Tax is rarely at the forefront of people’s minds at the end of a relationship. However, the breakdown of a relationship offers some tax planning opportunities which can reduce the tax payable on transfers of assets made as part of a divorce settlement and can affect how the settlement is structured.
Capital Gains Tax (CGT)
Generally, CGT arises when you make a gain on the disposal of an asset, for example, by selling it or giving it away. Each individual has an annual capital gains tax free amount, known as the annual exempt amount. For the 2016/2017 tax year this is £11,100. CGT is payable on gains over the annual exempt amount at either 10% or 18% (18% or 28% for residential property and carried interest), depending on the individual’s income in the tax year.
CGT and spouses
Each spouse is treated as a separate person for CGT, has their own annual exempt amount and the rate of CGT is determined by reference to their own income. Subject to certain exceptions (for example, the disposal of trading stock or exempt employee shareholder shares) transfers between spouses who are living together are treated as being made on a ‘no gain, no loss’ basis which means no CGT is due. Spouses are treated as living together unless they are separated under a court order or in circumstances in which the separation is likely to be permanent.
Separation, rather than the start of a divorce, is the key event for tax purposes. In the tax year of separation, spouses may transfer assets between themselves on a ‘no gain, no loss’ basis provided they were living together at some point in that tax year. For example, John and Julie are married and were living together on 6 April 2015. They separated on 1 December 2015 and John moved out later that month. Even though they are now not living together, they were living together at some point in the tax year and therefore they have until the end of the tax year, i.e. 5 April 2016, to transfer assets between themselves on a ‘no gain, no loss’ basis.
However, after the tax year of separation, transfers between spouses, either as gifts from one to the other, or by court order, may result in a CGT liability for the transferring spouse as (subject to any reliefs or exemptions) the transfers are deemed to take place at market value. Despite this, there are some circumstances where it may be tax efficient to make a transfer after the tax year of separation, for example for a remittance basis taxpayer to trigger a capital gain and up-base assets. The timing of transfers between divorcing spouses is therefore critical.
Transfer or sale of the family home
Principal private residence relief (‘PPR’) provides an exemption from CGT on the disposal of an individual’s main residence. The relief is proportionate to the period that the property was the individual’s main residence; the final 18 months of ownership are always covered by the exemption even if the individual has moved out. Spouses may have only one PPR between them. Sometimes, following separation, one spouse will leave the matrimonial home and agree to transfer it to the other spouse who remains. There are a number of planning opportunities:
- If the disposal is within the tax year of separation it will be on a ‘no gain, no loss basis’. This means that the spouse making the transfer will avoid CGT at that time and be free to make a PPR election on another property. If the spouse who receives the property sells it, any capital gain will be calculated by reference to the original purchase price and not the value when it was transferred. It is critical that the division settlement takes this liability into account.
- If the property is sold or transferred after the tax year of separation, a spouse who has moved out may still claim full PPR relief if the sale takes place within 18 months of moving out, even if they have bought a new place.
- If the property is transferred more than 18 months after the separation, relief may still be available under a specific statutory provision (section 225B Taxation of Chargeable Gains Act 1992) for the individual who has moved out if:
a. the disposal is pursuant to an agreement in the divorce or a court order as part of a financial settlement;;
b. the property continues to be the main residence of the spouse to whom the property is being transferred; and
c. the spouse who moved out has not elected another home to be his main residence for PPR purposes.
This relief is useful where the sale/transfer takes place a while after one spouse moves out. But there will be partial loss of PPR relief on any new property acquired in the meantime, for the period between the date of purchase of the new property and the disposal of the old matrimonial home.
It should be noted that for non-UK resident individuals, disposals of UK residential property will, unlike other types of property, attract CGT in relation to any gain accruing from 6 April 2015. A non-UK resident might qualify for PPR relief on UK residential property if he spent at least 90 days in the property in each tax year. The 90 days can be shared with the individual’s spouse (but if spouses are in the property on the same day, that day is only counted once).
Transfer of business assets
Assets held in a family partnership may be eligible for holdover relief from CGT that would otherwise apply on a transfer between separated (or even divorced) spouses. Both spouses need to be party to the claim for the relief. This would mean that there would be no CGT liability for the spouse making the transfer but the spouse receiving the business asset(s) would take on any accrued capital gains. Claiming holdover relief will depend on the willingness of both parties to sign the required holdover election.
Entrepreneurs’ relief (ER) may also be available when shares in a family business are transferred from one spouse to the other. ER requires that the individual who is disposing of the shares owns at least 5% of the ordinary shares and be a director or employee of the company for the 12 months up to the date of transfer. However, spouses should take care to avoid any traps. For example, if it is agreed, during negotiations between the divorcing spouses, that the spouse who is transferring the shares will step down as a director, ER will be lost if s/he steps down before the share disposal. ER reduces the tax on the gain to 10%.
Stamp Duty Land Tax (SDLT)
Property that is transferred as part of an agreement or court order in divorce is generally not subject to SDLT.
Inheritance Tax (IHT)
Transfers between spouses who are both UK domiciled or both non-UK domiciled are exempt from IHT until the date of the decree absolute. If a transfer is made after the decree absolute it may come within an exception (section 10 Inheritance Tax Act 1984) for transfers made on divorce pursuant to a court order or as a result of arm’s length negotiations. However, if the transfer is not spouse exempt or covered by the section 10 exemption, it may be considered a ‘potentially exempt transfer’. Consequently, if the transferring spouse dies within seven years of the transfer, IHT may be payable. The position is also more complex where the transferring spouse is domiciled in the UK and the transferee spouse is not; in such a case a limited spouse exemption operates.
Separation will also impact on the ex-spouses’ transferable nil-rate band. The nil-rate band (currently £325,000) is the value of an estate which is not subject to IHT. When the first spouse dies, any unused part of the nil-rate band may be claimed by the surviving spouse. However, it is not transferable as between ex-spouses.
Remittance Basis Taxpayers (RBT)
Individuals taxed on the remittance basis are only taxed on foreign income or gains which are “remitted” to the UK. They remain liable to UK tax on UK source income and gains.
A remittance can occur if foreign income or gains are brought to, received in, or used in the UK by a “relevant person”. A relevant person includes the RBU himself and, among others listed in the legislation, the RBU’s spouse. Therefore, a RBU cannot circumvent the remittance rules by giving income and gains to their spouse offshore who then remits the funds to the UK.
RBU’s who are going through a divorce may wish to consider the planning opportunities open to them. For example, once divorced, the ex-spouse of the RBU ceases to be a “relevant person” under the legislation and therefore a transfer of foreign income and gains to that former spouse, for example as part of a divorce settlement, can be made offshore and the recipient ex-spouse may then bring the funds to the UK without creating a remittance for the RBU. However, RBUs should be aware that if he (or his minor children from his former marriage) can benefit in any way from such a transfer, this may still be considered a remittance by the RBU. Sources of income also need to be carefully considered, for example where there is joint income or community of property.
RBUs should therefore carefully consider timings where a settlement payment is to be made offshore using foreign income or gains to a spouse. The spouse receiving the payment should wait until after the decree absolute has been obtained to remit the funds to the UK; a remittance before would be taxable on the RBU. However, advice should be taken on whether the settlement payment (as opposed to the remittance to the UK) should occur before or after the decree absolute because in some circumstances it can be advantageous to make the payment whilst still married (but make the remittance after the decree absolute). Ultimately, it is important that RBUs take UK tax advice at an early stage to ensure that any payment of foreign income or gains is structured in such a way so as not to be a remittance.
Other tax points and practical issues
- Both spouses may be required to file a tax return with HMRC depending on the settlement of the divorce and certain exemptions and reliefs may need to be claimed from HMRC for them to apply, for example PPR relief for non-UK residents, and holdover relief on business assets. Holdover relief is not available where the transferee is non-UK resident.
- Any existing trusts should be reviewed with particular attention paid to the definition of ‘spouse’ and any named beneficiaries, for example.
- It may also be appropriate to set up new trusts to receive a lump sum payment received as part of a divorce settlement, especially if the divorcing spouse is not UK domiciled or deemed domiciled and wishes to protect the assets from UK inheritance tax. (However, it is crucial that tax advice is taken (both in and outside the UK) before deciding on whether to set up a trust as there may be initial and/or on-going tax charges).
- A couple who own assets, or are resident or domiciled, in any other jurisdiction, should obtain tax advice in those other jurisdictions and not only focus on UK tax.
- Following separation, both parties should consider writing a new will if (understandably) there is no longer a wish for their spouse, from whom they have separated, to benefit from the estate. But be careful; death before divorce and a financial settlement may invite a claim against the estate under the Inheritance (Provision for Family and Dependants) Act 1975 (the “1975 Act”). Divorce will not preclude a claim under the 1975 Act either, especially if there are on-going financial obligations frustrated by death.
- On divorce, a spouse’s will, whilst still valid, takes effect as if the former spouse predeceased the person making the will. A subsequent remarriage will revoke, either expressly or impliedly, any previous will.