Separation and tax considerations in the UK | Withersworldwide (2024)

As the UK delays the introduction of ‘no fault’ divorces, separating couples will need to plan carefully to ensure they don’t get caught by unexpected tax traps.

Couples wishing to keep their divorce as amicable as possible will have been disappointed by the Government’s recent announcement that the introduction of ‘no fault’ divorce will not come into force until 6 April 2022, due to the delayed implementation of the Divorce, Dissolution and Separation Act 2020.

As it stands, the law provides that divorcing couples must prove that their marriage has irretrievably broken down. They can do so if they have already been separated for at least two years (with both parties consenting to the divorce proceedings – the period of separation extends to 5 years where the other party does not consent). However, where the separation is more recent, one party will have to allege fault, either due to the other party’s ‘unreasonable behaviour’ or their adultery.

The new law is a long overdue acknowledgement that this process starts off on an unnecessarily hostile basis and can add fuel to the fire of an already stressful life event, which is damaging not only to the couple but especially to any children of the family. This is especially true where a party’s conduct (such as having an affair, or being unpleasant to live with) is unlikely to impact on the financial aspects of divorce, except in extreme cases.

Under the new ‘no fault’ divorce law, rather than having to list out grisly examples of unreasonable behaviour or provide evidence of adultery, the applicant(s) will simply need to provide a statement of irretrievable breakdown which itself will be taken as sufficient evidence. If the decision to divorce is mutual then couples will also have the new option to make a joint application to the Court, rather than relying on one party to move matters forward. It is hoped and expected that these amendments will reduce conflict in divorce cases and allow couples to focus on practical and financial arrangements and, most importantly, their co-parenting relationship going forwards.

This all sounds so promising that we have seen several clients wishing to delay filing their divorce petition until the new law comes into effect, motivated by an admirable desire to keep the process as calm as possible. However, before that decision is taken, couples need to be aware of the unexpected tax traps which they could fall into if they have been separated for a longer period of time before turning their minds to the financial aspects of divorce.

Capital Gains Tax and the ‘year of separation’

Transfers of assets between spouses are generally not subject to capital gains tax unless the couple has separated. While it is usually straight-forward to determine when a couple has separated (i.e. because one party has moved out of the family home), sometimes the date of separation is not so clear-cut and in fact it is possible for a couple to have separated while they remain living under the same roof if they lead essentially separate lives. If the date of separation is likely to become a contentious issue then specialist advice should be taken at the outset of the divorce matter.

Once the couple has separated, the “no gain no loss” treatment for disposals between spouses only continues until the end of the tax year of separation. A couple that separated in June 2021, for example, would be able to make transfers of assets between them until 5 April 2022 without giving rise to a capital gains tax liability. If the couple transfer assets in a later tax year, however, those transfers will be subject to capital gains tax, if the market value of the asset being transferred is higher than its acquisition value, even if the couple is still married at the time.

This rule can result in quite unfair and seemingly arbitrary differences in tax treatment depending on the timing of the separation. Say, for example, the couple referred to above had separated in March rather than June 2021 (so just weeks before the end of the tax year on 5 April): in that case any assets transferred on or after 6 April 2021 could trigger a capital gains tax liability. However, a couple who separated on 6 April would have a full 12 months to complete any transfers between themselves on a “no gain no loss” basis.

With the deferral of the introduction of ‘no fault’ divorce, many couples who wish to take advantage of the new law in order to divorce without attributing (or accepting) blame or wrongdoing will face a potentially longer period of separation before the divorce can be finalised. As financial settlements on divorce often involve the transfer of assets from one spouse to another shortly before the divorce is finalised, this could result in capital gains tax arising simply due to the divorce settlement having been delayed in line with the new legislation.

It is worth noting that the Office for Tax Simplification has, as part of its review of the capital gains tax regime generally, recommended that the “no gain no loss” period for spousal transfers be extended to the end of the tax year at least two years after separation. This appears to have been well received, but couples should be wary of relying on the rules changing as this may take a considerable time to come into effect.

The family home

On separation, it is common for one spouse to remain in the family home and for the other to either rent or buy new accommodation if there are sufficient assets in the marital pot to allow them to do so. This can create issues if the family home is later sold as part of the divorce. The departing spouse will not have used the family home as their primary residence during the period since moving out, and so principal private residence relief (‘PPR’) may not apply in full to their share. That spouse’s share of the sale proceeds would be subject to capital gains tax at 28% (assuming the spouse is a higher rate tax payer) on a proportion of the gains based on the time during which the property was not used as that spouse’s main home.

If, however, the spouse has moved out within the final nine months before sale, PPR is still available on their share because the last nine months of ownership are disregarded for the purposes of PPR. Couples that have been separated for more than nine months should consider at the outset of any financial settlement negotiations the potential for capital gains tax liabilities to arise so as to ensure that this does not become a sticking point later on.

In certain circ*mstances, the nine month period can be extended. This is usually where it has been agreed that one spouse will remain in the family home and will take full ownership of the property. If the house is being sold, the period can also be extended if the spouse that has moved out transfers their share to the other spouse before the sale. If there has been no transfer before the sale, then the period cannot be extended.

Another potential trap is where the spouse that moves out makes an election for capital gains tax purposes for their new property to be treated as their main residence. In this case, the election would prevent the nine month period from being extended even if the family home is transferred to the occupying spouse before it is sold.

Inheritance tax

There are no equivalent rules for inheritance tax that limit the application of spouse exemption after the year of separation. Transfers between spouses will continue to be free of inheritance tax until the divorce is final. After divorce, any transfers between the individuals will be subject to inheritance tax if the transferor dies within seven years of making the transfer. The inheritance tax rate is 40% but a tapering relief is applied so that the tax rate applied to the gift decreases each year once the transferor survives three years.

Conclusion

Couples wishing to take advantage of the long-awaited ‘no fault’ divorce law need to think carefully about the tax consequences of delaying their divorce, as well as the impact a delay might have on any existing practical and financial arrangements. There are a variety of tax issues which should be considered in detail and with the benefit of legal advice. Couples should also be reassured that it is possible to navigate the current fault-based divorce system without creating a high level of conflict (for example, by agreeing with the other party in advance the content of the ‘unreasonable behaviour’ examples which will be included in the divorce petition). On a more personal note, it may also be sensible to move ahead so that both parties can get on with planning for the new chapter of their lives post-divorce.