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ANY PRACTITIONER GIVING tax advice on the so-called ancillary relief provisions under divorce proceeding needs to be aware that there are many capital gains tax issues to be borne in mind, some of which have not been fully resolved. A sea of uncertainty exists regarding certain aspects in this area and many couples are surprised to find that they have not only to share their assets between each other, but that the taxman wants his slice too. This is even when assets are simply being exchanged between the parties and no real disposals are taking place. A divorce settlement can also push up the tax payable on a subsequent transaction, compared to what it would have been had there been no breakdown of the marriage.
When an asset is sold on an arm's length basis to a third party for whatever reason, there is no problem. The capital gains tax position in such a case will be clear and the Treasury will take its slice, as it would on any other disposal. The problems arise when:
- redistributions of certain assets between the couple may trigger immediate or future CGT liabilities;
- certain transactions carried out post divorce may attract far higher rates of tax than would have applied had there not been a divorce; and
- some arrangements potentially give rise to liabilities on abstract assets such as 'chose in action'.
The Treasury should no longer be a party to the divorce settlement or, at the very least, the position should be made clearer so that solicitors handling divorce cases can advise their clients exactly where they stand.
Why is there an issue?
There is no single issue which causes the problems. Any one of a host of technical points can unexpectedly trigger a serious tax exposure if, that is, HMRC take the point in practice. In many cases it is obvious what entries must be made on a self-assessment return, but in other areas the position is questionable. In the writer's view, anyone who claims to have certain knowledge of all the answers cannot have spotted all the questions.
The CGT position arising out of divorce situations is far from straightforward, yet there has been no recent development in revenue law changing it. Why is this? Could it be that professional advisers prefer to address issues only when the position adopted is challenged? Self assessment does not work like that, however. One must either be certain about the entries on a tax return or, where there is doubt, the full facts concerning the point at issue need to be clearly visible to the Inspector examining the return.
There has recently been a number of high profile divorce cases, but many unpublicised cases concern significant CGT issues which are not easily addressed. While lawyers involved in family law may well turn to their clients' accountants to provide tax advice, unless all the finer points of the capital transactions are fully flagged, the tax adviser might not immediately recognise some of the technical issues. Similarly, unless technical points are flagged on self-assessment tax returns, HMRC may not challenge the CGT consequences of a particular course of action. As a result, HMRC may be perceived as having a policy of not taking the point in practice, whereas the reality is that it has not been fully explored. What is a cause for concern (in other areas too) is that at some point, the attitude of advisers seemingly morphs from 'we have done this several times before and never had a problem with HMRC' into 'this is our understanding of HMRC policy in this area'.
Tax advisers should also remember that each party to a divorce is duty bound to disclose all tax potential liabilities to the court. If a matter is ignored and, say, three years later one party to the marriage finds he or she is having to pay a CGT liability, possibly leading to penalties and interest, which was neither disclosed to the court on the divorce proceedings form E nor mentioned at any stage during the financial dispute resolution (FDR) hearing, it is possible that the full costs of any subsequent hearing before the court to remedy a perceived injustice may ultimately fall at the door of the taxation adviser. It is not just the parties to the marriage who may have something to lose.
It is widely known that TCGA 1992, s 58 (deemed no gain/no loss provision applying to spouses living together) ceases to apply on the 6 April following the date the couple became permanently separated, as is the fact that the spouses remain connected persons until the court grants the Decree Absolute. The CGT position as regards the application of private residence exemption in s 222, i.e. the former matrimonial home, is excellently explained in HMRC's CGT Manual and is not addressed here.
What follows is a canter through just a few of the many CGT issues arising on transactions carried out after the year of separation.
Asset transfers
A husband may transfer some of the shares he has held in his own name in the family trading company to his wife, Mrs T. This can happen before the granting of the Decree Absolute, at the time of the Decree Absolute or subsequent thereto. In theory, each circumstance gives rise to a different CGT position but I will look at the post settlement situation where the acquiring spouse decides to dispose of these shares or where there is a takeover of the company. For CGT taper relief purposes, the ownership period will begin with acquisition from the husband; even this is not always easy to identify although HMRC set out their guidelines at paragraph 22410 of the CGT Manual. A disposal less than 12 months after the acquisition date will not attract any business asset taper relief, which will leave Mrs A to pay, say, 40% CGT on any growth in value subsequent to her acquisition of the shares. A disposal following ownership of between 12 and 24 months will trigger tax at 20%. Only after two years will maximum business asset taper be restored. While it is easy for the Treasury to say that all Mrs T must do is retain the shares for two years, in a takeover situation she may have no real choice but to sell the shares irrespective of the penal tax consequences, or she may have to sell the shares urgently for other unexpected commercial reasons. Had the transaction taken place prior to the end of the year of separation, there would still have been taper relief issues but in this example we are left with the husband paying, say, 10% CGT on any gain he realises, even immediately after the divorce, while his former wife pays at 40%.
Similarly, where a freehold property is transferred to a wife, Mrs G, on divorce because it is the premises from which she trades as a sole trader, there may be problems for Mrs G in the event of an early post divorce realisation. Here it may be possible to argue that Mrs G has merely acquired a further interest in the property and that taper relief will run from the date she first became a 'tenant' of her husband. This will depend upon the facts of the case and may even lead to arguments about estoppel, etc.
Indeed, reverting to the example of Mrs T's acquisition of shares from her estranged husband, it may be possible to argue that Mrs T contributed in some way to her husband's acquisition of the shares held by him even though she had no legal title thereto. HMRC's CGT Manual paragraph 65310 addresses this point in connection with the family home. The principle following Hazell v Hazell [1972] 1 All ER 923 may have possible wider application if the wife's interest is specifically recognised by the divorce court, but this is something about which HMRC will not be enthusiastic.
Simple solution
Why should a divorced party to a marriage not be deemed to take on the other party's date of purchase and acquisition cost unless the parties elect otherwise within two years of the Decree Absolute?
More problems
Another area of concern is that relating to divorce court orders governing post divorce asset realisations. It may be that the court instructs a husband to hand over X% of the after tax proceeds of sale of an asset should he dispose of it. At first sight, this gives rise to a chose in action which, following the cases of Marren v Ingles [1980] STC 500 and Zim Properties Ltd v Proctor [1985] STC 90, is to be treated as a separate asset for CGT purposes. However, although the matter is not spelt out clearly, para 65377 of the CGT Manual gives an example of HMRC's approach which avoids the consequences of Mrs D being treated as disposing of an asset which is a chose in action. Here Mrs D is shown as being entitled post divorce to one-third of the net proceeds of sale in the event of the property being sold. In the example she receives £53,000 and the manual states:
'Mrs D is not chargeable to capital gains tax on the £53,000 she has received. It represents financial provision for her ordered by the court and is not a sum received in consideration for the disposal of an asset.'
The manual also states that Mr D is not entitled to a deduction for the £53,000 (that is, 1/3 x £159,000) paid to Mrs D, because this sum is an allocation of the proceeds and not a deduction in arriving at the gain.
But for the above approach, which is arguably an HMRC concession, were Mrs D to receive a proportion of the net proceeds, she would pay CGT at up to 40% on her share despite the fact that Mr D might have paid tax on the disposal of the asset and could not claim a deduction in calculating his taxable gain for the sum paid to Mrs D! This would be double taxation. As clean break divorce settlements get larger, they become more sophisticated; event triggered future payments will increase in regularity, partly due to the taper relief downsides to effecting immediate transfers of assets at the time of the Decree Absolute.
Corporate divorce
Anyone who has been through a divorce or advised closely on the mechanics thereof and who also has knowledge of a corporate divorce, usually referred to as a scheme of reconstruction, will recognise the similarities between what goes on in the two situations. It is a fact that some schemes of reconstruction (and demergers) benefit from targeted tax breaks designed to keep the wheels of business turning. These are a welcome feature of the taxation of chargeable gains in the UK for CGT and corporation tax purposes.
For example, if Mr A and Mr B own equally a trading company, AB Ltd, which runs a number of hotels and Mr A and Mr B decide they no longer wish to be in business together, it is a relatively easy exercise to split the company into two separate companies by carrying out a scheme of reconstruction, in the knowledge that all the steps required for Mr A to end up owning 100% of a new company A Ltd and for Mr B to be left owning 100% of another new company B Ltd may be carried out without triggering either income tax or CGT liabilities on the shareholders nor triggering corporation tax liabilities in AB Ltd. Yes, the taxation advisers to Mr A and Mr B have to jump through a number of hoops, but they do so knowing that the Treasury is not expecting to take a slice of the clients' wealth even though the company's assets and the value of the shares held reflect substantial capital growth during their time running the company together. (Incidentally, this example envisages a scheme shaped by Insolvency Act 1986, s 110.)
However, the much more common non-corporate schemes of reconstruction taking place on marriage breakdown attract few tax breaks. Even the ability to claim holdover relief is subject to doubt and, indeed, HMRC's practice only changed to what it is because of the judge's comments in G v G [2002] EWHC 1339. Financial provision orders in connection with divorce proceedings may well impact on the assets of an estranged married couple in a very similar manner to the division of assets on a scheme of reconstruction of a company described very briefly above. However, if the complexity of the many issues does not catch many individuals by surprise, the increased CGT payable on the family assets may well do so.
Change required?
Is it not time for a change here? Look at the stamp duty land tax exemption for transactions in connection with divorce, etc. FA 2003, Sch 3(3) exempts, inter alia, transactions between one party to a marriage and the other in pursuance of an order of a court made on granting a decree of divorce, nullity of marriage or judicial separation, and as regards court orders made under the Matrimonial Causes Act 1973 in respect of financial provision. This may be seen as going too far, but would it not be possible to introduce a new relief designed to remove the Treasury from its position as sleeping partner? Why not create a new relief for the reconstruction of family finances on divorce similar to that available on corporate reconstructions? Surely, the system could be revised to minimise the work of both lawyers and tax advisers.
If you think the taxation implications of divorce need reform, please write to the editor.
Kevin Slevin CTA (Fellow), ATT, TEP is a tax consultant based near Reading, tel: 0118 988 7055, e-mail: kevinslevin@btinternet.com. He practises as Slevin Associates handling tax disputes and advising professional firms on clients' tax problems and planning opportunities.
