As the world appears to shrink, more people acquire property in multiple jurisdictions or have family members living in different countries. Residents of the United States and other common law jurisdictions have historically used trusts to achieve their estate-planning objectives. Employing a trustee, who holds legal title to property for the benefit of one or more beneficiaries in accordance with the provisions of a trust agreement and applicable law, can provide effective property management, distribution objectives and tax benefits. Unfortunately, the traditional U.S. or common law trust may not provide the same benefits when trust property is located, or when the grantor, trustee or beneficiary resides, in a country that's unfamiliar with trusts.

The trust, as a creature of common law, has very little history in other legal systems, such as civil law and shari'a law. These systems operate quite differently from the common law system and many don't even recognize the concept of a trust. For example, civil law doesn't recognize the division of an estate into separate legal and beneficial interests.

In jurisdictions that don't recognize trusts, there's a risk that the separate fiduciary relationship won't be respected and the property administered by a trustee may be treated as being owned by him individually. There are concerns in these jurisdictions that trust assets could be subject to the claims of the trustee's personal creditors. Similarly, it may be possible for heirs of a deceased trustee to assert inheritance rights over property that the trustee held in a fiduciary capacity. In addition, jurisdictions that don't recognize trusts may tax trusts, transfers of property to trusts and distributions to beneficiaries quite unfavorably.

Nevertheless, several non-common law jurisdictions have begun to adopt laws governing trusts. These laws may have a very different view of what a trust is, how it operates and how it should be taxed. This often leads to unpredictable treatment of trusts.

The Hague Convention

In 1985, the Hague Conference on Private International Law concluded the Hague Convention on the Law Applicable to Trusts and their Recognition, a multilateral treaty, which took effect on Jan. 1, 1992 and has been ratified by 12 countries (the Convention). The Convention not only provides for the recognition of trusts, but also sets forth the characteristics of a trust and rules for determining the law that governs a trust.

Article 2 of the Convention defines a trust for purposes of the Convention and provides that a trust has the following characteristics: the assets constitute a separate fund and aren't part of the trustee's own estate; title to the trust assets stands in the name of the trustee or in the name of another person on behalf of the trustee; and the trustee has the power and the duty, in respect of which he's accountable, to manage, employ or dispose of the assets in accordance with the terms of the trust and the special duties imposed on him by law.

Article 11 of the Convention provides for the recognition of trusts. This recognition includes that the trust property constitutes a separate fund; that the trustee may sue and be sued in his capacity as trustee; and that he may appear or act in this capacity. Article 11 also provides that this recognition of trusts implies that the personal creditors of the trustee shall have no recourse against the trust assets; the trust assets shall not form part of the trustee's estate upon his insolvency or bankruptcy; the trust assets shall not form part of the matrimonial property of the trustee or his spouse nor part of the trust estate upon his death; and the trust assets may be recovered when the trustee, in breach of the trust, has mingled trust assets with his own property or has alienated trust assets. Thus, the Convention recognizes that a trustee holds property in a separate fiduciary capacity, apart from his own individual capacity, for the benefit of the trust beneficiaries.

The Convention, therefore, provides some comfort and predictability when a trust operates in a jurisdiction that has ratified it. Unfortunately, the benefits of the Convention don't extend the trust concept to many jurisdictions. Only 12 countries have ratified the Convention: Australia, Canada (eight provinces only), China (Hong Kong only), Italy, Luxembourg, Liechtenstein, Malta, Monaco, the Netherlands (European territory only), San Marino, Switzerland and the United Kingdom (including 12 dependent territories/crown dependencies). Australia, Canada and the United Kingdom already have developed trust legislation.

While the Convention sets forth some fundamental trust concepts, it doesn't necessarily ensure that the parties to the Convention will treat more nuanced issues related to trusts as would be expected in common law jurisdictions. Even if a country with no trust law has ratified the Convention, its legal system may be unfamiliar with the law of trusts and, consequently, may be unequipped to deal with the legal aspects of trusts and the application of a foreign law governing trusts that operates under a completely different legal system. This may lead to unpredictable and undesirable results.

It's unclear the extent to which a trust will be recognized by a country that has ratified the Convention when doing so conflicts with the laws of that country. For example, will a trust be recognized and respected by a civil law country if the trust owns real property in that jurisdiction and defeats the forced heirship rights of the grantor's family or the matrimonial property regime with respect to the grantor's spouse?

A brief review of some experiences in Switzerland, China, Latin America and Germany provides useful insight into several concerns faced by trusts operating in jurisdictions that are unfamiliar with the trust concept. These experiences also demonstrate why trusts may or may not be popular vehicles in non-common law jurisdictions.

Switzerland

Switzerland is a civil law country with no internal trust law. Its experience with foreign trusts, both before and after it ratified the Convention, provides useful examples of the struggles of many non-common law countries regarding trusts. Since Switzerland has long been an attractive jurisdiction for wealth, trusts have operated there for some time. Nevertheless, Swiss courts have struggled to properly understand trusts. Swiss law recognizes some legal institutions that are similar to trusts: the family foundation and the fiducia. But, these institutions are fiduciary relationships based on contract, which differ from the trust. While Switzerland didn't have any provisions for dealing with trusts in its statutory law, some Swiss courts recognized trusts before the ratification of the Convention.

The application of Swiss law to trusts has been difficult because Swiss civil law wasn't designed to work with trusts. Since Switzerland has no internal trust law, Swiss courts must work with trusts that are created under foreign law. Swiss courts have struggled with issues related to which law to apply to trusts and how to characterize trusts from a legal perspective within a legal system that doesn't recognize trusts.

Unfortunately, the outcome of these cases has largely been arbitrary because of the uncertain legal environment within which trusts have been administered. The legal issues arising in Switzerland with respect to trusts have generally related to conflict of laws, ownership of the trust assets by the trustee in his individual capacity and tax.

When Switzerland ratified the Convention effective on July 1, 2007, it also amended its internal laws to coordinate certain aspects of Swiss law with the Convention. The changes to Swiss law helped to define trusts, clarify the jurisdiction of Swiss courts in trust matters, determine the law that Swiss authorities must apply to trust matters, deal with situations in which a trust owns property that must be registered under Swiss law, such as land, aircraft, ships and intellectual property and regulate the recognition of foreign judgments. Switzerland also enacted legislation that addresses the enforcement of debts brought against trust funds and bankruptcy proceedings brought against trustees in their personal capacity. Even though Switzerland doesn't have its own trust law, its ratification of the Convention and the enactment of this new legislation have made the administration of trusts in Switzerland more predictable. Nevertheless, the use of trusts in Switzerland after the ratification of the Convention hasn't evolved smoothly.

Various Swiss tax authorities have struggled with how to tax trusts. Tax issues have frequently arisen when people moved to Switzerland with non-Swiss reasons for using trusts (such as property management or estate planning) or when a Swiss family has members living outside of Switzerland who used trusts. There was no uniformity with respect to how trusts were taxed in these situations, and various Swiss cantons had different approaches. In general, a trust with a non-Swiss grantor and no Swiss beneficiaries may be administered in Switzerland with no tax ramifications. The tax consequences of a trust with a Swiss resident grantor or with Swiss beneficiaries differ based on the applicable canton, but, in general, the Swiss authorities treat trusts as transparent entities, with the income and gains arising in the trust being attributed to the grantor or the beneficiaries.

Switzerland's ratification of the Convention has created several situations in which the recognition of trusts could conflict with internal Swiss law. For example, while the ratification of the Convention should make it possible, in principle, to transfer Swiss real property into trust, the Swiss legal concept of “Lex Koller” provides that persons abroad (including individuals and legal entities) must receive authorization to own residential property located in Switzerland. It's possible that a trust whose grantor, trustees and beneficiaries are all Swiss may not be considered a person abroad, but if one of those individuals is foreign, difficulties may arise and authorization for the property acquisition may be required. Since Switzerland's ratification of the Convention became effective in 2007, this issue hasn't been fully clarified and different cantons have issued inconsistent decisions.

China

In mainland China, which adopted a trust law in 2001, the use of trusts has been slow to evolve. Legal scholars assert that the non-use of trusts relates to vagueness in the law and confusion in its interpretation. For example, the trust law in China doesn't specify to what extent the trustee will have management flexibility or discretion over the trust property. It's unclear whether the grantor of a trust in China has certain residual ownership over trust property, which could limit the ability of the trustee to manage it. Moreover, there hasn't been any meaningful jurisprudence on the topic of trusts. China doesn't currently have an estate or gift tax, so the traditional transfer tax benefits of using trusts aren't attractive there. Additionally, Chinese tax law doesn't mention trusts, so the tax treatment of trusts, transfers of property to trusts and the receipt of property from trusts are uncertain. All of these factors have contributed to a lackluster appeal of trusts in China.

Chinese law governing Hong Kong provides, in general, for the maintenance of the laws that were in effect in Hong Kong before the handover from the British in 1997. Consequently, the current laws of Hong Kong have a strong common law foundation and trusts are common, although most trusts used there are established in offshore jurisdictions. While there's no longer an estate tax in Hong Kong, trusts are still regularly used there for succession purposes and creditor protection.

Latin America

No Latin American countries have ratified the Convention. Even though Latin American countries operate under civil law, many, including Argentina, Bolivia, Brazil, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Panama, Paraguay, Peru, Uruguay and Venezuela have domestic trust regulations and many of these countries also have regulations related to the taxation of foreign trusts. It's generally believed that these jurisdictions would recognize foreign trusts and Latin American case law has recognized trusts.

Trusts are used extensively in Latin America for business and guarantee purposes but aren't generally used for wealth transfer purposes. This is likely because the rules of forced heirship restrict the possibility of succession planning. In general, a Latin American grantor can avoid forced heirship only if the trustee and the trust assets are located in a jurisdiction that wouldn't enforce the forced heirship rules of the grantor's domicile.

While Latin American countries have typically adopted their trust laws by assimilating U.S. trust law concepts, several differences exist between Latin American trust law and U.S. trust law concepts. In several Latin American countries, only banks and special-purpose companies, not individuals, may serve as a trustee. In other Latin American jurisdictions, the grantor can't serve as trustee. Since trusts are generally used in Latin America for business purposes, they typically have much shorter permissible periods than in common law jurisdictions.

In Colombia, Ecuador and Mexico, the trust is a pass-through entity with profits being taxed to the beneficiaries. Peru, on the other hand, taxes the grantor on trust profits. Argentina typically taxes the trust, unless the grantor is the beneficiary, in which case he's taxed on trust profits. In Guatemala, Honduras and Uruguay, the trust is the taxpayer.

Germany

Germany is unfamiliar with the trust concept and German assets can't be settled into a trust. Settling non-German assets into a trust is typically a taxable event for German inheritance tax purposes. The trust is treated as the donee for inheritance tax purposes and the bequest falls into class III, the most unfavorable category with the highest tax rate, even if the trust beneficiaries are individuals who would qualify for the more favorable class I or class II categories (with lower tax rates) if the bequest was made outright to them. Distributions from trusts to German residents are also subject to an additional level of gift tax.

Universal Acceptance Not Imminent

As more individuals become multi-jurisdictional, whether with respect to their property, their personal relationships or both, the use of trusts in non-common law jurisdictions will continue to be more desirable. The Convention provides some degree of comfort with respect to how trusts will operate in jurisdictions that are generally unfamiliar with them. Nevertheless, for various reasons, trusts aren't attractive in all countries. As a result, we're still a long way from the universal acceptance and use of trusts. Practitioners should be careful when using trusts in jurisdictions that don't have an established body of trust law.

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Jeffrey B. Kolodny is a member of the private client services department in the New York City office of Cozen O'Connor

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Serenity

“Pueblo Maiden” (15 in. by 20 in.) by Lunda Gill, sold at the Jackson Hole Art Auction in Jackson, Wyo. on Sept. 17, 2011 for $13,800. Gill studied with Milford Zornes and Millard Sheets at the Chouinard Art Institute and continued at the Art Students League in New York. Early in her career, she painted a variety of subjects; later she traveled widely to paint indigenous cultures, as well as the Native American tribes of the Southwest.