We are right in the middle of potential far-reaching changes to the way the tax system in the UK operates for divorcing couples. The Finance Bill 2023 arising out of the recent Budget contains many changes to the rules governing the transfer and sale of assets in a divorce. It has now received Royal Assent, which makes the new rules effective as of the beginning of tax year 2023/2024, so back to April 6th. Caroline East posted an excellent blog on these pages back in April summarising the main provisions, including the ability to take more time after separation to decide how to divide assets without the pressure to do so by the end of that tax year to defer any tax charge.
As many people know, I also specialise in US taxation and assisting couples with any US connections. My ventures into public writing always have a weather eye on how things work in the US by contrast to the UK and where major traps that result in double taxation could arise without appropriate advice beforehand.
In light of the changes coming into effect, this article will focus on the tax treatment of the matrimonial home and pension plans, which tend to be the largest assets involved in a financial settlement.
The matrimonial home
In the vast majority of cases in the UK, tax is not due on a sale or transfer of the matrimonial home where both parties have occupied the property as their main home. Regardless of divorce, the last nine months are treated as a period of occupation even if one or both parties have left the home. Historically, it was possible for one party to transfer their share of the home to the other party without tax as long as the other party continued to live there and it was part of the formal divorce settlement, regardless of whether the transferring party had not lived there for any length of time. It came with other considerations for the transferring party especially if they had acquired a new residence but was generally a favourable outcome. The new rules effective from the start of this tax year should make that redundant, as any transfer of appreciated property is done on what is known as a no gain no loss basis. In layman’s terms it means you are treated as having ‘sold’ the property for the same price as it cost you originally, so no profit arises and therefore no tax can be charged. A no gain no loss transfer means the party receiving the asset does so with the original cost in the hands of the other party, so in principle they are taking on a potential tax liability in future when the property is sold which otherwise would have been payable by their ex-spouse. This would certainly be true of any asset other than the matrimonial home but all facts surrounding ownership and use of the property as the main home would have to be looked at to see how the primary residence rules apply.
If we layer on the US tax issues that may arise, it requires an understanding of the rules. The US does not have a provision to fully exempt a sale or transfer of the primary residence from taxation, there is a limited $250,000 allowance beyond which tax is due, usually at a rate of 23.8%. Where both spouses are American citizens or residents any transfer between them in the divorce is tax deferred and the no gain no loss approach applies. This is equally true even if the spouse giving up a share of the house is not a US person but is transferring it to a US person. However, here is the trap, if the spouse making the transfer is a US person and the spouse receiving the property is not, tax is due at the point of transfer on any built-in appreciation to the extent it exceeds the $250,000 allowance. Slightly different rules apply if the property in question is a US property, especially if both parties are not US persons, where tax can arise on the transfer. The same rules apply to any appreciated asset and so there is a genuine risk of double taxation if US tax arises on the transfer in the divorce but no gain no loss applies in the UK and then UK tax arises on a future disposal for whatever reason.
Perhaps, we should start with the good news. It is very unusual for a pension that is divided or transferred in a divorce to be subject to tax at that time. It is also true that the pension becomes the property of the recipient, and they are then responsible for all the tax consequences arising out of that pension, including paying tax on distributions — as if this were their own pension all along. The reason no tax arises on a division in divorce is because both the US and the UK have systems in place. Upon the order of a court or through a financial settlement, a pension can be shared or transferred without tax. In the UK, this is achieved through a pension sharing order and, in the US, through a qualified domestic relations order (QDRO).
So, what is the bad news? Well, this does not cross borders. Generally, a UK pension trustee cannot be bound by a divorce order made in the US calling for the division of a UK pension scheme — it must be an order made in a UK court. Similarly, a US pension trustee will require a QDRO from a local court in the US to divide a qualified US pension plan. It often requires at least one of the parties to be physically resident in the relevant jurisdiction to ask for a court order to divide a pension plan. This is a very complex area that requires expert advice from a Family Lawyer in the relevant jurisdiction. One exception to this rule relates to a US Individual Retirement Account. It is not necessary to obtain a QDRO to divide an IRA account on divorce. It would still require a court order of some kind, but the IRA trustee may be willing to accept a UK court order in a divorce to divide up the IRA. There is a tax treaty between the US and the UK which we believe permits cross border recognition of the tax deferral provided by a court order, but there is nothing which permits a pension itself to cross borders without tax arising.
In cases where it is not possible to obtain a court order to divide a pension on a tax deferred basis, the holder of the pension would have to gain access to their pension plan themselves, by taking a distribution if they needed to fund a financial settlement. They would, therefore, be subject to tax on that distribution, potentially with additional penalties depending on the age of the participant or the size of the pension. The right to tax a pension distribution, which in the case of the US and the UK would potentially fall to both under domestic tax rules, is further regulated by the income tax treaty which tries to define which country has the primary right of taxation. At the very least, this means one country must grant a credit for taxes paid to the other country on the same distribution to prevent double taxation, but in certain cases it may provide a complete exemption from tax in one jurisdiction, tax being payable only to the other. Making use of some of the special provisions, such as the UK 25% tax free initial lump sum, a US Roth IRA which is a tax-free retirement account, or foreign tax credits, may still provide some potential planning for tax-efficient division of a pension plan.
David Foster is a tax Director at EY Frank Hirth specialising in cross border US and UK tax matters.