Capital gains tax and divorce

As we approach the end of the tax year, it is important for practitioners to review their files to ascertain whether any potential capital gains tax (CGT) issues may arise upon the transfer of assets. If the government’s proposed CGT reforms come into effect, some significant problems will no longer arise. 

Position on transfer of assets

Assets transferred between spouses or civil partners take place on a no gain/no loss basis. That means that such transfers do not trigger a charge to CGT. The transferee is treated as having acquired the asset at the transferor’s base cost. When the transferee eventually disposes of the asset, they will pay the CGT on the entire gain, from base cost to disposal.

This principle continues to apply to divorcing couples (or to those going through a civil partnership dissolution) up to the end of the tax year in which they separate, or until decree absolute/final divorce order, whichever is the earlier. The relief being limited to the end of the tax year of separation has caused problems for divorcing couples for many years. Those couples who separate late in the tax year will have a narrow window in which to transfer certain assets, if they wish to avoid an immediate charge to CGT. While it may be possible to agree to a transfer of assets on an interim basis, understandably many divorcing spouses are reluctant to agree to such an arrangement. The court cannot compel the transfer of assets by way of an interim order.

Proposed changes to the law

On 22 July 2022, the government published draft legislation which extends the period for the transfer of assets on a no gain/no loss basis. Although announced in July 2022, it is still not known for certain whether the proposed legislation will become law. The key provisions are as follows:

a)    Separating spouses or civil partners will have three years after the year when they cease living together in which to make transfers on a no gain/no loss basis.

b)    More significantly, if the assets are transferred as part of a formal divorce or civil partnership agreement (which should usually be made as a court order), then the three-year time limit does not apply. It is open-ended.

c)    The provision will apply to Mesher orders and therefore will benefit spouses who are entitled to receive a share of the proceeds of sale of the former matrimonial home on a deferred basis.

d)    If implemented, the new provisions will only apply to transfers on or after 6 April 2023.

In view of such uncertainty, advising clients is difficult. If the new proposals come into effect, transfers should be delayed until after 6 April 2023. If the provisions do not come into effect, then couples may wish to take advantage of higher annual allowances before they are cut. Disposals or transfers made by 5 April 2023 will benefit from the present annual allowance of £12,300. This will be reduced by more than half to £6,000 in the 2023/24 tax year. It will be reduced further to £3,000 per annum in the 2024/25 tax year. 

Relevant assets

The most common scenario is that the parties may hold one or more investment properties, or holiday homes which would trigger a charge to CGT upon transfer. It should also be noted that the rates for CGT for residential property are either 18% or 28% (depending upon the rate at which the paying party pays income tax). The CGT is payable 60 days from disposing of the asset.   

CGT will also be payable in respect of other assets (such as commercial property, investments or shares in a limited company).  In respect of such assets, the usual rate of tax would be 20%. CGT is not, however, payable until 31 January, following the end of the tax year in which the asset is disposed of.

It should, however, be noted that holdover relief may be available upon the transfer of shares in a trading company (as opposed to an investment company) under present legislation. Accordingly, even if the government’s proposed reforms do not come into effect, an immediate charge to CGT on the transfer of shares after the tax year of separation can be avoided if an election is made for holdover relief.

Liquidity and payment of CGT

A key issue which arises from an immediate charge to CGT is that of liquidity and the ability to pay a charge to CGT which arises immediately or in the foreseeable future. Significant gains in the value of assets, such as property, can lead to large CGT liabilities arising, of which the parties may be unaware. Who is to pay the charge and how it is to be funded needs to be addressed.

In drafting settlement proposals or consent orders, care must be taken to address who would be liable for such CGT and whether indemnities are to be given. Payment of CGT should be dealt with by lump-sum orders, rather than undertakings. It should be remembered that indemnities can be included as orders, rather than undertakings – see CH v WH [2017] EWHC 2379 and the Standard Orders.

Impact of latent CGT

It is important to note that even if an immediate charge to CGT is avoided, that does not mean the liability is wiped out. It simply means that the payment of the CGT is deferred until the transferee disposes of the relevant asset. Accordingly, when calculating the total net assets of the marriage or civil partnership and when preparing an ES2 asset schedule, latent CGT needs to be deducted from the assets, as established in White v White [2000] UKHL 54. When looking at the net effect of any proposals or settlement, the net effect of latent CGT must always be taken into account, whether payable immediately or not.

There are, however, some very limited circumstances in which the latent CGT would not be deducted. For example, in circumstances where a structure has been established with a view to avoiding tax – see the decision of Mostyn J in BJ v MJ [2011] EWHC 2708 (Fam).

Andrew Newbury is a partner at Hall Brown Family Law, Manchester