When we think about the consequences of divorce, it’s not surprising that the first questions that spring to mind are often ‘What will happen to the children?’ or ‘How will we divide our finances so that we can both manage?’
A less obvious question is ‘Will there be any tax consequences?’ It is certainly no criticism that it is not top of a client’s list of priorities when life is in turmoil and the future seems so uncertain, but it is important not to overlook the potential tax consequences and how best to mitigate them when divorcing, so that a larger portion of the matrimonial pot is preserved for the parties and any children of the family.
Transfers between spouses can trigger a liability for Capital Gains Tax (CGT) and, whilst there are other potential tax issues to consider, this article will concentrate on CGT since HMRC has recently published draft legislation which would result in wide reaching changes to the existing rules on the transfer of assets between spouses who are separating and divorcing.
An asset, for the purposes of CGT, can include:
The current rules
A transfer of assets between spouses does not attract an immediate CGT liability - it is deemed that the transfer has taken place for nil gain or nil loss and that the receiving spouse takes ownership of the asset at the original base cost – usually the original purchase price. However, a transfer between spouses who are separated but not yet divorced will attract a CGT liability if the transfer does not take place in the same tax year as the separation.
Married couples who separate permanently in the months of January to March are therefore at a significant disadvantage since they will only have until 5 April that same year to transfer any asset from one to the other without the possibility of aa CGT liability. Given that most financial settlements very often include provision for the transfer of an asset from one spouse to another but often take many months (if not years) to conclude, separating parties would have to be well-informed and pro-active to be able to agree and conclude transfers before the end of the tax year of separation.
In reality, many married couples benefit from principal private residence relief (PPR) on the martial home which can significantly reduce the burden of any immediate CGT, even if the transfer between spouses does attract a charge. Any gain which occurs while the home is occupied by the spouses as their main or only residence is exempt from CGT (one caveat here is that this only applies if the home and garden are under 1 acre). Problems can arise where one spouse leaves the main residence after separation but the property is not transferred until after the tax year of separation - in some cases, several years later. Whilst the last nine months of ownership will automatically qualify for PPR even if the transferring spouse is no longer living there, the remaining period (which can sometimes be several years) will not be covered by the relief.
It is possible to extend the PPR where the spouse who has left the matrimonial home later transfers their interest in that home to the occupying spouse (thereby extinguishing any immediate CGT charge) but in order to so, the spouse transferring their share is not able to apply their PPR to any other property in which they may then be living (since an individual can only ever have one principal residence for CGT purposes) and it is often necessary to take expert financial advice about whether this is beneficial in the circumstances of the case.
The consequences of CGT become more apparent (and significant) in those cases in which spouses own more than one property e.g a rental property or holiday home, or other assets which can attract a CGT charge upon transfer; or they have not always lived in the family home, for example if there has been a period of working and living abroad. Since any transfer which takes place outside the tax year of separation is deemed to take place at market value and PPR will not apply since the asset is not (or has not always been) the couple’s main or only residence, a significant immediate CGT liability can arise and must be factored into the terms of any financial settlement e.g. how it is to be mitigated (if possible), who is to pay for it and how etc. This will often the involve the instruction of an expert accountant to calculate the tax liability of the parties at additional cost.
A change on the horizon?
However, in an important potential change to legislation, the Government is currently consulting on relaxing the CGT rules for separating spouses. If the draft legislation is passed, from 6th April 2023, transfers of assets between separated spouses will be deemed to be at nil gain/nil loss for up to three years after the tax year of separation (and before divorce) or for an unlimited period if made in accordance with a formal agreement or court order, a provision which will catch a significant proportion of separating and divorcing couples. We would always recommend that the terms of any financial settlement are recorded in an agreement, and preferably an order of the court to ensure clarity and enforceability. This would also ensure that the nil gain/nil loss provisions continue to apply to the transfer for an unlimited period.
Furthermore, where a married couple separate and one spouse leaves the family home, if it is later sold in connection with the divorce, the vacating spouse will be able to elect to treat the property as if it had remained their only or main residence until the disposal for the purposes of PPR, even if they have not been living there for longer than the preceding 9 months.
In addition, a spouse who transfers their interest in the home to the other but retains an interest in it (by way of deferred charge for example) will be able to utilise their PPR to reduce their CGT liability to nil when they receive a sum on the disposal at a later date. The current rules provide that the deferred charge on the home be treated as a new asset for CGT purposes meaning that any increase in value between the time of the charge and eventual sale would be subject to CGT. This will be a significant change for those spouses who retain an interest in the family home to be realised at a later date, perhaps when any children of the family reach adulthood.
What if I separated prior to April this year?
The current position is that you would have had until 5th April 2022 to benefit from the nil gain nil loss rules under the current law. Any transfers taking place for the remainder of this tax year would therefore incur a CGT liability (subject to the application of any available reliefs). If you have separated but not yet transferred any assets, under the proposed change, any transfers made after 6th April 2023, will benefit from the new rules and there would be no immediate CGT liability. You may therefore wish to consider waiting to see whether the proposed legislation is adopted without significant amendment, in which case you would benefit from the extended period to transfer assets without an immediate CGT charge.
If you have already reached a financial agreement and are in the process of drawing up a consent order now, careful consideration should be given to ensuring that the terms of the order relating to the transfer of assets between you and your spouse take account of the potential changes as the rules around the date of disposal of any assets are complicated but could lead to significant immediate CGT savings.
However, under the new rules, whilst a transfer would not trigger an immediate CGT charge, there will still be latent capital gains within the asset (deemed to be transferred at base cost) which could result in a large tax bill for the party who receives the asset, when it is later sold and this must also be taken into account.
What if we are considering a separation now?
As it stands, those couples separating during the remainder of 2022 or into early 2023 would only benefit from the nil gain, nil loss rule on transfers that occur until 5 April 2023. However, if the new legislation is adopted without significant amendment and those couples who separated during the course of this year have not already transferred their assets (or a disposal is not deemed to have taken place), the period for a nil gain/nil loss transfer will be extended to three years from the date of separation or indefinitely if it is made in accordance with a formal agreement or court order. The rules around the deemed date of disposal are complicated and it is essential therefore that anyone considering a separation before April 2023 considers any potential immediate and latent CGT consequences.
It is the writer’s view that the relaxation of the existing rules is long overdue and brings our stringent CGT rules in line with other, more generous, international interpretations. It reflects the reality that in many cases, separation and divorce is a complex and lengthy process (emotionally and legally) that should not be rushed if it is be done properly and fairly. Hopefully, from April 2023, separating and divorcing spouses will have the time and breathing space to work through the terms of their financial settlements without the burden and anxiety of immediate tax consequences where assets are to be transferred from one to the other.
However, we will be reminding clients that the liability for CGT has not disappeared and we will ensure that clients are mindful if they are to receive an asset, or share of an asset, which is taken at the other’s party’s base cost, this may trigger a CGT liability for them alone at a future sale date.