CGT and Divorce – changes ahead?
When negotiating a financial settlement on divorce (or dissolution of a civil partnership) it is crucial to factor in the tax implications, enabling the settlement to be structured tax efficiently and so as to ensure that there will be funds available to pay any tax arising at the point it becomes due. Recommendations contained in the second report published by the Office of Tax Simplification (OTS) following their wide-ranging review of Capital Gains Tax (CGT) would, if implemented, assist divorcing couples in minimising and managing the CGT implications of separating their financial affairs.
“No gain no loss” and the tax year of separation
The termination of the CGT exemption under which transfers can be made between spouses at “no gain no loss” at the end of the tax year in which separation takes place, has long frustrated practitioners.
As readers will know, assets can be transferred between spouses (or civil partners) without triggering an immediate CGT charge, and this exemption continues to apply to separated couples during the tax year of their separation. Such transfers are made on a “no gain no loss” basis, meaning that the base cost of the asset is inherited by the receiving spouse, so that the full amount of CGT will be payable when they subsequently sell or transfer the asset.
Following the tax year of permanent separation, transfers of assets between separated spouses are subject to CGT in the usual way. This would apply, for example, where a shareholding, holiday home or investment property is transferred from joint names into one party’s sole name. Unsurprisingly, most separating couples do not initially realise that this process of separating out their assets on divorce will generate a tax liability if not carried out within the tax year of separation – even where no cash is being realised. Moreover, in the case of residential property, CGT now has to be paid within 30 days of the transfer (as to which see further below).
As the OTS Report highlights (paragraph 4.4), “if a couple separate on 4 April 2022 they would only have until 5 April 2022 to transfer their assets without triggering a tax charge”. By contrast, a couple separating two days later, on 6 April 2022, would have not one day, but one year, to transfer their assets without triggering a tax charge.
Under the relevant legislation (s1011 Income Tax Act 2007 and s288(3) of the Taxation of Chargeable Gains Act 1992), a married couple will be treated as separated if they are separated under a court order or by a formal Deed of Separation executed under seal, or if “they are in fact separated in such circumstances that the separation is likely to be permanent”. It is the latter category which will be relevant to the vast majority of separating couples, and it is, as the OTS notes, “nebulous”, rendering it open to interpretation (paragraph 4.14).
The current rules therefore arbitrarily favour those separating earlier in the tax year. Many clients do not seek legal advice until some weeks or months after they have separated, by which time it may be too late to take advantage of the “no gain no loss” rule. Even those separating early in the tax year and taking prompt advice may struggle to conclude disclosure and negotiations, and obtain approval of a consent order within a year, particularly if their financial affairs are complex; for those needing a court decision on their financial arrangements the process is most unlikely to be concluded within twelve months, particularly given the current delays in the court system. Moreover, the current approach can put significant pressure on separated couples to make a decision in respect of particular assets prior to an overall agreement in order to benefit from the “no gain no loss” rule, before they have had time to consider fully all the implications.
It is therefore unsurprising that “all the respondents to the OTS Call for Evidence commenting on this issue agreed that the length of time given to separating couples was inadequate” (paragraph 4.12). Acknowledging that “it is unrealistic to expect separating couples to have resolved their affairs by the end of the tax year of their separation” (page 8), the OTS Report describes the current approach as “unsatisfactory” (paragraph 4.21) and recommends (Recommendation 7) that:
“The government should extend the ‘no gain no loss’ window on separation to the later of:
- the end of the tax year at least two years after the separation event
- any reasonable time set for the transfer of assets in accordance with a financial agreement approved by a court or equivalent processes in Scotland.”
Whilst retaining the link to the tax year of separation would still result in separating couples having different time periods available to them depending on the point in the year at which they separated, all couples would have the opportunity to benefit from the “no gain no loss” rule if their settlement was approved by the court and made into a court order (as is always advisable in any event), and those couples requiring a court determination of their financial arrangements would not lose out. Such a change would bring the approach to CGT on divorce closer to that taken to Stamp Duty Land Tax (SDLT) on divorce, under which transactions in connection with a divorce (whether ordered by a court or as part of an agreement) are exempt from SDLT; and consideration could be given to adopting this position in respect of CGT.
In any event, and irrespective of the precise way forward, it is to be hoped that the OTS report will precipitate long-overdue change on the application of the “no gain no loss” rule to divorcing couples.
Private Residence Relief
The OTS further suggest, though not as one of their formal recommendations, that an “extended time horizon could also apply in relation to eligibility for Private Residence Relief” (paragraph 4.29), so that (subject to the usual caveat that the relief cannot be claimed in respect of two properties at the same time) this relief too applied until the later of the end of the tax year at least two years after separation, and any reasonable time set for the transfer of assets in accordance with a court order. Such a change could make a significant difference to divorcing couples.
Under the Private Residence Relief homeowners do not pay CGT on their main home. If, on separation, one spouse leaves the family home, they will be eligible for full relief if they dispose of their interest within nine months of leaving, but once that period has expired they will be eligible only for partial relief. This “final period exemption” was 36 months prior to April 2014, and then 18 months prior to April 2020, before being cut to just nine months. As it has been reduced it has become increasingly difficult for divorcing couples to make and implement a decision as to whether the family home should be retained in joint names, transferred to one party, or sold, before the relief is lost.
Consequently, CGT may become payable in respect of the parties’ main home as a result of their separation – even though it has remained the main home for some members of the family throughout the ownership period. Even if the “no gain no loss” rule is extended as recommended by the OTS, this would not assist in circumstances where it is decided to sell the family home. Even where the family home was being transferred into the name of one spouse, it seems likely that under the “no gain no loss” rule, whilst no tax would be payable at the point of transfer, the receiving spouse would inherit the other spouse’s chargeable gain (between the end of the final period of exemption to the date of transfer) which would be subject to CGT on the eventual sale of the family home (if not within the annual exemption), and would result in a complex calculation to determine the tax payable.
Therefore, the extension of Private Residence Relief for divorcing couples would assist in ensuring that tax does not become payable on the family home as a result of the separation. However, as this suggestion is only discussed briefly in the report and not included as a formal recommendation, it seems unlikely that such an approach will be adopted in the near future.
Residential Property – 30 day time limit for reporting disposals
The second recommendation with potential to assist divorcing couples addresses an issue of wider application which can cause particular difficulties in a divorce scenario.
In April 2020 HMRC drastically reduced the period for reporting and paying CGT where tax is due following the disposal of UK residential property by UK-resident individuals, trustees or personal representatives. Previously, such disposals had to be reported and any tax paid by 31st January following the end of the tax year in which the disposal took place, giving between nine and almost twenty-two months, depending on when the disposal took place. Since 6th April 2020, the timeframe has been just thirty days from completion (not from disposal, which remains the relevant date for the tax calculation).
The authors of the OTS report consider that “for many taxpayers, 30 days is a very ambitious target… This was strongly reflected in the negative responses that this policy area received in the OTS call for evidence” (paragraph 1.81). For divorcing couples, the difficulties may be exacerbated – both in terms of cashflow and the practicalities of filing the return on time at what is already a very stressful period.
Whilst the gain on the family home will often be covered by Principal Private Residence (PPR) relief, the transfer between a divorcing couple of an investment property or holiday home is subject to an immediate charge to CGT (if outside the tax year of separation). As the property is not being sold, no liquidity is being released. When the parties had at least nine months to raise the necessary funds this could often be managed; for many it is now considerably more challenging, particularly given the significant financial demands (such as legal fees and moving costs) which often arise during a divorce.
The OTS were advised that “the timeframe presents a particular challenge for separating couples who may not receive their share of the money to pay the tax until any divorce settlement is finalised” (paragraph 1.84); reflecting that in some settlement arrangements, a residential property may be transferred between the parties (giving rise to an immediate CGT charge) with other assets being sold or transferred to enable the tax charge to be paid – meaning that the order in which these transactions take place will now need careful consideration to ensure liquidity is available at the point the tax charge crystalises.
In addition to the cashflow difficulties, there are the practicalities of ensuring the tax calculation and return are completed within the a very short timeframe, at a point when divorcing couples will have many other concerns. A considerable amount of information is required to calculate the CGT and complete the return, including: the base cost of the property (i.e. the acquisition cost or the value of the asset when inherited by the taxpayer or gifted to the taxpayer); the cost of any capital improvements; third party costs of acquisition and disposal (i.e. estate agent’s commission, legal fees); the extent to which PPR applies to any part of the gain; details of any capital losses or available Annual Exempt Amount to offset the gain; and an estimate of the taxpayer’s income for the relevant tax year to ascertain the rate of CGT which is likely to apply. Whilst much of this information may well have been collected or estimated for the purposes of financial disclosure within the divorce negotiations, it will need to be updated and finalised for the return, creating additional pressure for those managing the implementation of a divorce settlement.
In any event, thirty days is very a tight deadline, particularly when one considers the process involved in order to use the UK Property tax return system, which involves first creating a Government Gateway user ID (if the taxpayer does not already have one), and then setting up a UK property account. For taxpayers wanting their agent to deal with HMRC, a new authorisation must be put in place, even where the agent has been authorised previously. Clients will need to be warned about this process and the need to act swiftly. A penalty of £100 will be payable if the return is not filed within 30 days of completion, with a further penalty of 5% of any tax due or £300 (whichever is greater) if the deadline is missed by more than six months, and a further penalty of the greater of 5% of any tax due or £300, for failure to meet the deadline by more than 12 months.
Given the challenging timeframe, the OTS suggests that the reporting and payment deadline be extended “to say 60 or 90 days [the formal recommendation refers only to 60 days], to give taxpayers more time to fulfil their tax obligations” (paragraph 1.94), and as an alternative suggests that measures are taken to raise awareness of the 30 day deadline. Awareness-raising, whilst valuable in and of itself, would do little to address the specific difficulties faced by divorcing couples in this regard; an extension of the timeframe to 60 or 90 days would be of some, limited, assistance
Overall, it is welcome that the OTS have considered the implications of various CGT rules on divorcing couples, and their recommendations would alleviate some of the difficulties which arise. In particular, the extension of the “no gain no loss” rule would mean that CGT would rarely be payable on the transfer of a residential property between separating spouses, alleviating the difficulties caused by the current 30-day rule. It is to be hoped that the government take forward these sensible proposals.
In the meantime, pending adoption of the OTS’ recommendations, family lawyers need to continue to be mindful to consider CGT implications in detail, making their clients aware of the need to gather any relevant information required to calculate CGT liabilities and to plan financial settlement proposals carefully.
This article was originally published in Family Law Week and can be accessed here.