Divorce is often a time of conflict, stress and major disruption. The aim of professional advisors is to assist the parties in reaching a settlement acceptable to both sides, taking care to avoid unnecessary tax liabilities or financial repercussions that would deplete the available funds of those involved¹. For a UK family business, there are added complications, especially when both parties have been involved. For a sole trader or sole owner, the issues centre on valuing the business and the possible financing of the settlement. However, when both parties own and run the business, there is the future of running it to consider.

For capital gains tax (CGT) purposes, the date of separation is generally more relevant than the divorce itself. The basic rule that inter-spouse transfers are valued at an amount that gives rise to neither a gain nor loss only applies to transfers between spouses living together. It does, however, apply throughout the tax year of separation, so if a transfer is made in the same tax year as the separation, there will be no taxable gains for the transferor. The transferee then takes on the transferor’s base cost for the asset acquired.

A married couple are treated as living together unless they are separated under an order of a court, they are separated by a formal deed of separation executed under seal (except in Scotland, where the deed should be witnessed), or they are, in fact, separated in such circumstances that the separation is likely to be permanent. All three conditions require that the marriage should have broken down, so if the couple live apart but the marriage has not broken down, they are still treated as living together for tax purposes.

Trial separations and failed reconciliations can confuse the issue and ascertaining the date of separation can be difficult. Even if the date of separation is known in time to enable a no gain/no loss transfer, the parties may be reluctant to switch ownership of assets in advance of an overall agreement.

Although a separated couple are unable to benefit from the inter-spouse transfer rule after the end of the year of separation, they are still ‘connected’ to each other until the decree absolute. This means that a transfer before decree absolute is deemed to be at market value, which may mean a tax liability arises. It also means any loss on such a transfer is only available to set against gains on transfers to the same person. A transfer between the parties made under a court order, whether or not by consent, after divorce or dissolution also takes place at market value.

Being connected, though, provides the potential for a holdover claim on the transfer of a business asset, but this will depend on whether any consideration is received and on the willingness of both parties to sign the required election. In signing the election, the recipient inherits the accrued capital gain that would otherwise be assessable on the transferor on the eventual sale of the asset. Provided the inherent tax liabilities have been taken into account in the negotiations, and indemnified, the recipient should be prepared to sign.

‘If a couple live apart but the marriage has not broken down, they count as living together for tax purposes’

The question of whether consideration has been received will depend on whether settlement is made out of court. HMRC takes the view that, where there is no recourse to the courts, the disposal of an asset is usually made in exchange for a surrender of rights, which the donee would otherwise be able to exercise to obtain alternative financial provision. In such cases, the value of the rights surrendered represents actual consideration, which would reduce the gain potentially eligible for holdover relief. An exception is where there is a substantial gratuitous element in the transfer and the parties concerned can demonstrate the amounts transferred were substantially in excess of what the recipient’s spouse or civil partner could reasonably have expected from a contested court case.

HMRC considers that the spouse or civil partner to whom the assets are transferred does not give actual consideration, in the form of surrendered rights, for their transfer:

• where there is recourse to the courts and a court makes an order for ancillary relief under the Matrimonial Causes Act 1973, which results in a transfer of assets from one spouse to another
• for property adjustment under the Civil Partnership Act 2004; or
• when formally ratifying an agreement reached by the divorcing parties or by the partners of a dissolved civil partnership dealing with the transfer of assets.

The court makes the order in exercise of its independent statutory jurisdiction, so there is no question of any party to the proceedings agreeing to surrender alternative rights in return for assets.

Transfers between spouses continue to benefit from the inheritance tax exemption (subject to the GBP55,000 limit where the donee is non-UK domiciled or deemed domiciled). While this continues after separation, this exemption ceases after the decree absolute. Any non-exempt transfers will be potentially exempt transfers (PET).

Some relief may be available after that point if the transfers become failed PETs:

• s10(1) of the Inheritance Tax Act 1984 – a transfer of assets not intended to transfer gratuitous benefit will not be a transfer of value; and
• s11 of the Inheritance Tax Act 1984 – a disposition is not a transfer of value if it is made by one party to the marriage in favour of the other party or to a child of either party and is:
• for the maintenance of the other party; or
• for the maintenance, education or training of the child up to 5 April after attaining age 18 or, if later, finishing full-time education.

The family business structure and its continuation need careful reviewing. It must be considered, for example, how the business is held, who will operate it in the future, if it will be split up, how ownership is apportioned, and, importantly, the value of the business. For a husband and wife operating through a partnership, it is likely the partnership will be dissolved, with potentially one or both of the individual parties continuing on their own. If one or both parties cease their activities, they are subject to income tax on the profits taxable in the year of cessation. This means the relevant figure is profits for the period from the end of the basis period in the tax year prior to the date of cessation. Those profits are reduced by any ‘overlap’ relief brought forward from the opening years of trade or on the transition to self assessment.

Owning partnership assets may lead to problems. Typically, property may be held in the sole name of one spouse, yet be shown as a partnership asset in the partnership. In those cases it is necessary to check the partnership agreement, if there is one, and the history.

A corporate structure will have a share register showing the share holdings and, being a separate legal entity, a degree of clarity over the ownership of its assets.

Problems will often arise in agreeing valuations and the lack of liquidity. The value of the outgoing spouse’s interest in the business may exceed the value of other assets and it may prove difficult to obtain finance to cover the shortfall. It is generally tax inefficient to buy out an existing shareholder using funds drawn from the business. However, if the purchaser has to raise loans personally, that may be even more expensive than funding from the company.

If one spouse leaves the business, a possible solution for unquoted trading companies is for the business to buy back shares from the ex-spouse. This is treated as an income distribution, unless HMRC accepts CGT treatment. It requires showing that the purchase was wholly or mainly for the purpose of benefiting the company’s trade, which may be possible if the ex-spouse is not pulling in the same direction. There are several other conditions to fulfil, namely:

• the shares must have been held for a minimum of five years
• the vendor’s interest must be completely eliminated or substantially reduced (however, if the vendor’s interest falls by less than 25 per cent, this is not considered substantial); and
• the vendor must not be connected to the company immediately after the buy back (connection is established if the vendor, together with associates, has 30 per cent of voting rights, entitlement to profits or assets on a winding up).

Often, the stumbling block with this option is the lack of distributable reserves in the company to cover the purchase, rather than failing any of the above conditions. An alternative is a company reconstruction.

As an example, suppose Newco is formed, which excludes the outgoing spouse, and this company acquires the share capital previously belonging to Oldco by offering cash or loan notes. The loan notes could be guaranteed by the bank (at a cost) to provide security and carry commercial rates of interest with given encashment dates. In such cases, HMRC clearance should be sought, confirming that the transaction is for bona fide commercial reasons.

Although CGT will only become due on encashment of the loan notes, entrepreneurs’ relief is available unless the individual has owned 5 per cent of the ordinary shares and has continued to be a director or employee of the company for the 12 months up to the date of sale. Where a director’s loan account balances have accrued to the departing spouse, or bonuses are not yet withdrawn, agreement could be reached regarding the repayment period, with the ex-spouse charging a commercial rate of interest on any money owed by the company. A final option may be to sell the business outright. This may take time in the current economic conditions and a forced sale could reduce the sale price if the purchaser is aware of the circumstances.

The availability of entrepreneurs’ relief may have a substantial impact on the CGT payable on disposal of the shares. As indicated, this requires the individual to own 5 per cent of the ordinary shares and be a director or employee for the 12 months up to the date of sale. Therefore, stepping down as a director before the shares are disposed of means entrepreneurs’ relief is lost.

‘Pension sharing can prove very tax efficient if there is the means to rebuild the ex-spouses’ pensions’

The value of pension arrangements is taken into account and included in the list of matrimonial assets. There are various ways of dealing with pensions and care must be taken if the pension holds shares in the family business or owns the property from which the business is run. The main ways of dealing with pensions are offsetting, earmarking and pension sharing.

• Offsetting is where the value of a pension is compensated for by other assets, so the individual with the pension asset retains it intact.
• Earmarking is where the pension scheme, on instruction from the court, pays a specified amount of the member’s pension and/or lump sum (in England, Wales and Northern Ireland) or a specified amount of the member’s lump sum only (in Scotland) to the ex-spouse. The amount is specified at the time of the divorce, but, as with all periodical payment orders, either party can apply to the court to have it varied. The payment is made when the pension member retires, so there is little security for the recipient as the pension member has control of the fund and the contract until payment. Earmarking has never been popular as it does not achieve a clean break.
• Pension sharing was introduced for divorce or annulment filed on or after 1 December 2000 and is now commonly used. By way of a transfer into a pension plan in their own name, the ex-spouse receives a proportion of the member’s pension fund. Thus, the ex-spouse has total control of the pension in their name.

However, where the pension arrangements include illiquid assets, there could be additional complications and risk. Typically, illiquid investments include property and unquoted shares. The property may be related to the family business, so transferring ownership may not be desired. To avoid sale of the property, the pension fund has to create sufficient liquidity to provide for the transfer of benefits, which can be achieved either through selling other assets in the scheme or raising a loan. It’s worth remembering that pension sharing can prove very tax efficient if there is the means and the time to rebuild the ex-spouses’ pensions. This is largely because valuable tax relief can be gained when making pension contributions.

• For capital gains tax purposes, the date of separation is generally more relevant than the divorce itself.
• If a transfer is made in the same tax year as the separation, there will be no taxable gains or losses for the transferor.
• The disposal of an asset usually means that the donee surrenders rights to a certain asset. In such cases, the value of the rights surrendered may represent actual consideration towards the final settlement.
• Where the couple operate as a partnership, property may be held in the sole name of one spouse, yet is shown as a partnership asset elsewhere. Be sure to check the partnership agreement.
• Where the couple operate through a company, check shareholdings per the share register.
• If one spouse leaves the business, a possible solution for unquoted trading companies is for the company to buy shares from the departing spouse.
• If a pension needs to be divided, consider pension offsetting and pension earmarking. However, sharing a pension can prove very tax efficient if there is time and resources to rebuild assets before retirement.

As mentioned, it is unlikely that the couple will continue working together in a family company. This may require a payment to be made to the departing spouse for the loss of office or termination of their contract of employment. To be a tax allowable deduction the payment would need to be wholly and exclusively for the business. If excessive, HMRC could argue that it was part of the divorce settlement or payment for the transfer of shares and disallow a tax deduction for the excess. HMRC should be notified of any changes in the ownership of a partnership. If property is transferred under court order, no stamp duty land tax is payable unless consideration passes. Consideration means cash or assumption of a mortgage attached to the property.

There will be other issues during this period of change, not least uncertainty among employees, customers and clients. Ideally, the parties involved will appreciate that cooperation should retain as much value as possible in the pot for their mutual benefit.