the many investments solicitations I receive. Nor can I evaluate the true quality of my financial performance”. This comment is too often heard from the mouths of busy and successful entrepreneurs, still heavily involved in their business.

This illustrates that successful family businesses which create large amounts of cash find themselves with the new profession of wealth manager, but with limited time and sometime interest, to dedicate to it.

Some are inebriated by their business success and feel that the same rewards should flow naturally in the financial world. This is a common mistake and some have paid a costly price before understanding that public market investing is one of the most competitive business across all industries and that their one stock control it all approach is different to a multi stock portfolio.

The elaboration of a successful financial governance structure assumes that the family governance architecture is established and sound. Clearly setting a family strategy which defines values and objectives associated to a family business plan is important. It then provides the prerequisite information for the creation of an investment policy which should translate the family objectives into financial objectives. Family objectives depend on where the family stands in the wealth cycle, whether it is creating or preserving its wealth. One key advantage a wealthy family has is that its financial objectives can be set on several generations. That way, financial turmoil and periods of increased market volatility can then better be endured. This unique characteristic shapes choices of asset classes.

Performing such a process allows to create formal guidelines which will guide the investment committee. Furthermore, it offers the opportunity to truly understand the family’s culture and dynamics while providing time also for interaction amongst family members. More importantly, the platform should also unite the family around financial expectations and consequently should result in the most appropriate, long lasting tailored solution.

Families generally have more than one asset manager or private banker. The role of the investment committee varies from an institutional approach to a private banking approach. The former rests on a delegation principal which consequently requires a strong investment committee, whilst the latter offers more flexibility and customization, with a more controlling responsibility.

With an investment policy created and agreed upon, the implementation can begin, from the RFP (request for proposals) to beauty contests, right through to the elaboration of reporting tools. Once the investments have started, the monitoring of the various managers in terms of risk and investment guidelines, supervision and market reviews become the investment committees’ core activity.  A fine-tuned financial governance set up should manage it efficiently.

As the wealth cycle evolves, the importance of and the dependence to the financial wealth increases. Creating an adequate platform at the beginning is paramount to the success of both: meeting the financial objectives and insuring a smooth transition to the next generations. It prepares them for their future and increasing responsibilities in the world of financial asset management.  Additionally, it provides for a truly, long term fiduciary relation to develop with external advisors.

In the current financial turmoil many families would love to have their Alexander The Great in their entourage, helping them explore and conquer prosperous opportunities. Financial assets can be very complicated but sometimes made to look more complex than they really are. A golden rule is to keep it as simple as possible, which in some cases may require a straight and brutal sabre cut. Although debatable as to when and if it should be recognised as a Gordian knot or not, many have addressed the issue with diverse success. But one thing is certain: for some families, a proper financial governance may be the Alexander they are seeking, sometimes desperately, sometimes without being able to name it and sometimes even unknowingly.

The amount of off shore wealth—defined as assets booked in a country where the investor has no legal residence or tax domicile—increased to $7.8 trillionin 2010, up from $7.5 trillion in 2009.) The increase was driven by a combination of market performance and asset inflows, primarily from emerging markets. At the same time, however, the proportion of wealth held off shore slipped to 6.4 percent, down from 6.6 percent in 2009. 

The decline was the result of strong asset growth in countries where off shore wealth is less prominent, such as China, as well as of  stricter regulations in Europe and North America, which prompted clients to move their wealth back onshore, thus lowering the net increase in off shore assets. Off  shore private banking, in general, remains a tumultuous part of the business. The relative importance of off shore centers is changing rapidly. Some are benefiting from continued asset growth, while others are seeing large asset outflows, with wealth being repatriated to on-shore banks, transferred to other off shore centers, redirected into non financial investments, or simply spent at a faster rate.

Constraints on Growth and Profitability

There will always be clients wanting to putt heir money off shore. Tax considerations have certainly influenced the flow of off shore assets, particularly for clients fromNorth America and Western Europe. Most off shore clients, however, are less concerned with taxes and more concerned with safety and stability, often because their own countries have shaky political systems or badly regulated or poorly run financial sectors. In addition, some clients value the discretion, privacy, and secrecy ensured by off shore private banks, owing to a lack of trust in local banks or authorities or concerns about criminal threats in their home countries. More discerning clients rely on off shore centers for their unmatched expertise, specialized products, access to sophisticated investments, and integrated wealth services. 

A small minority of clients value off shore centers for the status and prestige they confer.Although most of the core drivers of demand remain relevant—as evidenced by the recent unrest in parts of Africa and the Middle East—other trends are undercutting the appeal of off shore banking. For example, there is a widely held but misguided presumption that all off  shore wealth is illicit, even though tax considerations—as de-scribed above—are far from the only reason why wealthy individuals hold their assets off shore. In most countries outside of Western Europe and the United States, taxes play a minor role in the decision to hold assets on off shore.

The de facto criminalization of offshore wealth has helped drive a concerted push for greater transparency.This effort, which is certain to cause at least some of the wealth held offshore to evaporate, is unfolding on several fronts. 

In March 2009, Austria, Belgium, Luxembourg, and Switzerland withdrew their reservations to Article 26 of the OECD Model Tax Convention on Income and on Capital, paving the way for the bilateral exchange of tax information. In the case of Switzerland, government authorities now provide information on individual clients and their holdings to foreign tax authorities, not only in cases of tax fraud (such as submitting false documents to avoid taxes) but also in cases of tax evasion (such as not declaring assets). But Swiss authorities have taken a stand against so-called fishing expeditions—they do not allow foreign tax authorities to have automatic access to account information or to conduct investigations at random, and will provide in-formation only if there is reasonable suspicion. The implementation of Article 26is now being codified in individual double taxation agreements between offshore centers and client-domicile countries that are seeking tax information from abroad.

In October 2010, Switzerland signed a declaration of intent with Germany and the United Kingdom to collect a flat-rate tax on earnings accruing to clients from these two countries. The tax revenues will be transferred to the respective country, although the clients will remain anonymous. Switzerland also agreed in principle to levy a one-time tax on any undeclared as-sets held in Switzerland by German and U.K. clients,thus rendering the assets tax-compliant. The modus operandi of this tax has yet to be defined.

Under the U.S. Foreign Account Tax Compliance Act (FATCA), which takes effect on January 1, 2013, all foreign financial institutions—including banks, tradition-al funds, hedge funds, and private-equity companies—will be required to disclose information about theirU.S.-taxable clients to the U.S. Treasury. This will affect clients who are from the United States, as well as an clients who hold U.S. assets in any form. If an institution is not willing to comply, its clients will be charged a tax of 30 percent on all “withholdable payments” in the United States, including investment returns, personal income, and gross proceeds from the sales of se-curities or property. To comply with FATCA, institutions will need to adopt a more intensive know-your-client process and will have to fulfill additional reporting requirements stipulated by theU.S. Internal Revenue Service