Capital Gains Tax on divorce – worrying gaps in the new rules for deferred sale arrangements
15 January 2024
In the Finance Act 2023 the government introduced new tax reliefs intended to lessen the Capital Gains Tax (CGT) cost of divorce. The changes were widely applauded as a long-overdue correction to the existing regime which often unjustly landed divorcing couples with a hefty tax bill to pay in addition to all the other costs associated with divorce. However, there are at least two unprincipled gaps in the new reliefs which may leave unwary clients with unexpected CGT charges.
In what follows, “divorce” is a short-hand and includes annulments, dissolution of civil partnerships and permanent judicial separation. “Marriage” and “spouse” should be read accordingly.
Rules prior to 6 April 2023
CGT is a tax triggered when a person disposes of an asset at a gain. ‘Disposal’ includes a sale of an asset for cash, but a simple transfer or gift of an asset (or a beneficial interest in an asset) is also a disposal. Despite the lack of cash consideration for these non-sale disposals it is still possible to make a taxable gain and trigger a CGT charge, either because the transfer is made for other non-cash consideration (such as to settle a legal claim in divorce proceedings) or because gifts made between “connected parties” (e.g. spouses) are deemed to be made for full market-value consideration.
There is no CGT on transfers between spouses whilst they are married and living together. These are known as “no-gain-no-loss” disposals, in which the transferee simply takes the asset at the transferor’s original base cost, thus deferring the CGT charge. However, following separation, CGT must be considered.
Coming to a financial settlement in divorce proceedings typically involves many disposals between separated spouses as assets are transferred between them in settlement of one-another’s claims. Commonly, this might involve:
- immediate transfer of the property interest to one spouse in return for a lump sum payment (or other offsetting exercise);
- immediate transfer of the property interest in return for a secured charge over the property to protect the other party’s interest (which is repaid on a sale at an agreed date, if the remaining party is not able to buy out the departing party earlier than this date); or
- the property to stay in joint names for a period of time (typically coinciding with the children’s age or education) under an interim trust arrangement, after which there is a sale or buy out of one of the parties’ interests.
Under the previous rules, a disposal from one divorcing spouse to the other would be taxable unless it takes place within the same tax year as the couple separated. In practice, few couples achieve financial settlement within the tax year of separation and divorcing couples would often transfer assets between themselves after this deadline, thereby triggering “dry” CGT charges (meaning a CGT charge which is not triggered by a sale of the asset, and for which there may not be any liquid cash available to meet the tax).
Slightly more generous rules existed for disposals of the marital home – where one spouse had left the jointly owned main residence (the Departing Spouse) and later transferred their interest in the property to the other spouse who had continued to occupy it (the Occupying Spouse), the pre 6 April 2023 rules permitted the Departing Spouse to treat the property as though it had been their main residence up until the transfer, thereby allowing them to claim principal private residence relief (PPR) on the disposal. However, this prevented the Departing Spouse treating any other property as their main residence during the same period – and often this would be a long period of time, typically until the youngest child finished secondary education or reaches 18 years old. Loss of PPR on another property greatly diminished the value of this relief for many Departing Spouses.
Disposals on or after 6 April 2023
The new rules make several key improvements. Firstly, under the amended Section 58 Taxation of Chargeable Gains Act 1992 (TCGA 1992), no-gain-no-loss treatment now applies for transfers between spouses until the end of the third tax year after the tax year of separation (or until decree absolute if earlier). In practice this deadline will rarely matter because no-gain-no-loss status also applies to any disposal between separated spouses or former spouses which is in accordance with an agreement or court order made in contemplation of or otherwise in connection with the divorce. The definition of such agreements is so wide that arguably even a prenup made before the marriage (and many years before the divorce) may qualify as an agreement “in contemplation of” divorce (although this is yet to be put to the test).
The other major change relates to “deferred sale” arrangements also known as “transfer and charge-back” where the Departing Spouse makes an initial disposal by transferring their entire interest in the property to the Occupying Spouse, in exchange for a charge on the property entitling the Departing Spouse to receive a portion of the property’s sale proceeds when it is sold upon a specified future date or trigger event set out in the agreement/order. These arrangements are particularly common where the property is the home of children of the marriage, and the arrangement will usually last until the children become adults or finish their education.
Prior to 6 April 2023, the Departing Spouse may have claimed PPR on their initial disposal (i.e. the transfer of the property) but would make a chargeable gain on the uplift in the value of their charge when he makes a second disposal upon the eventual sale of the property and redemption of the charge. The Occupying Spouse is entitled to PPR on sale of the property, but no PPR is available to the Departing Spouse on their second disposal, meaning there would often be a significant CGT charge under the old rules.
The new Section 225BA TCGA 1992 provides that the profits received by the Departing Spouse on the second disposal are read-back to the initial disposal and taxed on the same basis. So long as the initial disposal took place after 6 April, the second disposal will therefore be eligible for no-gain-no-loss treatment in most cases.
Gaps in the new rules for deferred sales
The April 2023 changes are certainly an improvement, and far fewer divorcing couples will now face CGT charges during financial settlement. However, there are a number of traps in s.225BA TCGA 1992 which practitioners and their clients should be aware of:
- Replacement properties
In a deferred sale arrangement, it is very normal to include wording permitting the Occupying Spouse to move to a new property during the course of the arrangement. After all, these arrangements may last decades, and it is quite understandable the Occupying Spouse should want flexibility to relocate themselves and the children during this time. It can also enable some of the other party’s interest to be released if the Occupying Spouse moves in to a smaller property, and so holds some attraction to the Departing Spouse to include these terms.
In principle, there is no difficulty including wording in the order or agreement so that the Occupying Spouse may sell the property and reinvest the proceeds in a new property, carrying over the arrangement (and the Departing Spouse’s charge) to the new property.
However, the new s.225BA relief for deferred sale arrangements (and reading back treatment for the Departing Spouse) only applies where the Departing Spouse receives a share of the profits on the sale of the original dwelling house. If in fact the Departing Spouse is receiving a share of sale proceeds of a replacement property, ordinary CGT principles apply, and a CGT charge is likely to arise.
- What if the Occupying Spouse buys out the Departing Spouse?
What if, some time after the initial transfer of the property, the Occupying Spouse chooses not to sell the property after all, but instead manages to arrange alternative funding to buy out the Departing Spouse’s interest? In principle, this should pose no problem whatsoever and indeed it is very common for the agreement/order to expressly give the Occupying Spouse the option of doing so. So long as the Departing Spouse realises the value of their interest in the property by the agreed date/event, why should it matter whether or not the property is actually sold?
The answer is that the sale, or lack thereof, may make a big difference for the Departing Spouse’s tax position, putting them in the unenviable position of having a CGT liability arising due to events entirely out of their own control at the whim of their former spouse.
The new s.225BA relief only applies where the Departing Spouse receives a share of any profit made by the Occupying Spouse on their disposal of the dwelling house. If the Occupying Spouse does not dispose of the property, the Departing Spouse is not eligible for the relief.
The Departing Spouse in a deferred sale arrangement might easily face a CGT charge falling outside of the new s.225BA relief introduced in April 2023. It is perhaps arguable that, regardless of falling outside s.225BA, the redemption of their charge on the property should be eligible for no-gain-no-loss treatment under the newly expanded s.58 as a disposal to the Occupying Spouse in accordance with a divorce agreement/order. However, time will tell whether HMRC agrees with this interpretation – after all, if that argument is successful s.225BA would seem to be redundant.
Practitioners acting for the Departing Spouse should ensure at an early stage that if a deferred sale agreement gives the Occupying Spouse power to elect to buy out the Departing Spouse’s interest, or the power to carry over the arrangement to replacement properties, then the Occupying Spouse should bear the cost of any CGT arising from this decision.
In the meantime, those acting for the Departing Spouse may wish to consider whether a trust arrangement is more suitable if a buyout is anticipated.
Please get in touch with our team of experts if you would like to discuss any of the issues raised in this article.
The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at January 2024.