Amid the emotional turmoil of divorce, probably the last thing on the minds of the parties involved will be the tax implications. The tax system, however, does contain a number of rules and special provisions which are relevant to divorce and separation. Understanding these can ease the already onerous burdens of a difficult situation.
In this article, we consider the types of taxation that may need to be considered by divorcing couples and their advisers.
Capital Gains Tax (CGT)
A divorce settlement may well involve the transfer of assets from one spouse to another. However, a separation with a view to divorce may alter the tax effects of any transfer between the spouses.
The disposal of assets from one spouse (or civil partner) to the other is usually on a ‘no gain/no loss’ basis for CGT purposes. This treatment, however, only applies to spouses who are ‘living together’ in the tax year of disposal. Individuals will be treated as living together unless they are separated under a Court Order or formal Deed of Separation, or, they are separated in circumstances in which the separation is likely to be permanent.
The partners only need to have been living together (in these terms) at some point in the tax year of divorce for this special treatment to apply. So, a CGT charge could arise on any disposal or transfer between divorcees in the tax year following a formal separation.
The timing of the disposal of an asset from one spouse to another can then be of paramount importance. A transfer on the 6th of April may have entirely different consequences compared with a transfer on the 5th April of the same year.
Where no gain/no loss treatment is not available, it may be possible to holdover the gain by using a transfer into trust for the benefit of the other party. Where an asset is gifted into trust with a value in excess of the available ‘nil-rate band’ for Inheritance Tax (‘IHT’), there will be a lifetime charge on that value at 20%. The nil-rate band is currently £325,000.
The main risk with this approach is that, depending upon the circumstances, the gift may not be considered to be ‘bounty’ but instead, may represent a commercial transaction as part of the settlement. In these circumstances, ‘holdover’ relief will be lost or restricted. In some cases, however, a trust may provide a solution and should not be overlooked.
Private Residence Relief
The main asset in a divorce settlement will, in many cases, be the marital home. As the ‘principal private residence’ (PPR’) of both spouses, it may be assumed that any gain on the transfer of an interest from one party to the other will be exempt by virtue of the special PPR exemption available for any disposal of the main residence.
The relief might not be available in full where one of the spouses has left the marital home and is living elsewhere. If the property is sold within 9 months of the departing spouse or civil partner leaving the property, then the whole of any gain can still be covered by the PPR exemption.
If the property is sold later than that, then the PPR exemption may still be available for the whole period, including the period after the individual making the disposal has been absent. A number of conditions need to be satisfied for this to apply:
The tax position of the departing spouse may then be affected on any disposal of the residence they then occupy and an exemption on a later sale of that property could be restricted.
Many other assets involved in a divorce will not be subject to CGT. Transfers of cash or chattels may be outside the scope of the tax or may be exempt.
A commonly encountered situation will involve the common ownership by spouses of investment properties. The divorce agreement may include clauses on the division of common property interests to ensure that each party retains outright, certain properties from a portfolio that was previously jointly owned.
Relief can be available where there is an exchange of interests in land, for example, where an interest in one property or piece of land is in effect transferred in consideration for the receipt of an equivalent land interest. Where the relief is available, the gain can be rolled over into the asset acquired so that there is no immediate taxable gain.
The relief can allow a completely CGT-free exchange where the values are the same, although, there may be a partially taxable disposal where different land values are involved in the exchange. Stamp Duty Land Tax may still be payable on the land interests acquired.
Any transfer between spouses or civil partners is exempt from IHT under the spouse exemption, however, once a divorce has taken place, this exemption is no longer available.
Unlike CGT, the IHT rules look only at the legal status of the marriage or civil partnership. There is no test based on, for example, whether the parties are living together, the intentions of the parties or any other factors.
It is worthwhile noting that, in the case of a long-term separation, where there is no formal divorce, exemption for IHT remains on any inter-spouse transfers. This can be valuable where IHT planning and the drafting of Wills is concerned.
For example, a ‘defeasible life interest trust’ may provide a medium through which assets can, in effect, be transferred through to children free from IHT. Assets will first pass into trust notionally for the benefit of the surviving spouse, but the trustees can (within a sensible time period) exercise an ‘overriding power of appointment over capital’ to transfer these assets on to trust or, outright for the benefit of children.
Preferably, this approach would have the consent of both parties and it will be very important to ensure that the parties intentions are known and understood universally. Although planning would be required, this is a method which can facilitate access to the spouse exemption where it might otherwise be assumed to be unavailable.
With the exception of the marital home, the pension rights of the parties will often be the most valuable assets – but will also often be initially overlooked or at least not given appropriate priority.
Depending upon the nature of the pension rights in question, dealing with these in an efficient manner can present some challenges. Our next article will consider this subject in more detail.
A divorce may present enormous practical and emotional challenges. With proper planning, further issues related to tax law may, at the very least, not increase this burden further.