The cost of divorce….red wine, tears and…CGT?
Tax Telegraph, December 2012
According to Australia’s number one divorce website mydivorce.com.au, every third marriage in Australia ends in divorce. This means that if you are currently married and living in Australia, there is a 33% chance that you could find yourself going through a divorce at some point in the future (if you haven’t been through one already).
The statistic is disheartening. However, the tax rules may provide some sort of relief to the complexities that come from divorce… CGT roll-over relief!
The ATO’s position
In June this year, the ATO updated its online content relating to the CGT roll-over relief that can occur as a result of a marriage breakdown (subdivision 126-A of the ITAA 1997), so there is no denying that this is something on the Commissioner’s radar.
Subdivision 126-A provides roll-over relief from CGT on the transfer of CGT assets as a result of marriage breakdown. The roll-over relief is a deferral of CGT and it is only applied in situations where there is a compulsory transfer of assets.
For those of you out there who are not currently married but have been in a de facto relationship (this includes same sex relationships) and are thinking that the intricacies of sub-division 126-A do not apply to you, hold that thought. In 2008 the definition of “spouse” in ITAA 1997 was amended to include people living in a “genuine domestic basis in a relationship as a couple”. Subject to satisfying the other conditions, you also may be entitled to roll-over relief!
The transfer of assets and the appropriate treatment can vary depending on the entities between which the transfer occurs (i.e. spouse to spouse, company to spouse, trust to spouse etc.). The tax law recognises that in the following circumstances entities will attract the roll-over relief upon the transfer of CGT assets:
- A court order is made under the Family Law Act 1975 (FLA 1975), or a state of territory law, or a corresponding foreign law;
- A court approved maintenance agreement is prescribed;
- Something done under a financial agreement made under Part VIIIA of the FLA and which entities are bound to;
- Something done under an award made in arbitration; or
- Something done under a written agreement that is binding because of a state or territory law or foreign law relating to breakdowns of relationships between spouses.
Note that to access the relief the transfer must involve a spouse or former spouse. Further to these circumstances that identify the compulsion to transfer a CGT asset, there are situations that the ATO has identified in which CGT roll-over relief will NOT be allowed under a marriage breakdown. The two most common situations in which roll-over relief is not granted include:
- The transfer of a CGT asset occurs between spouses by agreement before a court order has been made under any of the above mentioned laws; or
- The CGT asset transferred is considered to be trading stock of the transferor.
Couples who divide their assets under private and or informal arrangements can often be caught out by the first situation identified above. This can be the case with many couples going through a break up, who, aside from the heart ache, also want to minimise the legal costs of the divorce and therefore avoid using solicitors. The ATO have identified that such dealings will result in the transferee being taken to receive the market value of the CGT asset transferred, as there is no act of compulsion to transfer the assets. The consequences for the transferee, where no roll-over relief is granted, would be a capital gain or loss – based on the market value of the CGT asset transferred.
As spouse to spouse (individual) transfers of CGT assets must occur within the parameters of the two exemptions above, the eligibility for roll-over relief is relatively straight forward. Perhaps a more intricate situation occurs when the transfer occurs by differing entities. Let us examine the treatment of an asset transfer between a company and a former spouse by way of an example.
After being friends for a number of seasons, Ross and Rachael decide to finally tie the knot. The couple were married in October of 1990. Rachael owns all of the shares in Central Perk Pty Ltd (Central Perk), which she acquired from Joey after 20 September 1985, making them post-CGT shares. Central Perk owns a number of rental properties which are its main source of income. After a series of unresolvable issues Rachel and Ross decide to get a divorce. Upon the signing of the divorce papers the Family Court orders Central Perk to transfer one of its properties to Ross. As this compulsory transfer of a CGT asset is made between a company and a former spouse (Ross), adjustments are required to the relevant cost base and reduced cost base of Rachael’s interests in the shares of Central Perk.
Rachael’s cost base for her interest in Central Perk is reduced, at the time of transfer of the property, by an amount that reasonably reflects her shares decrease in market value resulting from the transfer of the property to Ross.
Because the transfer of the rental property was done under the compulsion of a court order the company is entitled to the CGT roll-over relief. So, how does Ross treat the receipt of the property?
Ross is taken to receive the property on the day on which its title is transferred to him, the first element of cost base of which would be the previous assets cost base in the hands of Central Perk. Whether this is a good thing or not depends on whether the market value of the property is greater or less than the cost base of the property.
Even though there is CGT relief for the transfer of the property, another area of law may tax the transfer of the property to Ross for no consideration.
Where property is transferred at a discount to market value, Division 7A of the Income Tax Assessment Act 1936 (ITAA 1936) may potentially tax the recipient of the property on the discount.
Therefore, Ross may unexpectedly end up with a tax bill for a property that he receives under the divorce settlement.
However, ITAA 1936 permits a dividend which is taken to be paid because of a family law obligation to be franked. As such, Ross would then be able to use the tax offsets against his taxable income. However, Ross would still be required to pay the “gap tax” between the tax paid on the dividend at the company level and the tax required to be paid at his marginal tax rates. Furthermore, the CGT cost base of the property will not be increased to the market value of the property or for the tax that he has paid.
For example, assume that Ross is on the top marginal tax rate.
Assume that the value of the deemed dividend under Division 7A is calculated to be $700,000 – being the market value of the property in the company. The tax paid on that amount at the company level would have been $300,000 (@ the company tax rate of 30%). Because the dividend is taken to be paid under a family law obligation, the dividend should be fully franked. As Ross is on the top marginal tax rate, he will need to effectively pay the 16.5% top-up tax on the deemed dividend (approximately $165,000).
The roll-over relief has meant that the transfer of the property between Central Perk and Ross has deferred any CGT event from occurring until such time that Ross disposes of the property on his own accord. However, even though he has paid tax based on the market value of the property, Ross has a cost base equivalent to the cost base of the property in the company.
A common transfer of a CGT asset that can occur upon marriage breakdown is the spouse’s main residence.
If a dwelling, or an interest in a dwelling, acquired by your spouse after 19 September 1985 is transferred to you after 12 December 2006 and marriage or relationship breakdown roll-over applies, you take into account the way the property was used by both you and your spouse in determining their your eligibility for the main residence exemption at the time that you sell.
This means taxpayers are entitled to a full exemption from CGT (when they dispose of it) if the land on which the dwelling is situated is two hectares or less, and:
- During the period your spouse owned the dwelling, it was their main residence and was not being used by them to produce assessable income
- During the period your spouse owned the dwelling, it was their main residence and was not being used by them to produce assessable income.
If any of these conditions are not met, you may qualify for a partial exemption.
The rules can get complicated in the situation where the couple owns several properties and lives in different properties at different times. Let’s take the example of Ross and Rachel again.
Assume that before their divorce, Ross and Rachel lived in a property together in Balmain for three years. They then moved to a property in Strathfield for two years.
After their divorce, Ross moves to the property in Balmain and Rachel continues to live in the property in Strathfield.
In this situation, both parties will need to make an election as to which property they will nominate as their main residence at different periods of time. If Ross nominates the Balmain property as his main residence for the period up until the time the parties became permanently separated, this will impact Rachel’s ability to claim 100% of the main residence exemption when she sells her property. Unfortunately, if this question is not resolved at the time of the divorce settlement (and agreed between the parties), it will be impossible to appropriately deal with main residence exemption. Most likely your client will be annoyed that you did not deal with it appropriately at the time of the proceedings
Sometimes the decision on which property is nominated as the main residence is dependent upon the capital gain being realised on the sale of the property and the good news is that you don’t have to choose until you sell one of the properties. In the case of a divorce, it is further complicated by “who gets what” in a property settlement and whether the separation is amicable.
Even though you might have experienced the ugliest of divorces, the ATO still expects spouses to keep all relevant records. Make sure you get any records you need from your spouse if you don't already have a copy, including records that show:
- How and when they acquired the dwelling (or the interest in a dwelling); and
- Its cost base when they transferred it to you.
When dealing with a transfer of CGT assets upon marriage breakdown the best approach is to consider the following issues:
- Is the transfer occurring compulsory or in the shadow of compulsion?
- Who is the transfer occurring between? If a company is the transferor, have you considered Division 7A?
- What is the CGT event occurring upon the transfer?
- Does the main residence exemption apply? If so, both the parties have to agree as part of the property settlement which property is the main residence at different times. Trying to do this sometime after the divorce proceedings can be problematic.
Note: There may also be other implications surrounding the transfer of property (including stamp duty and the GST). For the purposes of this article, we have only considered CGT implications associated with a marriage breakdown.
So if you find yourself struggling to deal with the aches and pains of divorce, understand that you are in the company of 33% of Australians out there and more importantly, you may be eligible for some relief if there is a transfer of assets. Keeping these items in mind will hopefully help couples avoid any extra financial and economic ramifications resulting from their separation.
If you have any questions, please contact your local Deloitte Private tax advisor.
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